Fitch Rates Los Angeles, CA's Water Rev Bonds 'AA'; Outlook Stable

AUSTIN, Texas--()--Fitch Ratings assigns its 'AA' rating to the following water system revenue debt issued by the Los Angeles Department of Water and Power, CA (LADWP):

--Approximately $647 million water system revenue bonds, series 2016A;

--Approximately $333 million water system revenue bonds, series 2016B.

Proceeds of the series 2016A and 2016B bonds will fund a portion of LADWP's capital program, repay a short-term credit facility used to fund capital projects, refund outstanding debt for savings and pay costs of issuance. The 2016A bonds are expected to price on April 7, 2016 and the 2016B bonds are expected to price on May 26, 2016.

Fitch also affirms its outstanding 'AA' rating on the following bonds issued by LADWP:

--$3.9 billion water system revenue bonds;

--$325 million in bank bond rating corresponding to the variable rate series 2001B-1, B-2, B-3, and B-4 bonds.

The Rating Outlook for all bonds is Stable.

SECURITY

The bonds are special obligations of LADWP payable solely from water system revenues.

KEY RATING DRIVERS

LARGE DIVERSE SERVICE AREA: LADWP's greater Los Angeles service territory is broad, mature, and diverse, with stable customer growth. Customer growth is modest while water sales have declined as a result of conservation.

UNIQUE, ADAPTABLE RATE STRUCTURE: A five-year rate package approved in March 2016 provides strong revenue certainty to LADWP and funding for planned capital investment. Adjustable rate mechanisms provide enhanced revenue protection from variable sales and costs. The adjustable rate components, which have helped preserve strong financial performance over the last two years of higher imported water costs, provide approximately 63% of water revenues.

HEALTHY FINANCIAL MARGINS: Financial margins remain healthy despite lower water sales and escalating debt costs. Slightly lower margins in fiscal 2015 are expected to occur in fiscal 2016 as well. Financial metrics have remained in line with the rating category, in large part due to the adjustable rate factor that recovers higher imported water costs as a result of the drought.

STRONG CAPITAL INVESTMENT: Capital investment in the system has been strong in recent years. LADWP projects high levels of investment will continue to be funded with a robust pay-as-you-go contribution from revenues.

HIGH DEBT; CONTINUED ESCALATION: LADWP's anticipated debt issuance to fund its very large $5.5 billion capital plan is significant at $4.2 billion over the next five years, including the 2016 bonds. Leverage will increase substantially from already high levels.

RATING SENSITIVITIES

PRESSURE FROM INCREASING LEVERAGE: Los Angeles Department of Water and Power's (LADWP) projected leverage is high for the sector. While the recently passed rates should provide a funding source for capital over the next five years, unexpected additional capital needs or the inability to used securitized debt, as anticipated, has the potential to pressure financial margins. Financial margins that fall consistently below LADWP's 1.7x financial policy or debt needs greater than those currently expected could pressure the rating.

CREDIT PROFILE

Los Angeles (the city) is the commercial and cultural center of a very large, diverse economy. LADWP provides retail water service in the city of Los Angeles to 676,000 customers, or a population of 3.9 million. The customer base is extremely diverse, with a strong commercial presence. Water consumption has historically been strong and consistent, though it declined in the past five years with the weak economy, conservation efforts and cooler weather. Water use restrictions were put in place in Los Angeles during fiscal 2010 and remain currently.

RATE ACTION APPROVED IS FAVORABLE CREDIT DEVELOPMENT

LADWP released a five-year rate proposal in July 2015 that was recently approved by City Council in March 2016. The five year rate plan (LADWP had previously adopted rates for two-year periods) is viewed as a credit positive given the lengthy rate approval process that exists for LADWP, the large scope of planned capital spending and the variable nature of both revenues and expenditures at this utility. Revenue volatility is similar to other water utilities in California that have experienced two periods of dramatic declines in water sales from droughts in the past decade - the most recent occurring in fiscals 2015 and 2016. Expenditure variability results more directly from LADWP's dual water supply and the sizable cost differential between the two supplies.

LADWP's current water rates include two tiers of rates and six cost-adjustment factors. The new structure includes four tiers and seven cost-adjustment factors, which LADWP feels will better allocate costs to the appropriate ratepayers while incentivizing conservation. The key developments that improve revenue security are that six of the seven adjusters are now un-capped and one of the adjusters is a decoupling mechanism. This mechanism disassociates revenues from variable usage that can occur with changing weather, economic or regulatory (in the case of the state's mandated water conservation amounts) by allowing LADWP to recover or return revenues in the event that base rate revenues fall below or exceed budgeted amounts. The adjustment factors mitigate concerns about potential delays in the consideration of rate requests, as have occurred in LADWP's past.

