Société en commandite Gaz Métro
Cause tarifaire 2009, R-3662-2008
Gaz Metro Inc.
~rimaryredit Analyst:
Bato Kacarevic,.Toronto ( 1 ) 416-507-2589; bato~kacarevic@standardandpoors.com
Secondary.Credit Analyst:
Nicole Martin, Toronto (1) 41 6-507-2560; nicole-martin@standardandpoors.com
,
Table Of Contents
Major Rating Factors'
Business.Description
Strong Business Risk Profile
Intermediate Financial Risk Profile
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Métro - 8, Document 11
(12 pages)
Gaz Metro Inc.
Major Kating Factors
Strengths:
Strong core gas distribution and transportation businesses
* Stable financial performance and predictable cash flows
Supportive regulatory regime
Weaknesses:
* Low residential customer penetration rate
Reliance on industrial customers, resulting in greater cyclicality
RationaBe
The ratings on Gaz Metro Inc. (GMI) and Gaz Metro L.P. (GMLP or the trust) reflect the company's prudent
management of its operations and balance sheet, its measured Pace of investment in other energy sectors, its
stabilized credit metrics, a reasonable 2008 rate case decision, and the expected equity issue in 2008. The ratings
also reflect the Province of Quebec's (A+/Positive/A-1)supportive regulation, moderate operational risk of GMI's
key gas distribution business in Quebec, and consistent financial performance. Counterbalancing these positive
elements are natural gas' relatively low market penetration in Quebec compared with that of electricity; and
significant exposure to the industrial sector, where cash flows tend to be cyclical. The ratings also factor in the
trust's strategy to diversify incrementally into other energy enterprises. The ratings of the parent company (GMI)
and the operating company (GMLP) are equalized based on the unconditional debt guarantee from GMLP to GMI,
investment activity restrictions at GMI, and GMLP's dominant position in the parent's business operations.
GMI is the general partner of and holds a 71% interest in GMLP, the company's main asset and a Montreal-based
partnership. GMI's business diversification is moderate, and cash flows are stable through the trust's interests of
regulated gas and electricity distribution, and gas transportation and gas storage assets. Gas distribution assets in
Quebec, which represent the vast majority of earnings, drive operating performance. GMLP's total debt outstanding
at fiscal year-end Sept. 30,2007, was approximately C$1.7 billion. Standard & Poor's treats the parent company's
approximately C$708 million of subordinated debentures as equity.
Supportive regulation in Quebec underpins the gas distribution business' strong market position. The regulator
determines the allowed return on capital that GMLP can generate for the delivery of natural gas. Commodity
exposure is negligible, as natural gas commodity costs are entirely passed on to customers, thus reducing the adverse
effects of price volatility. In addition, GMLP benefits from a performance-based regulatory arrangement with
incentives. For 2008, the regulator accepted most of GMLP's proposals. As a result, the allowed return on equity
(ROE) is 9.52%, composed of a base rate of return of 9.05% (higher than 2007 levels) and an incentive of 0.47% as
a share of anticipated productivity gains. The regulator's assessment of the trust's business rislc is a key element of
the base rate. Incentive returns have the potential to mitigate decreases in base rates of return that are linlted.to
lower government bond yields.
Standard & Poor's Ratings Services views the trust's natural gas distribution and transmission businesses as low
t
20,2008
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1
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Gaz Metro Inc.
risk. Nevertheless, GMI's recent shift in strategy to develop a more diversified energy services platform, including
increased nonregulated services, could worsen its business risk profile. GMI appears to be diversifying at a modest
rate; therefore, a ratings impact is unlilcely unless a material change in strategy occurs. Moreover, through its
Limited Partnership Agreement and trust deed governing first-mortgage bonds, GMLP's investment in unregulated
energy activity is limited to 10% of its aggregate assets. The 2007 acquisition of Green Mountain Power Corp.
(GMP; BBBIStablel--) in Vermont illustrates this strategy and malces strategic sense. Other projects of interest to
GMI include a proposed liquefied natural gas terminal and a proposed partnership to develop wind generation
assets in Quebec. Accompanying any large-scale expansion projects are potential regulatory, construction,
cornrnodity, and financing risks.
