Fitch Rates Philadelphia, PA's Water & Sewer Rfdg Revs 'A+'; Outlook Stable

NEW YORK--()--Fitch Ratings has assigned an 'A+' rating to the following Philadelphia, PA (the city) revenue bonds:

--Approximately $192,585,000 water and wastewater revenue refunding bonds, series 2016.

The city expects to sell the bonds in a negotiated sale on Oct. 13. Proceeds of the series 2016 bonds will be used to refund all or a certain portion of outstanding parity bonds (series 2007A, 2009A and 2010C) for interest cost savings and to pay issuance costs.

In addition, Fitch affirms the following rating:

--$1.72 billion in outstanding water and wastewater revenue bonds at 'A+'.

The Rating Outlook is Stable.

SECURITY

The bonds and outstanding parity bonds are secured by a senior lien on combined net revenues of the Philadelphia Water Department (PWD) water and sewer system. The series 2016 bonds will also be secured by a debt service reserve fund.

KEY RATING DRIVERS

SATISFACTORY FINANCIAL PERFORMANCE: PWD generates narrow, but consistent operating margins. All-in debt service coverage (DSC) has remained somewhat low relative to the median ratio for the rating category, averaging 1.32x over the prior five years. However, the number of days of cash on hand has continued at a fairly robust level equal to nearly 300 days cash, which exceeds the median number for the rating category. Fitch expects similar operating results through PWD's current forecast period ending in 2021. Generally affordable water and sewer rates provide a degree of flexibility.

ELEVATED DEBT BURDEN: Debt levels are moderately high and sizeable additional borrowing plans are expected over the medium term. Leverage concerns are heightened by a ratemaking board that authorizes rate recovery and will affect the extent to which PWD is able to fund future capital program costs from a healthier mix of equity and long-term debt.

LARGE CAPITAL PROGRAM: The capital program remains sizeable and will continue to be elevated for some time as a result of required consent order projects and sizeable maintenance costs associated with the city's aging infrastructure. Terms and conditions under the consent order provide the city with some flexibility as to its affordability and projected timeline.

ECONOMIC CHARACTERISTICS REMAIN MIXED: The service area is highly diverse and well anchored by a broad and stable economy. However, low income levels persist, contributing to chronically below-average collection rates and high water loss.

AMPLE CAPACITY: Water supply and overall system treatment capacity are sufficient for the foreseeable future.

RATING SENSITIVITIES

INSUFFICIENT RATE RELIEF: Difficulty in achieving sufficient rate relief under the Philadelphia Water Department's ratemaking board, particularly as capital program costs continue to escalate, would likely prompt negative rating action.

CREDIT PROFILE

LARGE, DIVERSE CUSTOMER BASE

The water system serves all of the 1.55 million residents of the city as well as a small wholesale customer that serves customers in neighboring Montgomery and Delaware Counties. The customer base is highly diverse, comprised predominantly of residential users with the 10 largest customers accounting for just 11% of fiscal 2015 total revenue. The wastewater service area, which serves greater portions of the surrounding counties, includes a larger population estimated at nearly 2.3 million.

SUFFICIENT CAPACITY

Average daily water demand is comfortably below permitted water supply and treatment capacity at all facilities, and daily wastewater flows are well within treatment plant permit limits. Available water supplies from the Delaware and Schuylkill rivers are sufficient for the foreseeable future, although significant water loss through the city's delivery system persists. Unauthorized consumption was reduced significantly during the 1990s, but progress has since stalled as non-revenue water has remained high, in excess of 30%.

SOUND FINANCIAL MANAGEMENT LEADS TO CONSISTENT OPERATING RESULTS

Fitch considers the system's financial operations to be well managed, despite historically narrow DSC levels. Management budgets to meet a 1.3x DSC target, which in some years requires transfers from the department's rate stabilization fund (RSF) to balance lower projected cash flow amounts.

Operating results for fiscal 2015 were in line with prior projections, continuing a consistent trend of satisfactory financial performance. DSC improved slightly to 1.33x over the prior year, allowing for a sizeable deposit to be made from excess cash flow to the RSF, increasing the year-end balance to $206.4 million. Fitch's DSC calculation incorporates below the line transfers out of the water and sewer fund related to various contractual obligations.

