OREANDA-NEWS. Fitch Ratings affirms the 'AA' rating on the following debt of San Luis Obispo, California (the city):

--$17.7 million water revenue bonds series 2006 and 2012.

The Rating Outlook is Stable.

SECURITY
The bonds are secured by net revenues of the water system after payment of operating and maintenance expenses.

KEY RATING DRIVERS
STRONG HISTORICAL FINANCIAL PERFORMANCE: Financial performance has been healthy with debt service coverage (DSC) averaging 2.2x over the three most recent fiscal years with audited results (through June 30, 2014). Liquidity also remained strong with 466 days cash on hand.

DROUGHT TO REDUCE COVERAGE: Fitch expects DSC to dip this fiscal year as the utility weathers a period of reduced sales due to aggressive conservation of water in reaction to the record-setting California drought. DSC tends to vary with weather cycles due to a largely volumetric rate structure and high fixed costs.

STRONG MANAGEMENT AND OPERATIONS: System operations are sound, led by an experienced, forward-looking management team and policymakers who have implemented disciplined rate hikes. Water resources are diverse and independent, and treatment capabilities are more than sufficient to meet projected demand.

HEALTHY CUSTOMER BASE: The utility is the monopoly provider of an essential service to the cultural and economic center of California's Central Coast region. The customer base is mostly residential, growing very gradually, and reasonably diverse.

HIGH DEBT, SIGNIFICANT INVESTMENTS: The utility's debt burden is very high at $5,529 per customer and $1,747 per capita. This concern is partially mitigated by the city's development of a diverse, reliable, and independent water supply, and moderate additional borrowing plans.

RATING SENSITIVITIES
DROUGHT PRESSURES: The rating could come under downward pressure if the current extreme drought continues to reduce sales without offsetting rate action, eroding coverage on a sustained basis.

DEBT, VOLATILITY CAP RATING: The rating is unlikely to move higher due to the very high debt burden and continued volatility in revenues and debt service coverage.

CREDIT PROFILE
The water system serves the entire city of San Luis Obispo and several users outside the city, including California Polytechnic University (Cal Poly), which enrolls roughly 15,000 students. The system serves 14,899 retail connections in a developed, stable service area. About 85% of customer accounts are residential. The top 10 customers generally provide less than 10% of revenues. Cal Poly is the largest customer, but it is a large, stable governmental employer that presents limited risk.

SOLID FINANCIAL PERFORMANCE
Financial performance has recovered to a high level after adjusting to an escalation in water supply expense due to costs for new water supplies from the Nacimiento Lake 40 miles to the north. Coverage was strong at 2.3x in fiscal 2013 and 2.8x in 2014, bolstered by significant rate increases. Strong coverage provided ample revenues for continued investment in the water system with free cash to depreciation above 100% in both years.

Coverage is expected to dip in the near term due to drought pressures and the city's plan to issue new bonds in fiscal 2017. Coverage is forecast to fall as low as 1.3x in fiscal 2016 before gradually recovering to solidly above 2x again by the end of the forecast horizon. The city's forecast appears reasonably conservative, assuming that customers beat a state target to reduce water use by 12% from 2013 levels by a significant margin and assuming a significant decline in development impact fees. However, the actual path of water usage appears quite uncertain, suggesting a meaningful, albeit temporary, decline in coverage over the next two to three years.

Liquidity remains very strong with $17.9 million of unrestricted cash and investments, or 466 days cash, on hand at the end of fiscal 2014. The utility's strong cash position provides an adequate buffer against near-term revenue shortfalls and allows a gradual approach to rate adjustments. However, a sustained period of coverage significantly below 2x could put downward pressure on the rating.

SOLID RATE DISCIPLINE AMID HIGH RATES
The city council has shown strong rate discipline, raising rates as needed to restore financial metrics, but the city's rate structure and high rates remain a challenge. The city has moved to stabilize revenues by adopting drought rates and gradually increasing its fixed meter charges to reduce its dependence on volumetric rates. However, the city's rate structure remains more highly volumetric than the typical California water utility with only about 13% of revenues provided by fixed meter fees. Expenses are largely fixed, including a large take or pay contract for Nacimiento water.

Rates have risen an average of 12.6% over the past five years (including temporary drought surcharges), pushing rates to a very high 2.5% of median household income, although Fitch's standard affordability metric is somewhat distorted by low incomes of the local student population. Still, rates appear somewhat elevated for a California water utility in dollar terms at $94.92 per month for 7,500 gallons of water. Fitch believes the utility's rate flexibility could be a challenge if further, unexpected declines in water usage require additional rate hikes.

LARGE DEBT BURDEN
The system's debt burden is well above average for rated water and sewer utilities. Total debt exceeds $100 million, including the city's share of the Nacimiento project bonds. Debt per customer is almost 3x the median for 'AA' rated water and sewer utilities. The utility plans to issue an additional $5 million of water revenue bonds over the next five years. Debt per customer is expected to remain well above average at $5,249 per customer in five years.

The current high debt levels are largely related to the Nacimiento project, which is expected to provide the utility with adequate water supplies through its full build out. The utility's supply position is a significant offsetting credit strength with adequate supply redundancy to withstand drought periods. The current period of deep water conservation is driven more by state regulatory demands than local supply concerns.

SOLID ECONOMIC BASE
San Luis Obispo is located approximately 10 miles inland of CA's central coast, approximately midway between San Francisco and L.A. The city serves as the region's economic and cultural center. The local economy is anchored by Cal Poly and includes significant governmental, public utilities, tourism, and agricultural sectors. The city also benefits from a small high tech industry supported by engineering and business departments at Cal Poly. The region has outperformed the state over many years with an annual unemployment rate below the statewide average for more than a decade. The unemployment rate has been declining from recessionary levels over the past three years and was below the state and national averages at 4.6% in October 2015.