GMI has an intermediate financial rislc profile, which is largely indicative of its highly leveraged balance sheet (60%
debt to total capital) and low authorized rates of return compared with those of U.S: peers. Regulated assumptions
and a deemed capital structure set rates. Debt levels increased materially in 2007 to finance the GMP acquisition.
Influencing solid EBITDA performance in 2007 was increased volume in the industrial customers and more than
5,000 new residential customers. Cash flow generation will be more than adequate to finance al1 capital
expenditures in 2008. GMLP's policy of distributing 95%-100% of its earnings to unitholders continues to
constrain its financial flexibility. Nevertheless; the trust's capital market access remains intact and it plans to issue
equity in 2008 to improve its capital structure.
Despite its monopolistic-like position in the natural gas marlcet in Quebec, GMI must contend with low natural gas
marlcet penetration in the province's energy marlcet. The penetration is appro~imatelyone-half the national average,
due to highly competitive electricity rates. Consequently, GMI has a low penetration rate in the residential energy
market, which undermines profitability due to high margins in this segment. In addition, the company has a large
industrial customer base that faces economic fluctuations and results in less predictable cash flows. Quebec's
economy is somewhat cyclical, given its significant manufacturing base. GMLP's key subsidiaries posted mixed
performance in fiscal 2007, but they are mostly regulated entities with robust market positions.
The trust's marketing strategy has increasingly focused on bolstering its position in the residential energy market.
This strategy, which emphasizes the benefits of natural gas as an energy source along with more competitive gas
prices, has gained some traction. Higher residential market penetration would improve operating margins and
earnings stability, thus resulting in more predictable cash flows.
Liquidity
Standard & Poor's considers GMI's liquidity to be adequate. Organically geierated cash flow and accéss to credit
facilities should provide sufficient funds to support capex, variable working capital requirements, and meet 2008
debt maturities. Cash flows should also be sufficient to meet the company's 2008 capital spending of approximately
C$140-C$UO million (per Standard & Poor's estimates). GMI's various credit facilities and lines of credit, totaling
nearly C$790 million at Sept. 30,2007, enhance liquidity. At Sept. 30,2007, the company had approximately
C$300 million outstanding on these facilities. In addition, GMI's debt maturity schedule is laddered, and despite
nearly C$5OO maturing during the next several years, debt maturities are manageable. The company is complying
with al1 of the financial tests and covenants contained in its credit facilities. The commercial paper program is
adequate when factoring in normal seasonal fluctuations resulting from building gas inventories in the surnrner and
fa11 to meet winter demand.
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Gaz Metro 1kc.
Recovery analysis
The rating on GMI's first mortgage bonds is 'A', with a recovery rating of '1+', indicating a high expectation of full
recovery (100%) in the event of a default. The secured debt at GMI is rated one notch higher than the corporate
credit rating due to the amount of collateral securing the debt. The company's first mortgage bonds are secured
under a trust deed that contains a hypothec on the universality of GMI's Quebec movable and immovable property,
current and future. The creditors are also covered by a first immovable hypothec on GMLP's present and future
pipelines and gas distribution system. The first mortgage bonds comprise nine individual debt issues, with maturities
ranging from 2009 to 2036 (on a fiscal-year basis).
Standard & Poor's believes that if GMI were to default, it would continue to operate as part of a reorganized entity
because of the essential service nature of its business. The single most important factor in determining a utility's
asset value upon emergence from bankruptcy is the revenue stream that regulators allow it to collect. In GMI's case,
there is a high correlation between the value of the regulated rate base and the book value of the assets. Therefore,
absent extenuating circumstances, we will assume that the book value of the assets represents a fair value for the
assets. The recovery estimate compares the level of collateral to the potential amount of secured debt.
Outlook
The stable outloolc reflects the regulated aspect of GMI's operations, the dominant market position of most of its
major businesses, and the trust's disciplined approach to managing its operations and financial position. The GMP
acquisition has slightly weakened GMI's consolidated business risk and financial risk profiles, but offsetting this is
the trust's solid operating performance and limitations of engaging in unregulated businesses. A negative ratings
action is possible if GMI pursues large debt-financed acquisitions outside of its core cornpetencies, or its financial
risk profile deteriorates. Conversely, a positive ratings action is not likely at this time, given the trust's energy
diversification strategy and volatility of cash flow from the industrial customers in gas distribution.
