Fitch Rates Houston, TX Combined Utility System First Lien Bonds 'AA'; Outlook Stable

AUSTIN, Texas--()--Fitch Ratings assigns an 'AA' rating to Houston, Texas' (the city) Combined Utility System (the system) first lien revenue and refunding bonds as follows:

--Approximately $887 million series 2016B.

The bonds are scheduled to sell via negotiation on Feb. 9. Proceeds from the bonds will be used to provide funds for, and refund approximately $245 million in outstanding commercial paper issued for capital improvement program (CIP) projects. Other proceeds will be used to refund about $581 million outstanding first lien revenue bonds (on parity) for debt service savings and pay issuance costs.

In addition, Fitch has affirmed the following ratings on system-related debt:

--$57.3 million junior lien water and sewer system revenue bonds (senior to the first lien revenue bonds) at 'AA+';

--$3.8 billion (pre-refunding) first lien revenue bonds at 'AA';

--$428.3 million bank bonds in aggregate corresponding to the first lien revenue refunding bonds, series 2004B bonds at 'AA';

--$375 million bank notes in aggregate corresponding to commercial paper notes series B-1, B-3, B-4, and B-6 at 'AA-'.

The Rating Outlook is Stable.

SECURITY

All bonds are special obligations of the city, payable from and secured by a pledge of the net revenues of the system. The junior lien water and sewer system revenue bonds are senior to the first lien revenue bonds and have a closed lien. Reflecting its first priority position in the flow of funds and its closed lien, these bonds are assigned a higher rating. The bank notes are secured by a third lien on net revenues of the system.

KEY RATING DRIVERS

SOUND FINANCIAL METRICS: The system completed implementation of large rate hikes (above annual adjustments) resulting in solid operating margins as well as above-average working capital and liquidity. All-in debt service coverage (DSC) remains slightly weaker than similarly rated credits, but the high liquidity and closed loop in the flow of funds largely offset this weaker metric.

RATES ADJUSTED AUTOMATICALLY: The provision for minimum annual automatic rate adjustments, determined by population growth and inflation measures, provides ongoing revenue increases to keep pace with cost of service. Despite these annual adjustments, rates remain affordable and provide flexibility for additional increases.

SIGNIFICANT CAPITAL NEEDS: The system's extensive CIP is substantial, but a large portion is attributable to the city's role in the regional groundwater reduction efforts and will correspondingly be funded from contributions of the various water authorities that purchase wholesale water from the city.

HIGHLY LEVERAGED: The system is highly leveraged and expected to remain so given its large capital plan, which was developed to actively manage the system's ageing infrastructure and growing service area. Despite debt issuance plans, debt per customer and debt per capita levels are projected to remain relatively stable.

AMPLE WATER SUPPLIES: The system's ample water supplies positioned the service area well in the most recent drought. Moreover, projects to develop additional water supplies to meet the area long-term needs are included in the CIP.

EXPANSIVE SERVICE AREA: The service area has broad and diverse economic underpinnings.

RATING SENSITIVITIES

FINANCIAL PROFILE BALANCES LEVERAGE: Maintenance of strong balance sheet and adequate coverage ratios commensurate with historical levels are key credit components of the city of Houston's Combined Utility System rating given high leverage and growing capital improvement plans.

CREDIT PROFILE

The system serves the Houston-Sugar Land-Baytown metropolitan statistical area (MSA), the sixth largest MSA in the U.S. and second largest in Texas, with an estimated population currently at 6.3 million. Service is provided either directly or indirectly through wholesale contracts with municipalities, water districts, and water authorities.

The post-recession recovery of Houston's regional economy outpaced that of many other large U.S. cities. As a robust energy sector, the Port of Houston and healthcare all contributed to healthy population and employment gains. However, the downturn in the oil market has significantly decelerated Houston's economy. Regional employment contracted 1.8% year-over-year (yoy) through November 2015. The MSA unemployment rate of 4.9% for the month was up from 4.3% in the same period last year and is now slightly higher than the state (4.5%) and U.S. rate (4.8%).

Although the plunge in oil prices is expected to affect the pace of economic growth in the city over the near term, its diverse regional economy will help to offset losses attributable to the oil sector. Employment changes by sector through Nov. 2015 shows yoy employment gains of 6.7% in leisure and hospitality and 4.2% in educational and health services counterbalanced the 6% job losses in manufacturing.

