Fitch Affirms San Luis Obispo, CA's Water Revenue Bonds at 'AA'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings affirms the 'AA' rating on the following San Luis Obispo, CA bonds:

--$20.1 million outstanding water revenue bonds.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by net revenues of the water system after payment of operating and maintenance expenses.

KEY RATING DRIVERS

ADEQUATE FINANCIAL PERFORMANCE: Financial performance has been satisfactory, but inconsistent, with debt service coverage (DSC) fluctuating over the past four fiscal years due to weather and increased costs. Liquidity in fiscal 2012 remained strong at 365 days cash. Coverage is expected return to more typically strong levels by fiscal 2015 due to a series of rate increases.

STRONG MANAGEMENT AND OPERATIONS: System operations are sound, led by an experienced forward-looking management team and policymakers. Water resources are diverse and independent, and treatment capabilities are more than sufficient to meet projected demand.

HEALTHY CUSTOMER BASE: The utility is the monopoly provider of an essential service to the cultural and economic center of California's Central Coast region. The customer base is mostly residential, growing very gradually, and reasonably diverse.

HIGH DEBT, SIGNIFICANT INVESTMENTS: The utility's debt burden is very high at about $6,985 per customer and $2,235 per capita. This concern is partially mitigated by the city's development of a diverse, reliable, and independent water supply, and the lack of additional debt plans.

RATING SENSITIVITIES

PROLONGED PERIOD OF WEAK COVERAGE: Fitch expects the utility's coverage to return to strong levels of around 2.0x in the near term, as the utility completes its adjustment to higher water costs. If coverage fails to approach the forecast levels in a timely manner, the rating is would come under downward pressure.

CREDIT PROFILE

The water system serves the entire city of San Luis Obispo and several users outside the city, including California Polytechnic University (Cal Poly), which enrolls roughly 15,000 students. The system serves 14,742 retail connections in a developed, stable service area. About 85% of customer accounts are residential. The top 10 customers provide a moderate 9.2% of revenues. Cal Poly is the largest customer, but it is a large, stable governmental employer that presents limited risk.

SOLID FINANCIAL PERFORMANCE

The utility's traditionally very strong financial performance temporarily weakened beginning in fiscal 2011 due to a combination of wet weather that decreased sales and increased water supply expenses associated with a new supply from Nacimiento Lake 40 miles to the north. All in DSC dipped to 1.0x in fiscal 2011, well below the 3.0x coverage recorded previously.

Management formulated a plan to restore debt service to above 2.0x, and they report the recovery is progressing more quickly than previously expected due largely to strong water usage. Coverage was adequate at 1.5x in fiscal 2012 (counting debt prepayments made just before the fiscal year as 2012 debt service) but significantly surpassed expectations. Coverage jumped to a strong 2.3x in 2013 according to unaudited results. Sales were helped by particularly dry weather that bolstered demand.

The utility's budget shows coverage dipping to 1.2x in fiscal 2014 before approaching 2.0x again in 2015 and surpassing it thereafter. The forecast is based upon prior period consumption results with revenues adjusted for rate changes as they occur and incorporates a sharp drop in development impact fees from fiscal 2013 levels.

The weather-related aspects of demand variability are transitory, and such volatility is not a credit concern for utilities with sufficient reserves. The utility amassed very large reserves in anticipation of the Nacimiento project and has used very little of them as it phased in higher rates to pay for the new supply. Unrestricted cash and investments totaled a solid $13.7 million, or 365 days cash, in fiscal 2012. Available cash is expected to remain above 300 days over the next five years.

SIZABLE RATE INCREASES

The city has raised rates in a disciplined way, adjusting rate plans as necessary in response to changing demand. Rates have climbed an average of 9.9% annually over the past five years. Bills are very high at 2.1% of median household income; however, income data is deeply suppressed by the low incomes of the local student population. Monthly bills are fairly typical for a California water utility at $73.88 for 7,500 gallons of water.

Rates hikes are expected to slow to about 4% a year over the next three years. Fitch believes the utility should maintain adequate rate flexibility for the near-to-medium term, given the smaller planned increases and policymakers' strong history of rate discipline. The utility's rate structure is more heavily volumetric than the typical California water utility, creating somewhat greater revenue volatility. The utility has begun to address this situation by adding a small fixed charge in its last rate package, but it remains a volatile revenue structure.

LARGE DEBT BURDEN

The system's debt burden is well above average for rated water and sewer utilities. Total debt exceeds $100 million, including the city's share of the Nacimiento project bonds, water revenue bonds and state revolving fund loans outstanding. Debt per customer is almost four-times the median for 'AA' rated water and sewer utilities. The utility has no further debt plans, which will lead to improving debt ratios over time as debt is amortized.

The current high debt levels are largely driven by the Nacimiento project, which is expected to provide the utility with adequate water supplies through full build out. The water reliability provided by the project will position the utility well after it has fully absorbed the additional cost. Fitch considers the utility's supply position a significant credit strength.

SOLID ECONOMIC BASE

San Luis Obispo is located approximately 10 miles inland of California's central coast, approximately midway between San Francisco and Los Angeles. The city serves as the region's economic and cultural center. The local economy is anchored by Cal Poly and includes significant governmental, utility, tourism, and agricultural sectors. The city also benefits from a small high tech industry supported by engineering and business departments at Cal Poly.

The region historically has outperformed the state economically, with an annual unemployment rate below the statewide average for more than a decade. The local unemployment rate has been declining from recessionary levels over the past three years and was below the state and national averages at 6.7% in October 2013.

Additional information is available at 'www.fitchratings.com'

In addition to the sources of information identified in Fitch's 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' (June 3, 2013);

--'U.S. Water and Sewer Revenue Bond Rating Criteria' (July 31, 2013);

--'2014 Water and Sewer Medians', dated Dec. 12, 2013;

--'2014 Outlook: Water and Sewer Sector', dated Dec. 12, 2013.

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=709499

U.S. Water and Sewer Revenue Bond Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715275

2014 Water and Sewer Medians

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724358

2014 Outlook: Water and Sewer Sector

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724357

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=813096

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Contacts

Fitch Ratings, Inc.
Primary Analyst
Andrew Ward, +1-415-732-5617
Director
Fitch Ratings, Inc.
650 California Street, 4th Floor
San Francisco, CA 94108
or
Secondary Analyst
Shannon Groff, +1-415-732-5628
Director
or
Committee Chairperson
Steve Murray, +1-512-215-3729
Senior Director
or
Media Relations
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Sharing

Contacts

Fitch Ratings, Inc.
Primary Analyst
Andrew Ward, +1-415-732-5617
Director
Fitch Ratings, Inc.
650 California Street, 4th Floor
San Francisco, CA 94108
or
Secondary Analyst
Shannon Groff, +1-415-732-5628
Director
or
Committee Chairperson
Steve Murray, +1-512-215-3729
Senior Director
or
Media Relations
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com