Fitch Affirms Hampton Roads Sanitation District, VA Wastewater Revs at 'AA ' & Sub Revs at 'AA/F1 '
--\\$504 million in outstanding wastewater revenue bonds at 'AA+';
--\\$4 million in outstanding subordinate wastewater revenue bonds, series 2012 at 'AA';
--\\$25 million in outstanding subordinate wastewater revenue bonds, series 2011 at 'AA'/'F1+'.
The Rating Outlook is Stable.
The senior bonds are payable from a senior lien pledge of net revenues of the district. Subordinate lien bonds are payable from a subordinate lien pledge.
KEY RATING DRIVERS
LARGE REGIONAL SERVICE PROVIDER: The district provides sewer treatment and disposal services to Virginia's Hampton Roads region to 462,000 direct retail accounts. The service territory encompasses 670 square miles and includes nine cities, eight counties and several large military installations with an estimated population of 1.7 million.
MIXED FINANCIAL PERFORMANCE: Financial performance remains solid with adequate all-in debt service coverage (DSC) and ample liquidity, despite reduced net margins in recent years as rate increases have not kept pace with increased debt costs. All-in debt service coverage is expected to improve in the near term with anticipated rate increases although planned additional subordinate lien debt issuance may pressure future margins.
LARGE, REGULATORY CAPITAL PROGRAM: Capital needs over the next five years are large but manageable. Substantial long-term mandated spending for regional sanitary sewer overflow (SSO) mitigation projects is expected to lead to much higher leverage over the long term and annual rate increases to support the expected 50% pay-go funding component and increasing debt service costs.
AFFORDABLE RATES, INCREASES EXPECTED: Rates remain affordable despite sizable increases over the past several years. Consistent annual rate increases going forward will be necessary to service planned debt.
FAVORABLE INTERNAL LIQUIDITY: The 'F1+' short-term rating on the series 2011 bonds reflects the district's strong overall credit fundamentals and its ability to cover the maximum potential liquidity demands by at least 1.25x from internal resources, including cash and highly liquid, highly rated investments.
CHANGE IN FINANCIAL PROFILE: A return to stronger financial performance is expected over the next two years with continued rate increases and expenditure controls. Consistently healthy debt service coverage and liquidity will be key to preserving the rating given the expected pressure to the district's debt profile from the sanitary sewer overflow (SSO) program in the outer years.
SIGNIFICANT RISE IN CAPITAL COSTS: Escalation of current SSO cost estimates and or compression or acceleration of the SSO program costs could result in negative credit pressure.
LARGE REGIONAL PROVIDER, SOLID OPERATING FUNDAMENTALS
The district is the region's wastewater interception, treatment and disposal provider. Local collection utilities operate within the service area and provide wastewater collection services that are then transferred to the district. The district bills retail customers directly for its services and, in some areas, bills on behalf of the local collection utility as well. The customer base is mostly residential and there are no concentration concerns. The Hampton Roads region is almost entirely developed with growth expected to be limited.
The sewer system consists of nine major treatment plants and several smaller treatment facilities located throughout the service area. Total average daily flows consistently approximate 60% of total capacity, leaving plenty of treatment capacity for the long term.
REGULATORY DRIVEN CAPITAL TO MEET EPA CONSENT ORDER
The district has a large, 10-year \\$1.45 billion capital improvement program (CIP). The majority (66%) of the spending focus on regulatory requirements associated with nutrient reduction standards and SSOs as required by a consent order with the Environmental Protection Agency (EPA). The district has assumed the role of ensuring regional compliance in the consent order, which requires the district to fund capital improvements that will be owned by the local collection utilities and private property owners. Local improvements account for 32% of the \\$1.45 billion, which cannot be debt financed and will be funded from the district's robust 56% share of capital funding from ongoing revenues, reserves and grants. The local improvements will not appear on the district's balance sheet.
Longer-term capital spending (beyond the current 10-year plan) is also significant with SSO mitigation projects accelerating in size and in scope. From 2025-2034, management anticipates capital needs will total an additional \\$2.8 billion (for a total 20-year CIP of around \\$4 billion), roughly half of which will be funded with new debt, raising concerns over the district's ability to manage its future long term fixed cost obligations.
