CHICAGO--(BUSINESS WIRE)--Fitch Ratings has assigned an expected rating of 'BBB+(EXP)' to approximately $230 million of senior tax-exempt revenue bonds series 2015A and $57 million of senior taxable revenue bonds series 2015B1-2 issued by the Kentucky Economic Development Finance Authority on behalf of the KentuckyWired Infrastructure Company, Inc. (KWIC) for the Next Generation Kentucky Information Highway project (the project). The Rating Outlook is Stable.
The final ratings are contingent upon the receipt by Fitch of final documents and legal opinions conforming to information already received and reviewed as well as the final pricing of the bonds. Fitch has not been provided any of the customary legal opinions as of the expected ratings. The bonds are expected to price on or about Aug. 26, 2015.
The rating reflects an adequate completion security package from two experienced contractors completing a relatively low-risk project under a design-build (DB) contract with joint and several guarantees. The rating further incorporates the project's expected stable revenue profile due to modest performance requirements and a fully-indexed revenue component for operations and maintenance (O&M) costs under the availability-based contract with a highly-rated commitment from the Commonwealth of Kentucky (the Commonwealth). The rating also reflects the project's ability to withstand prolonged financial stresses during the operating phase due to the market-based re-pricing of the O&M contract every 10 years.
KEY RATING DRIVERS
Completion Risk: Midrange
Experienced DB Contractor with Sufficient Security Package: The project is expected to be constructed via a DB contact whose members Black & Veatch and Ledcor (collectively, the DB contractor) are experienced contractors. DB requirements under the Project Agreement (PA) are fully passed down to the DB contractor. Completion risk in the 35 month design and construction schedule is mitigated by joint and several parent company guarantees of the DB contractor, a 40% limitation of liabilities, a 10% liquidated damages cap and a 10% LOC, which Fitch finds adequate given the complexity of the project and experience of the contractors.
Cost Risk: Stronger
Operations Self-Performed and Capital Expenses Passed-Through: Project operations are contracted to Ledcor under the Services Contract in three 10-year contracts to allow for pricing and service definition adjustments over the life of the concession. Additionally, the performance requirements under the Service Level Agreements (SLAs) for the project are on the lower end of comparable commercial fiber networks. Due to the inability to forecast advances in technology over the concession term, the project will undertake two equipment refreshes prior to years 11 and 21. The Commonwealth and project company will mutually agree upon the replacement equipment and the upgrade cost will be fully compensated through an adjustment in the availability payments, such that the Commonwealth effectively bears the risk of the refresh.
Revenue Risk: Stronger
Availability and Periodic Payments Supported by Strong Counterparty Obligation: Payments during construction and operation of the project stem from an in-kind contribution, milestone payment, and availability payments from the Commonwealth of Kentucky. Fitch has assigned an expected rating of 'A' to the Commonwealth's commitment to make these payments. The grantor's obligations meet Fitch's expectations for a rateable PPP counterparty obligation. Structural provisions are sound with the PA establishing an explicit commitment on the part of the Commonwealth to make performance-based payments to the project company. The Commonwealth itself, rather than a subsidiary agency or department, serves as the grantor and obligated counterparty under the agreement.
Debt Structure: Midrange
Typical High Leverage Offset by Conservative Structure: As for virtually all availability-based projects, leverage is initially high (15x range Net Debt/CFADS in the first steady state year). The presented debt structure is fixed rate with no refinance risk. There is a six-month tail on the senior bonds. The expected covenant package is adequate with a debt service reserve fund equal to 6 months of debt service, and a lockup trigger of 1.10x.
Solid Coverage Ratios
The Fitch case demonstrates average and minimum coverage of 1.25x. Fitch ran a sensitivity case with a 10% increase to all O&M costs excluding special project vehicle (SPV), with a lower sensitivity applied to insurance, based upon the technical advisor's (TA) assessment of a realistic outside cost (ROC) estimate in the project. This resulted in an average and minimum coverage of 1.18x. Fitch notes that after year 10 the O&M contract would be reset, taking into account the increased cost realized over the first term, returning the project to a higher coverage level near the Fitch case.
