Fitch Affirms Otay Water District, CA's Water COPs at 'AA-'; Outlook Stable

AUSTIN, Texas--()--Fitch Ratings affirms the following rating on the Otay Water District, California (Otay or the district):

--$37.8 million revenue certificates of participation (COPs), series 2007 (2007 water system project) at 'AA-'.

The Rating Outlook is Stable.

SECURITY

The COPs are secured by net revenues of the district's water system.

KEY RATING DRIVERS

SINGLE WATER SUPPLY SOURCE: The district purchases all of its potable water supply from the San Diego County Water Authority (SDCWA). Its reliance on imported water is a vulnerability.

POTENTIAL DESALINATION INVESTMENT: Otay is contemplating participation in a desalination project. Water available from SDCWA would provide a redundant back-up supply.

WATER SALES STABILIZING: Water sales stabilized in fiscals 2012 and 2013 after four years of declines. The drought in California and statewide calls for conservation could soften sales although Otay does not anticipate mandatory cutbacks from SDCWA given the investments in drought-proof supplies and water storage.

RATE INCREASES IMPLEMENTED: The district has implemented sizable rate increases since the recession began in 2008 to compensate for lower connection fee revenues and lower sales. While additional increases are anticipated, Otay's rates are competitive within the county.

IMPROVED FINANCIAL MARGINS: Financial margins, helped by firmer sales and rate increases, improved from a low point in fiscal 2012 when coverage dipped below 1.0x without connection fees. Fitch calculated revenue bond debt service coverage in fiscal 2013 was 1.4x and 1.1x without connection fees. However, free cash flow remains weak and does not cover annual depreciation.

CAPITAL NEEDS MODERATE: The utility's capital needs are moderate at $75 million over the next five years, a portion of which will be paid from remaining 2010 bond proceeds. No additional debt is expected.

CHALLENGES IN SERVICE AREA: The district's service area is estimated at 74% of its developed population. While growth was strong in the early 2000s, there is uncertainty about when and to what magnitude growth will resume.

RATING SENSITIVITIES

SHIFTS IN FINANCIAL MARGINS: The rating is sensitive to shifts in fundamental credit characteristics, including the improving debt service coverage. The Stable Outlook reflects Fitch's expectation that such shifts are highly unlikely.

CREDIT PROFILE

GROWTH-SENSITIVE SERVICE AREA

The district serves a population of 211,000 in southeastern San Diego County, including areas of the city of Chula Vista and a small portion of the City of San Diego. Otay provides water to 48,962 connections and an additional 704 recycled water customers. Otay also provides wastewater service to a small area with 4,655 customers, but wastewater net revenues are not pledged to bondholders.

Water connections previously grew 4% annually in the early part of the last decade but recent five-year growth has averaged just 0.7% annually. Recent connection growth has shown some momentum, with between 250-450 new meters in the last three fiscal years. Management's forecast includes rapid growth, with between 550-950 new meters occurring in fiscals 2015-2018. While the region is poised to accommodate new growth, Fitch's rating analysis also considered the potential for more modest growth at a level similar to the last few years.

RELIANCE ON IMPORTED WATER SUPPLY

Otay buys all of its water for potable water delivery from SDCWA. The district has diversified delivery points and treatment plants in recent years through multiple take-out points and contracts with other water treatment providers to treat raw water deliveries from SDCWA. However, single supply risks remain, similar to the rest of the region.

SDCWA continues to make investment to reduce its reliance on imported water, which once made up all of its supply. It now purchases water from Imperial Irrigation District (IID) that is ultimately delivered from the Colorado River and will purchase water from the Poseidon desalination plant once that project is complete in 2016. The desalination project will result in a rate increase to customers (including the district) given the higher project cost than imported water at this time. But the desalination plant provides a drought-proof supply that would not be subject to curtailment for hydrologic conditions.

