Fitch Affirms South Coast Water District, CA Water Revs at 'AA+'; GOs at 'AAA'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings has affirmed South Coast Water District, California's (the district) debt as noted below:

--$34.3 million revenue refunding bonds series 2010A and 2010B (federally taxable direct pay Build America Bonds), issued by the South Coast District Financing Authority, California (the authority), at 'AA+';

--$1.9 million general obligation (GO) refunding bonds series 2011A at 'AAA'.

The Rating Outlook is Stable.

SECURITY

The revenue bonds are payable by installment payments made by the district to the authority. The district's obligation is absolute and unconditional and backed by net revenues of the district's water and wastewater systems.

The GO bonds are payable by an unlimited ad valorem property tax on all taxable property within the South Coast Service Area.

RATING RATIONALE:

VERY STRONG FINANCIAL OPERATIONS: The district benefits from impressive debt service coverage, cash levels, and free cash flow to depreciation. Financial metrics may soften somewhat due to sizeable capital needs and related debt issuances. However, Fitch expects financial performance to remain solid overall.

STRONG SERVICE AREA: The district's suburban, coastal Orange County service area is affluent and well established.

GOOD RATE DISCIPLINE, STRUCTURE: The district's rate structure, which includes a significant fixed-rate component, mitigates revenue losses in times of reduced water consumption. The district has been disciplined in its rate-setting, imposing significant rate increases to keep up with imported water cost hikes and infrastructure investments to date.

DESALINATION A MIXED BAG: Fitch views the district's plans for a desalinization plant as mixed for credit quality. The plant likely would raise debt levels, increase the district's operating costs and complexity, and generate construction risks. However, management anticipates the plant would essentially end the district's reliance on increasingly expensive imported water and would enhance supply reliability.

ADEQUATE DEBT PROFILE: The district's debt levels are low-to-moderate currently, although the district's capital improvement plan (CIP) is large and financing it likely will result in materially higher debt levels over the intermediate term. Much of the district's CIP is composed of two long-lived assets, with subsequent capital needs consisting mostly of routine maintenance as the district is at a mature stage of its capital cycle.

STRONG TAX BASE: The tax base supporting the GO bonds is strong, benefiting from its location in the large and diverse Orange County economy. Assessed value (AV) is somewhat concentrated in the high-end tourism sector as is the utility's customer base.

RATING SENSITIVITIES

STABLE OUTLOOK: The rating is sensitive to shifts in fundamental credit characteristics including the district's manageable debt profile, and strong financial operations and economy. The Stable Outlook reflects Fitch's expectation that such shifts are unlikely.

CREDIT SUMMARY

The district provides water and wastewater services to about 40,000 residents in an 8.3-square-mile service area located in southern, coastal Orange County, CA. The affluent and mature service area is fully built out.

STRONG FINANCIAL PERFORMANCE

The district benefits from its consistently robust financial performance, including high debt service coverage and cash reserve levels. This performance stems from the district's disciplined approach to raising rates, including fully passing through significant imported water cost hikes in addition to providing cash flow for capital needs and reserve accumulation.

The district's rate structure includes a significant fixed-rate component that has mitigated the impact of water conservation on water revenues. Management notes that the board has a history of unanimously passing rate increases, and there appears to be little ratepayer opposition, based on minimal Proposition 218 protest letters. A rate study is currently underway, and it has yet to be determined what future rate increases are in store. Subsequent to years of double-digit rate hikes, the prior three years' rate hikes have averaged a more moderate 4.3% annually. Based on an assumed 7,500-gallon average residential water consumption, combined water and sewer rates equal an affordable $105 monthly, or 1.6% of median household income. This rate level suggests a moderate degree of remaining rate flexibility.

All-in debt service coverage (inclusive of the district's general obligation bonds) increased to a very high 4x in fiscal 2014 from 3.5x the prior year. Debt service coverage is projected to remain robust through the district's five-year forecast period, though anticipated debt issuances likely will lower coverage moderately from current levels. As discussed below, the district plans to construct a desalinization plant, which would significantly increase operating costs from current levels.

Liquidity is very strong, with audited fiscal year-end 2014 unrestricted cash totaling $60 million, or 941 days cash on hand (DCOH). The district projects cash to remain at very high levels through its multi-year forecast period. However, there are two large capital items that likely will be financed in part through a draw-down in reserve levels. The magnitude and timing or any such draw has not yet been determined, though Fitch expects reserve levels to remain at high levels based on policy minimums and historical practice. Management notes that, based on its financial policies, the district would be required to retain a minimum of $28 million (449 DCOH), which Fitch views as a still very strong balance.