MANAGEABLE DEBT PROJECTED TO RISE
A nearly five-fold increase in debt since fiscal 2007 has led to a large but still manageable debt burden. As of fiscal 2014, outstanding debt totaled approximately \\$740 million and constituted a somewhat elevated 76% of net capital assets. Carrying costs were more manageable, equating to \\$1,659 debt per customer, below Fitch's 'AA' category median of \\$1,934, and annual debt service debt comprised 28% of gross revenues as compared to Fitch's 'AA' category median of 23%. Amortization of existing debt is a somewhat slow 35% over the next 10 years and 75% retired over 20 years.
While the district's debt burden is projected to rise, it is expected to increase only modestly over the next five years with key debt metrics remaining close to the medians for similarly-rated systems. In total, the district anticipates issuing \\$2 billion in new debt through 2034, with the majority of future issuances occurring over the last 10 years (2025-2034) and expected to funded on the subordinate lien.
In October 2015 the district plans to establish a \\$90 million maximum letter of credit (LOC) to provide short-term liquidity during construction. The borrowing will periodically be taken out by permanent long-term debt. The district plans to draw \\$57 million of this total through early calendar year 2016. Current permanent financings are expected to occur in fiscal years 2018 and 2021 for approximately \\$120 million each.
In February 2016, the district plans to issue \\$25 million additional variable rate demand bonds (VRDBs) supported by the district's internal liquidity. Based on the district's current total return pool of liquid assets, available liquidity will cover the proposed \\$25 million and the existing \\$25 million, series 2011 VRDBs by a healthy 2.3x.
PROPOSED SUBORDINATE LIEN AMENDMENTS
The district plans to amend its 2011 subordinate lien master trust agreement in connection with the anticipated 2016 issuance of VRDBs. The proposed amendments to the trust agreement will redefine operating expenses to exclude cash expended for local utility improvements, among other amendments to modernize the trust language. Proposed trust amendments will also increase the minimum all-in rate covenant and additional bonds test requirement to 1.2x from 1.0x.
Fitch views the proposed revision to the definition of operating expenses in the subordinate lien trust agreement as credit neutral. While the amendment will allow for a more lenient interpretation of net revenues by the subordinate lien trust agreement, the change adjusts the consideration of cash funded capital outlays below the line, which is typical. The district's audit will still reflect GAAP-based accounting, and Fitch will continue to monitor both the legal and the cash flow (from audited financial statements) coverage calculations. The senior trust agreement is not expected to be amended.
FINANCIAL PERMORANCE STILL SOLID, LIQUIDITY A CREDIT POSITIVE
Overall financial performance remains solid despite a weakening of several key financial metrics over the past six years, including DSC and free cash to depreciation. DSC has declined from very high levels in fiscal 2007 (more than 7.0x on the senior bonds and 3.0x all-in) as a result of rising debt service costs, although the district implemented regular rate increases in anticipation of the higher debt service. The district ended fiscal 2014 with \\$81.7 million in net revenues available for debt service, providing 1.7x coverage of senior lien bonds and 1.3x coverage of all debt service. The rate increases also enhanced the district's liquidity, which more than doubled from fiscal 2008-2014.
While not expected, a trend of low DSC margins at the levels experienced in fiscal 2014 would be viewed negatively, especially if accompanied by a significant drop in liquidity. Unaudited fiscal 2015 results show improved revenues and increased expenses but slightly lower ADS yielding continued 1.7x senior and 1.3x all-in DSC. Updated pro forma financials provided by the district show DSC coverage improving in fiscals 2016 and 2017 as additional proposed annual rate increases outpace new debt issuance.
Unrestricted cash and available investments, inclusive of renewal and replacement fund balances, totaled roughly \\$153 million in fiscal 2014, or the equivalent of a strong 390 days cash on hand (DCOH). Unaudited fiscal 2015 cash totaled about \\$205 million, or over 460 DCOH.
INDEPENDENT RATE-SETTING, LONGER-TERM AFFORDABILITY CONCERNS
The district maintains sole rate-setting authority on charges relating to the provision of wastewater interception and treatment services. Billed service charges are higher when including monthly charges for sewer collection provided by each of the local municipal utility systems, but appear manageable overall.
The district's user charges are expected to rise roughly 80% over the next 10 years based on the district's long-range forecast which points to 6%-10% adjustments annually. Despite rate escalation concerns, Fitch views favorably the district's approach to implementing annual rate increases over time, thereby keeping pace with cost recovery.