Fitch Rates Eastern Municipal Water District, CA's Subordinate Revs 'AA+'; Upgrades Sr Bds to 'AAA'
--Approximately $131 million subordinate lien water and sewer revenue bonds series 2016B to be issued by the Eastern Municipal Water District Financing Authority (authority).
The bonds are scheduled to sell via negotiation on or about Aug. 24, 2016. The proceeds will be used to refund the district's outstanding 2008H revenue certificates of participation (COPs) for debt service savings and to pay cost of issuance.
In addition, Fitch takes the following rating actions on debt issued by the district and authority:
--$233.9 million senior water and sewer revenue bonds, COPs and associated bank bonds upgraded to 'AAA' from 'AA+';
--$104.6 million senior water and sewer revenue bonds, series 2012A and 2013A (SIFMA bonds) long-term rating upgraded to 'AAA' from 'AA+', short-term rating affirmed at 'F1+';
--$477.7 million subordinate water and sewer revenue bonds and associated bank bonds upgraded to 'AA+' from 'AA';
--$34.5 million Western Riverside Water and Wastewater Financing Authority revenue bonds (Eastern Municipal Water District improvement district general obligation (GO) bond financing) upgraded to 'AA+' from 'AA'.
The Rating Outlook is Stable.
The outstanding senior revenue bonds and COPs are payable from a first lien on net water and sewer revenues, including rate stabilization fund transfers and connection fee revenues. The subordinate bonds are payable from a second lien on net revenues.
The GO bonds are payable from net system revenues after payment of all revenue bonds (senior and subordinate lien) and COPs, from available reserves and from ad valorem property taxes.
KEY RATING DRIVERS
FINANCIAL PERFORMANCE REMAINS HEALTHY: The utility's financial performance remains healthy despite an extreme multi-year California drought. All-in debt service coverage (DSC) jumped to a very strong 2.3x in fiscal 2015. Liquidity remains very healthy with 513 days cash on hand on June 30, 2015.
DIVERSE, STABLE REVENUES: Operating revenues have held up well in the face of variable demand for water due to disciplined rate increases, the district's allocation based rate structure, and very stable sewer and property tax revenues. The utility remains reliant on economically sensitive connection fee revenues, but overall financial performance has remained strong even during downturns in new home construction.
STRONG MANAGEMENT PRACTICES: Management practices include detailed, multi-year water supply, capital and financial planning processes. Budgeting is generally conservative with actual results regularly exceeding projections and corrective action taken quickly to restore performance during periods of revenue weakness. Elected officials have shown strong rate discipline.
SOLID SUBURBAN SERVICE AREA: The district provides essential water and sewer services to a large and diverse service area in western Riverside County. The region has emerged from a deep cyclical downturn due to the collapse of the local housing market and remains fundamentally sound.
SIGNIFICANT DEBT BURDEN: Debt levels are above average and expected to remain somewhat elevated near current levels with slow amortization and about $110 million of additional borrowing planned over the next five years.
CHANGE IN FINANCIAL STRATEGY: Management has developed a credible plan to improve financial margins from recurring revenues and to reduce reliance on debt funding over the next five years. The ratings could come under downward pressure if the district fails to achieve expected improvements in all-in debt service coverage (DSC) and/or fails to increase pay-go funding of capital spending as planned.
INCREASED LEVERAGE AT SENIOR LIEN: The senior lien revenue bond ratings assume the district limits leverage at the senior lien level, continuing to provide very strong excess coverage margins for senior lien bondholders. A significant increase in senior lien leverage could put downward pressure on the senior rating.
Eastern Municipal Water District provides water service and sewer service to 785,000 people, or about a third of Riverside County's population, through retail and wholesale accounts. The service area covers 550 square miles and includes the cities of Temecula, Murrieta, Moreno Valley, Hemet, San Jacinto and Perris, as well as unincorporated areas. The formerly agricultural region suburbanized rapidly in recent decades and is close to both Orange and San Diego Counties.
SOLID FINANCIAL PERFORMANCE
The utility performed well in very difficult operating environments in recent years, including periods of surging imported water costs, extreme drought and very weak connection fee revenues. Fitch calculated all-in DSC, which includes the district's general obligation bond revenues and debt service, was solid at 1.8x in fiscal 2014 and 2.3x in fiscal 2015. Unaudited results for fiscal 2016 show all-in DSC jumping to a very strong 2.8x.