Peer Group: Fitch-rated comparables include I-69 Development Partners LLP ('BBB'/Stable Outlook) and Portsmouth Gateway Group ('BBB'/Stable Outlook). Both include low operational risk, similar debt service coverage ratio (DSCR) profiles and construction security packages. The notch difference in this project is related to better protections against potential cost increases as seen in the O&M contract approach.
Negative - Diminished Counterparty Credit: Credit deterioration of project counterparties leading to weaker risk mitigation within the project.
Negative - Project Delays: Construction delays beyond scheduled substantial completion and anticipated final acceptance dates.
Negative - Payment Deductions: Significant payment deductions during operations that reduce coverage levels well below current projections.
Positive - Outperformance During Operating Period: Successful completion and sustained operating performance materially above expectations.
The debt will be issued to fund the development of the Next Generation Kentucky Information Highway, a modern, primarily aerial high-capacity fiber network within the state of Kentucky. Fiber optics cable will span 3,393 miles and connect 1,097 sites, including K-12 schools, public universities and Commonwealth facilties within Kentucky's 120 counties to high-speed, high-capacity internet services. The network will be constructed into six network rings designed for redundancy, such that should a ring be broken at any point, functionality will continue. Ring 1B is expected to reach ring completion first. Fiber optics cable within each ring will connect to user sites, which will deliver high-speed broadband to the communities.
The Commonwealth will enter into a PA with the KWIC to design, build, finance, operate, and maintain the project for a 30-year term. The Commonwealth will compensate KWIC through an availability payment mechanism. Construction is estimated at approximately $303 million including equipment contributed by the Commonwealth with a construction period of approximately 35 months, followed by a 27-year operating period. The Commonwealth will contribute $30 million to the project in the form of designated equipment specified in the PA and any remaining amounts contributed in cash in the period following financial close and a milestone payment of $23.5 million at the completion of Ring 1B. The availability payment is split with 58.4% of the payment fixed to an annual escalator of 2.5% while the remaining 18.1% and 23.5% are linked to the Employment Cost Index for Utilities (ECI-U) and the Consumer Price Index for Utilities (CPI-U), respectively. The TA ran several downside scenarios to test the impact on deductions and concluded that penalties are not easily triggered under the PA requirements.
KWIC is a non-profit entity of the Commonwealth, incorporated to function as the project company and borrower of the debt. The bonds will be issued by the Kentucky Economic Development Finance Authority, serving as conduit. KWIC has no employees and is governed by a board of directors consisting of only Commonwealth employees. KWIC will enter into a Project Implementation Agreement, back-to-back with the PA, with KentuckyWired Operations Company, LLC (OpCo). OpCo, a special project vehicle (SPV) composed of equity members Macquarie NG-KIH Holdings, LLC (75%), Ledcor US Ventures Inc. (15%), and First Solutions LLC (10%), has been established for the purposes of designing, building, operating and maintaining the project as well as contributing a portion of subordinated capital. Total subordinated capital (junior debt plus equity) in the amount of $21 million will be supported by acceptable LOCs at financial close. Fitch was not provided with a non-consolidation opinion as the project company, as borrower, is a non-profit entity of the Commonwealth.
Construction will be performed by a joint venture of Ledcor and Black & Veatch. The obligations will be joint and several and a parent company guarantee will be provided by Ledcor Contractors Group Inc. and BVH, Inc. The construction security package further includes: a 40% limitation of liabilities under the DB contract, a LOC equal to 10% of the DB contract, and liquidated damages capped at 10% of the DB contract. Fitch's examination of the TA's replacement analysis shows that in the unlikely event that both contractors simultaneously default the security package would be sufficient to bring in a replacement contractor to complete the project. Additionally, Fitch's internal assessment of the contractors combined with the completion security package does not constrain the rating at the current level. Fitch analyzed completion risk in this project consistent with the approach outlined in Fitch's 'Completion Risk in Project Finance' special report dated Oct. 13, 2013.
The construction is relatively straightforward and standard and the project is not considered overly complex. With 85% of the network aerial and the remaining 15% submerged underground at a depth of only three feet, the complexity of construction is viewed as low. Mobilization and coordination within the DB contractor is viewed as the largest obstacle to overcome. There is no new technology involved in the construction or operation.
