Fitch Downgrades San Juan Water District, CA's COPs to 'AA'; Outlook Stable
OREANDA-NEWS. Fitch Ratings has downgraded the following San Juan Water District (SJWD), California debt ratings to 'AA' from 'AA+':
--$29.3 million San Juan Water District revenue certificates of participation (COPs), series 2009A;
--$13.5 million San Juan and Citrus Heights Project revenue COPs, series 2012A.
The Rating Outlook on both series of bonds remains Stable.
The San Juan Water District COPs are secured by net water revenues of the San Juan Water District.
The San Juan and Citrus Heights Project COPs are secured by payments to the San Juan Suburban Water District Financing Corp. from the San Juan Water District (on parity with its other COPs) and the Citrus Heights Water District on a joint and several basis; there are no step-up provisions between the two. Each district's payments to the Financing Corp. are secured by an absolute and unconditional pledge of their respective net water revenues.
KEY RATING DRIVERS
SUSTAINED LOWER FINANCIAL MARGINS: San Juan's financial performance has weakened in the past three fiscal years due to a sharp decline in water sales and increased expenses related to drought. While debt service coverage (DSC) remains adequate and liquidity remains strong, the sustained levels of lower coverage are not consistent with the 'AA+' rating.
DROUGHT REGULATORY PRESSURE: The state of California ordered San Juan to reduce water usage by 33% from 2013 levels in response to a statewide drought emergency. While local water supply conditions have improved in 2016 with El Nino rains and some easing in drought restrictions is expected, some degree of conservation has likely become habitual. Usage levels may remain low.
STRONG DEBT PROFILE: San Juan's direct debt burden is very low at about $800 per underlying retail customer. The district has no further borrowing plans, which will allow the debt burden to decline gradually.
HEALTHY SERVICE AREA: San Juan provides essential services to a sizeable and economically healthy suburban service area as a retail and wholesale water provider.
WEAKEST LINK APPROACH: The San Juan and Citrus Heights Project rating is based on a weakest-link analysis because the COPs are secured a joint but not several obligation of the two water districts. The rating is based on the credit quality of San Juan Water District, which is responsible for about 90% of debt service payments.
CITRUS HEIGHTS PERFORMS BETTER: Citrus Heights Water District purchases wholesale water from the San Juan Water District. Citrus Heights is a retailer to a smaller, less affluent part of the overall San Juan service area. Its credit quality is supportive of the 'AA' rating on the bonds issued by the Financing Corp.
FURTHUR FINANCIAL DETERIORATION: The ratings could come under further downward pressure if the utility's financial performance slips further on a sustained basis. The stable outlook reflects rate action taken mid-year in fiscal 2016 that is expected to reverse the downward trend in margins.
CHANGE IN SAN JUAN CREDIT QUALITY: A shift in the rating of the San Juan Water District would result in a corresponding rating change on the bonds issued by the Financing Corp.
The San Juan Water District provides retail and wholesale water services to about 182,000 residents in a 46-square-mile suburban service area about 25 miles northeast of downtown Sacramento. It provides retail services to 10,500 accounts and wholesale services to the Citrus Heights Water District, Fair Oaks Water District, Orange Vale Water Co., and the city of Folsom. The district's service area is largely residential and nearly fully built out.
FINANCIAL PERFORMANCE WEAKENED BY DROUGHT
San Juan's historically strong financial performance weakened more than expected in the last three years due to a severe and ongoing California drought. Fitch calculated DSC fell to 1.7x in fiscal 2014 and is projected to drop to 1.4x in fiscal 2015 (unaudited), well below the district's average of 2.3x in the four years before the drought (2010 to 2013) and below Fitch's sector median of 2.1x. The decline reflects a particularly large state water conservation mandate, as well as deeper, earlier drought conservation due to local supply conditions. Free cash-to-depreciation fell to just 52% in fiscal 2014 and an estimated 33% in fiscal 2015.
Another year of below-average coverage is expected in fiscal 2016, but the exact degree of the weakness is unclear given management's uncertainty over final projected sales volumes. Fiscal year-end is June 30, 2016 but the utility does not currently have a long-term financial forecast, including results for fiscal 2016.
