Fitch Revises PEPCO Holdings' Rating Outlook to Negative; Affirms IDR

Fitch Ratings has revised the Rating Outlook for PEPCO Holdings, Inc. (PHI) to Negative from Stable and affirmed the company's 'BBB' Issuer Default Rating (IDR) and debt ratings.

Fitch has also affirmed the Ratings of PHI's subsidiaries Potomac Electric Power Co. (PEPCO), Delmarva Power and Light Co. (Delmarva), and Atlantic City Electric Co. (ACE) with a Stable Outlook. Fitch has withdrawn the ratings of Potomac Capital Investment Corp. (PCI) since no public debt remains outstanding at this entity. For a list of ratings affected by these actions, see the list below.

The Negative Outlook for PHI reflects the unfavorable outlook for wholesale energy prices and their impact on its merchant energy business, Conectiv Energy Holdings (CEH). Performance at CEH in the first half of 2009 (1H'09) has been hampered by a slump in power demand due to mild weather, weak economic conditions, and compressed generation spreads. Fitch expects that continued weakness in wholesale energy prices will adversely affect CEH's energy margins in 2009 and beyond. The impact is mitigated to some extent by hedges in place for 2010 and 2011. Approximately 60 percent of 2010 and 55 percent of 2011 gross margin has been hedged, a large part of which is in the form of capacity revenues.

Fitch believes PHI has adequate liquidity to withstand higher collateral postings in its competitive businesses as a result of lower energy prices and a stress case of a downgrade in the unsecured credit rating of PHI. As of June 30, the amount of cash plus borrowing capacity under PHI's primary credit facilities available to meet future liquidity needs of the competitive energy businesses totaled $915 million and the consolidated credit availability for the PHI group was approximately $1.5 billion. In assessing corporate liquidity, Fitch assumed that the company will be successful in extending its $400 million unsecured credit facility, which expires on Nov. 6. Fitch further notes that PHI is conducting a strategic review of its retail electric and natural gas supply business at Pepco Energy Services (PES). In the event of a sale, collateral and working capital will be returned to PHI. If the sale is unsuccessful, PHI will continue to wind down the business; approximately 80 percent of the book and collateral rolls off by the end of 2010.

Affirmation of the ratings of PHI's regulated utility subsidiaries reflects the expectation of improvement in their credit measures with roughly 80 percent of electric and gas sales decoupled from actual usage by the end of 2010, the increasing proportion of transmission earnings in the overall business mix and declining pension contributions in 2010 and beyond. In 1H'09, the performance of the utility subsidiaries was affected by lower demand due to mild weather and the effect of economic slowdown as well as by higher operating costs including higher pension expense. Further, cash flow from operations in 1H'09 was reduced by $220 million due to discretionary tax-deductible pension contributions from PHI, PEPCO, ACE and DPL. Fitch's Stable Outlook assumes that the regulators in Maryland and other jurisdictions will provide reasonable and timely recovery of costs incurred by PHI's utility subsidiaries, including pension costs.

Potential causes for negative rating actions include:

--Additional collateral requirements at PHI's competitive businesses due to further deterioration in wholesale power prices;

--Inability of the utility subsidiaries to recover their costs including pension expense on a timely basis;

--Large cash liability as a result of an adverse resolution in the cross-border lease matters with the IRS.

Potential causes for stabilization or positive rating actions include:

--Recovery in wholesale power prices;

--Reduction of collateral and external funding requirements.

PHI, through its regulated utility subsidiaries, plans to make $5 billion of capital investments over 2009-13 to maintain and expand its transmission and distribution system in coming years. Of this amount, roughly 40 percent is for transmission investments, which includes a $1.2 billion 230-mile 500-kilovolt (kv) transmission line in the PJM region that runs from Possum Point, VA to Indian River, DE to be constructed over the 2009-2014 time period. Fitch views such transmission investments favorably because of the higher potential returns and explicit capital cost recovery mechanisms that are in place. Fitch expects that PHI will fund the project with a balanced mix of debt and equity to support credit quality.

PHI remains involved in a tax dispute with the Internal Revenue Service (IRS) that may affect future cash flow. The IRS has challenged the tax benefits PHI claimed from Potomac Capital Investment's (PCI) portfolio of cross-border energy leases. PHI claimed approximately $488 million in tax benefits from these leases over the 2001-June 30, period. If the IRS ultimately prevails in this dispute, PHI would be subject to additional taxes, interest and possibly penalties. PHI may also eventually have to write down the value of the leases. However, this dispute could remain unresolved for an extended period and PHI's financial liquidity and access to capital are adequate to meet such a contingency.

Fitch affirms the following ratings:

PEPCO Holdings, Inc.

--Long-term IDR at 'BBB';

--Short-term IDR at 'F2';

--Senior unsecured debt at 'BBB';

--Commercial paper at 'F2';

--Rating Outlook Negative.

Potomac Electric Power Co.

--Long-term IDR at 'BBB+';

--Short-term IDR at 'F2';

--Secured debt at 'A';

--Senior unsecured debt at 'A-';

--Preferred stock at 'BBB+';

--Commercial paper at 'F2';

--Rating Outlook Stable.

Delmarva Power and Light Co.

--Long-term IDR at 'BBB+';

--Short-term IDR at 'F2';

--Secured debt at 'A';

--Senior unsecured debt at 'A-';

--Preferred stock at 'BBB+';

--Commercial paper at 'F2';

--Rating Outlook Stable.

Atlantic City Electric Co.

--Long-term IDR at 'BBB';

--Short-term IDR at 'F2';

--Secured debt at 'A-';

--Senior unsecured debt at 'BBB+';

--Preferred stock at 'BBB';

--Commercial paper at 'F2';

--Rating Outlook Stable.

The following ratings are being withdrawn:

Potomac Capital Investment Corp.

--Long-term IDR 'BBB'

--Senior unsecured debt 'BBB'

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, 'fitchratings.com'.

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