SAN FRANCISCO--()--Fitch Ratings has downgraded the rating on the following San Luis Obispo County Financing Authority, CA, debt to 'A+' from 'AA-':
--$152.9 million Nacimiento Water Project revenue bonds, series 2007A (tax-exempt);
--$37.5 million Nacimiento Water Project revenue bonds, series 2007B (taxable).
The Rating Outlook is Stable.
The Project bonds are backed by take-or-pay water delivery entitlement contracts with five San Luis Obispo County water providers: the city of San Luis Obispo (SLO), the city of El Paso de Robles (Paso Robles), Atascadero Mutual Water Company (Atascadero), the Templeton Community Services District and San Luis Obispo County Service Area 10A. Contract payments are senior obligations payable from participants' gross water revenues and subject to a 25% step-up provision.
KEY RATING DRIVERS
DOWNGRADED ON FINANCIAL PERFORMANCE: The downgrade reflects poor financial performance of Paso Robles, the weakest of the three primary participants (SLO, Atascadero and Paso Robles).
WEAK FINANCIAL PERFORMANCE: Financial performance of most participants has been adequate, but tardy rate action, reduced connection fee revenues and weak water sales in Paso Robles have yielded several years of inadequate financial performance with debt service coverage below 1.0x in fiscal years 2011 and 2012 and unlikely to reach a sustainable level until fiscal 2014 or 2015.
STRONG RESERVES ALLOW ADJUSTMENT: Each of the primary participants has significant reserves. Paso Robles came into the project with a significant cash cushion (1,275 days of unrestricted cash at the end of fiscal 2011) that it is utilizing as it adjusts to project debt service costs. While liquidity is forecast to remain adequate, multiyear draws on reserves to meet debt service obligations are unusual and not compatible with the 'AA-' category rating.
VARIABLE RATES, FIXED EXPENSES: Paso Robles has approved rates that should provide adequate coverage by fiscal 2015, but the new rates are entirely volumetric, creating a mismatch between high fixed costs and the entirely variable rate structure.
HIGH DEBT BURDEN: The participants all have high debt burdens relative to their customer bases due to the project. The resulting debt service has challenged most of the participating agencies, but particularly Paso Robles.
SIGNIFICANT SERVICE AREA: The Nacimiento Water Project is of vital economic importance to California's Central Coast region. The project provides increased water supply reliability and allows for future demand growth, improving the economic prospects of the region. The area was less hard hit by the economic downturn than most California communities and is recovering at a gradual pace.
SOLID LEGAL FRAMEWORK: Debt service is supported by take-or-pay water delivery entitlement contracts that provide strong bondholder protection despite variable water supply and demand conditions. A 25% step up provision lessens risk of failure by any given member, but are insufficient to fully offset payments of largest members.
WEAKEST LINK ANALYSIS: Fitch's analysis centers on the three primary participants, which pay 96% of debt service and whose contributions could not be fully recouped through step-up provisions. The 'A+' rating reflects the credit quality of Paso Robles, the weakest of the primary participants.
ATASCADERO, SLO REMAIN STRONG: Fitch rates the city of San Luis Obispo's water revenue bonds 'AA' with a Stable Outlook. Atascadero's financial performance is solid with healthy liquidity and adequate, consistent debt service coverage.
WHAT COULD TRIGGER A RATING ACTION
CONTINUED WEAK FINANCIAL PERFORMANCE: Fitch expects the current period of financial weakness to be temporary, but any further decline in performance or continued weakness after the current period of adjustment would put downward pressure on the rating.
The participating water agencies are located on California's central coast about halfway between Los Angeles and San Francisco. The project consists of a 45-mile pipeline that connects the agencies to Lake Nacimiento, a reservoir in the sparsely developed region near the border between San Luis Obispo and Monterey counties. The connection provides the region with an additional 15,750 acre feet of water annually.
PASO ROBLES PERFORMS POORLY
Financial performance has been weaker than expected in Paso Robles due to weak water sales, decreasing connection fee revenues, and tardy rate adjustments. The utility posted a small loss before paying debt service in fiscal 2011, providing no debt service coverage and requiring $1.2 million of debt service to be paid from reserves. Preliminary unaudited results show Fitch calculated coverage rising to just 0.5x in fiscal 2012, the first year of full debt service. The city's cash flow projections don't show it reaching 1.0x coverage until 2014, and the system is unlikely to generate enough excess revenues to sustainably maintain and invest in the system until 2015.
Paso Robles faced significant opposition to fixed capital charges it tried to impose to support project costs, including protests under California's Proposition 218 and legal challenges. The rate controversy delayed the city's plan to gradually raise rates to fully cover debt service costs by about four years. After scrapping its initial rate plan, the city has imposed a five-year, 2012 - 16 rate package that will provide adequate debt service coverage when fully phased-in, but leaves it with very weak performance and vulnerable to various risks in the early years of its financial forecast.