Busbess Description
Standard & Poor's RatingsDirect 1 February 20,2008
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Gaz Metro Inc.
GMI's core business is the regulated distribution, transportation, and storage of natural gas in Quebec and Vermont.
Overall, GMI has more than 200,000 customers and operates greater than 10,000 lcilometers of pipeline. In 2007
(approximately), 86% of GMLP's EBITDA and 80% of its assets came from gas distribution. As a result, the
distribution segment's performance is critical to the ratings.
In 2007, GMI acquired GMP, the second largest electricity distributor in Vermont, expanding its presence in the
U.S. The trust is also involved in the transportation of natural gas through its 50% interest in Canada-based Trans
Quebec & Maritimes Pipeline Inc. (TQM; BBB+/Stable/--), its 38.3% interest in Portland Natural Gas Transmission
System (PNGTS), and the activities of the Champion Pipe Line Corp. Ltd. subsidiary. GMI also has interests in
several small, nonregulated companies. On a consolidated basis, the contribution to revenues from nonregulated
assets is approximately 4.5% at fiscal year-end 2007, and is not a material ratings factor.
1
Stroi~gBusiness Risk l[Psofile
Canadian regulatory fiamework has unique features
.
The Regie de l'energie (in .Quebec) and the National Energy Board regulate GMI's Canadian operations. The
regulation for the Quebec distribution assets is sirnilar compared with regulation in other provinces.
Performance-based regulation limits any downside risk to a cost-of-service and rate-of-return method. In 2007, the
total authorized ROE was 9.57% (9.91% was achieved), and it is 9.52% for 2008. Although the base rate is fixed,
productivity gains allow GMLP to potentially earn up to 375 basis points higher than the base rate of return.
Similar to other Canadian regulatory jurisdictions, the Company is insulated from commodity price risk, directly
flowing these costs through to distribution customers. Quebec regulation also allows for a weather-normalization
and as of Oct. 1,2007, wind normalization, deferral account. Rates are calculated on normal weather and wind
velocity (30-year average); any variation is deferred through a normalized account and collected through rate
adjustments in a five-year period. Interest-rate risk is also not a concern, because GMLP can defer any variation in
floating interest rates through a normalization account.
Unique to the regulatory environment in Quebec (for gas distribution assets) in Canada, the distribution operations
are allowed to generate and have earned incentive earnings greater than the regulated base ROE. For the 2007 fiscal
year, the allowed ROE was 9.57%, composed of a base return of 8.73% and an incentive of 0.84% as a share of
expected productivity gains.
The U.S. operations, which expanded considerably with the GMP acquisition, are subject to Federal Energy
Regulatory Commission and the Vermont Public Service Board. In Standard & Poor's view, the regulatory
framework for gas distribution in Vermont is not as favorable as that of Quebec, despite recent revisions. At
Vermont Gas Systems Inc. (VGS), a new regulatory framework was adopted Oct. 1, 2006. It includes an adjustment
mechanism for the price of gas sold to customers that reflects its acquisition cost and a mechanism where
productivity gains can be shared. VGS is no longer exposed to commodity cost risk. Also, GMP's business risk is
reduced with a price adjustment mechanism for electricity sold to customers.
Market position depends heavily on the industrial customer base
GMI's market position is weaker than that of other gas distribution companies in Canada. Due to a relatively higher
concentration of customers within the industrial sector, operating results are more vulnerable to throughput changes
due to price volatility of natural gas and econornic cyclicality. Furthermore, industrial customers have lower margins
than residential customers. Residential customers account for a small portion of GMI's business mix, which is a
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February 20,2008
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6
6.a~
1 :,r:<i>$.157
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Gaz Metro Inc.
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competitive disadvantage. In 2007, approximately 60% of throughput volumes were industrial-based, of which
about 12% had dual-fuel capabilities, approximately 30% came from commercial customers, and about 10% from
residential customers. Standard & Poor's expects that the business mix will remain fairly stable in the
near-to-medium term.
1
The industrial customer base is well-diversified, which tempers the division's concentration and volatility. According
to Standard & Poor's estimates, the highest concentrations of total volume are in the metallurgical sector. The pulp
and paper sector, which once captured a considerable proportion of total volumes, has decreased significantly.
