Fitch Rates Citizens Energy Group, IN Water System First Lien Revs 'A'; Outlook Stable
--$220.1 million water system first lien refunding revenue bonds, series 2016B.
The bonds are expected to sell via negotiation during the week of Oct. 10. Bond proceeds will be used to current and advance refund all or portions of outstanding series 2011B, 2011C, 2011E and 2011F bonds for interest savings, and pay issuance costs. The savings will be taken annually and maturities are expected to match the bonds to be refunded.
The Rating Outlook is Stable.
The bonds are secured by and payable from a senior lien on the net revenues of CEG's water system.
KEY RATING DRIVERS
SOLID REGULATORY (RATE) ENVIRONMENT: Regulatory oversight over rate-setting has historically presented uncertainty to CEG's financial profile. However, CEG's solid history of obtaining rate case approvals and recently passed legislation provides more timely and consistent rate recovery than was possible previously.
STABLE FINANCES TO IMPROVE: The system's all-in annual debt service (ADS) coverage is satisfactory but remains well below Fitch's median for water utilities rated in the 'A' category. However, Fitch expects the most recent rate case coupled with an improved rate recovery environment will likely lead to improved financial results over the next few years.
MANAGEABLE CAPITAL NEEDS: Capital plans continue to focus on system reliability and maintenance projects. Annual capital costs have been reduced using enterprise-wide asset management tools that integrate preventative maintenance and better target projects based on needs assessments.
ELEVATED DEBT LEVELS: Debt ratios are somewhat high but expected to decline with a mostly pay-as-you-go funded capital plan.
FAVORABLE SERVICE TERRITORY: The city of Indianapolis (the city) has a large and well-diversified economy. Consistent employment growth and steady gains in income levels indicate a strengthening ratepayer base.
FINANCIAL PERFORMANCE: The 'A' rating on Citizens Energy Group's bonds could be upgraded if improved rate recovery leads to stronger financial metrics and higher free cash flow for capital spending over the next several years.
The system is a largely retail provider of water service to the vast majority of the Indianapolis metropolitan statistical area (MSA). The system has approximately 317,207 customer accounts, including six wholesale customers with volume purchasing contracts. The customer base has remained stable with annual average growth of less than 1% since 2009.
SYSTEM ACQUISITION BY CEG
On Aug. 26, 2011, CEG acquired the water system from the Indianapolis (the city) Department of Waterworks, assuming all assets and certain liabilities of the system. Organized as a political subdivision of the state of Indiana, CEG is governed by a nine-member board of directors, which is appointed annually by a five-member board of trustees. CEG's board of directors is an executive department of the city and pursuant to statute has exclusive oversight and control of all public utilities acquired by the city.
CEG is responsible for the day-to-day operation, maintenance and repair of the water system including management of all utility assets (raw water supply, treatment facilities, etc.) billing and collections, capital planning and other related functions pertinent to providing utility services. CEG has been in operation for over 100 years, providing various utility services to the city and surrounding areas.
IMPROVED REGULATORY ENVIRONMENT
Regulatory oversight, particularly over rate-setting by the Indiana Utility Regulatory Commission (IURC), has historically presented uncertainty to CEG's financial profile. The IURC's oversight has hindered timely rate relief in the past, due to a prolonged, two-year period between previous petitions for a permanent rate increase and the IURC's final rate order. During this time, and prior to the acquisition by CEG, the system's ADS coverage remained below 1.0x and reserves were exhausted.
However, two significant developments have emerged since then. First, in 2013, the Indiana Legislature passed Senate Enrolled Act 560, which helps to mitigate the effects of regulatory lag by requiring that rate cases take no longer than 300 days from the original filing date. Failure by the IURC to act within the 300-day time frame will result in 50% of the rate request becoming effective immediately, subject to refund if the final order authorizes less than the 50%. In addition, the system is authorized, by law, to petition the IURC for adjustments of basic rates for certain capital costs including water system replacements and upgrades.
Secondly, in March 2016, the Indiana Legislature passed Senate Enrolled Act 383 (SEA 383), which enables regulated utilities to adjust rates to recover IURC-approved, but unearned revenue requirements that may result when, for instance, revenues are affected by weather or other factors that can lower demand. SEA 383 is essentially a revenue make-whole mechanism, providing another important offset to previous rate recovery concerns.
