Fitch Rts Memphis, TN MLGW Sub PrePaid Electric & Sr Lien Bnds 'AA'.

Business Editors

NEW YORK--(BUSINESS WIRE)--Nov. 6, 2003

Fitch Ratings assigns a 'AA' rating to the City of Memphis, TN's, (on behalf of Memphis Light, Gas & Water (MLGW)) $1.4 billion of electric system subordinate revenue bonds, series 2003A and $100 million of electric system subordinate revenue bonds series 2003B (auction rate securities). The 2003A and 2003B bonds have final maturities on Dec. 1, 2018. Fitch also assigns a 'AA' rating to MLGW's $42 million of outstanding senior lien electric system revenue bonds, series 2002. The Rating Outlook is Stable.

The senior lien will remain open, but will be used sparingly, primarily to fund distribution and transmission facilities. The 2003A bonds are expected to price the week of Nov. 17, 2003 with JP Morgan as senior manager and the 2003B bonds are expected to price the week of Dec. 1, 2003 with JP Morgan as senior manager.

Proceeds will be used to prepay the Tennessee Valley Authority (TVA), a lump sum payment for a portion of base load electric capacity costs for the next 15 years. MLGW will receive a fixed credit on its monthly TVA bill equal to the prepaid capacity costs spread over the same 15-year period. The annual credit of about $156 million will be sufficient to cover debt service on the bonds of about $143 million and includes annual savings to the electric division of about $13 million.

Fitch recognizes that there are a number of benefits associated with entering into this type of transaction for both MLGW and TVA. MLGW will lock in low cost base-load power at a guaranteed discount for 15 years, improve its cash flows, enhance its competitive position, and receive protections under the contract that are not available under the current power contract with TVA.

While MLGW's financial ratios will be adjusted downward due to the increase in debt and debt service costs, Fitch believes the economic viability of the utility remains largely the same. TVA benefits via access to an alternative source of capital -- helping to lower borrowing costs, solidifying customer relations by providing distributors an option to lower power costs, and this transaction locks in TVA's larges customer for 15 years. In addition, from a structural standpoint, Fitch views MLGW's obligation to pass prepaid power costs through to customers the same as if they were an O&M expense under the power contract.

In our analysis Fitch focused on three fundamental areas: the credit quality of MLGW's Electric Division as ultimate obligor, the strength of TVA as the supplier and counterparty, and credit issues associated with the pre-payment structure. Structural issues reviewed include: supply or delivery risk, volume risk, energy price volatility, security provisions, and regulatory risk (see below for a summary of a few of these credit factors).

In short, Fitch believes that the deal structure, high credit quality of, and unique self-regulatory and oversight relationship between TVA and MLGW mitigate many of the potential credit issues, thus supporting the rating. In addition, this unique relationship provides a layer of credit protection not readily available to other wholesale suppliers and their customers. Fitch Ratings will issue a full report shortly discussing the major credit factors in greater detail.

Credit assessment of MLGW's Electric Division:

MLGW is a city-owned utility providing electric, gas, and water service throughout the city service area under separately secured divisions. The electric division of MLGW operates an electrical transmission and distribution system that serves 414,823 retail customers. The electric division purchases all of its power requirements from the TVA. This transaction will reduce the current purchase power costs due to TVA by about $156 million, and convert the payment into a $143 million debt service obligation, thus increasing operating cash flow by $13 million. The prepayment accounts for just 27% of the Electric Division's total power requirements (kwh) and 20% of 2002 total power costs.

The Electric Division's 'AA' rating is supported by the value of its transmission and distribution system as essential electrical services and their limited business risk. The rating also takes into account underlying strength of TVA as the system's sole wholesale electricity provider. Additional credit strengths include a growing and diverse economic base, low cost and reliable electric service, and historically strong financial performance. The customer base is favorable with primarily residential and small commercial users, with no customer concentration, and stable sales growth of just under 2%. Credit concerns are not material and center on uncertainties associated with federal restructuring plans that could affect TVA and its competitive position, as well as risks relating to MLGW's investment in a new Telecommunications Division, a limited liability company (Memphis Networx, LLC).

While the economic impact to MLGW of this prepayment transaction is positive, the systems pro forma financial metrics will substantially change reflecting lower debt service coverage levels, and higher debt leverage ratios. Fitch believes that the best way to view MLGW's historical financial performance compared to future financial results is on a fully adjusted basis. The adjustements should reflect direct debt (including prepaid debt) and appropriate adjustements for the system's net obligation to TVA, as total system debt.

Under this type of financial analysis the electric division's economic position is little changed, in fact some ratios are slightly better. Financial results for fiscal 2002 were solid providing debt service coverage of 2.10 times (x), operating margins of 1%, and 40 days of operating cash on hand (adjusted ratios were 1.11x, 1%, and 40 days, respectively). Pro forma financials calculated by Fitch reflected slightly better adjusted ratios with debt service coverage of 1.14x, an improved operating margin of 2.6%, and about 50 days of operating cash.

