OREANDA-NEWS. Fitch Ratings affirms its 'AA+' rating on the following bonds issued by the Rancho California Water District Financing Authority, CA on behalf of the Rancho California Water District (RCWD):

--\$296.2 million, series 2002A, 2005C, 2008A, 2010A, and 2011A at 'AA+';
--\$44.6 million series 2008B (variable rate) underlying long-term rating and bank bond rating of 'AA+'.

The Rating Outlook is Stable.

SECURITY

The bonds are issued by the Rancho California Water District Financing Authority and payable from installment payments made by the RCWD from its system net revenues, including ad valorem taxes and assessments. The district's obligation to make installment payments is absolute and unconditional as governed by the installment purchase agreement between RCWD and the financing authority. The series 2010A and 2011A bonds do not have debt service reserve funds.

KEY RATING DRIVERS

IMPORTED WATER SUPPLY DEPENDENCE: The district is dependent on an imported water supply, as is much of the region, which is subject to availability challenges and cost pressure. The imported water purchase arrangement is flexible in that there are no minimum amounts the district must purchase each year.

FIXED REVENUE STRUCTURE: The district relies on significant revenues from property taxes and property assessments, collected by the Riverside County tax collector. In addition, the district's overall rate structure is weighted toward fixed charges that provide a high degree of revenue stability but can be outpaced by expenditure variability.

EXPENDITURE VARIABILITY: Local water supplies account for around 40% of supply at a stable cost. Imported water purchases provide the balance of supply. Imported water costs have increased significantly in recent years and pushed expenditures higher in the last two years to meet increased water demand.

DECLINE IN FINANCIAL MARGINS: Debt service coverage levels declined in recent years as a result of imported water supply costs. However, the rating reflects management's intent to improve coverage levels and return to over 2x coverage by fiscal 2017.

EXCEPTIONALLY STRONG RESEREVES: The district's liquidity position remains very strong, which helps to mitigate this period of lower financial margins. Liquidity levels including the board designated funds totaled 1,131 days operating cash. Reserves declined in fiscal 2015 to fund a property acquisition surrounding Vail Lake but will continue to remain strong.

RATING SENSITIVITIES

CHANGE TO FINANCIAL RECOVERY: Fitch expects that the current financial margin weakness is temporary. Debt service coverage should improve in fiscal 2017 as a result of a scheduled decrease in debt service, even with the district's continued expenditure variability. Any dilution of the expected recovery could result in rating pressure.

CREDIT PROFILE

RCWD has experienced a historical period of economic weakness combined with fluctuating weather conditions in the state, as is the case with many California utilities. These conditions led to a weakening of the district's financial profile despite rate increases implemented to date. Higher water sales than projected in the past two years, following substantial increases in imported water supply costs, have resulted in lower net margins.

The district provides water and wastewater services to a population of approximately 145,000 in southwest Riverside County, California. The service area encompasses nearly 100,000 acres and includes the city of Temecula, a portion of the city of Murrieta, and unincorporated areas of Riverside County. RCWD provides water service to the Rancho Division and the Santa Rosa Division. Wastewater collection and treatment services are provided to the smaller Santa Rosa division through a small 5 million gallon per day (MGD) treatment plant.

VARIABLE WATER SALES ARE RISK TO FINANCIAL MARGINS

Water sales have fluctuated considerably over the past decade ranging from a low of 62,477 acre-feet (af) in 2010 to 87,639 af in 2008. The variable sales resulted from drought conditions, mandated reductions from Metropolitan Water District (MWD), economic cycles, and investments in conservation and efficiency. Following sizable declines from 2008-2011, water sales have trended upward in the last three years to 75,746 af in fiscal 2014 (as compared to budgeted water sales of 64,005 af). The result of the higher sales is a need to purchase the additional water supply from MWD.

The district's financial forecast continues to assume water sales at lower levels around 65,000 af. As the California drought enters its fourth year, a statewide conservation campaign as well as steps taken by the district have resulted in conservation by customers. If the drought continues in this level of severity, further mandatory allocation steps could occur in fiscal 2016.

EXPOSURE TO MWD COSTS

Much of the district's water supply is provided by the MWD, the regional wholesale provider of imported water to communities that do not have sufficient local water resources, such as the district. The district purchases MWD water through contracts with Eastern Municipal Water District and Western Municipal Water District that serve the two geographic water service areas of RCWD. In typical years, treated water purchased from MWD provides around 40% of the district's water supply while another 15%-20% is untreated water purchased from MWD that is recharged into the local water basin and extracted from the aquifer for later use. The purchase contracts for imported water do not require a minimum amount or a fixed payment, so RCWD is able to reduce or increase its purchases in response to customer water demand.

FIXED REVENUE STRUCTURE

The district's revenue structure is heavily weighted toward fixed-rate base charges in the water rates and property taxes and assessments. The result is that fluctuations in water demand have had a more muted impact on its revenues but, conversely, as water sales increase, the district's expenditures increase without an accompanying increase in revenues of a similar magnitude.

Approximately 40% of the district's revenues are provided by tax receipts and property assessments. The district receives a share of the county's 1% property tax revenues and levies its own property assessments on land value within the district. These revenues are susceptible to assessed value declines, which occurred in fiscal 2010 and fiscal 2011. The district's property assessments existed prior to 1996 and are grandfathered under California's Proposition 218 amendments regarding voter authorization of such charges. The district does not participate in the county's Teeter plan, taking the full risk and reward of collections, which it has found to be beneficial.

DECLINING FINANCIAL METRICS; STRONG LIQUIDITY

Fitch-calculated debt service coverage (DSC) had historically been strong at above 2x through fiscal 2010. In the past four years, DSC narrowed with increasing debt service from new debt and increasing imported water costs. As a result of these trends, DSC fell to 1.6x in fiscal 2013 and 1.3x in fiscal 2014. Management's financial forecast projects that DSC will improve to between 1.5x-1.7x in the next two years and then to over 2x in fiscal 2017, when scheduled debt service payments decline. However, if water sales are experienced above the low projected levels, actual DSC will be lower.

Liquidity is healthy with \$50.1 million in unrestricted reserves, or 244 days operating cash at the end of fiscal 2014. However, the district had another \$182.6 million in board-designated reserves at the end of fiscal 2014 collected through capacity fees and property assessments. The funds can be legally used for any purpose at the board's discretion. For example, in fiscal 2015, the district used approximately \$50 million in reserves to purchase land surrounding Vail Lake.

Debt levels are high at \$5,648 per customer (based on the combined system), compared with Fitch's median for the 'AA' rating category of \$1,934 per customer. This should decline slightly over time given the limited projected additional debt in the next five years (\$41 million of \$223 million capital improvement plan). However, the district's existing debt has a relatively slow amortization with only 28% of debt maturing in the next 10 years.