According to SEA 383, CEG is authorized to add a rider to each residential customer's monthly bill when previous year's collections are less than 98% of total revenue requirements for the year. Properly calculated adjustments shall be approved by the IURC, and once approval is provided, CEG is required to make annual filings for up to four years. After 48 months, a new rate case must be filed.
SOLID HISTORY of CEG RATE CASE APPROVAL
CEG has a solid track record of filing and receiving approval for periodic rate petitions. The most recent rate case for the water system was filed in mid-2015 and approved by IURC later in 2015 for implementation in 2016. CEG was granted a $27.7 million base revenue increase, which while less than the original rate request still amounted to a 16% overall rate increase. The new rates went into effect on April 22, 2016. Given management's experience effectively managing in the regulated utility space both at CEG and a local investor-owned utility and its favorable history in recent rate petition filings, Fitch is confident future rate cases will be properly managed.
FINANCIAL PERFORMANCE TO IMPROVE
System financial performance has been stable, albeit below previous expectations over the past three fiscal years. At 1.25x, all-in debt service coverage (DSC) recorded in fiscal 2014 was slightly better than the previous year's 1.19x but did not meet budgeted expectations despite an authorized $15.7 million revenue increase that year. Revenues increased in fiscal 2014 but by only $6 million.
Similar results were recorded in fiscal 2015 and, although still satisfactory (at 1.24x all-in) at the current rating level, were lower than expected. The lower actual DSC from the projections was a product of lower billings due to milder weather over the past several years.
For fiscal 2016, management projects 1.39x coverage of all debt service, a consequence of higher projected financial margins from the aforementioned rate increase. Margins are expected to improve throughout management's financial forecast with all-in DSC projected to be no less than 1.54x through fiscal 2021.
While actual results underperformed projections over the past several years, Fitch believes the projections are attainable and based on reasonable assumptions: the 2016 authorized rate revenues, which are reinforced by SEA 383; modest future rate increases; expected debt service savings related to the 2016B bonds; future debt service from new money bonds (beginning 2019); and manageable increases in operating costs.
System liquidity has been adequate, although unrestricted cash has declined over the past few years. Fiscal 2015 ended with roughly $11 million in cash and cash equivalents, which combined with a $30 million working capital line of credit from BMO Harris, brings the system's days liquidity on hand to a solid 160 days. The line of credit is scheduled to expire in 2017 but will likely be extended.
MANAGEABLE CAPITAL NEEDS; DEBT LOAD to SLOWLY DECLINE
The system's five-year capital improvement plan (CIP) through 2021 totals $236 million, and represents a decline in planned spending over prior CIPs. Management attributes the decline to comprehensive asset management and a paring down of annual spending in light of lower free cash flow relative to expectations over the past two years but especially in fiscal 2016.
The focus of the CIP continues to be on system reliability with more than two-thirds of the program dedicated to treatment plant and distribution system improvements, but also addresses water supply and storage. At approximately $149 per customer annually, Fitch considers the capital program manageable. The CIP is expected to be funded primarily on a pay-go basis with a small portion funded from existing bond proceeds and future debt.
The system's debt profile remains elevated, with debt per customer at $3,020 and debt per capita at $1,014, but has steadily declined since the system was acquired by CEG in 2011. Debt carrying costs are somewhat high but typical of a utility system with annual debt service comprising roughly 40% of annual system revenues. With CEG's plans to increase the amount of equity funding for capital projects over the next five years, the debt burden is expected to slowly decline.
Amortization of existing debt is slow with 35% of principal retired by 2025. Amortization accelerates somewhat over the following 10 years with 86% of outstanding principal maturing within 20 years.
LARGE AND DIVERSE SERVICE AREA
Fitch rates the city's general obligations bonds 'AAA' with a Stable Outlook, reflecting a well-diversified economy that serves as the economic engine for the surrounding area. The city, which serves as the state's capital and largest city, has a large retail sector as well as a significant manufacturing presence, which includes pharmaceuticals and automotive manufacturing. The city's geographic location and interstate highway network make it an ideal trade and transportation hub for the Midwest.
The city's economy also includes health services, life sciences, and other business and professional service companies. Major employers include St. Vincent Hospital and Health Service (17,398 employees), Indiana University Health (11,810), Eli Lilly and Company (10,565), Community Health Network (10,402) and WalMart (8,830).
The unemployment rate for the entire metropolitan area has dipped to 3.9% in June 2016, which is down from the 5.8% in June 2014 and lower than the unemployment rate of both the state and the nation. Income levels in the county are on the rise and approximately 11% and 18% of state and national levels, respectively.