STABLE FINANCIAL PROFILE FACILITATED BY MODERATE ANNUAL RATE HIKES

In fiscal 2010 management began implementation of rate hikes to support a shift in capital improvements to a 'best practices' approach that also included transitioning to the use of pay-go versus an entirely debt-funded capital plan. However, the increase in capital investment caused a large spike in debt service costs ahead of the full implementation of the rate hikes, resulting in a reduction of DSC and even the utilization of general purpose funds (as permitted by the master bond ordinance) in fiscal years 2009 and 2010.

All-in actual DSC ranged between 1.5x to 1.6x from fiscal 2011 to fiscal 2014 as the rate increases took effect. Fiscal 2015 results slipped to 1.36x all-in DSC due to extremely wet weather. Although these coverage levels are weaker than that of other 'AA' rated credits, an offset to this lower coverage is the substantial liquidity that the city has built-up. At the close of fiscal 2015, the system maintained over 600 days' cash on hand and nearly 10 months in working capital.

Moreover, the flow of funds ends with the accumulation of monies after all obligations are satisfied in the general purpose fund (GPF). The use of the GPF is restricted for system improvements and a limited portion for city drainage purposes. At the close of fiscal 2015, the GPF had an available balance for debt service of $487 million, more than double the $222 million available in the GPF in fiscal 2011.

The system's updated projections, through fiscal 2020, reflect that all-in annual DSC will hover between 1.3x and 1.4x, which is unchanged from prior forecasts. It will be important for the system to meet or exceed these projections given the expected operating and capital pressures associated with the system's sizeable CIP.

HIGH DEBT/SUBSTANTIAL CIP

The system is highly leveraged with a large capital plan. Total debt to net plant assets is a high 108% compared to the 47% median for the 'AA' category. The system's 2016-2020 CIP is also substantial, totaling $3.6 billion with roughly 75% for water projects and 25% for sewer. Contributing to the massive capital needs are the old age of infrastructure, expected growth including regional supply shift to surface water from ground water, and the city's proactive efforts to make 'best practices' improvements instead of reacting to regulatory mandates.

A large portion of the CIP is solely attributed to the city's role as the wholesale provider for the larger metropolitan area. Approximately $1.3 billion or one-half of the water CIP will be funded with contributions from four water authorities that will be purchasing treated surface water from the city under wholesale water contracts. Also related to the wholesale surface water project is about $500 million for transmission lines, which will be funded with system debt through the State Water Implementation Revenue Fund for Texas (SWIRFT) and capital contributions from two water authorities. Although the project has been in planning stages over the last decade, it was added to the CIP recently to secure consideration of funding through SWIRFT. Funding sources for the remaining $1.8 billion in projects include about 79% of other system debt and 21% pay-go.

INCREASING SERVICE RATES

The 2004 master ordinance provides for automatic rate adjustments based on regional inflation, which requires no council action. Beginning in fiscal 2011, the city revised the inflation component of the annual automatic rate adjustments and also implemented a series of large rate hikes resulting from a cost of service rate study. The monthly residential water and sewer bill increased an average of 9.1% annually from 2011-2013. The fiscal 2014 rate hike was a modest 1.2 based on the producer price index. The city recently completed another rate study in fiscal 2015 to ensure rates remain in line with rising service costs and implemented a 4.4% rate increase effective April 1, 2015. Despite the moderate rate hikes, average residential bills remain affordable at 1.6% of the MSA median household income level.

DRAINAGE TRANSFERS EXPECTED TO DECLINE

Prior to 2011 revenues from water and sewer rates funded all of the city's drainage needs. The city began assessing and collecting a drainage fee in fiscal 2011 after city voters approved a charter amendment that provides for improvements to the city's drainage system by imposing separate charges on property owners. While transfers from water and sewer operations remain sizeable, the transfer trend is now relatively steady and is expected to decline over time. The drainage transfers will continue to support debt service of previously issued bonds (through maturity in 2042) and some operational support, but the establishment of a dedicated fund evidences a commitment to discontinue the subsidy over the long 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 and IHS Connect.

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. 03 Sep 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869223

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Contacts

Fitch Ratings
Primary Analyst:
Gabriela Gutierrez, CPA, +1-512-215-3731
Director
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst:
Major Parkhurst, +1-512-215-3724
Director
or
Committee Chairperson:
Doug Scott, +1-512-215-3725
Managing Director
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
New York
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst:
Gabriela Gutierrez, CPA, +1-512-215-3731
Director
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst:
Major Parkhurst, +1-512-215-3724
Director
or
Committee Chairperson:
Doug Scott, +1-512-215-3725
Managing Director
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
New York
elizabeth.fogerty@fitchratings.com