LOW DEBT LEVELS LIKELY TO RISE WITH SIZABLE CIP

The district's current debt burden is affordable but will likely rise significantly over the next several years. The district's debt is fully fixed rate and debt service descends over time as currently structured. Total outstanding debt per customer and debt to net plant assets were low in fiscal 2014 at $1,291 and 28%, respectively. These debt levels compare well with the 'AAA' medians. However, the district's large CIP includes two substantial and long-lived projects that likely will be funded with a higher percentage of debt than had been the case in prior years.

Although funding sources and debt issuance sizing have yet to be determined, Fitch anticipates debt levels to increase materially from current levels over the intermediate term. Given that the district is well advanced into its capital lifecycle, subsequent capital needs are likely to be relatively subdued, consisting largely of routine maintenance and repairs. Debt amortization is somewhat slow, with 71% paid down over 20 years.

The district's CIP is temporarily elevated due to the planned replacement of an aging sewer transmission tunnel and pipeline as well as a desalinization plant. The projects are estimated to cost $60 million-$90 million and $50 million-$60 million, respectively. The current sewer tunnel was constructed in the 1950's and is deteriorating, posing safety and other concerns. The replacement tunnel is expected to last 100 years. The district has secured approval for a state revolving fund loan of up to $100 million for the project, though management does not anticipate that the full amount would be drawn upon given the availability of cash reserves, grants, and other financing sources.

Management projects the desalinization plant would lower reliance on expensive imported water from the Metropolitan Water District of Southern California (MWD) to 40%-50% when the plant is projected to open in fiscal 2022, and further lower reliance to just 5% by fiscal 2027. The district typically imports approximately 80% of its water from MWD, which Fitch views as a costly supply source. The recent shut-down of a district well from saltwater intrusion temporarily raises MWD reliance to an even higher 90%, though a new well is expected to come online next year that will produce an equivalent water supply.

Although the desalinization plant would diversify local water sources, it will also pose construction and operating risks. Further, management estimates high supply costs, inclusive of capital costs, of $2,000-$2,200 per acre foot compared to $970 per acre foot from MWD currently. Due to expectations of rising MWD prices and allocation penalties, management expects water costs from the desalinization plant to fall below MWD's costs by fiscal 2026 or 2027.

VERY STRONG ECONOMY AND TAX BASE

The service area economy is strong with relatively low unemployment and high income levels. The service area is part of the massive and diverse Orange County and greater Los Angeles employment markets and includes the communities of the City of Dana Point and portions of Laguna Beach, San Clemente and San Juan Capistrano. Dana Point's December 2014 unemployment rate of 3.2% was well below the national (5.4%) and state (6.7%). The city, which represents the bulk of the service area, has a very high median household income equal to 151% of the national and 131% of the state medians. The district's customer counts and population are stable with very slow growth from limited in-fill development.

The $7.9 billion tax base supporting the GO bonds showed great stability throughout the housing downturn. The South Coast Service Area is the tax base for the GO bonds and has different boundaries from the district itself. The area is primarily residential and includes some of California's most expensive water-front properties. The tax base is slightly concentrated with the top 10 taxpayers representing 12.4% of assessed value. AV growth slowed during the housing downturn, but the district suffered no declines.

WASTEWATER ADDS STABILITY

The combined water and sewer pledge diversifies the pledged revenues compared to a typical water or sewer revenue bond. Sewer operations are limited because the enterprise is a collection-only system with wastewater treatment agreements with two regional treatment facilities. Sewer revenues tend to be quite stable, lessening the volatility of total revenues.

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

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 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:

2015 Outlook: Water and Sewer Sector

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

2015 Water and Sewer Medians

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

U.S. Water and Sewer Revenue Bond Rating Criteria

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

Revenue-Supported Rating Criteria

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

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=981810

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Contacts

Fitch Ratings
Primary Analyst
Scott Monroe
Director
Fitch Ratings, Inc.
+1 415-732-5618
650 California Street
San Francisco, CA 94108
or
Secondary Analyst
Andrew Ward
Director
+1 415-732-5617
or
Media Relations, New York
Elizabeth Fogerty
+1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Scott Monroe
Director
Fitch Ratings, Inc.
+1 415-732-5618
650 California Street
San Francisco, CA 94108
or
Secondary Analyst
Andrew Ward
Director
+1 415-732-5617
or
Media Relations, New York
Elizabeth Fogerty
+1 212-908-0526
elizabeth.fogerty@fitchratings.com