Free cash to depreciation, a key measure of the utility's ability to maintain its existing assets from revenues, averaged a modest 45% over the five year period but has been increasing gradually. The measure rose to 56% in fiscal 2015 and is expected to continue to rise over the next several years.
The senior lien bonds are rated a notch above the subordinate working lien debt due to the additional bondholder protection provided by priority of payment and higher debt service coverage. Senior lien DSC was strong at 2.1x in fiscal 2014 and rose to 2.5x in fiscal 2015. Unaudited results for fiscal 2016 show senior DSC jumping to 4.3x.
The utility's revenues are diverse but somewhat volatile. Connection fees have traditionally been the main source of revenue volatility for the utility and are currently on the upswing. Connection fees have averaged $29.2 million over the past two years (roughly 10% of total system revenues), about three times the level seen at their recent low in fiscal 2011. Non-connection fee revenues are diverse and stable, with sewer charges, fixed water meter charges and stable property taxes providing more than half of revenues. Coverage excluding connection fees rose from a narrow 1.2x in fiscal 2014 to a solid 1.6x in fiscal 2015. Fitch expects coverage excluding connection fees to trend higher over the next five years as the utility ramps up pay-go funding of capital.
While connection fees are volatile they have remained a significant source of revenues even in downturns, and Fitch does not expect them to decline to zero in a typical economic downturn. During the Great Recession, a particularly severe downturn, the pace of home construction decreased sharply in fast-growing Riverside County, but the district continued to see an average of 3,400 new connections a year during the period of relative weakness from 2009 to 2012. The number of new connections rose to 6,710 in fiscal 2016.
The utility's very strong financial reserves mitigate concerns about revenue volatility in the near term. Unrestricted cash and investments equaled $180.9 million, or 346 days of operating expenses, at the end of fiscal 2015. The district has an additional $87.2 million of construction and other somewhat flexible reserves that are restricted on its balance sheet but available for appropriation for debt service or operations at the district board's discretion.
IMPROVED FINANCIAL PERFORMANCE IN FORECAST
The district's financial forecast shows a positive financial trend. Fitch-calculated all-in DSC is projected to average a strong 2.4x over the next five fiscal years if results meet the forecast with coverage increasing annually, while senior coverage would jump to an average of 11.8x across the period reflecting refinancing of debt to the subordinate lien and underlying improvements in financial performance. The current transaction will refund about $131 million of debt into the working lien. The district will have about $198.4 million of senior lien debt outstanding and $723 million of debt outstanding in the subordinate working lien after the current transaction.
Recent gains in financial performance are driven by rate adjustments to fund increased pay-go funding of capital investments and by increasing connection fee revenues. The forecast appears reasonable, but gains in connection fees are dependent on broader macroeconomic conditions. The issuer projects connection fee increases based both on higher rates and rising connections due to increasing development and housing permit activity in the area.
While the assumptions underlying this forecast appear plausible, connection fee revenues remain the main downside risk to the forecast. All-in DSC excluding connection fees is forecast to average a healthy 1.5x across the forecast horizon. At Great Recession connection fee levels, all-in DSC would average about 1.9x, suggesting that strong performance should continue even in the event of an economic downturn.
DROUGHT CONSERVATION MANDATE
The California State Water Board ordered the district to reduce water production by 20% to 28% in recent years due to an extreme California drought. While drought conditions continue, recent regulatory changes have eased conservation requirements. The district demonstrated to regulators that it could meet full customer demands even if the drought continues for another three years, freeing the district from the state's mandatory conservation requirements. The district is currently asking ratepayers to maintain conservation efforts to keep usage 10% below 2013 levels.
The district's financial performance held up very well during the period of mandatory conservation because its allocation-based rate structure increased the average cost of water as drought measures pushed sales volumes down. When the district needs to conserve water, policymakers declare a higher drought stage, which reduces the amount of water allocated to residents at low rates for indoor and efficient outdoor use. The rate structure stabilizes revenues by pushing usage into more expensive tiers, increasing the average price of water sold. The district also benefits from reductions in purchases of expensive imported water as demand declines and the district can meet a greater proportion of needs from local supplies. About 30% of operating costs (excluding depreciation) went to water purchases in fiscal 2015.