Heavy reliance on industrial customers exposes GMI to economic slowdowns and cyclical commodity prices,.which
can depress distribution revenue due to lower volume. As a result, GMI is focusing more marketing on developing
its residential customer base to bolster operating stability and margins.
1
I
1
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Regulatory environment reduces operating risks
Regulation protects the Company from the financial consequences of many operating rislts. Commodity prices do
not present a risk to cash flow because regulation allows the flow through of these costs in a tirnely manner through
an automatic monthly adjustment mechanism. Because new home development represents a large Portion of
customer growth, the Quebec-based distribution assets are fairly new and efficient. Furthermore, GMI's interest in
natural gas storage facilities has strategic advantages, as it ensures that there are natural gas reserves and secures a
short-to-medium-term natural gas supply.
GMI has a low penetration rate on high-margin residential customers, which constrains increased economies of scale
. and margin expansion potential. Consequently, the company's operating statistics, on a per customer basis, do not
1
compare favorably with those of other Canadian gas distributors such as Enbridge Gas Distribution Inc.
(A-/Stable/--),Union Gas Ltd. (BBB/Positive/--),or Terasen Gas Inc. (BBBAVatch Negl--).
The National Energy Board regulates the trust's 50% interest in Trans Quebec & Maritimes Pipeline Inc. (TQM;
BBB+/Stable/--),a gas transportation pipeline in Quebec. This represents a substantial investment and operating risks
are rnitigated by the existing long-term take-or-pay contract the pipeline has with its other joint owner,
TransCanada PipeLines Ltd. (TCPL; A-Negativel--). Tolls are based on a cost-of-service approach, thus providing
earnings stability.
Volatile prices and fickle customers could mean a cornpetitive landscape
A shifting energy landscape, price volatility, and growing energy needs could increase competition in the natural gas
industry. GMLP's residential penetration rate in Quebec is quite low, at approximately 19%, despite delivering
about 97% of the natural gas consumed in Quebec. For years, the Quebec government promoted cheap electricity
through provincially owned Hydra-Quebec. Natural gas market penetration for Quebec is just 16%, according to
Standard & Poor's estimates, which is low compared with that of neighboring Ontario and the national average of
about 35%. We view tliis as a good market opportunity for GMLP, because there is growth potential inherent in
new home construction and natural gas use in appliances. As such, this is a strategic imperative for the trust.
Nevertheless, convincing non-gas consumers to switch, given the upfront conversion costs, will be challenging. Price
volatility in energy markets, combined with the flexibility of large customers to switch energy sources, underpin
more competitive market conditions wliere customers increasingly seek alternative energy sources in times of high
energy prices.
1
1
Vermont Gas Systems Inc. is the sole gas distributor in Vermont, where natural gas continues to enjoy a price
advantage over electricity. Standard & Poor's expects additional customer growth will continue at the historical rate
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Gaz Metro Inc.
of 1%-2% in the near-to-medium term.
In GMLP's transportation segment, the TQM pipeline is an extension of the TCPL system. TQM's low business rislz
is due to its monopolistic position where there are no other means of transporting natural gas into Quebec.
Nevertheless, the volumes that pass though TQM, where the pipeline interconnects with PNGTS, face more
competition from primarily the Maritimes & Northeast Pipeline system, which transports offshore Canadian gas
into the northeastern U.S.
Profitability reflects customer consumption and new energy streams
Because GMI is mostly a regulated business, its profitability is not expected to fluctuate materially, on a ROE basis.
The most meaningful contributor to the trust's net income is its gas distribution business in Quebec, which for 2008
has an authorized rate of return of 9.52%, including anticipated productivity gains of 0.47%. Nonetheless,
profitability growth has been inhibited by decreased energy consumption from residential customers, despite adding
new customers. In our view, earnings could improve moderately based on several factors including: productivity
improvements, organic growth opportunities, and green-field development projects. Conservation and renewable
energy trends provide a back-drop for new energy streams such as liquefied natural gas and wind power.
