Fitch Rates Nacimiento Water Project Revenue Bonds at 'A+'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings has assigned an 'A+' rating to the following San Luis Obispo County Financing Authority, CA (the financing authority) debt:

--$112.1 million Nacimiento Water Pipeline Project revenue refunding bonds series 2015A and 2015B.

Bond proceeds will refund selected maturities of the authority's 2007A and 2007B bonds and cost of issuance.

In addition Fitch affirms the following ratings:

--$183.1 million financing authority revenue bonds series 2007A and 2007B at 'A+';

--City of El Paso de Robles, CA's (the city or Paso Robles) implied water revenue obligation rating at 'A+'.

The Rating Outlooks are Stable.

SECURITY

The Nacimiento Water Project (the project) bonds are backed by take-or-pay water delivery entitlement contracts with five San Luis Obispo County water providers: the city of San Luis Obispo (SLO), Paso Robles, Atascadero Mutual Water Company (Atascadero), the Templeton Community Services District and San Luis Obispo County Service Area 10A. Contract payments are senior obligations payable from participants' gross water revenues and subject to a 25% step-up provision.

The city's implied water revenue obligation rating considers obligations payable from a senior lien on the city's water system (the system or utility) revenues; the city's utility currently has no debt outstanding beyond its contractual obligations to the authority.

KEY RATING DRIVERS

WEAKEST LINK ANALYSIS: Fitch's analysis centers on the three primary participants -- Atascadero, SLO and Paso Robles -- which pay 96% of debt service and whose contributions could not be fully recouped through step-up provisions. The 'A+' rating reflects the credit quality of Paso Robles, whose rating is the lowest of the primary participants.

PASO ROBLES WEAKNESS CONTINUES: The 'A+' rating for Paso Robles reflects the water utility's modest debt service coverage, strong liquidity, elevated debt burden, history of rate controversy, and healthy service area. However, given a fully volumetric rate structure and large conservation mandate, financial performance is likely to be weaker in at least the short-term.

ATASCADERO, SLO REMAIN STRONGER: Fitch rates the city of San Luis Obispo's water revenue bonds 'AA' with a Stable Outlook. Atascadero's financial performance is solid with healthy liquidity and adequate, consistent debt service coverage.

FINANCIAL PERFORMANCE REDUCED BY DROUGHT: Financial performance of most participants has been solid through 2015, but state mandated drought conservation measures will force deep cuts in sales volumes in 2016, reducing revenues and debt service coverage.

STRONG RESERVES ALLOW ADJUSTMENT: Each of the primary participants has significant reserves that will allow them to absorb near-term revenue misses with limited impact on overall credit quality.

HIGH DEBT BURDEN: The participants all have high debt burdens due to the project, which is quite large relative to the utilities' customer bases.

SIGNIFICANT SERVICE AREA: The Nacimiento Water Project is of vital economic importance to California's Central Coast region. The project provides increased water supply reliability and allows for future demand growth, improving the economic prospects of the region.

SOLID LEGAL FRAMEWORK: Debt service is supported by take-or-pay water delivery entitlement contracts that provide strong bondholder protection despite variable water supply and demand conditions.

RATING SENSITIVITIES

OBLIGOR FINANCIAL PERFORMANCE: The rating is sensitive to changes in financial performance of underlying obligors. The rating could come under downward pressure if Paso Robles fails to set rates that improve financial performance over the next few years.

SIGNIFICANT WORSENING OF DROUGHT: Rating pressure could also develop if the extreme drought worsens and forces multi-year water rationing that reduces financial performance of the primary participants on a sustained basis.

CREDIT PROFILE

The participating water agencies are located on California's central coast about halfway between Los Angeles and San Francisco. The project consists of a 45-mile pipeline that connects the agencies to Lake Nacimiento, a reservoir in the sparsely developed region near the border between San Luis Obispo and Monterey counties. The connection provides the region an additional 15,750 acre feet of water annually.

PASO ROBLES WEAKNESS CONTINUES TO DRIVE RATING

The Paso Robles water enterprise's financial performance has been improving very slowly over the past several fiscal years as it navigated weak water sales, decreasing connection fee revenues, and rate controversy to build in the cost of the Nacimiento project into rates. After generating less than 1.0x DSC in fiscals 2011 and 2012, coverage reached 1.0x in fiscal 2013 and 1.11x in fiscal 2014. Projected DSC for fiscal 2015 is 1.37x.

PASO ROBLES CONSERVATION IMPACTS UNCERTAIN

The California State Water Resources Control Board in May 2015 mandated that the city reduce water usage by 28% from 2013 levels. Thus far the city has achieved 31% conservation. The city has a water ordinance in place and has enacted an amendment to the ordinance effective Aug. 1, 2015 imposing fines upon customers that use above an allotted amount. The city has not provided a projection regarding the impact of the additional conservation or penalties on revenues.

The current drought measures are likely to set back efforts to improve financial performance. Paso Robles is currently conducting a rate study and projections do not yet incorporate its state-mandated 28% reduction in water usage in 2016. The city's fully volumetric rate structure suggests a significant decline in revenues is likely.

