Page 8 of 26 1 included with the Proposed Transaction, although it is quite possible that EPE will 2 experience a one-notch downgrade of its Moody’s rating due to weaker cash flow, 3 regardless of whether the Proposed Transaction is consummated. As is discussed below, 4 Moody’s placed EPE on negative credit outlook more than a year before the 5 announcement of the Proposed Transaction, therefore any future downgrade by Moody’s 6 would likely be the result of factors unrelated to the Proposed Transaction. While both 7 Moody’s and S&P took ratings action following the announcement of the merger 8 agreement, when the Proposed Transaction closes the protection of the credit ratings of 9 EPE will be aided by the full and complete set of ring-fencing commitments proposed by 10 the Joint Applicants. 11 In preparing my Direct Testimony, I compared the ring-fencing provisions 12 proposed by the Joint Applicants against a systematic and comprehensive list of standards 13 that reflects my prior experience regarding credit defaults and bankruptcies particularly in 14 the utility and energy sector. This master list of standards incorporates the guidelines 15 applied by the three major credit rating agencies. The Joint Applicants’ proposed ring- 16 fencing provisions satisfy every aspect of these standards. Taken together, these 17 protective provisions will provide strong separation for EPE and EPE’s customers and 18 communities from risk of involuntary consolidation in bankruptcy with Sun Jupiter, IIF 19 US 2, or any IIF US 2 affiliate. Equally important, the proposed ring-fencing provisions 20 will enable EPE to retain access to all of its own financial and physical assets and cash 21 flow so that EPE can properly conduct its business and remain viable, even in the case of 22 financial distress of Sun Jupiter, IIF US 2, or any IIF US 2 affiliate. 23 Therefore, I recommend that the Commission approve the Proposed Transaction, 24 including the proposed protective mechanisms. 25 III. TRANSACTION IMPACT ON EPE’S FUTURE FINANCES 26 A. EPE’s Current Financial Circumstances 27 Q. PLEASE DESCRIBE EPE’S CURRENT CIRCUMSTANCES AS AN 28 INDEPENDENT INVESTOR-OWNED ELECTRIC UTILITY. 29 A. EPE is a relatively small independent investor-owned utility. Other electric operating 30 utilities that are comparable in size to EPE are generally subsidiaries of larger holding ______________________________________________________________________________ Lapson – Direct Page 9 of 26 1 company groups, while EPE functions as a stand-alone company with a geographically 2 concentrated customer base. EPE’s shares are traded on the NYSE, where EPE is among 3 the smallest shareholder-owned companies in the electric and gas utility sector. EPE’s 4 small size is evident from the information provided in Exhibit EL-2, which shows a 5 comparison of 52 electric and gas utilities ranked by magnitude of market capitalization 6 (that is, the value of an entity’s common equity at the prevailing market price.)3 EPE is 7 48th out of 52 companies and represents a mere 0.3% of the aggregate market valuation of 8 the sector. 9 Q. WHAT IS EPE’S CURRENT FINANCIAL CONDITION? 10 A. EPE is solvent and financially sound, with investment grade credit ratings in the broad 11 category of Baa and BBB from both Moody’s and S&P, respectively.4 12 Moody’s Baa1 rating for EPE is only one notch below the sector median rating of 13 A3 for Moody’s portfolio of 111 rated U.S. investor-owned electric operating utilities. 14 However, the agency placed EPE’s rating on Outlook Negative over a year ago on March 15 26, 2018 due to Moody’s expectation that EPE’s cash flows will decrease due to the 16 implementation of the Tax Cut and Jobs Act of 2017 (“TCJA”), increasing capital 17 expenditures, and rising dividends.5 Prior to the announcement of EPE’s merger 18 agreement with Sun Jupiter, Moody’s rating outlook for EPE was on Outlook Negative. 19 In a credit update published on March 27, 2019, Moody’s commented that “[EPE] has an 20 adequate liquidity profile.” 21 S&P rates the credit of EPE at BBB, equivalent to a rating one notch below 22 Moody’s Baa1 rating. S&P commented in a May 2018 report that “El Paso Electric has 23 adequate liquidity and can more than cover its needs for the next 12 months, even if 24 EBITDA declines by 10%.”6 S&P assessed EPE’s business risk position as Strong and 25 financial risk as Significant (using the rating agency’s benchmarks for companies of 3 The 52 North American utilities with publicly-traded equity securities in Exhibit EL-2 were selected by Bank of America as potential competitors to EPE in the capital market or comparable companies. 4 The correspondence of the rating scales of Moody’s and S&P is presented in Exhibit EL-3. 