NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed its 'BBB+' rating on approximately $232 million of senior tax-exempt revenue bonds series 2015A and $58 million of senior taxable revenue bonds series 2015B-1 & B2 issued by the Kentucky Economic Development Finance Authority on behalf of the Kentucky Wired Infrastructure Company, Inc. (KWIC) for the Next Generation Kentucky Information Highway project (the project). The Rating Outlook has been revised to Negative from Stable.
KWIC also holds $15.2 million in subordinate debt which is not rated by Fitch.
With construction about one year delayed, the Negative Outlook reflects uncertainty regarding the Commonwealth of Kentucky's approval of a new target system completion date, and whether the potential for further delays can be accommodated without jeopardizing the long stop date. The Outlook also reflects uncertainty as to the magnitude of costs disputed between the Commonwealth and project's design build (DB) contractors, and whether adequate contractor security will remain to support obligations through the construction period. Resolution of the Negative Outlook is predicated upon approval of a new target system completion date, which sufficiently mitigates against future construction delays unprotected by the project agreement (PA) and clarity and/or resolution of disputed costs between the Commonwealth and the DB contractors which does not materially erode the contractors' security package (including letter of credit [LOC]).
The 'BBB+' rating reflects the project's relatively low complexity, whose construction is supported by two experienced contractors within the design build joint venture (DBJV) with joint and several guarantees and an adequate security package. The rating further incorporates the project's low exposure to operating cost risk as a result of its limited scope, experienced operator, proven technology, and ability to fully pass-through capital expenses to a financially strong counterparty, the Commonwealth of Kentucky. The rating also reflects KWIC's expected stable revenue profile due to modest performance requirements and fully-indexed availability payments via the project agreement (PA) with the Commonwealth. Solid rating case average debt service coverage ratios (DSCR) of 1.18x and an adequate realistic outside cost (ROC) multiple of over 5x falls on the cusp of 'BBB' and 'A' category guidance provided within Fitch's availability payment criteria.
KEY RATING DRIVERS
Manageable Completion Risk [Completion Risk: Midrange]: The medium-scale project benefits from a DBJV of experienced contractors, including Black & Veatch and Ledcor, with a joint and several liability. The contract is fixed-price with DB requirements passed down to the DBJV via the PA. Cost and scheduling budgets are considered in line with market standards. Though the duration of construction is currently expected to span an additional year as a result of delays, some of the risk is mitigated by permitted extensions under the PA. The project's security package, which contains a 40% limitation of liabilities, 7.5% liquidated damages cap and 10% LOC, is expected to serve as a sufficient mitigant against reasonably stressful scenarios including a simultaneous contractor default, further offset by a deep telecommunications contractor market.
Limited Scope, Pass-Through Capex [Cost Risk: Stronger]: The project's relatively limited scope of operations, established technology, and self-performed O&M by experienced operator, Ledcor, via three 10-year contracts allows for higher levels of cost predictability. Capital expenses in the form of replacement equipment and system upgrades will be mutually agreed upon by the Commonwealth and project company, and fully compensated via an adjustment in the availability payments. The absence of lifecycle reserves is mitigated by the project's ability to fully pass-through capital expenses to the Commonwealth.
Payments Supported by Strong Counterparty [Revenue Risk: Stronger]: The project's financial position is supported by an in-kind contribution, milestone payment, and availability payments from the financially strong counterparty, Commonwealth of Kentucky, whose obligation has been rated at 'A'/ Stable. The project's contractual provisions establish strong incentives for grantor performance, involving compensation for debt and potentially equity under a voluntary termination scenario. Positively, deduction exposure is deemed minimal as a result of modest performance requirements under the Service Level Agreements.
Conservative Debt Structure, Adequate Reserves [Debt Structure: Midrange]: Senior debt is fully amortizing, fixed-rate debt with relatively flat debt service obligations through final maturity in 2044. The covenant and reserve package is adequate with a debt service reserve fund equal to six months of debt service and an equity distribution trigger of 1.10x DSCR.
Solid Coverage Ratios, Suitable ROC Multiple
Fitch's rating case assumes a 10% increase to O&M costs, a 5% increase to insurance costs and no special project vehicle (SPV) cost increases, per the technical advisor's (TA) assessment of the project's ROC, for an all-in ROC of approximately 7.3%. The rating case yields solid average and minimum DSCRs of 1.18x. The project's 42% all-in O&M breakeven and all-in ROC lends to a ROC multiple of over 5x, which is somewhat uplifted by the project's ability to rebid and adjust for increased costs at the time of each O&M contract renewal.
Peer Group: Fitch-rated peers include NYNJ Link Borrower LLC ('BBB'/Stable) and Portsmouth Gateway Group (PGG, 'A-'/Stable), which share low revenue risk and similar base case DSCR profiles. PGG's higher rating is explained by its robust ROC multiple of over 16x, while NYNJ's rating is capped at 'BBB' as a result of a relatively weaker security package than peers.
- A new target system completion date which does not adequately accommodate the potential for further delays, jeopardizing completion by the long stop date.
- Failure to maintain adequate contractor liquidity to support obligations and/or significant credit deterioration of DB contractors leading to weaker risk mitigation within the project;
- Significant payment deductions during operations which pressure coverage levels below 1.18x on a sustained basis.