1ntem.ediateFPn.ancial Risk Profile
Accounting
GMI reports its financial statements in accordance with Canadian GAAP. Standard & Poor's makes adjustments to
GMI's financial risk profile to reflect the financial risk the company faces. Debt adjustments are made for accounts
receivable sold and pension liabilities. Furthermore, the gross interest figure is adjusted to account for allowance for
funds used during construction. The effect of these adjustments on overall financial metrics is immaterial.
Expanded mission statement could increase risk
GMI's expanded mission statement to dedicate more resources for business development outside of its core gas
distribution business heightens the trust's risk profile to some extent. Although the diversification benefits are
evident, cash flows could have greater uncertainty. Nevertheless, management's growth policy remains somewhat
conservative, as strategic fit remains a key criterion for growth initiatives.
While the Regie largely influences GMLP's modest financial risk profile, the trust has historically maintained fairly
conservative financial policies for its nonregulated businesses. Standard & Poor's expects the company's financial
policies, which include risk-management programs for interest rates and foreign exchange, will remain in effect in
the medium-to-long term. Involvement in nonregulated energy activities is limited to 10% of GMLP
non-consolidated assets by the trust deed governing first-mortgage bonds and by the partnership agreement, and
GMLP cannot issue, assume, or guarantee long-term debtif the total long-term debt, after giving effect to suc11 issuer
assumptions or guarantees, exceeds 65% of its nonconsolidated total capitalization.
Baseline level of stable cas11 flow expected to continue
GMI's cash flow protection measures have been stable in recent years and currently are satisfactory for the ratings.
Despite fluctuating gas prices and the economy's impact on volume, the company has demonstrated relatively stable
cash flow generation. Regulation of most of the trust's revenues reinforces cash flow stability and limits downside
risks. In Standard & Poor's view, the trust will continue to generate a stable baseline level of cash flows.
Standard & Poor's RatingsDirect
1. February 20,2008
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Gaz Metro Inc.
However, because the trust distributes nearly al1 free cash flow to unitholders, it could have to increase debt on an
incremental basis to finance growth projects or acquisitions. This could result weaker cash flow coverage metrics in
the interim until such projects are in-service and accretive to cash flow.
Capital structure and asset protection remain stable thanks to regulatory guidelines
Standard & Poor's believes that GMI's capital structure will remain stable in the long term, given the regulatory
directives it is subject to. In addition, an acceptable balance sheet must be maintained because of the capital
intensive nature of the business. Regulatory guidelines largely dictate balance-sheet leverage; the guidelines stipulate
a 38:5% (for Quebec distribution activity) deemed cornmon equity capital component and a 7.5% deemed preferred
equity component. There is no incentive to diverge from these directives as excess equity generates a lower return
than the approved ROE, while successfully operating with less than the deemed equity might signal that the allowed
equity return is too generous.
GMLP's commitment to pay out 95%-100% of earnings to unitholders limits its financial flexibility somewhat.
Although the distribution policy is not fixed, management would be reluctant to curtail cash distributions to
unitholders.
Table 1
Industry sector: Gas
--Average of past three fiscal years-(Mil. C$)
'Ratinq as of Feb. 14,2008
Gaz Metro Inc. Enbridge Gas Distribution Inc. Terasen Gas Inc. Union Gas Ltd.
A-/Sta blet-A:/Stable/-- A/Stable/-BBBt/Stable/A-2
Revenues
Net income from continuing operations
1.919.6
3,040.5
1,432.1
2,001.3
43.9
179.0
68.2
125.7
408.9
172.1
286.1
357.5
126.7
237.0
1,567.3
3,279.2
1,771.9
2,227.3
749.3
1,707.4
824.9
1,088.4
Funds from operations (FFO)
319.1
Capital expenditures
151.O
Debt
Eauitv
Adjusted ratios
Operatinq income (before D&A)/revenues (%)
^
19.4
19.5
22.2
25.0
EBlT interest coverage (x)
2.4
2.1
2.0
2.1
EBITDA interest coverage (x)
3.8
2.8
2.7
3.1
10.2
9.1
8.8
9.8
Return on capital(%)
"Fully adjusted (including postretirernentobligations).D&A--Depreciation and arnortization.