The rate package replaces a fixed capital charge with a volumetric rate that's likely to provide less consistent results. While the forecast appears reasonably conservative in terms of water demand and connection fee revenues, it is materially weaker than prior expectations and incompatible with an 'AA'category rating. The Paso Robles water enterprise's financial liquidity appears adequate to withstand this period, having started with a very robust $23.0 million of unrestricted cash and investments at the end of 2011. The utility's cash flow projections show it drawing reserves below policy targets over the next five years, in part due to required deposits to a coverage fund (essentially a prepayment of debt service) due to its failure to meet its 1.25x debt service coverage target.
While these deposits are a sign of stress, they do benefit bondholders more than some other uses of the funds and help support the rating at the 'A+' level. Fitch believes the utility's cash position will remain healthy, but it is vulnerable to further shocks and unlikely to support a higher rating in the near term.
The delay in increasing rates has also forced the city to delay construction of a water treatment plant that would allow it to fully utilize its share of Nacimiento water. The city plans to begin using the pipeline water for groundwater recharge in the next year or so, but it has been forced to maintain water rationing in the meantime, artificially reducing sales and financial performance. With Paso Robles' reserves diminished to pay debt service in the early years of project operations, the city will likely need to rely on debt to finance construction of a water treatment plan that would allow it to take fuller advantage of project water, increasing already high debt ratios. Paso Robles plans to issue about $8 million of bonds over the next several years to finance construction of a scaled back treatment plant. Debt per customer is forecast to rise from $6,500 at the end of fiscal 2012 to about $6,700 in 2017.
IMPORTANT SUPPLY TO SOLID SERVICE AREA
The Nacimiento project provides significant new water supply that should bolster the prospects of the underlying regional economy. The service area is known for its mild climate, vineyards and natural beauty. While development was slowed by the recession and the downturn in the U.S. housing market, the San Luis Obispo County economy has outperformed the state of California during the downturn. The local economy is relatively stable - anchored by government, educational institutions, and utilities. The state is a major employer via a local prison, university and hospital. Tourism, agriculture, retailing and construction are major private industries. San Luis Obispo County's unemployment rate was well below the state average at 7.3% in October. The rate has declined by three percentage points since the beginning of 2010. Over the longer term, the county's labor market has performed better than the nation as well. The jobless rate was well below the national average for the decade prior to the current recession and held below 5% for every year from 1997 to 2007.
STRONGER OBLIGORS ADJUST MORE QUICKLY, BUT FEEL STRESS
The City of San Luis Obispo's water enterprise (water revenue bonds rated 'AA' with a Stable Outlook by Fitch) has exhibited strong financial performance during the recession due to its stable and diverse customer base, annual rate increases and long-range financial planning. Net revenues available for debt service have averaged 2.4x in recent years, and liquidity has been consistently strong with more than 600 days cash on hand. The utility also encountered stress due to the rising Nacimiento debt service burden and recent adverse weather and economic conditions, but coverage is likely to remain at or above 1.0x during its adjustment to the new debt service and likely to recover to approach 2.0x before the end of the current forecast horizon.
Atascadero's financial performance remains adequate with debt service coverage at 2.7x in 2011 and about 1.3x according in 2012, the first year of full debt service. The private, non-profit water utility expects to post debt service coverage of about 1.2x over five year forecast horizon. While this coverage is slim, capital needs are minimal, leaving the utility with less need for excess revenues than other project participants. The forecast appears conservative both in terms of connection fee revenues and water demand. The utility has significant rate flexibility because it is not regulated by the California Public Utilities Commission or subject to the tax and fee limitations that apply to rate-setting at governmental water agencies. The utility has ample liquidity to withstand any near-term financial stress with 430 days cash on hand at the end of fiscal 2012.
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 the Revenue-Supported Rating Criteria, this action was informed by information from CreditScope and IHS Global Insights.
Applicable Criteria and Related Research:
--'Revenue-Supported Rating Criteria', dated June 12, 2012;
--'U.S. Water and Sewer Revenue Bond Rating Criteria', dated Aug. 3, 2012;
--'2012 Water and Sewer Medians', dated Dec. 8, 2011;
--'2012 Outlook: Water and Sewer Sector', dated Dec. 8, 2011.
Applicable Criteria and Related Research:
Revenue-Supported Rating Criteria
U.S. Water and Sewer Revenue Bond Rating Criteria
2012 Water and Sewer Medians
2012 Outlook: Water and Sewer Sector