Tucson Electric Power Co. (TEP; BB/Watch Neg/—) is an investor-owned utility in Arizona that serves about 360,000 electric customers in the Tucson metropolitan area. TEP is a wholly owned subsidiary of UniSource Energy Corp., which also owns UniSource Energy Services (UES), a natural gas and electric utility that serves more than 200,000 customers in northern and southern Arizona. UniSource also owns two smaller subsidiaries, Millennium Energy Holdings Inc. and UniSource Energy Development. On Nov. 24, 2003, TEP’s ratings were placed on CreditWatch with negative implications.

Why is TEP on CreditWatch?

Ratings were placed on CreditWatch following the announcement that parent UniSource (not rated) had agreed to be acquired by a group of private investors led by Kohlberg Kravis Roberts & Co. (KKR). KKR and its partners expect to purchase UniSource for $880 million, offering shareholders $25.25 per share, a 30% premium over the closing price in effect before the sale’s announcement. As proposed, the transaction would increase UniSource’s already highly leveraged consolidated capital structure by nearly $400 million. This additional leverage increases the pressure on TEP’s financial profile as TEP is the principal source of funds for UniSource. It also reverses, or delays, the debt-reduction progress of the past several years, which has underpinned the stable outlook on TEP. On a consolidated basis, UniSource’s outstanding debt at yearend 2003, including net lease obligations, was $1.9 billion, of which $1.8 billion was at TEP.

When will the transaction be completed?

A number of approvals are required to complete the acquisition, and management expects to receive needed authorizations during the third quarter of 2004. Approvals are needed from the Arizona Corporation Commission (ACC), the FERC, the SEC, and the Department of Justice’s antitrust division. UniSource shareholders must also approve the sale, and are scheduled to vote on the transaction on March 29. On Feb. 5, the ACC opened a docket to address the issue and scheduled hearings for June 21. The merger is expected to be completed before the end of 2004.

If the acquisition is not concluded by March 31, 2005, either UniSource or KKR and its partners may terminate the acquisition. In certain circumstances, UniSource would be required to pay termination expenses of up to $25 million.

Will the acquisition strengthen TEP’s financial profile?

Although the transaction would improve TEP’s stand-alone capital structure, it would be accomplished through issuing additional debt by the parent, thereby increasing the leverage of the consolidated company. Specifically, the purchase is to be financed by issuing $660 million in new debt at the parent and $575 million in equity and cash. After paying about $880 million in cash to shareholders and holders of stock options, the remaining funds, net of transaction costs and other fees, would be used to retire about $260 million of debt at the utility. These funds would be made available to TEP through a cash equity injection of up to $168 million and repayment of a $95 million note from UniSource to TEP. While debt retirement at the utility level offsets some of the $660 million in new senior secured and unsecured notes to be issued by the holding company, the net effect of the proposed acquisition is to increase the UniSource family’s debt burden by $400 million.

Why do the terms of the acquisition propose to retire debt at TEP while increasing it at the holding company level?

The recapitalization of TEP will remove ACC restrictions that prevent the utility from providing dividends to UniSource of more than 75% of its net income. This restriction remains in place so long as the utility’s equity is below 40% of total capitalization; above this level TEP can dividend 100% of annual net income. TEP’s common stock equity is currently 25%, based on the ACC approach for calculating equity ratios, which excludes capital leases from total capital. The contribution of equity and the retirement of up to $260 million in TEP debt is expected to be sufficient to reach the 40% threshold. TEP’s actual common stock equity, including capital leases, is 18% of total capitalization; after the merger it is expected to increase to 28%.

How is the acquisition structured?

KKR and its partners, JP Morgan Partners LLC and Wachovia Capital Partners, will purchase the common stock and options to acquire the UniSource family of companies. Except for targeted debt retirements at TEP, all debt outstanding will remain outstanding. UniSource consists of TEP, which generates the majority of consolidated revenue, and three smaller companies, UniSource Energy Services (UES), UniSource Energy Development, and Millennium Energy Holdings. UES is the holding company for UNS Gas and UNS Electric and serves 127,000 gas and 80,000 electric retail customers in Arizona. UES was formed from the purchase of the electric and gas assets from Citizens Communication Co. in August 2003. UniSource Energy Development is an unregulated company that develops generation resources. Millennium has acquired unregulated companies engaged in thin-film batteries and photovoltaic cells technology.

Post-merger, the company will be held through a limited partnership structure, Saguaro Utility Group L.P. (Saguaro L.P.). Saguaro L.P. is backed by KKR and its partners and will be operated by a general partner, Sage Mountain LLC. Saguaro L.P. will in turn own Saguaro Utility Group Corp., which will issue debt, hold the common stock of UniSource Energy, and receive the equity proceeds funneled from the investing partners to UniSource.

