Fitch Rates Norfolk, VA's Water Revs 'AA+'; Outlook Stable

NEW YORK--()--Fitch Ratings has assigned an 'AA+' rating to the following Norfolk, VA (the city) revenue bonds:

--$85 million water revenue and refunding bonds, series 2015.

The bonds are expected to sell via negotiation the week of March 30.

Proceeds will be used to finance certain capital improvements to the city's water system, to refund all or a portion of the outstanding series 2005 and 2008 bonds for savings, and pay a portion of the issuance costs.

In addition, Fitch affirms the following outstanding ratings:

--Approximately $325 million water revenue bonds, at 'AA+'.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a senior lien pledge of the net revenues of the city's water system (the system). The 2015 bonds will not carry a debt service reserve.

KEY RATING DRIVERS

LARGE REGIONAL SERVICE PROVIDER: The system is the primary service provider for a large, mostly residential and economically stable region.

HYBRID SYSTEM, SOLID FINANCIAL MANAGEMENT: Debt service coverage (DSC) has reached 2.0x over the past several years, which is strong given that approximately 50% of operating revenues are derived from wholesale customers. Large annual transfers out to the city's general fund somewhat limit free cash flow, although the system's strong liquidity and automatic rate adjustments provide flexibility.

STRONG SYSTEM CAPACITY LIMITS CAPITAL NEEDS: 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 remain manageable with most key metrics aligning with the medians for the 'AA' category. A manageable capital improvement plan (CIP) focused on system renewal and upgrade will be funded by 2015 proceeds and pay-as-you-go sources allowing the debt burden to slowly decline.

RATING SENSITIVITIES

SOLID CREDIT FUNDAMENTALS: The rating is sensitive to shifts in various credit characteristics including financial and operating performance, capital needs and debt burden. The Stable Rating Outlook reflects Fitch's expectation that such shifts are unlikely over the next several years.

CREDIT PROFILE

The city of Norfolk (general obligation [GO] 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 245,000.

REGIONAL SERVICE PROVIDER ROLE VIEWED AS CREDIT POSITIVE

The system is the primary water provider for the entire region, providing retail service to its mostly residential customer base 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 system directly serves more than 65,000 retail accounts and an additional 197,000 retail customers through wholesale contracts. The entire service area covers more than 330 square miles 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.

STABLE ECONOMIC UNDERPINNINGS, STRONG MILITARY PRESENCE

The area is mostly residential in nature, although the 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 has improved to 6.2% in October 2014, but remains slightly elevated compared to the rate for the Commonwealth and the nation.

LONG-TERM CONTRACTS PROVIDE STABILITY & OFFSET CONCENTRATION

The system serves several utilities on a wholesale basis, leading to some concentration in its revenue stream. Norfolk's direct retail customers make up roughly 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.

Virginia Beach is the system's largest wholesale customer, making up 30% of total revenues in fiscal 2014. Pursuant to the long-term water services contract (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 Virginia Beach's water and sewer utility system, 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 (WTWA), 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 2014 while the U.S. Navy comprised 13% and WTWA 3%.

SOLID FINANCIAL PERFORMANCE AND MANAGEMENT; ROBUST LIQUIDITY

The system's financial profile is solid with much-improved financial metrics over the past few years. Historical DSC of between 1.5x and 1.8x on the senior lien bonds (fiscal 2009-2011) was considered adequate for the rating, especially given the hybrid nature of the system, its regional importance, and strong liquidity levels. However, due largely to a decline in annual debt service, the system generated 2x DSC on the senior bonds in fiscals 2012 and 2013, and 2.1x DSC in fiscal 2014. All-in coverage including GO bonds (which are paid out of the system's general reserve, and will be fully defeased in fiscal 2015) was slightly lower but still solid at 1.8x in fiscal 2012, but around 2x in fiscals 2013 and 2014.

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 (GF) as an annual return on investment since 2005, which limits the amount of free cash flow available for capital spending and lowers overall fixed-charge coverage. The annual transfer, while not unusual for a utility system, is high at roughly 10% of annual revenues, and is expected to continue at the same rate.

Free cash flow (revenues available after operating costs, debt service, and transfers) has been weak historically but has improved to more than 100% of annual depreciation over the past two years. Coverage of both debt service and transfers was solid at 1.6x in fiscals 2013 and 2014. Fitch is comfortable with somewhat lower coverage levels given the system's strong liquidity and ability to pass through costs to wholesale customers.

A financial forecast provided by the city's feasibility consultant shows stable financial performance with DSC ranging between 1.9x-2.2x through fiscal 2019. The forecast includes additional rate revenues from automatic rate increases and the new debt service from the 2015 bonds. Assuming transfers out to the GF similar to historical levels, coverage of all fixed charges is projected to be no lower than 1.6x.

The system's balance sheet resources are strong, having more than doubled since fiscal 2009 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 $79 million in total resources in 2014, which equaled an exceptional 783 days cash on hand. A strong liquidity profile provides significant financial flexibility, allowing the system to fund its CIP with more pay-go sources than previously expected.

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. 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.

STRONG SYSTEM INFRASTRUCTURE LIMITS CAPITAL NEEDS

Water supplies are extensive and diverse, consisting of a series of eight city-owned surface water reservoirs, raw water from Lake Gaston (Virginia Beach-owned water source) and two supplemental sources consisting of intakes from the Blackwater and Nottoway rivers, and four deep groundwater wells (located in Suffolk). 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 spending on system upgrade and rehabilitation.

The CIP is a manageable $80 million through fiscal 2019. The city expects to fund the capital plan with the 2015 bonds and internal sources, which is feasible given the system's robust liquidity and sizable anticipated future cash flows. Capital projects will focus mainly on water line replacement and rehabilitation, and reservoir and treatment plant upgrades.

DEBT TO REMAIN MANAGEABLE

The system ended fiscal 2014 with about $360 million in total debt outstanding, leading to a somewhat mixed but manageable debt profile. Debt was a somewhat high 74% of net plant in fiscal 2014. However, debt per capita, which takes into account the entire service area population, was just $336 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 $1,382, moderately below the categorical median of $1,934 for retail systems.

Fitch projects the debt burden will rise slightly after issuance but remain below the rating category medians over the intermediate term.

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 additionally informed by information from Creditscope.

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria' (June 2014);

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

--'2015 Water and Sewer Medians' (December 2014);

--'2015 Outlook: Water and Sewer Sector' (December 2014).

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Water and Sewer Revenue Bond Rating Criteria

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

2015 Water and Sewer Medians

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=818409

2015 Outlook: Water and Sewer Sector

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=818410

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=981791

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Contacts

Fitch Ratings
Primary Analyst
Andrew DeStefano
Director
+1 212-908-0284
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Eva D. Rippeteau
Associate Director
+1 212-908-9105
or
Committee Chairperson
Adrienne M. Booker
Senior Director
+1 312-368-5471
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Andrew DeStefano
Director
+1 212-908-0284
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Eva D. Rippeteau
Associate Director
+1 212-908-9105
or
Committee Chairperson
Adrienne M. Booker
Senior Director
+1 312-368-5471
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com