NEW YORK--()--Fitch Ratings assigns an 'AA+' rating to the following city of Norfolk, VA (the city) revenue bonds:
--Approximately $44 million water revenue bonds, series 2013.
Bond proceeds will be used to fund various capital improvements to the water system (the system), and pay issuance costs.
The bonds are scheduled for competitive sale the week of Feb. 11.
In addition, Fitch affirms the following:
--Approximately $290 million outstanding water revenue bonds at 'AA+'.
The Rating Outlook is Stable.
The bonds are secured by a senior lien on and pledge of the net revenues of system. The city will not fund a debt service reserve for the series 2013 bonds.
LARGE REGIONAL SERVICE PROVIDER: Norfolk's water system is the primary service provider for a large, mostly residential, and economically stable region. The system directly serves more than 64,000 retail accounts and an additional 196,000 retail customers through wholesale contracts.
HYBRID SYSTEM, STABLE FINANCIAL MANAGEMENT: Fitch views the debt service coverage levels to be adequate given that more than 50% of operating revenues are derived from wholesale customers, making the system somewhat unique. Fitch is comfortable with coverage levels more consistent with those of wholesale systems given the ability to pass through costs and, importantly, the system's strong liquidity.
STRONG SYSTEM CAPACITY: Ample water supply and treatment capacity provide operating flexibility and limit short-term capital needs, which are mainly to repair, replace, and maintain system facilities.
MANAGEABLE DEBT BURDEN: Debt ratios are manageable when including the system's direct retail customers and all of the retail customers it serves on a wholesale basis. A mainly debt-financed capital improvement plan (CIP, with about $90 million issued over the next five years) is expected to only modestly raise the debt burden.
The city of Norfolk (general obligation bonds rated 'AA+' by Fitch) is located in the Hampton Roads region of Virginia, along the Atlantic Ocean. The city covers 66 square miles and has an estimated population of 244,000.
REGIONAL SERVICE PROVIDER ROLE VIEWED AS CREDIT POSITIVE
The system is the primary water provider for the entire region, providing retail service to its own roughly 64,500 mostly residential customers as well as wholesale service to the city of Virginia Beach (water and sewer revenue bonds rated 'AAA'), the U.S. Navy, and other nearby communities. The entire service area covers more than 330 square miles, includes a total retail customer base of more than 261,000 customers, and serves a population of about 1,100,000 according to city estimates. Water supply sources are diverse and ample, providing long-term stability to the system.
The area is mostly residential in nature, although its favorable location and significant waterway access promotes significant industrial, trade, and tourist activities. The economy, which is anchored by the presence of the U.S. military, continues to expand, with employment gains in business and other services. A large commercial port and Norfolk International Airport provide significant employment and trade opportunities. The city continues to focus its economic development efforts on downtown and neighborhood revitalization to diversify the economy and help offset the sizable proportion of tax-exempt property. The city's unemployment rate remains above historical levels at 7.2% in December 2012, although the rate is lower than the 8.2% recorded in Dec. 2011.
LONG-TERM CONTRACTS PROVIDE STABILITY, OFFSET CONCENTRATION CONCERNS
The system serves several utilities on a wholesale basis, leading to some concentration in its revenue stream. Norfolk's direct retail customers comprise a little less than half of the system's total revenues. While concentration is moderately high, service is provided to several highly-rated utility systems mainly through long-term contracts, and flows have been relatively stable. The city of Virginia Beach is the system's largest wholesale customer, making up 32% of total revenues in fiscal 2012. Pursuant to the long-term water services contract which expires in 2030, Norfolk receives and treats raw water from Virginia Beach and conveys potable water back to Virginia Beach up to an average of 45 millions of gallons per day (mgd).
Virginia Beach is charged based on a cost of service approach, whereby it pays Norfolk a proportionate share of operations and maintenance expenses, depreciation expense, and a return on assets. Fitch notes the charges are well secured as they are designated as operating expenses of the Virginia Beach water and sewer utility system and paid ahead of any debt service related thereto.
Norfolk also provides service to the city of Chesapeake (utility system rated 'AA', with a Stable Outlook), the Western Tidewater Water Authority, and the U.S. Navy. Service to Chesapeake consists of a small amount of treated water and a larger amount of surplus raw water, which is paid for on a take-or-pay basis. Revenues from Chesapeake accounted for about 10% of total revenues in fiscal 2012 while the U.S. Navy comprised 11%. The city is still negotiating terms for extension of the U.S. Navy contract, which have typically been short-term three-year contracts. Management expects a contract extension for an additional three-year term.
