Fitch Ratings affirms its 'A-' rating on the following bonds issued by the Pend Oreille Public Utility District No. 1 (Pend Oreille or the district):

--$19.4 million electric system revenue bonds, series 2005B and 2010;

--$132.2 million Box Canyon Production System revenue bonds, series 2009A, 2009B, 2010 and 2012.

The Rating Outlook is revised to Negative from Stable.

SECURITY

The Box Canyon Production System bonds are secured by a lien on the revenues of the project. The electric system is obligated to purchase all available power from the project, and pay for all system costs including debt service regardless of system availability.

The electric system revenue bonds are secured by the net revenues of the electric system.

KEY RATING DRIVERS

LOSS OF MAJOR CUSTOMER: The Outlook revision to Negative reflects the district's announced termination of its power sales contract with the Ponderay Newsprint Company (PNC), a large industrial customer that accounted for approximately 74% and 67% of retail energy sales and operating revenues, respectively. While PNC continues to operate and pay its bills, the district expects PNC to cease operating at some point over the near term. The loss could pressure financial margins as the district attempts to reduce its excess power supply.

SALE OF EXCESS POWER SUPPLY: The current rating reflects Fitch's expectation that any excess power supply following the loss of PNC could be sold on a short-term basis or under long-term wholesale agreements, limiting the financial strain. Current power purchases from Bonneville Power Administration (Bonneville) would be reduced to zero following a transition period. Retail load requirements, excluding PNC, would be met by the district's share of the Boundary Hydroelectric Project.

RATE INCREASES EXPECTED: Meaningful rate increases may be necessary to stabilize margins over the long term. The district's low retail rates provide considerable flexibility. However, coping with the economic implications of the mill shutdown in its service area and recovering lost margins from the remaining small retail customer base could present challenges.

LOW-COST RESOURCES: The district's generation resources are a credit positive with blended power costs at a competitive $25.82/MWh in 2014, driven by Boundary's $5/MWh production cost. The relatively low cost of power has helped the district maintain competitive rates historically and should allow the district to sell excess generation through long-term power sales contracts.

LIQUIDITY OFFSETS SOME RISK: The district's healthy liquidity position of $23.2 million or 252 days cash on hand will initially help offset financial disruptions from the loss of PNC. An additional $10 million in collateral held by the district against the termination of the power sales contract with PNC is also available.

HIGH DEBT LEVELS: The district's significant capital program has begun to wind down, although debt levels are projected to remain high for the rating category with debt to retail customers at $17,767 in 2014.

DECLINING DEBT SERVICE COVERAGE: Rising debt service, modestly lower revenue, and gradually increasing costs have reduced the district's coverage of full obligations to 1.19 times (x) in 2014 from 1.45x in 2011. Increased debt service costs through 2017 and the loss of the modest margin on PNC sales are likely to pressure coverage levels further over the near term.

RATING SENSITIVITIES

MANAGING LARGE CUSTOMER LOSS: Pend Oreille Public Utility District's (the district) inability to offset the loss of its largest industrial customer by reducing excess power supply and implementing retail rate increases, as needed, to preserve financial metrics and an operating profile consistent with an 'A-' rating would lead to a downgrade.

CREDIT PROFILE

SALES AGREEMENT TERMINATED WITH LARGEST CUSTOMER

On Jan. 4, 2016, the district announced that it had terminated its power sales contract with its largest customer, PNC. The district has stated that the termination event was driven by PNC's recent submission of its power schedule, which showed a sharp reduction in operations in violation of the power sales agreement. District management expects the newsprint mill operated by PNC will likely cease operations at some point in the near term. At this point, the mill remains open and operating and PNC continues to pay its bills in a timely manner.

IMPACT FROM PNC LOSS

The loss of PNC as a district customer would have several potential impacts that could reduce the district's credit quality. The district would be in a long power position, as the majority of its retail load, excluding PNC, can be served by the district's 48 MW share of Boundary. Management has stated that it expects to sell power in excess to the district's retail needs, which would include a significant portion of Box Canyon, through long-term contracts to reduce the district's exposure to variable pricing in the short-term market. Power purchases from Bonneville would be reduced to zero following a short transition period, as permitted by the Bonneville contract.

The district is expected to be pressured financially by these changes. Already thin debt service coverage levels are expected to narrow with the loss of the modest margin on PNC sales and the potential long-term contracting of Box Canyon, which has a modestly increasing cost of production that is already higher than recent spot market prices in the region. However, the very low cost Boundary resource provides the district with some flexibility by keeping the total blended cost of energy production competitive at $25.82 per MWh in 2014.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Public Power Rating Criteria (pub. 18 May 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=864007

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=997882

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=997882

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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