Project operations are contracted to Ledcor (responsible for 52% of annual O&M costs) under the Services Contract in three 10-year contracts to allow for pricing and service definition adjustments over the life of the concession given the challenges of pricing 30 years of technological and operational uncertainty into a single contract. Fujitsu Network Communications Inc. (36% of O&M costs) will be subcontracted to maintain the equipment and network operations center. The remaining 12% of costs are related to SPV, administration, and insurance. Ledcor has a 12-month LOC included as additional security, which the TA opined would be sufficient to cover the long-term premium for an O&M contractor replacement, although very unlikely due to Ledcor and Fujitsu's extensive experience.
There is no risk to the project in lifecycle costs, as the Commonwealth is taking on the risk of replacement equipment. The lifecycle costs of the project are captured in the network refresh, which occurs before years 11 and 22. Leading up to those periods, the Commonwealth and KWIC will negotiate what equipment to replace the system with, as it is envisioned equipment has a useful life of approximately 10 years as opposed to the fiber, which has an expectancy of life beyond the concession term. The financial model predicts each network refresh to cost approximately $44 million, with the project company being fully compensated for the cost through additional availability payments from the Commonwealth. Unlike most availability projects, there is no major maintenance reserve due to the direct compensation for replacement costs.
Fitch has adopted the sponsor's base case as the Fitch case due in part to Fitch's comfort level with the project's construction and O&M cost assumptions as a result of its own analysis and extensive dialogue with the TA. The results of the Fitch case (1.25x minimum and average DSCR) are in-line with coverages typically seen in the 'BBB' category for availability projects, given their lack of volume risk.
Discussions with the TA indicate that if expenses exceeded initial projections in a conservative cost over-run scenario, it is reasonable to believe they could increase up to 10% over budget. Fitch applied this cost risk as the realistic outside cost (ROC) estimate in this project consistent with the approach outlined in Fitch's 'Analysing Cost Risks in PPP Projects' special report dated June 22, 2015.
Fitch applied a 10% ROC to all O&M costs, excluding the SPV while applying a reduced stress to insurance to assess the impact stresses would have on the profile. The results are consistent with a 'BBB+' rating, having a 1.18x average and minimum DSCR. No sensitivity was applied to SPV costs due to the view of control for such costs, and the lower insurance sensitivity is due to the Commonwealth self-insuring significant components of the project including property. Fitch notes the O&M contract will be market tested every 10 years, mitigating the likelihood of persistent higher costs for the complete concession term, which the rating case does not reflect. It is practical to forecast coverages would return to the Fitch case levels near 1.25x at the beginning of a new O&M term and would have to experience a further 10% increase to costs after the adjustment to return to rating case levels.
Fitch analyzed a number of loan life coverage ratio break-even scenarios related to the proposed financial structure and considers the levels consistent with investment grade. When run on the adopted Fitch case, the model indicates the financial structure can withstand a 15.8% deduction in availability payments, and a 42% increase in O&M costs. Although the O&M break-even is lower than Fitch has seen on other projects rated in the 'BBB' category, the risk of cost increases is mitigated by the rebidding and market testing of the O&M contract every 10 years to better reflect service definition and pricing adjustments. This will allow any increased costs in the first term to be adjusted for in the second term, essentially resetting the break-even metric to recalculate over the remaining, shorter term and resulting in an improvement.
All secured obligations will be secured by a security interest in the borrower's right, title, and interest in its assets (subject to exclusions), including the right to availability payments and other payments due or to become due under the PA. The senior revenue bonds will constitute senior secured obligations of KWIC, and along with the other senior secured obligations, will rank in priority to the secured subordinate revenue bonds, which rank in priority to all unsecured obligations of KWIC.
Additional information is available at 'www.fitchratings.com'.
Exposure Draft: Rating Criteria for Availability-Based Projects (pub. 17 Jun 2015)
Rating Criteria for Infrastructure and Project Finance (pub. 12 Jul 2012)
Rating Public-Sector Counterparty Obligations in PPP Transactions (pub. 23 Jul 2015)
Dodd-Frank Rating Information Disclosure Form