SJWD has significant financial reserves to withstand expected variability in revenues. Unrestricted cash and investments equaled a robust $23.1 million, or 607 days cash, as of June 30, 2014, exceeding the 485-day median for 'AA' category utilities. However, this sizable increase from $14.4 million in fiscal 2013 reflected a reclassification by the auditors of formerly restricted reserves. Cash is expected to end fiscal 2015 strong at $27.7 million, but the 2015 audit is not yet available.
MANAGEMENT TURNOVER, LACK OF DEPTH
The utility has a very small finance staff and has suffered repeated turnover of finance directors. The utility was unable to provide a financial forecast, which is a typical practice among California water agencies given the variability in water sales in the region, and its 2015 audit is not yet complete, more than nine months after the close of the fiscal year. The audit has been delayed by the implementation of a new accounting system. Management now believes that it has sufficient staffing to allow resumption of typical financial planning in the future, and it believes it has largely succeeded in implementing its new accounting software. The 'AA' rating reflects Fitch's expectation that the district will resume more timely reporting and forecasting.
STATE FORCES CONSERVATION
An extreme California drought reduced San Juan's water sales, as both state regulatory action and local supply constraints decreased water usage. The California State Water Resources Control Board imposed mandatory conservation targets on every retail utility in the state to combat a drought emergency in 2015. The board ordered San Juan to reduce its production by 36%. It has since reduced the conservation target to 33%. District management expects additional significant reductions in the conservation target when the state board meets to review drought regulations again next month. San Juan has allowed residents to resume normal water use with only voluntary conservation efforts. This approach could boost sales for the remainder of the current fiscal year; however, the durability of the improvement will depend on state regulatory decisions that have not yet been made.
SJWD's supply position is generally strong with high-priority water rights significantly in excess of demand on the American River, which feeds Folsom Lake, California's ninth largest reservoir, but the current drought has highlighted the risks of the agency's surface water dependence. Declines in Folsom Lake levels early in 2014 threatened to draw water levels below intakes that serve San Juan and would have required the U.S. Bureau of Reclamations to use water pumping barges to serve the agency, prompting a period of deep conservation even before state regulatory action. The reservoir has since recovered to well above the levels of San Juan's intakes, and the risk of actual supply interruptions appears to have receded.
SOLID RATE FLEXIBILITY
San Juan has generally shown solid rate discipline but has not raised rates enough to stabilize net revenues in the current drought. The utility raised base rates by 15% on Jan. 1, 2016 and imposed a 10% drought surcharge on users. Even following the sizable rate increase, base retail water rates appear very affordable with 10 hundred cubic feet (HCF) of water costing $40.47 a month, or 0.4% of median household income, and wholesale rates appear competitive compared to other wholesale water providers in the state of California.
STRONG DEBT PROFILE
SJWD's direct debt burden is quite low at $43.2 million, or $800 per customer. This is well below Fitch's sector median of $1,865. With no further borrowing planned, the debt ratios are expected to continue to decline rapidly. Amortization of the district's outstanding debt is about 70% repaid in 20 years.
The district has regularly maintained and improved its infrastructure with minimal borrowing. Capital expenditures averaged a solid 211% of depreciation over the past five years. Future capital plans are driven by the need to maintain the district's aging pipe system, but appear to be quite manageable.
SOLID SUBURBAN SERVICE AREA
The district serves a sizeable and diverse suburban Sacramento service area. The metropolitan area's non-seasonally adjusted unemployment rate was near the national average at 5.4% in February 2016. The district's retail service area is centered on the community of Granite Bay, which has median household income about twice the national level.
CITRUS HEIGHTS CREDIT CHARACTERISTICS SUPPORT RATING
The Citrus Heights Water District (CHWD; obligor for about 10% of the San Juan and Citrus Heights Project COPs) is the largest of San Juan's wholesale water customers. CHWD serves the suburb of Citrus Heights and small areas of adjacent communities. Financial performance is solidly above Fitch's sector medians for all rating categories with DSC averaging 6.5x over the three years ended Dec. 31, 2014 and unrestricted cash and investments equal to 530 days cash. The district's direct debt burden is low at just $286 per customer. Debt levels are expected to decline rapidly because the district has no further borrowing plans and amortization of outstanding debt is very rapid with 74% of principal repaid in the next 10 years.