Does the use of a leveraged buyout structure by KKR and its partners mean that the company is troubled?

No. Financial metrics for UniSource and TEP have been relatively stable for several years. TEP benefits from operating in a rapidly growing service territory, from supportive regulatory treatment, and from healthy cash flow from operations, which it had been using to reduce its indebtedness, and thereby supporting the stable outlook. The noninvestmentgrade credit rating of TEP resulted from a major generation construction program and related regulatory disallowances and deferrals that took place in the 1980s and early 1990s.

KKR’s interest in this acquisition appears to be part of a slowly emerging trend of private equity interest in energy companies. Texas Pacific Group announced last year its intent to purchase Portland General Electric Co. from bankrupt Enron Corp. for $2.35 billion in cash and debt. Berkshire Hathaway Corp., which already owns MidAmerican Energy Co., has long made its interest in expanding its investment in the sector known, and has pushed vigorously for repeal of the Public Utility Holding Company Act (PUHCA) to make acquisitions of utilities by nonutility firms more palatable. KKR and its partners have indicated their intent to make UniSource a medium-term investment, with a hold horizon of about six to eight years.

KKR has made two major energy investments. In 2000, the company acquired a minority stake in DPL Inc. and in February 2003 it invested in International Transmission Holdings L.P., which owns and operates International Transmission Co., an independent transmission utility based in Michigan.

Will Standard & Poor’s take a ratings action before the acquisition is complete?

TEP’s ratings are under review, and a rating action may occur before the transaction closes. Because it is not known whether the acquisition will occur and what the final terms of the transaction will be, any such action would not consider the ultimate credit quality of TEP and its parent if the merger is consummated. Rather, the assessment would be based on whether TEP’s current credit rating is appropriate given UniSource’s willingness to add debt to an already highly leveraged balance sheet, whether or not the acquisition proceeds.

What factors will Standard & Poor’s likely consider in making this decision?

TEP’s financial profile is weak for its rating category, and the current ratings reflect the expectation that management would continue to aggressively pay down debt and capital lease debt obligations. UniSource’s debt to total capitalization ratio at year-end 2003 was 78%, including net obligations on TEP’s capital leases. Post-merger, the ratio would increase to 80%. In absolute terms, the transaction would increase total consolidated debt by roughly 18%, relative to 2003 debt levels. Because management had expected to make debt retirements in 2004 that will not occur if the merger is consummated relative to forecast 2004 debt levels, the absolute increase in consolidated debt is expected to be higher.

Management’s decision to increase debt levels as part of the acquisition strategy will be considered against several possible mitigating factors:

• Annual free cash flows at TEP after capital expenditures are projected to remain strong at at least $100 million over the next four years;
• The transaction will reduce the utility’s exposure to variable rate debt by one-half to about 15%; and
• The transaction may lower TEP’s regulatory risk in future rate reviews, the first of which will occur in 2004 when TEP is expected to file a transmission and distribution general rate case.

Could further rating actions occur in the near term?

Yes. There is currently no debt at the UniSource level. The parent expects to issue about $360 million in senior secured loans and $300 million in unsecured notes to finance the transaction. This will necessitate a rating for UniSource. Standard & Poor’s will issue this rating once all approvals have been obtained and the debt levels and final terms of the acquisition are certain. At the time the UniSource rating is established, Standard & Poor’s will also evaluate whether there are sufficient regulatory protections for TEP to warrant a separation between the parent’s and utility’s ratings.

What qualitative credit quality concerns would be factored into the rating of TEP and its parent if the acquisition moves forward as planned?

KKR and its partners have stated that the business of the company will not change as a result of the acquisition and that it will retain existing management, who will continue to control the company’s day-to-day operations. Standard & Poor’s therefore expects UniSource to continue to focus on core electric operations, make needed capital investments in its electric infrastructure, and to continue to deleverage at the holding company and utility levels.

However, UniSource will cease to have publicly traded equity, which may result in more limited public disclosure requirements, although the ACC will continue to regulate TEP. This potential lack of transparency puts particular pressure on privately held entities to have strong corporate governance structures. The recent failures of certain major U.S. corporations have shaken public and investor confidence, and have raised questions about U.S. corporate governance standards. These concerns may be heightened for UniSource, particularly because the acquisition will result in the replacement of an independent board of directors with a two-person board that will consist of the manager of Sage Mountain LLC and the current CEO of UniSource.