Fitch revises Calpine’s outlook to positive; affirms ratings

Fitch Ratings has affirmed the Issuer Default Ratings (IDRs) and security ratings of Calpine Corp. (Calpine) and its subsidiary, Calpine Construction Finance Company (CCFC) and revised the Rating Outlook for both companies to Positive from Stable.

The Outlook revision is driven by Fitch’s view that the fundamental positioning of the company in the merchant generation space continues to improve. This is leading to accelerated strengthening of credit metrics compared to Fitch’s prior expectations.

Some of the key trends in the U.S. power generation sector, namely tightening environmental regulations, looming generation scarcity in certain markets such as in the Electricity Reliability Council of Texas (ERCOT), and a sharp fall in natural gas prices in the recent months that has reversed coal-to-gas spreads, are all favorable for Calpine. These trends are reflected in Fitch’s upwardly revised EBITDA and cash flow estimates for 2012 as Calpine has benefited from a run up in market heat rates in ERCOT and significant coal-to-gas switching in various power regions it operates in.

A prolonged low natural gas price environment and, consequently, depressed economics, is likely to further accelerate the pace of retirements at several coal-fired power plants. Fitch expects this trend to further bolster Calpine’s competitive position and support improved credit metrics in 2013 and beyond.

Longer-term, Calpine remains positively leveraged to a recovery in natural gas prices with its highly efficient fleet and natural gas being on the margin for power prices in most of the markets Calpine operates in.

Calpine’s ‘B’ IDR reflects the company’s high consolidated gross leverage, relatively stable EBITDA (due to lower sensitivity to changes in natural gas prices as compared to other coal/ nuclear competitive power generators), strong liquidity position including a growing free cash flow profile, manageable debt maturities and consistently demonstrated capital market access.

Fitch estimates Calpine’s consolidated gross leverage to be approximately 5.9x and funds flow from operations (FFO) to total debt to reach 10% in 2013, which is in line with Fitch’s guideline ratios for a high risk ‘B’ rated issuer. Fitch expects Calpine’s gross leverage to approach a range of 4.5 – 5.0x and FFO to total debt to be in the 12-14% range by 2015. Given the company’s strong excess cash position, the net leverage metrics are much stronger. Management has a stated net leverage target of 4.5x, which Fitch expects to be reached by 2014.

Fitch expects Calpine to be a strong cash flow generator over the forecast period. Calpine’s announced growth plans consists of construction of two contracted assets, Russell City and Los Esteros. Russell City is a 619 MW net baseload capacity natural gas combined cycle plant in which Calpine has a 75% ownership interest.

The full output of the plant is committed to Pacific Gas & Electric (PG&E) under a 10-year PPA. The Los Esteros generating facility will be upgraded from a 188 MW simple-cycle generation plant to 309 MW combined cycle plant, which also has a 10-year PPA with PG&E. Both of these plants are being financed with project debt, which is non-recourse to the parent.

Calpine recently announced three additional generation projects: 1) Deer Park expansion, a 260 MW combined cycle plant expected to be operational by June 2014 at an expected capital cost of less than $550/kw; 2) Channel expansion, a 260 MW combined cycle plant that is expected to be operational by June 2014 at an expected capital cost of less than $550/kw; and 3) Garrison, a 309 MW combined cycle plant that is expected to be operational by June 2015 at a capital cost of less than $800/kw. Highly competitive cost of construction compared to new entry costs and location in favorable markets assuage Fitch’s concerns regarding the uncontracted basis of these assets.

Fitch expects Calpine to generate upwards of $600 million in free cash flow in 2014 and beyond. These free cash flow estimates incorporate both maintenance capex and growth capex based on announced new projects. Fitch does not expect management to proactively reduce debt from the current levels aside from the scheduled debt maturities/ amortizations. Over the last 12 months, management has announced $600 million in share repurchases, which has been above Fitch’s expectations. The level of free cash flow generation is strong enough to accommodate modest level of share repurchases, which is incorporated in Fitch’s forecasts. However, it is Fitch’s expectation that management prudently invests excess cash flow proceeds in growth oriented projects and continues to manage its balance sheet in a conservative manner. Fitch acknowledges the success that Calpine has had in simplifying its capital structure, pushing out debt maturities and gaining financial flexibility in capital allocation decisions.

Calpine’s liquidity position is strong with approximately $1.07 billion of cash and cash equivalents and $649 million of availability under the corporate revolver, as of March 31, 2012. Variability in collateral postings driven by $1/MMBtu move in natural gas price movements is higher than it was a year ago, however, strong current liquidity and excess cash flow generation provide adequate cushion to unexpected large movements in natural gas prices.

Fitch expects to resolve its Positive Outlook for Calpine over the next 12-24 months after gaining further evidence of how Calpine’s fleet fares in the current commodity environment. Any material change in the company’s capital allocation decisions will also play a part in the future rating decisions by Fitch, most notably the pace of share repurchases. A significant proportion of growth capex diverted towards merchant assets could be a cause for concern.

In accordance with its Parent and Subsidiary Rating Linkage Criteria, Fitch is currently linking the IDRs of Calpine and CCFC. Calpine and CCFC are distinct issuers, the subsidiary debt is non-recourse to the parent, and there are no cross-guarantees or cross-default provisions between the two entities. However, there are strong contractual, operational and management ties between Calpine and CCFC. CCFC sells a majority of its power plant output under a long-term tolling arrangement with Calpine’s wholly owned marketing subsidiary. CCFC is also a party to a master operation and maintenance agreement and a master maintenance services agreement with another wholly owned Calpine subsidiary. For these reasons, Fitch is assigning the same IDR to CCFC as the parent even though its standalone credit profile is stronger.

Recovery Analysis:

The individual security ratings at Calpine are notched above or below the IDR, as a result of the relative recovery prospects in a hypothetical default scenario.

Fitch values the power generation assets that guarantee the parent debt using a net present value (NPV) analysis. A similar NPV analysis is used to value the generation assets that reside in non-guarantor subs and the excess equity value is added to the parent recovery prospects. The generation asset NPVs vary significantly based on future gas price assumptions and other variables, such as the discount rate and heat rate forecasts in California, ERCOT and the Northeast. For the NPV of generation assets used in Fitch’s recovery analysis, Fitch uses the plant valuation provided by its third-party power market consultant, Wood Mackenzie as well as Fitch’s own gas price deck and other assumptions.

Fitch has affirmed Calpine’s corporate revolving facility, first lien credit facility and senior secured notes, which rank pari passu, at ‘BB/RR1’. The ‘RR1’ rating reflects a three-notch positive differential from the ‘B’ IDR and indicates that Fitch estimates outstanding recovery of 91-100%. Similarly for CCFC, Fitch has affirmed the senior secured notes at ‘BB/RR1’.

Fitch has affirmed the following ratings with a Positive Outlook:

Calpine

–IDR at ‘B’;

–Corporate revolving facility at ‘BB/RR1’;

–Senior secured first lien term loan at ‘BB/RR1’;

–Senior secured first lien notes at ‘BB/RR1’.

CCFC

–IDR at ‘B’;

–Senior secured notes at ‘BB/RR1’.