STRONG MANAGEMENT PRACTICES, SIGNIFICANT SUPPLY INVESTMENTS
The district's management practices are particularly strong with a long track record of delivering better than forecast financial results, investing to increase the reliability of supplies and raising rates as needed to maintain financial performance. For example, the district began investing in water recycling long before most California water agencies and now produces a very significant 33% of supplies from relatively drought-proof, highly treated wastewater. The district also produces about 16% of supplies from local groundwater, including an increasing amount of desalinated brackish ground water. The investments position the utility better than other Southern California water importers in drought periods. Eastern imports about half of its water from the Metropolitan Water District of Southern California (revenue bonds rated 'AA+'/Outlook Stable), down from about 60% in 2002.
SOLID RATE DISCIPLINE
The district's elected board has raised rates as needed to maintain healthy financial performance. The board raised water rates an average of 4.8% annually over the five years through fiscal 2016 and sewer rates by 5.3%. Combined water and sewer rates are currently affordable at just 1.6% of Riverside County's median household income for 10 hundred cubic feet (HCF; about 7,500 gallons) of water. Actual water usage is significantly higher in this arid, suburban service area, suggesting somewhat less rate flexibility than Fitch's affordability measure suggests. But even with average use of 18 HCF of water per month, combined bills remain moderate. Rates also compare favorably to other local jurisdictions.
SIGNIFICANT DEBT BURDEN
The district's debt burden is somewhat above average. The district's $1 billion debt burden at the end of fiscal 2015 was about 131% of the median for 'AA' category water and sewer utilities at $2,690 per customer. Fitch expects debt to remain fairly steady as the district issues about $110 million of additional debt to fund its $398 million fiscal 2017 to fiscal 2021 capital improvement plan (CIP) and amortizes a similar amount of debt. Amortization is slow with about 60% of bonds repaid in 20 years versus an 'AA' median of 84%.
The utility's physical plant appears well maintained. The district has invested heavily in maintaining and expanding its infrastructure with capital expenditures to depreciation averaging 157% over the past five years. Unaccounted water loss has averaged a moderate 6% over the past five years. Financial average age of plant is below average at 11 years.
The district's debt portfolio is more complex than the typical municipal water and sewer utility with $350.7 million, or 34.4% of the district's outstanding debt, as short-term and variable rate debt. About $94.7 million of the debt is hedged with interest rate swaps, lowering the percentage of unhedged variable rate exposure to 25.1%. Management has taken prudent measures to reduce counterparty risk by replacing some variable rate demand obligations with SIFMA index notes with staggered rollover dates and diversifying liquidity providers, while maintaining strong reserves as an asset to hedge variable rate exposure. Fitch expects variable rate exposure to slowly decrease as a percentage of the debt portfolio as the district plans to utilize significant amounts of fixed-rate state revolving fund loans to fund capital over the next few years.
RELATIONSHIPS AMONG RATINGS
The subordinate lien revenue bond rating reflects Fitch's opinion of the general creditworthiness of the district based on fully consolidate financials and is driven by all-in debt service coverage (in addition to other criteria factors that affect all liens).
The senior revenue bonds are rated a notch higher than the subordinate bonds due to their higher priority of payment from net revenues and strong excess coverage margin. The district has been gradually shifting outstanding debt into the subordinate working lien over time, improving margins for senior bondholders.
The GO bonds are payable from an unlimited ad valorem property tax levied against a number of small, concentrated improvement districts. They are rated based on the district's covenant to pay debt service from available reserves or net revenues after payment of revenue bond and state loan debt service, which is the stronger of the two pledges.
The 'F1+' short-term rating on the SIFMA index bonds reflects Fitch's expectation that the highly-rated district will maintain the market access necessary to remarket the debt as necessary. The short-term ratings are mapped to the senior bond ratings as described in Fitch's short-term rating criteria ('Rating US Public Finance Short-Term Debt'). The bank bond ratings are equal the related underlying long-term ratings, which consider the risk of penalty interest rates and term-out provisions, among other factors.