Fitch Affirms Pontiac, MI's Water and Sewer Revs at 'B-'; Outlook to Positive

SAN FRANCISCO--(BUSINESS WIRE)--Fitch Ratings takes the following rating action on Pontiac, MI (the city) as part of its continuous surveillance effort:

--Approximately $2 million water revenue bonds, series 1995 and 2002, affirmed at 'B-';

--Approximately $3.3 million sewer revenue bonds, series 2002, affirmed at 'B-'.

The Rating Outlook is revised to Positive from Stable.

SECURITY

The water revenue bonds are secured by net revenues of the city's water system. The sewer revenue bonds are secured by net revenues of the city's sewer system.

KEY RATING DRIVERS

RELATIONSHIP TO GENERAL FUND: The ratings of the water and sewer bonds reflect a strong connection with the city's overall financial condition. The Positive Outlook reflects favorable developments in general fund operations (see Fitch's press release dated Jan. 20, 2012 regarding the city's unlimited tax general obligation bonds rated 'CCC' with a Positive Outlook). As the city's overall financial picture improves, the risk of its use of residual utility revenues diminishes, resulting in an improved overall credit profile for water and sewer operations.

OPERATIONS PRIVATIZED; SAVINGS EXPECTED: Fitch finds the city's expectation for meaningful savings from the recent privatization of both utility systems to be reasonable. Additionally, new authority to shut-off service in the event of non-payment, effective February 2012, could provide further improvement in poor revenue collections.

REVENUES INCREASE; FINANCIALS IMPROVE: Rate increases were implemented in December 2009 and June 2011 to achieve stable financial margins.

Financial performance in 2011 improved with water and sewer funds experiencing strong cash flow and coverage of existing debt obligations. Although management did not provides financial projections, cash flow and debt service coverage will likely decline as state loans repayments of approximately $12 million in new revolving fund loans begin in fiscal 2012. Fitch anticipates that debt service coverage should remain adequate with the additional savings expected from the United Water operating agreement.

STATE OVERSIGHT: The state-appointed emergency financial manager (EFM) has depoliticized financial operations and has privatized and/or regionalized most of the city's municipal functions. Fiscal Accountability Act 4 of 2011, which gives the appointed EFM enhanced powers, has come under opposition. A material change to the EFM's authority could raise credit concerns.

SIGNIFICANT PERSONNEL TURNOVER: Management and staff turnover and the availability of timely information is an ongoing credit concern.

WHAT COULD TRIGGER A RATING UPGRADE

IMPROVEMENT IN OVERALL CREDIT QUALITY: Improvement in the health of the city's overall credit quality could provide support for a higher rating.

CREDIT PROFILE

CLOSE CREDIT CONNECTION TO GENERAL FUND

In Fitch's view, the credit quality of the water and sewer ratings is closely tied to the overall health of the city. In the past, the city has used funds from the water and sewer funds to provide cash flow relief to the general fund. While there are currently no outstanding loans due from the general fund to the two systems, the potential still exists.

Ongoing discussions about a potential sale of excess wastewater treatment capacity contemplate potential use of the funds to benefit general fund operations. Although these discussions have been ongoing for years and remain tentative, it continues to reflect the collective approach to city financial operations that leads to the credit relationship.

However, as the city's general financial position improves, there is less risk to the utility enterprise funds of the use of system revenues to support general government obligations. Further decoupling of the credit quality of the water and sewer systems from the general government will also include improved financial reporting and forecasting made available by management for the enterprise systems. Fitch expects these additional functions to develop as the city progresses towards overall financial health.

STATE OVERSIGHT CONTINUES

Following multiple years of weak financial performance, the state appointed an EFM in March of 2009. The EFM is employed by the state to re-establish structural integrity and eliminate the city's overall accumulative deficit within five years with authority over labor negotiations, hiring, spending, and most other financial concerns. The third EFM is in place since 2009, creating some concern regarding turnover. Importantly, the EFM has unilateral control over rate setting for the utilities.

IMPROVED FINANCIAL RESULTS; PRESSURE FROM ADDITIONAL BORROWING

Both the water and sewer funds experienced strong cash flow according to the 2011 audit. Each system achieved positive debt service coverage (over 7.0x for the water system and 3.0x for the sewer system) with sizable increases to their previously slim cash reserves. Water system cash reserves improved to over $5 million (234 days operating cash) and the sewer system cash reserves totaled $3.5 million (175 million days cash). However, coverage will decline as debt payments at each of the utilities increase with the additional loan repayments to the state beginning in fiscal 2012.

Loan proceeds are needed to comply with regulatory requirements for both systems, certain of which were mandated by the state. In 2009, the city received authorization to borrow $5.5 million from the state drinking water revolving fund and $16 million from the state revolving fund for sewer fund improvements. Both loans allowed the city to take advantage of funds provided by the American Recovery and Reinvestment Act which provide 40% principal forgiveness on the loan amounts. Based on the city's estimated draw-down of loan funds, the first interest payments are due in fiscal 2012.

PRIVATE OPERATOR IN FISCAL 2012

As of July 1, 2011, United Water took over operations of the water and sewer systems under an operating agreement with the city. The city anticipates that United Water will be able to improve water losses and revenue collections as well as operate the systems for a savings of $2 million annually for both funds combined under a fixed price contract.

RATE INCREASES IMPLEMENTED; COLLECTIONS WEAK

Rates were increased 5% at the water system and 14% at the sewer system as of July 1, 2011 as well, although this reflects increasing water supply and treatment costs from Detroit, the city's wholesale water provider.

Collection levels were only 84% based on information last provided to Fitch. Additional rate review is being conducted by United Water with consideration given to both operating and capital requirements and additional rate increases may be necessary within fiscal 2012.

Collectively, both funds had around $8 million in customer receivables at the end of fiscal 2011, as compared to $22 million in annual revenues. However, a city ordinance was passed allowing for water service shut-off in the event of non-payment, which the city is hoping will both improve collections and reduce the uncollected amounts. Uncollected amounts after six months can be transferred to the county for collection on the property tax bill.

For additional information on Fitch's rating of the city's general obligation bonds (rated 'CCC'; Outlook Positive), see the Fitch's press release dated Jan. 18, 2012, which is available at 'www.fitchratings.com'.

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.

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria' (June 20, 2011);

--'US Water and Sewer Revenue Bond Rating Criteria' (July 26, 2011).

For information on Build America Bonds, visit www.fitchratings.com/BABs.

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=637130

U.S. Water and Sewer Revenue Bond Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=647331

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