PASO ROBLES COVERAGE INCONSISTENT

Coverage is likely to drop significantly in 2016 and could fall below 1.0x. A stress scenario assuming a 20% decline in estimated fiscal 2015 revenues shows coverage falling to 0.6x in fiscal 2016. Revenues would only have to fall 6% in fiscal 2016 to equal 1.0x.

The utility has ample cash reserves to withstand near-term revenue misses. It had $17.9 million of unrestricted cash and investments, or 832 days cash, on hand at the end of fiscal 2014. Fiscal 2014 cash levels equaled more than four years of annual debt service.

The utility has been required to make deposits to a coverage fund (essentially a prepayment of debt service) due to its failure to meet its 1.25x debt service coverage target. It had anticipated no longer needing this deposit of about $1.5 million after fiscal 2015; however, given potential revenue impacts related to the drought, the deposit may still be necessary.

While these deposits have been a sign of stress, they do benefit bondholders more than some other uses of the funds and help support the rating. Fitch believes the utility's cash position will remain healthy but vulnerable to further shocks and unlikely to support a higher rating in the near term.

Strong reserves give the utility some room to adjust rates gradually, but the rating would likely come under downward pressure if the system experiences significant revenue pressure without offsetting actions that could include additional rate increases and/or changes to the rate structure. Management says the city may consider the reintroduction of a fixed component to the rate structure during the current rate study, which could improve performance and reduce revenue volatility after fiscal 2016.

PASO ROBLES RATE CONTROVERSY

Paso Robles faced significant opposition, including protests under California's Proposition 218 and legal challenges, to fixed capital charges it tried to impose to support project costs. The rate controversy delayed by about four years the city's plan to gradually raise rates to fully cover debt service costs. After scrapping its initial rate plan, the city imposed a five-year, 2012 - 16 rate package that appeared likely to provide adequate debt service coverage when fully phased-in, but the rate package's replacement of fixed capital charges with volumetric rates exposes it to greater revenue losses in periods such as the current drought.

STRONGER OBLIGORS ADJUST MORE QUICKLY

Atascadero's financial performance has been on an upward trend in recent years with DSC at 1.25x in fiscal 2012, 1.8x in fiscal 2013 and 2.3x in fiscal 2014 with authority contractual obligations treated as debt service. DSC has outperformed expectations due to a recovery in connection fee revenues. The private, non-profit water utility expects to post DSC of about 2.3x in 2015, followed by a drop in coverage to 1.2 to 1.1x over the next five years. The forecast appears reasonably conservative both in terms of connection fee revenues and water demand, and the utility has routinely beaten such forecasts in the past.

Fitch expects coverage to dip meaningfully in 2016 due to state drought conservation regulations, which require a 28% cut in water usage. Fitch also expects the utility to continue to adjust rates as needed to restore financial performance, but if performance falls to the forecast level, it could put downward pressure on the rating. The utility has ample liquidity with 507 days cash on hand at the end of fiscal 2014, providing a solid margin of safety against any near-term revenue misses.

The Atascadero utility has significant rate flexibility because it is not regulated by the California Public Utilities Commission or subject to the tax and fee limitations that apply to rate-setting at governmental water agencies.

For information on the city of San Luis Obispo, CA's water revenue bond rating, see 'Fitch Affirms San Luis Obispo, CA's Water Revenue Bonds at 'AA'; Outlook Stable,' dated Dec. 30, 2013.

IMPORTANT SUPPLY TO SOLID SERVICE AREA

The Nacimiento pipeline project provided significant new water supply that should bolster the prospects of the underlying regional economy. The service area is known for its mild climate, vineyards and natural beauty. The local economy is relatively stable - anchored by government, educational institutions, and utilities. The state is a major employer via a local prison, university and hospital. Tourism, agriculture, retailing and construction are major private industries. San Luis Obispo County's unemployment rate of 4.3% in May 2015 was well below the state and national averages.

PROJECT LEAK REPAIRED

The pipeline was shut for repairs in June 2014 after a leak was detected in the pipeline under the Nacimiento River. Project participants did not receive deliveries during peak summer watering months of 2014, exacerbating the impact of the current drought on local supplies. Management believes the pipeline leak is the result of a construction defect. The county repaired the pipeline using about $1.5 million of unspent bond proceeds and is seeking reimbursement from the project contractor. The county restored pipeline capacity to the level necessary to provide contracted deliveries in April 2015. It plans an additional repair to restore full pipeline capacity (beyond currently contracted deliveries) at a later date.

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

In addition to the sources of information identified in the Revenue-Supported Rating Criteria, this action was informed by information from CreditScope.

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

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

U.S. Water and Sewer Revenue Bond Rating Criteria (pub. 31 Jul 2013)

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

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=988151

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=988151

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

Contacts

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:
Arlene Bohner, +1-212-908-0554
Senior Director
or
Media Relations:
Sandro Scenga, New York, +1 212-908-0278
sandro.scenga@fitchratings.com

Contacts

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:
Arlene Bohner, +1-212-908-0554
Senior Director
or
Media Relations:
Sandro Scenga, New York, +1 212-908-0278
sandro.scenga@fitchratings.com