Fitch Downgrades Detroit, MI Water Sr and Sub Revs to 'BBB+'/'BBB'; Outlook Revised to Negative
CHICAGO--(BUSINESS WIRE)--Fitch Ratings has downgraded the following ratings for the City of Detroit, Michigan (the city) issued on behalf of the Detroit Water and Sewerage Department (the department):
--Approximately $1.9 billion senior lien water revenue bonds to 'BBB+' from 'A';
--Approximately $1.1 billion second lien water revenue bonds to 'BBB' from 'A-'.
The Rating Outlook is revised to Negative from Stable.
SECURITY
Senior lien bonds are secured by a first lien on net revenues of the city's water system (the system). Second lien bonds are secured by a second lien on net system revenues after payment of senior lien bonds.
KEY RATING DRIVERS
UNCERTAINTY DRIVES NEGATIVE OUTLOOK: The investment grade ratings continue to reflect Fitch's belief that system operations are sufficiently separated from the city's very weak general credit fundamentals (unlimited tax general obligation bonds rated 'CCC' by Fitch). Fitch nevertheless is concerned that potential actions to improve the city's financial position could negatively impact the system's long-term credit characteristics.
WEAKENED FINANCIAL PROFILE DRIVES DOWNGRADE: The downgrade reflects consistently weak financial results that have been below prior expectations. Financial results have trended positive in recent years, but key metrics remain inconsistent with Fitch's 'A' category medians.
ELEVATED DEBT BUT MANAGEABLE CAPITAL: Debt levels are relatively high and payout of principal is slow. Somewhat offsetting debt concerns, minimal capital needs alleviate future borrowing pressures.
EXPANSIVE SERVICE TERRITORY: The system provides an essential service to a broad area that includes roughly 43% of Michigan's population, with over 70% of operating revenues coming from wealthier suburban customers.
STRONG RATE-ADJUSTMENT HISTORY: The governing body has instituted virtually annual rate hikes in support of financial and capital needs. While recent changes in the governance structure and rate approval process could make it more difficult to achieve rate hikes in the future, Fitch does not view this change as a concern at this time.
RATING SENSITIVITIES
CITY INFLUENCE: Any change or influence by the city via the emergency manager (EM) that negatively affects governance or operations of the system would call into question the insulation of the system from the city. This would likely result in immediate and severe negative pressure on the system's rating given the city's marginal credit quality.
INABILITY TO MAINTAIN FINANCES: Failure to maintain financial performance at a level commensurate with financial projections, including the ability to sustain over 1.0x debt service coverage (DSC), would be viewed negatively.
CREDIT PROFILE
RATINGS CONTINUE TO REFLECT SEPARATION FROM CITY OPERATIONS
The ratings on the system bonds consider the regional economy - including the city - and its potential impact on the system. The ratings also consider other factors that historically have separated system operations from those of the city. These factors include a separation of system funds from other city funds as required under city charter and the bond ordinance; billing and collection of rates and charges by the department; relative autonomy by the department's governing structure to oversee the affairs of the system without undue influence by the city; and retention of surplus funds by the system.
Fitch expects the separation of system operations from those of the city to continue, but notes that the department is a component unit of the city and therefore is not entirely free from potential city influence. Consequently, any actions taken that directly or indirectly change the historical paradigm could exert immediate and significant credit pressure on system bonds, particularly given the city's very weak credit quality.
CONTINUALLY WEAK FINANCIAL PROFILE
Fiscal 2011 financial performance improved over the prior year but results still fell below 1.0x DSC on an all-in basis (0.91x). For fiscal year 2012, all-in DSC barely exceeded 1.0x due in part to ongoing rate hikes resulting in increased revenues. Nevertheless, fiscal 2012 results fell well below the median for 'A' category credits (1.5x). Fitch's calculation of DSC is based on operating activity contained in the financial statements and includes certain non-cash items such as other post-employment benefit accruals for the year.
Other key metrics also are low. Days cash, which slightly declined to 183 days for fiscal 2012 was short of the 285 days for 'A' category credits. Also, system free cash for fiscal 2012 equaled just 6% of depreciation expenses compared to 57% for 'A' category credits. Despite projections of improved financial performance through the fiscal 2017 forecast period, margins may continue to be pressured if the system experiences significant water sales declines or increased costs for capital or operations.
ELEVATED DEBT, YET MANAGEABLE CIP
The system's debt burden is relatively high with long-term debt per customer totaling $2,079. Also, principal payout is slow with only 26% of the debt maturing in 10 years. Fitch notes that the 2012 $200 million in debt issuance used to make termination payments and unwind the system's entire swap portfolio contributed to the weak debt profile, although the system has eliminated certain interest rate and credit risks associated with the swaps.
Medium-term capital costs are expected to remain manageable as there are no regulatory compliance issues for the system. The fiscal 2013-2017 capital improvement plan (CIP), which totals $504 million, significantly declined from over $900 million the prior year. Given the system's excess treatment capacity, management was able to strategically align certain system flow with system demand, thereby reducing plant replacement and renovation costs in the CIP.
BROAD SERVICE AREA ENHANCES SYSTEM STABILITY
The system is a regional provider serving around 4.2 million people or nearly 43% of Michigan's population, including Detroit's population of over 700,000. The system serves the city on a retail basis and 124 communities through 84 wholesale contracts. The service territory consists of an area of 138 square miles in Detroit and 981 square miles in eight counties. Population and customer growth have experienced modest annual declines for a number of years. Detroit's population in particular has experienced continuous decline, but suburban areas have picked up most of the migration.
CONSISTENT SYSTEM RATE INCREASES
The governing body has consistently raised rates to meet financial and capital needs, although unfavorable operating conditions and rising fixed costs have eroded the revenue impact. Fiscal 2012 charges were raised 9% for city retail and suburban wholesale customers. An additional 9.7% and 7.9% rate adjustment for city retail and suburban wholesale customers respectively, were implemented for fiscal 2013, and another rate increase of 4% has been approved for fiscal 2014. Annual increases of 4% are preliminarily forecasted for fiscals 2015-2017.
Retail city rates remain among the lowest of most major U.S. metropolitan areas despite recent rate increases but are around Fitch's median household income (MHI) affordability benchmark given the weak MHI within the city. On the suburban side, rates remain very affordable even with the estimated retail tack-on added by those wholesale entities in excess of the cost of service charged by the department; reportedly, department charges represent around 50% of the average suburban bill.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
In addition to the sources of information identified in Fitch's Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope.
Applicable Criteria and Related Research:
--'Revenue-Supported Rating Criteria' (June 12, 2012);
--'U.S. Water and Sewer Revenue Bond Rating Criteria' (Aug. 3, 2012);
--'2013 Water and Sewer Medians' (Dec. 5, 2012);
--'2013 Outlook: Water and Sewer' (Dec. 5, 2012).
Applicable Criteria and Related Research
2013 Outlook: Water and Sewer Sector
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=695755
2013 Water and Sewer Medians
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=695756
U.S. Water and Sewer Revenue Bond Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684901
Revenue-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=681015
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