Projected results through fiscal 2021 appear achievable with DSC and liquidity continuing at acceptable levels. DSC before applying transfers to or from the RSF is forecast to decline over the near term, decreasing to a weaker range of 1.10x-1.20x through fiscal 2018. Cash flow metrics rebound in the outer years of the forecast as a sizeable drop-off in debt service obligations leads to improved coverage ratios of 1.45x. DSC after adjusting for planned RSF transfers should remain within a range of 1.25x-1.35x.

RSF balances follow a similar trend, decreasing in the initial years of the current forecast before positive growth follows, leading to a slightly higher ending balance ($212.5 million) than at fiscal year-end 2015. Assumptions built into the forecast appear reasonable, although planned rate increases will depend on board approval.

NEW RATE SETTING BODY

Passage of an ordinance in January 2014 established the Philadelphia Water, Sewer, and Storm Water Rate Board (the board), an independent rate-making body responsible for fixing and regulating water, sewer and stormwater rates. The board's initial ruling was made earlier this year, resulting in the adoption of modest annual rate increases for fiscal years 2017 and 2018. The authorization to enact multi-year rate adjustments is generally viewed positively by Fitch as it somewhat mitigates near-term concern regarding PWD's ability to gain needed rate relief under the new regulatory body.

ENVIRONMENTAL REGULATIONS DRIVE LARGE CAPITAL PROGRAM

The city continues to operate under a consent order and agreement (COA) that was signed in 2011 with the Pennsylvania Department of Environmental Protection. The COA requires the department to address combined sewer overflows over a 25-year term ending in 2036. Terms of the agreement, including total cost and timeline are considered by Fitch to be generally favorable for the city when compared to alternative, likely more costly strategies.

ESCALATION IN DEBT EXPECTED TO CONTINUE

PWD's capital improvement program (CIP) remains substantial, typical of most large, older urban combined utilities. Projected capital spending spanning fiscal years 2017-2022 totals $1.92 billion. The current CIP represents an increase of nearly 8% over the prior six-year plan, bringing the average annual growth rate to 7.6% over the prior six years. The utility's ratio of debt to net plant has steadily weakened as a result of the CIP's growth, increasing to 98% in fiscal 2015 compared to 87% in fiscal 2010 and the rating category median of 67%.

The current capital plan continues a trend of relying heavily on long-term debt as a funding source, primarily the result of modest operating margins and narrow debt service coverage that yield modest amounts of excess cash flow for pay-go. PWD is projecting annual borrowings totaling approximately $1.35 billion over the next five years, more than twice the amount of existing bond principal scheduled to be retired over that span.

The projected increase in leverage is increasingly concerning, although a sizeable drop-off in debt service that begins in 2019 should allow future bond issuances to be structured around existing obligations and prevent more rapid escalation in annual debt service obligations. Nevertheless, Fitch believes the ongoing escalation in the size of the CIP coupled with the continued strategy of funding capital program costs almost entirely with long debt will eventually begin pressuring financial margins absent more robust rate relief.

ECONOMIC IMPORTANCE OFFSETS WEAK SOCIOECONOMIC INDICATORS

Philadelphia's large population, sound economic underpinnings and distinct role as the economic driver for the broader metropolitan statistical area ensure the continued stability of PWD's service area. Unemployment continues to trend downward but remains elevated relative to the state and nation. The city's June 2016 unemployment rate fell to 6.9% compared to 7.4% at the same point in 2015.

Weak income levels persist, as the city's 26.7% poverty rate remains nearly twice the national rate and median household income approximates just 70% of state and national averages. Consequently, PWD's accounts receivable balances and annual write-offs are consistently high relative to most utilities. Including the collection of delinquent accounts, management estimates annual revenue collection at about 96% of the current amount billed each year. On a current basis, collections are estimated at about 90%.

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

Applicable Criteria

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

https://www.fitchratings.com/site/re/750012

U.S. Water and Sewer Revenue Bond Rating Criteria (pub. 03 Sep 2015)

https://www.fitchratings.com/site/re/869223

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Fitch Ratings
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Christopher Hessenthaler
Senior Director
+1-212-908-0773
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Andrew DeStefano
Director
+1-212-908-0284
or
Committee Chairperson
Doug Scott
Managing Director
+1-512-215-3725
or
Media Relations
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elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Christopher Hessenthaler
Senior Director
+1-212-908-0773
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Andrew DeStefano
Director
+1-212-908-0284
or
Committee Chairperson
Doug Scott
Managing Director
+1-512-215-3725
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com