- Successful completion, sustained operating performance, and DSCRs persistently above base expectations.
The Next Generation Kentucky Information Highway is a modern, primarily aerial high capacity fiber network within the state of Kentucky. Fiber optic cable will span 3,393 miles and is designed to connect 1,097 sites, including K12 schools, public universities and Commonwealth facilities within Kentucky's 120 counties to high-speed, high-capacity internet services. All secured obligations have 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 project agreement.
As detailed in Fitch's August 2016 non-rating action commentary titled "Fitch: Concession Provisions Mitigate Delay Risk for Kentucky Wired Infrastructure Co.", the project is currently facing delays of up to one year as a result of challenges experienced in obtaining pole attachment agreements (PAA) with telecommunication providers. The resulting delays are mitigated via a compensation event provision in the PA, which entitles the project to relief in the form of a schedule extension. The PA's long stop date will consequently be extended and remain one year after the target system completion date, as adjusted for the compensation event. Additional potential permitting or easement delays could also trigger future schedule extensions.
The target system completion date is currently under negotiation, with the Commonwealth and DB contractors each aiming to minimize absorption of delays. Should the new target system completion date be deemed reasonable by the TA, Fitch expects the 12-month allowance between system completion and the long stop date to be sufficient to accommodate additional unplanned delays not protected under the PA.
However, the potential for an aggressive new target system completion date causes credit concern, as overly optimistic milestones could result in construction delays that materially erode the 12-month buffer between system completion and the long stop date. Adding to the delay concerns, the project is dependent on completion of ring 1B to receive the milestone payment of $23.5 million to support construction activities. Further, the project's early stage of construction elevates the risk of additional unplanned delays not protected by permitted extensions under the PA. Fitch expects the TA to opine on the potential for further delays not protected under the PA.
Since August 2016, PAA activities have progressed, evidenced by an increase of the total percentage of poles covered by executed PAAs to 81% from 75%. Between October 2016 and August 2016, engineering activities have increased to 69% completion from 62% completion. Procurement activities have increased to 26% completion from 23% completion, and overall construction activities have grown slightly to 1.2% completion from 0.8% completion. Once Fitch receives the newly established schedule including a revised system completion date, the agency will evaluate in consultation with the TA whether the new timeline leaves the project with an adequate allowance for project completion.
The project has limited exposure to potential cost overruns, which would be absorbed by the Commonwealth and/or the security package provided by the DB contractors. However, the Commonwealth and the DB contractors are currently in dispute with respect to responsibility for the costs of securing private easements. The magnitude of the potential costs and the extent to which the contractors' liquidity could be affected are currently unclear. The project has reported that the contractors' LOC has not been drawn and the contractors' have made liquidated damage payments as required, which Fitch views positively.
The dispute resolution process is currently at the independent referee stage, and the parties believe the referee will provide a non-binding decision within the upcoming weeks. If the dispute is not resolved by the referee at that time, the dispute could be first escalated to Kentucky's Finance and Administration Cabinet and then ultimately to the state court. Clarity in terms of which party is likely to bear the cost burden is currently unavailable. Once there is greater clarity over the disputed amounts and/or the dispute has been resolved, Fitch plans to review whether adequate contractor security remains to support obligations through the project's construction.
KWIC maintains adequate liquidity to support near-term obligations. Monthly availability payments by the Commonwealth continue to be timely and fully funded through fiscal year (ending June) 2018. In addition, bond proceeds of nearly $190 million support construction and capitalized interest costs.
The progress of construction activities, cooperation of relevant parties to reach resolution, and the Commonwealth's continued public support of the project are relevant factors for project's completion. Nevertheless, negative rating action may be warranted if potential delays jeopardize completion by the long stop date, and/ or if there is significant erosion of the contractors' security compared to the remaining works.
Fitch has made no changes to the project's projected financial profile as availability payments are expected to continue uninterrupted, in line with KWIC's base case profile. Fitch adopted the sponsor's base case as the base case due to Fitch's comfort level with the project's construction and O&M cost assumptions as a result of its own analysis and dialogue with the TA. Discussions with the TA indicated O&M costs could realistically increase up to 10% over budget, which led Fitch to apply a 10% ROC to all O&M costs, a 5% increase in insurance costs, and no increase to SPV costs (due to view of control for such costs) in its rating case, for an all-in ROC of approximately 7.3%. As a result, Fitch's base and rating case average DSCRs are 1.25x and 1.18x, respectively.
The project's model indicates the financial structure can withstand a 15.8% deduction in availability payments and a 42% increase in O&M costs (draining the debt service reserve) before breaking even over the first 10 years of operation, which yields a ROC multiple of over 5x. The project could also benefit from rebidding and market testing of the O&M contract every 10 years to better reflect service definition and pricing adjustments, which could allow for first-term cost increases to be adjusted during the second term, thereby potentially allowing Fitch's breakeven metric to increase. Currently, the project's DSCR and ROC multiple profiles are on the cusp of 'BBB' and 'A' category in comparison to guidance within Fitch's availability payment criteria, explaining the 'BBB+' rating.
Additional information is available on www.fitchratings.com
Rating Criteria for Availability-Based Projects (pub. 21 Jul 2016)
Rating Criteria for Infrastructure and Project Finance (pub. 08 Jul 2016)
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