Otay is in the planning stages of an agreement with Consolidated Water on its construction of a large desalination plant located 25 miles south of the U.S. Border in Mexico. The district anticipates that, if the project is built, it will enter into a water purchase agreement for the rights to around 20,000 acre-feet (af) annually. The district would build a pipeline 3.5 miles from its system to the U.S. border where it would take delivery of the water. Project development is still preliminary but the district plans to have payment terms that require payment only for actual water delivered. Also, the district does not expect to take operational risk in the event of a plant outage.

STABLE WATER SALES; DROUGHT NOT A CONCERN

Water sales declined between fiscal 2007-2011, which was consistent with other regional utilities as a result of the economic recession, conservation investments and water rationing. The revenue impact of the declines was mitigated somewhat by rate increases and lower water purchase costs. Water sales have stabilized in recent years at 32,000 af in fiscals 2011 and 2012 with an uptick in fiscal 2013 to 34,500 af, or around 31 million gallon per day (mgd).

The fiscal 2014 budget conservatively assumed sales around 32,000 af although actual sales are more in line with fiscal 2013 levels. Sales may be softer in fiscal 2015 as a result of the voluntary 20% conservation goal encouraged by the Governor as a result of the severe drought. The district's conservative financial planning estimates of water sales will mitigate the impact of softer sales.

Supply issues are not a concern at this time given SDCWA's access to stored water at the Metropolitan Water District, its investment in the IID supply and anticipated desalination water in 2016. SDCWA does not anticipate curtailments until 2015 at the earliest. Otay also has very efficient water delivery infrastructure with average system line breaks and leaks per 100 line miles of only 13.6 in 2013 as compared to the national average of 25-30 breaks. This limits water loss that must be paid for without any sales to recover the cost.

IMPROVED FINANCIAL MARGINS

Financial performance at the district declined in fiscal years 2009-2012 as a result of a substantial decline in growth-related capacity fees, declining water sales, higher debt service costs and increased water purchase prices from SDCWA. Otay responded through rate increases (averaging 9.2% annually over the past five years) and cost containment efforts. Financial performance has improved although the district still relies on capacity fees to a degree. Fitch calculated revenue bond debt service coverage was 1.4x in fiscal 2013 (excluding wastewater revenues that are not pledged). Combined coverage of revenue bonds and remaining general obligation bonds was slightly lower at 1.3x.

Coverage levels are projected to continue to increase as additional rate increases are implemented, with the district's goal to recover to 1.5x debt service coverage excluding connection fees. Assuming growth resumes to more historical levels, these additional revenues will be needed to resume growth-related capital expansion. Cash reserves remain strong with $65 million in unrestricted cash at the end of fiscal 2013, equal to 339 days operating expenses.

For financial reporting purposes, the district consolidates the water and sewer systems but only the water system net revenues are pledged to bondholders. However, according to its continuing disclosure agreement, the district provides investors with segment information for the balance sheet and income statement for the water system.

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

Applicable Criteria and Related Research:
--'Revenue-Supported Rating Criteria' (June 2013);
--'U.S. Water and Sewer Revenue Bond Rating Criteria' (July 2013);
--'2014 Water and Sewer Medians' (December 2013);
--'2014 Sector Outlook: Water and Sewer' (December 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 Outlook: Water and Sewer Sector
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724357
2014 Water and Sewer Medians
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724358

Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=822675
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Contacts

Fitch Ratings
Primary Analyst
Kathy Masterson, +1-415-732-5622
Senior Director
Fitch Ratings, Inc.
650 California Street
San Francisco, CA 94008
or
Secondary Analyst
Shannon Groff, +1-415-732-5628
Director
or
Committee Chairperson
Douglas Scott, +1-512-215-3725
Managing Director
or
Media Relations
Elizabeth Fogerty, New York, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Sharing

Contacts

Fitch Ratings
Primary Analyst
Kathy Masterson, +1-415-732-5622
Senior Director
Fitch Ratings, Inc.
650 California Street
San Francisco, CA 94008
or
Secondary Analyst
Shannon Groff, +1-415-732-5628
Director
or
Committee Chairperson
Douglas Scott, +1-512-215-3725
Managing Director
or
Media Relations
Elizabeth Fogerty, New York, +1 212-908-0526
elizabeth.fogerty@fitchratings.com