Credit Assessment of TVA:

Fitch Rates TVA 'AAA' reflecting its status as a wholly-owned corporation of the U.S. government and Fitch's assessment of the likelihood and quality of government support similar to government sponsored entities (GSE). The rating also takes into account the TVA's strong utility operating and financial platform, as well as its solid competitive position (compared to other electric utilities in the 'AA' category), and its integral role in developing the regional economy.

TVA provides wholesale electric service to virtually all of Tennessee, northern Alabama, northeast Mississippi, southwestern Kentucky and a small portion of Georgia and North Carolina. Non-power services, including, flood control, agricultural and industrial development, are also responsibilities of TVA. Underlying TVA is the original Tennessee Valley Authority Act of 1933 and certain updated amendments. Pursuant to this legislation, TVA is limited from the sale or delivery of electric power outside the area for which the TVA or its distributors were the primary source of electric power on July 1, 1957, and other wholesale suppliers are limited on their ability to sell power to existing TVA customers (known as the TVA 'fence' and 'anti-cherry-picking' amendments).

TVA has worked closely with its distributors, and federal and state parties on a consensus position to address the possibility of statutorily eliminating current restrictions through new legislation (known as TVA Title) which would place TVA more in line with other utilities that are working to position themselves for electric deregulation. However, it currently remains uncertain whether the new legislation relating to TVA will pass in the near term. Whether or not new legislation is passed regarding TVA, Fitch does not expect this to have a material credit impact on TVA's 'AAA' debt rating.

While existing limitations remain in effect, TVA has recognized the need to prepare for the likelihood of increased competition. For example, TVA has developed shorter/more flexible power supply contracts for its distribution members, focused on cost cutting efforts, and has implemented a major new strategic planning initiative. It is TVA's expectation that it would remain a wholly-owned agency of the Federal Government and continue to sell power and offer transmission service, but a primary goal of the TVA plan is to improve its financial flexibility, increase free cash flow and lessen its dependence on borrowing.

TVA's business strategy is to pay down debt, improve operating efficiency, and lower wholesale rates. Over the next ten years, TVA expects to pay down $3 billion to $5 billion of debt and increase cash reserves. TVA's current competitive profile appears strong and TVA should remain well situated for the potential of greater electric industry competition in the future.

Included in TVA's current business plan is an August 2003 approved rate increase, which re-allocated rates among major customer classes (increasing residential and commercial users and lowering industrial customers); the planned startup of Browns Ferry Nuclear Unit 1 in mid-fiscal year 2007 (projected to be a very low cost operating unit); the implementation of prepaid power programs (includes Discount Energy Unites program and the Memphis style prepaid tax-exempt power bonds); and funding for key environmental initiatives. TVA benefits from its highly diverse power supply mix; although its coal-fired capacity could be negatively impacted by future legislation were it to place unexpectedly tight restrictions on fossil-fired plants.

Summary of certain structural credit issues:

Supply or delivery risk: The prepaid electric supply represents just 27% of the energy provided to MLGW by TVA under a 5 year rolling take-and-pay all requirements contract. The power will come from TVA's diverse mix of low cost generating resources comprised of 60% fossil, 27% nuclear, 6% hydro, 6% purchases, and 1% combustion turbine. The contract also guarantees a 100% availability factor. Fitch views TVA's obligation to serve power under the pre-pay contract and MLGW's obligation to pass those cost through to customers, equal to an O&M expense.

Volume risk: MLGW will receive a fixed credit on its monthly TVA bill equal to the prepaid capacity costs spread over the same 15-year period. The credit will be sufficient to cover debt service on the bonds and provide annual savings to the electric division of about $13 million. The monthly credit is approximately $13 million, compared to the Electric division's average monthly bill of about $60 million, which should provide more than enough headroom to cover the credit even under extreme stress scenarios. In addition, in the event that MLGW's monthly credit exceeds monthly power costs, the balance can be carried forward or TVA will remit a check back to MLGW to make them whole, further mitigating this issue.

Energy price volatility: This transaction locks in a discount, not power prices movement. TVA's future rates may go up or down, reflecting changing energy prices and other cost movements and MLGW is committed to automatically pass all power costs through to its retail customers with out board or city council approval. However, MLGW will always receive a fixed discount from TVA's postage stamp wholesale rate sufficient to pay debt service on the bonds and provide about $13 million savings.

Security provisions: While security provisions on the new debt are weak, including a debt service covenant of 1.00x, and no debt service reserve fund, Fitch believes that the high credit quality of, and the unique self-regulatory and oversight relationship between TVA and MLGW provides a layer of credit protection not readily available to other wholesale suppliers and their customers, thus mitigating this issue.

Regulatory risk: In the event that the TVA Title becomes law, Fitch believes the relationship between MLGW and TVA will materially be preserved and the pre-paid power contract will remain in affect. In the unlikely event that TVA assigns the agreement without MLGW permission or by operation of law, MLGW may terminate the agreement and TVA must pay MLGW a make-whole default payment.