STRONG SYSTEM INFRASTRUCTURE AND CAPACITY LIMIT CAPITAL NEEDS
Water supplies are extensive and diverse, consisting of a series of eight city-owned surface water reservoirs totaling 15.2 billion gallons in storage capacity. In addition, supply comes from Lake Gaston (a Virginia Beach-owned water source) and two supplemental sources consisting of intakes from the Blackwater and Nottoway rivers. Four deep groundwater wells (located in Suffolk) are also available during dry periods. The city estimates it has enough supply to serve the needs of the region for another 50 years. Two water treatment facilities have a current capacity of 136 mgd, which is more than twice the average daily demand. Infrastructure capacity is ample, allowing the system to focus long-term capital needs on system upgrade and rehabilitation.
STABLE FINANCIAL PERFORMANCE AND MANAGEMENT; ROBUST LIQUIDITY
The system's stable financial profile is evidenced by strong historical financial margins and good debt service coverage. Historical debt service coverage of between 1.5x and 1.8x on the senior lien bonds was considered adequate for the rating, especially given the hybrid nature of the system, its regional importance, and strong liquidity levels. Due in large measure to a decline in annual debt service, the system generated roughly 2.0x debt service coverage on the senior bonds in fiscal 2012. All-in coverage including general obligation bonds (which are paid out of the system's general reserve) was slightly lower but still solid at 1.8x.
Operating margins have averaged more than 50% over the past six fiscal years, which is considered strong. However, the system has annually transferred more than $8 million to the city's general fund as an annual return on investment since 2005, which limits the amount of free cash flow available for capital spending and lowers overall fixed coverage. The annual transfer, while not unusual for a utility system, is high at roughly 10% of annual revenues, and is expected to continue. Free cash flow (revenues available after operating costs, debt service, and transfers) has been weak historically, averaging just 73% of annual depreciation. Coverage of both debt service and transfers was adequate at 1.6x in 2012.
Pro forma financial results show debt service coverage of 1.9x all-in for fiscals 2013 and 2014, and about 1.4x net of annual system transfers. Coverage begins to decline in fiscal 2015 due mostly to proposed issuance of debt and an increase in annual debt service. The projections for fiscals 2015 through 2017 show coverage margins similar to results demonstrated prior to fiscal 2012 (roughly 1.7x on the bonds, and 1.3x net of transfers)
The system's balance sheet resources are strong despite the large annual transfers to the general fund. Including operating reserves, repair and replacement fund balances, rate stabilization funds, and the unrestricted general reserve, the system had about $56 million in total resources, which equaled a strong 462 days cash on hand as of fiscal year-end 2012. Other important liquidity ratios such as working capital and current ratios are also above average. A strong liquidity profile provides significant financial flexibility, which, in addition to the partially wholesale nature of the system, helps mitigate the below-average expected pro forma debt service coverage.
DEBT TO REMAIN MANAGEABLE DESPITE A MOSTLY DEBT-FINANCED CIP
The system ended fiscal 2012 with about $330 million in total debt outstanding, leading to a somewhat mixed but manageable debt profile. Debt is a somewhat high 70% of net plant in fiscal 2012. However, debt per capita, which takes into account the entire service area population, was a low $326 for the same period and below the median for the rating category. In addition, when including the retail customers Norfolk serves indirectly through its large wholesale contracts, debt per customer was just $1,266, moderately below the categorical median ($1,828).
Principal amortization of outstanding bonds is average, with 40% of principal retiring within 10 years and 77% retiring in 20 years. The $97 million five-year CIP is expected to be mainly funded with debt, including the series 2013 bonds. But Fitch projects the debt burden will remain manageable. Capital projects will focus mainly on water line replacement and rehabilitation. Management expects to issue an additional total of $74.5 million in parity bonds in fiscals 2015 and 2017.
RATES TO CONTINUE TO RISE WITH AUTOMATIC ANNUAL INCREASES
Retail rates are set by the city council and are reviewed annually during the budget process. The retail rate structure is primarily consumption-based, which introduces some vulnerability to weather and other factors affecting demand. After double-digit rate increases in 2004 and 2005, increases have been moderate at approximately 3.5% annually. In 2012, residential rates for 1,000 cubic feet of use per month (about 7,500 gallons) were competitive relative to other regional utilities at about $42, but a somewhat high 1.2% of median household income. Rates are expected to remain competitive despite automatic annual rate increases of 3.5% designed to provide for baseline revenue growth. The rate increases do not need city council approval.
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 U.S. Municipal 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 Sector' (Dec. 5, 2012).
Applicable Criteria and Related Research:
2013 Water and Sewer Medians
U.S. Water and Sewer Revenue Bond Rating Criteria
Revenue-Supported Rating Criteria