OREANDA-NEWS. Fitch Ratings has assigned the following ratings to Hampton Roads Sanitation District, VA (HRSD, or the district) revenue bonds:

--$256 million subordinate wastewater revenue bonds, series 2016A rated 'AA';
--$50 million subordinate wastewater revenue bonds, series 2016B rated 'AA'/'F1+'.

The 2016A bonds will be sold via negotiation during the week of February 8. The 2016B bonds will also be sold via negotiation during the week of March 8.

Proceeds of series 2016A will be used to finance a portion of HRSD's capital program, refinance an outstanding line of credit, refund a portion of outstanding senior lien bonds for savings and pay issuance costs.

The 2016B bonds will be used to tender the outstanding series 2011 variable-rate demand bonds (VRDBs), provide funds for capital spending and pay issuance costs.

In addition, Fitch affirms the following ratings:

--$609 million (prior to the refunding) 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.

SECURITY

The senior bonds are payable from a first lien on the net revenues of the district's sewer system (the system) and other funds related to the operation of the district. The subordinate bonds are secured by a lien on the net revenues after payment of operating expenses and senior debt service.

KEY RATING DRIVERS

LARGE REGIONAL SERVICE PROVIDER: HRSD provides sewer treatment and disposal services within Virginia's Hampton Roads region to 465,000 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.

SOLID FINANCIAL PERFORMANCE: Financial performance remains solid with adequate all-in debt service coverage (DSC) of 1.5x in fiscal 2015 and ample liquidity, despite reduced DSC margins in recent years. Additional subordinate lien debt may pressure future margins, especially on a GAAP basis as debt service rises and capital spending on local systems ramps up over time.

LARGE, REGULATORY-DRIVEN CAPITAL PROGRAM: Capital needs over the next five years are large but manageable. Substantial long-term mandated spending for regional sanitary sewer overflow mitigation projects is expected to lead to much higher leverage over the intermediate and long term. The district anticipates issuing future bonds predominantly under the subordinate lien.

AFFORDABLE RATES, INCREASES EXPECTED: Rates remain affordable despite sizable increases over the past several years. Consistent annual rate increases going forward of 6%-9% annually are necessary to support the large capital program.

FAVORABLE INTERNAL LIQUIDITY: The 'F1+' short-term ratings on the series 2011 and 2016B bonds reflect 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.

RATING SENSITIVITIES

CHANGE IN FINANCIAL PROFILE: 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.

CREDIT PROFILE

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 contains pockets where development is expected to continue at a manageable rate.

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. All of the district's treatment facilities are operating under current Virginia Department of Environmental Quality (DEQ) operating permits.

REGULATORY-DRIVEN CAPITAL TO MEET CONSENT ORDER

The district has a large, 10-year $1.45 billion capital improvement program (CIP). The majority (66%) of the spending will focus on regulatory requirements associated with nutrient reduction standards and SSOs as required by a consent order with the U.S. 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 collection system improvements will account for about one-third of the $1.45 billion in projected capital spending, which the district does not plan to debt-finance. Instead, the district will finance the majority of this from ongoing revenues, reserves and grants. The local improvements will not appear as assets 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 roughly $2.8 billion (for a total 20-year CIP of around $4.3 billion), roughly one-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.

DEBT BURDEN PROJECTED TO RISE SUBSTANTIALLY OVER LONG TERM

As of fiscal 2015, outstanding par totaled approximately $700 million, constituting a somewhat elevated 68% of net capital assets. Debt relative to the customer base was a more manageable $1,609 per customer, below Fitch's 'AA' category median of $2,050. Debt carrying charges are also moderate at 25% of gross revenues. Amortization of existing debt is a somewhat slow 35% over the next 10 years, and 75% 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 over $300 million in additional debt from 2017-2021. Fitch projects the district's debt per customer ratio will rise to a still manageable $2,200 by 2021 assuming a slight rise in customers and amortization of existing bonds at the current rate. Debt continues to rise through the 10-year CIP and beyond with issuances expected to occur roughly every other year.

Over the next 20 years, which includes the majority of the planned spending for SSOs, the district will issue approximately $2.2 billion in new debt almost entirely at the subordinate lien level. In addition, management anticipates defeasing or refunding most of its senior lien bonds with subordinate lien debt by 2025.

The 2016B bonds will be used to tender the $25 million series 2011 VRDBs currently outstanding and provide new money for capital spending. As has been the case with the current VRDBs, the new bonds will also be 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 $50 million series 2016 VRDBs by a healthy 2.3x assuming the district's outstanding line of credit authorization is lowered to $1 million as expected after issuance of this sale. Even if the $90 million authorization were to remain outstanding, self-liquidity would still be sufficient at 1.5x.

SUBORDINATE LIEN AMENDMENTS

With the 2016 issuance, the subordinate lien master trust agreement will be amended and restated. The proposed amendments include redefining operating expenses to exclude cash expended for local utility improvements not owned by the district. The proposed amendments will also increase the minimum all-in rate covenant and additional bonds test requirement to 1.2x from 1.0x on the subordinate lien, among other proposals.

Fitch views the 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 and in Fitch's view not inconsistent with traditional operating expense items. 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 with a slight uptick in several key financial metrics in fiscal 2015, including DSC and free cash-to-depreciation. DSC declined from very high levels in fiscal 2007-2008 (more than 5x on the senior bonds and 2.2x 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 2015 with $84 million in net revenues available for debt service (GAAP basis), providing 1.9x coverage of senior lien bonds and 1.5x coverage of all debt service, beating previous estimates. These results were slightly better than fiscal 2014 results due to a combination of higher revenues and lower annual debt service.

Updated budgeted financial pro forma results provided by the district indicate results in fiscal 2016 (non-GAAP) similar to fiscal 2015 and improved performance through the forecast, especially senior lien DSC, as additional proposed annual rate increases provide the majority of the expected revenue growth.

Unrestricted cash and available investments totaled roughly $129 million in fiscal 2015, or the equivalent of a strong 309 days cash on hand (DCOH). Liquidity should improve in fiscal 2016 as debt service reserves triggered in fiscal 2014 have been released as per the legal documents. The district expects to keep the roughly $45 million in cash formerly set aside for debt service reserves in a separate account, although these funds are not legally restricted.

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.

HRSD 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%-9% 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.