WATER SUPPLY DIVERSITY PROVIDES FLEXIBILITY

LADWP's water supply is derived from four sources: 1) deliveries via the city's Los Angeles Aqueduct, 2) local groundwater, 3)recycled water, and 4) imported water purchased from the Metropolitan Water District of Southern California (revenue bonds rated 'AA+' by Fitch), which typically provides the remaining water supply not available from the other sources. Water supplies from the Los Angeles Aqueduct are the least expensive but are variable, providing as high as 60% in fiscal 2011 (a wet hydrological year in the region) and 10% in 2015 fiscals 2014 and 2015.

DROUGHT IMPLICATIONS CREDIT NEUTRAL

The ability to purchase water, only when needed, from Metropolitan provides supply and cost flexibility by allowing LADWP to purchase and pay for only the balance of supply. This has allowed LADWP to buy more water from Metropolitan as its other supplies suffered from the drought but also purchase less water from Metropolitan as conservation efforts escalated across the state and LADWP's water sales declined. The cost of water from Metropolitan is higher than LADWP's other supplies but is recovered through an adjustment factor in the rate structure. The result of cost recovery through all the adjusters, but primarily the water cost recovery adjuster, in fiscals 2014 and 2015 was an increase in overall water rates of 15.1% and 9%, respectively, which preserved financial margins.

LADWP's mandated conservation tier required by the state beginning in June 2015 is 16% conservation over 2013 levels. LADWP is in compliance with this requirement. The state has extended required compliance with the conservation tiers through October 2016.

STRONG FINANCIAL PERFORMANCE

All-in debt service coverage is strong as calculated by Fitch at 1.9x in fiscal 2015 and averaging 2.1x over the past three years. These strong financial margins reverse the decline in margins during fiscal years 2009-2011 that resulted from below-budgeted water sales, increasing debt service costs and lack of rate action. Increased coverage levels reflect a change to one of the rate adjustment factors just prior to fiscal 2013. Based on preliminary, unaudited numbers, all-in debt service coverage in fiscal 2016 is expected to be in a similar range to fiscal 2015.

LADWP has financial policies that target debt service coverage of 1.7x, unrestricted cash at a minimum of 150 days cash and debt to capitalization of under 65%. Liquidity levels are robust, including the expense stabilization fund, at $376 million, or 187 days of operating cash at the end of fiscal 2015. LADWP expects debt service coverage to remain at or above its minimum target of 1.7x, based on the package of adopted rate increases and the use of securitized debt for a healthy portion of its capital plan. Revenues and debt service related to the securitization are not included in LADWP's calculation of debt service coverage. Fitch views the assumption in the financial forecast as conservative and the approved rates through fiscal 2020 as providing a high degree of likelihood that the forecast levels will be achieved or exceeded.

SIGNIFICANT CAPITAL NEEDS; INCREASINGLY HIGH LEVERAGE

Significant capital investment has been made in the past decade. Improvements were funded from a mix of debt (debt doubled to $4.6 billion over the five-year time frame) and revenues (free cash flow to depreciation exceeded 100% in each year, with the exception of fiscal 2011). As a result, debt levels are high. Debt per customer at year-end fiscal 2015 was $6,738 (as compared to Fitch's median of $2,050 for 'AA' rating category water utilities) and is projected to climb to over $11,000 next five years, including securitized debt. However, debt service as a percentage of revenues is about average at 19% (Fitch 'AA' rating category median is 20%). LADWP could exceed 30% by fiscal 2020. Over the long term, continuous increases in the leverage position could reduce financial flexibility and pressure the rating.

A component of capital funding (23%) will come from rate revenue, which provides an important degree of financial flexibility and cushion for bondholders. LADWP generates over $190 million annually in revenues to contribute towards capital spending. The system's free cash/depreciation has been over 140% in the past three years, which exceeds Fitch's median for the rating category of 91%. Fitch considers maintenance of the pay-as-you-go portion of capital funding to be a critical component of the LADWP financial flexibility, in addition to its adaptable rate structure.

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

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

Additional Disclosures

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https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1001692

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1001692

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

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Contacts

Fitch Ratings
Primary Analyst
Kathy Masterson
Senior Director
+1-512-215-3730
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Douglas Scott
Managing Director
+1-512-215-3725
or
Committee Chairperson
Dennis Pidherny
Managing Director
+1-212-908-0738
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Kathy Masterson
Senior Director
+1-512-215-3730
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Douglas Scott
Managing Director
+1-512-215-3725
or
Committee Chairperson
Dennis Pidherny
Managing Director
+1-212-908-0738
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com