Table 2
lndustry sector: Gas
--Fiscal year ended Sept. 30-(Mil. C$)
Rating history
2007
A-/Negative/--
2006
A-/Negative/--
2005
A-/Stable/--
2004
A-/Stable/--
2003
A-/Stable/--
1,954.2
2,001.2
1,803.5
1,778.0
1,750.4
Revenues
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Gaz Metro Inc.
Table 2
Net income from continuing operations
Funds from operations (FFO)
Capital expenditures
47.0
29.7
55.0
40.9
49.0
342.8
290.6
345.7
352.3
334.7
,124.8
153.9
174.2
124.4
105.7
32.2
36.9
25.4
13.6
8.0
Debt
1,751.6
1,475.1
1,475.2
1,250.2
1,339.3
Equity
Debt and equity
762.0
755.6
730.4
775.5
755.7
2,513.5
2,230.7
2,205.6
2,025.7
2,095.0
2.3
2.5
2.6
2.7
2.7
Cash and investments
Adjusted ratios
EBlT interest coverage (x)
FFO interest coveraqe (x)
FFOIdebt (%)
4.7
4.7
5.6
5.6
5.5
19.6
19.7
23.4
28.2
25.0
Discretionary cash flowldebt (%)
9.7
3.4
2.8
10.2
5.9
196.6
125.2
137.5
211.6
238.0
Debtldebt and equity (%)
69.7
66.1
66.9
61.7
63.9
Debtldebt and equity (%)y
68.0
63.0
63.9
60.0
62.3
Return on comrnon eauitv (%)
43.7
34.7
63.5
53.3
82.6
Net'cash flow/caciex i%)
-
"Fully consolidated & adlusted (including postretirementobligations) We treated subordinated debt as equity, and adjusted interest expense on subordinated debt as
dividends nComplementary ratios for Gaz Metro L P
Table 3
--Fiscal year ended Sept. 30,2007Gaz Metro Inc.
reported
amounts (mil.
Cs)
Reported
Debt
2,402.2
Operating
income
(before
D&A)
389.8
Operating
income
(before
D&A)
389.8
Operating
income
(after
D&A)
234.4
lnterest
expense
170.4
Cash flow
from
operations
322.1
Cash flow
from
operations
322.1
Dividends
paid
34.9
707.8
NIA
NIA
NIA
(62.5)
62.5
62.5
62.5
Shareholders'
equity
134.7
Standard & Poor's adjustments
Equity-like
(707.8)
hybrids
Postretirement
benefit
obligations
57.2
(80.5)
2.1
2.1
2.1
NIA
11.9
11.9
NIA
Reclassification
of nonoperating
lncome
(expenses)
NIA
NIA
NIA
NIA
7.5
NIA
NIA
NIA
NIA
Reclassificatiop
of interest,
dividend, and tax
cash flows
NIA
N/A
NIA
NIA
NIA
NIA
(4.0)
(4.0)
NIA
Reclassification
of working-capital
cash flow
changes
NIA
NIA
NIA
NIA
NIA
NIA
NIA
(49.7)
NIA
(650.6)
627.3
2.1
2.1
9.6
(62.5)
70.4
20.7
62.5
Total
adiustments
Standard & Poor's RatingsDirect
1
'
February 20,2008
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Gaz Metro Inc.
1
Table 3
Standard &
Poor's adjusted
amounts
Adjusted
Debt
1,751.6
Equity
762.0
Operating
incorne
(before
D&A)
391.9
EBITDA
391.9
EBIT
244.0
lnterest
expense
107.9
Cash flow
from
operations
392.5
Fundsfrom . Dividends
operations
paid
342.8
97.4
"Gaz Metro Inc. reported amounts shown are taken from the company's financial statements but might include adjustments made by data providers or reclassifications
made by Standard & Poor's analysts. Please note thattwo reported amounts (operating income before D&A and cash flow from operations] are used to derive more than
one Standard & Poor's-adjusted amount (operating income before D&A and EBITDA, and cash flow from operations and funds from operations, respectively).
Consequently, the first section in some tables may feature duplicate descriptions and amounts. D&A--Depreciation and amortization. NIA--Not applicable.
"Unless otherwise noted, al1 ratings in this report are global scale ratings. Standard & Poor's credit ratings on the global scale are comparable across countries. Standard
& Poor's credit ratings on a national scale are relative to obligors or obligations within that specific country.
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