5 Moody’s, “Rating Action: Moody’s Affirms El Paso Electric at Baa1; Outlook Revised to Negative,” March 26, 2018 (Exhibit EL-4.1). 6 S&P Global Ratings, “Summary, El Paso Electric Co.,” May 21, 2018 (Exhibit EL-5.1). ______________________________________________________________________________ Lapson – Direct Page 10 of 26 1 medial volatility). Immediately prior to the announcement of EPE’s merger agreement 2 with Sun Jupiter, S&P’s rating outlook was Stable. 3 Q. WHAT CHALLENGES DO INVESTORS SEE FOR EPE AS AN INDEPENDENT 4 COMPANY? 5 A. Equity and fixed income investors generally mention regulatory risk as a concern; they 6 consider the regulatory jurisdictions of the City of El Paso and New Mexico to be 7 challenging, and the Texas regulatory environment has been less supportive for integrated 8 electric utilities like EPE than it has been for transmission and distribution utilities that 9 are located within the Electric Reliability Council of Texas, Inc. Another concern is the 10 heightened capital expenditures that EPE faces in the future, for which external financing 11 will be required. Tax reform has raised concerns among fixed income investors and 12 rating agencies about the erosion of EPE’s cash flow metrics after implementation of 13 TCJA and the termination of bonus depreciation; this issue affects credit and fixed 14 income investment more than it does the equity market. Finally, EPE’s small size is 15 problematic as a trend of consolidation has increased the size of other participants in the 16 utility sector. Regarding EPE’s small size, Moody’s commented in its March 2019 17 Credit Opinion on EPE: 18 SMALL SIZE AND SCALE CONSTRAIN THE CREDIT PROFILE 19 [EPE]’s credit profile also factors in its relatively small size and scale as 20 well as market concentration as it serves about 425,000 customers in a 21 small area of Texas and New Mexico. Texas accounts for 80% of total 22 non-fuel revenues, the majority of which are generated in the City of El 23 Paso, while New Mexico accounts for about 20% of total revenues. 24 Although [EPE]’s service area is concentrated, we acknowledge that 25 customer and load growth is expected to continue to surpass national 26 averages.7 27 One of the challenges that EPE faces as a relatively small utility is that it must 28 compete with much larger utilities for access to lenders and attention from equity analysts 29 and investors. EPE’s market capitalization is only 0.3% of the aggregate market 7 Moody’s, “Credit Opinion: El Paso Electric Company; Update to Credit Analysis,” March 27, 2019 (Exhibit EL-4.2). ______________________________________________________________________________ Lapson – Direct Page 11 of 26 1 capitalization of 52 companies in the utility sector shown in Exhibit EL-2. The top ten 2 companies in that exhibit comprise approximately 54% of the aggregate value of the 3 group, and the top twenty companies comprise over 77% of the aggregate valuation. 4 Investors and analysts have limited time and resources available to cover dozens of 5 companies, so small companies tend to suffer from a dearth of analytical coverage. IIF 6 US 2’s indirect ownership of EPE and its greater access to equity capital and credit will 7 resolve this issue. 8 B. Impact of the Transaction on EPE’s Access to Credit 9 Q. HOW WERE EPE’S CREDIT RATINGS AFFECTED BY THE 10 ANNOUNCEMENT OF THE AGREEMENT TO MERGE WITH SUN JUPITER? 11 A. After the announcement of the agreement between Sun Jupiter and EPE, Moody’s and 12 S&P each took actions on their rating outlooks. The resulting ratings and outlooks are 13 shown below in Table 1. 14 Table 1: El Paso Electric Credit Ratings as of July 24, 2019 Prior to Transaction May 31, 2019 August 5, 2019 Credit Rating [1] Outlook Status Credit Rating [1] Outlook Status Outlook On Review for Moody’s (a) Baa1 Baa1 Negative Downgrade S&P (b) BBB Stable BBB Outlook Negative (a) Moody’s long-term senior unsecured debt rating (b) S&P’s long-term Issuer Credit Rating [1] A rating of Baa1 by Moody’s is equivalent to a credit rating of BBB+ by S&P, and Moody's Baa2 is equivalent to S&P's BBB rating. For the correspondence of credit rating scales of Moody’s and S&P, please see Exhibit EL-3. 15 16 17 Moody’s: Moody’s affirmed the rating of Baa1 but changed EPE’s outlook status to 18 “On Watch for Possible Downgrade” from “Outlook Negative.” The rationale expressed ______________________________________________________________________________ Lapson – Direct Page 12 of 26 1 in the announcement of that change on July 1 of this year indicates that the expected 2 decline in credit metrics even in the absence of the merger transaction is the leading 3 factor while the announced change of ownership is a secondary factor that could spur a 4 downgrade of EPE’s rating.