NEW YORK--()--Fitch Ratings downgrades the rating on approximately $68 million of Pennsylvania Economic Development Financing Authority (the authority) sewage sludge disposal revenue bonds, series 2009 to 'BBB' from 'BBB+'. The proceeds were loaned by the authority to Philadelphia Project Finance, LLC (the borrower) to finance the construction of a new biosolids processing facility (the project) and improvements to the existing facility in Philadelphia, PA. The Rating Outlook is Stable.
The downgrade to 'BBB' from 'BBB+' reflects reduced debt service coverage ratio (DSCR) projections resulting from the inclusion of annual allowances for contractual management service fees assessed to the project by Synagro's (the project sponsor) parent company, STI, and additional expected capital maintenance costs. Fitch's base case coverage projections are now expected to average 1.35x over the next five years which is consistent with a 'BBB' rating given the risk profile of the project. Fitch's prior projections indicated DSCRs would be approximately 1.5x. The project did open one month late but on budget and after nearly a full year of operations, Fitch does not expect further volatility in operating or capital expenditures. Revenue from the sale of pellets (sludge dewatered to pellet form) is higher than previously expected. While such sales are not currently projected to result in a profit, Fitch understands management is attempting to secure various outlets for the sale of these pellets which could improve margins over time.
KEY RATING DRIVERS:
Strong Counterparty & Robust Contractual Protections: Project revenue comes from an operating payment of the Philadelphia Water Department (PWD), rated 'A+' by Fitch. Pursuant to a Service Agreement between the project and the Philadelphia Municipal Authority, the PWD will deliver at least 49,000 dry tons per year (DTY) of sludge for processing. The project will be fully covered for the cost of debt, and for the fixed and variable operating expenses associated with treatment and disposal. To the extent that the project processes more than 4,000 DTY at the lower class B level, deductions will be made to project revenue. Related trucking expenses would also be higher.
Routine Operations: The drying and processing of municipal sewage sludge is a common process and will be implemented in this instance at a standard scale with proven technology. Changes in the regulatory regime for sewage treatment could increase operating costs or introduce unforeseen tensions between the sludge supplier and project company, as the service contract explicitly excludes pass through of costs from changes in local or regional law, though this risk is minimized in the Class A period. The project was designed to handle 80,000 DTY and thus has nearly 100% redundancy, limiting operating risk. In addition, the Services Agreement passes through nearly all costs to the PWD, with the exception of power consumption beyond projected levels and disposal of class B solids.
Parent exposure: The 'BBB' rating is based on the project's stand-alone credit profile but is limited by potential exposure to the credit quality of Synagro Technologies Inc. (STI), Synagro's parent and a deeply sub-investment-grade entity. While the project has been organized as a bankruptcy-remote, special-purpose vehicle, partially mitigating potential linkage to STI, Synagro is vulnerable to potential volatility in STI's overhead costs, as management service fees are currently allocated across STI's entities as a percentage of revenues.
Level Debt Service With Adequate Structural Features: The bonds are fully amortizing, and there is no escalation of annual debt service obligations. The dividend lock-up test is 1.2 times (x) and the cash funded debt service reserve covers one year of maximum annual debt service.
Adequate Financial Profile and Moderate Leverage: Under a base case scenario evaluated by Fitch, annual debt service coverage ratios should remain near or above 1.3x through the life of the debt. Leverage is moderate at 7.3x net debt to cash available for debt service.
--Sustained operational performance that results in DSCRs below 1.3x would be inconsistent with the current rating;
--A significant decline in the credit quality of the Philadelphia Water Department could pressure the rating;
--An inability to sell processed product at improving margins would further stress ebitda, lowering DSCRs to a level inconsistent with the current rating.
The bonds are secured solely by a first and exclusive lien on the trust estate and a leasehold mortgage which pledges all of the borrower's right, title and interest in the project site and project facility and the borrower's rights as lessor under the facility lease and various contract rights associated with the project facility.
The project is the result of a public private partnership between the PWD and a wholly owned subsidiary of STI to construct a new biosolids processing facility and to make improvements necessary to the existing facility. The newly constructed facility is designed to more effectively process the sewage sludge generated from three water pollution control plants in the city of Philadelphia into Class A biosolids.
Class A operations commenced in February 2012, approximately one month later than initially expected. Dry tons treated in 2012 were approximately 20% below prior expectations, due in part to the one month delay in Class A processing. Synagro presently expects that 53,450 dry tons will be treated in 2013, up 11% from the prior year. Based on budgeted expectations for 2013, Fitch expects cash flow available for debt service, which reflects deductions for the aforementioned management fees and additional maintenance expectations, will total approximately $8.5 million resulting in 1.37x coverage for the year.
Fitch's base case scenario, which assumes expenses grow 1% faster than revenues and management fees increase by 2% annually, indicates that DSCRs would average approximately 1.35x during the next five years. In Fitch's rating case, which assumes expenses grow 1.5% faster than revenues and management fees increase by 3% annually, DSCRs average approximately 1.3x over the next five years. Fitch will continue to monitor the net results from sales of processed product generated at the facility as they currently result in net losses. Widening net loss operations from such sales could pressure future coverage levels, as could increases in management fees beyond projected levels.
Synagro is the largest recycler of organic residuals in the United States. It serves over 600 water and wastewater treatment facilities in the municipal and industrial sectors across the United States and currently manages over 350 dry tons of municipal biosolids per day through thermal drying and pelletization processes.
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:
--'Rating Criteria for Infrastructure and Project Finance' (Aug. 2, 2012);
--'Rating Guidelines for Availability-based Infrastructure Projects' (June 19, 2012);
--'Pennsylvania Economic Development Financing Authority, Philadelphia Biosolids Facility Project' (Nov. 24, 2009).
Applicable Criteria and Related Research
Rating Criteria for Infrastructure and Project Finance
Pennsylvania Economic Development Financing Authority (Philadelphia Biosolids Facility Project)- sew rev bonds ser 2009