Fitch Rates Houston, TX Combined Utility System First Lien Bonds 'AA'; Outlook Stable
AUSTIN, Texas--(BUSINESS WIRE)--Fitch Ratings assigns an 'AA' rating to Houston, Texas' (the city) Combined Utility System (the system) first lien revenue bonds as follows:
--Approximately $778 million first lien revenue refunding bonds, taxable series 2014B;
--Approximately $550 million first lien revenue refunding bonds, series 2014C.
The bonds are scheduled to sell the week of March 10. Proceeds will be used to refund the majority of the currently outstanding series 2004B bonds for savings and to pay issuance costs.
In addition, Fitch takes the following rating action on system-related debt rated by Fitch:
--$57.3 million junior lien water and sewer system revenue bonds (senior to the first lien revenue bonds) affirmed at 'AA+';
--$4.2 billion first lien revenue bonds affirmed at 'AA';
--$428.3 million bank bonds in aggregate corresponding to the first lien revenue refunding bonds, series 2004B bonds affirmed at 'AA';
--$375 million bank notes in aggregate corresponding to commercial paper notes series B-1, B-3, B-4, and B-6 affirmed at 'AA-'.
The Rating Outlook is Stable.
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, and above-average working capital and liquidity. All-in debt service coverage remains slightly weaker than similarly rated credits, but the high liquidity, ample balance in the general purpose fund, 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 revisions.
SIGNIFICANT CAPITAL NEEDS: The system's capital improvement plan (CIP) remains extensive but is relatively manageable given the system's size and broad service area.
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 (although they are considered high).
AMPLE WATER SUPPLIES: The system's ample water supplies positioned the service area well in the extreme drought of 2011; operating and financial performance was not adversely affected by the drought.
EXPANSIVE SERVICE AREA: The service area has broad and diverse economic underpinnings.
FINANCIAL PROFILE BALANCES LEVERAGE: Maintenance of the system's strong balance sheet and adequate coverage ratios are key credit components of the rating given some concern related to the system's high leverage.
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 area economy fared better than many other large U.S. cities during the recession, as relatively high energy prices and a favorable business climate provided some cushion against other recessionary forces. The MSA unemployment rate decreased to 5.5% as of December 2013 from 6.1% a year prior. The MSA's rate is now just marginally lower than the state (5.6%) and well below the national average of 6.5%.
IMPROVED 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 debt service coverage and even the utilization of general purpose funds (as permitted by the master bond ordinance) in fiscal years 2009 and 2010.
All-in actual debt service coverage exceeded management expectations over the last three fiscal years as the rate increases took effect. All-in coverage ranging between 1.5x and 1.6x for those years is slightly weaker than that of other 'AA' rated credits, but an offset to this lower coverage is the substantial liquidity that the city has built-up. At the close of fiscal 2013, the system had over 600 days cash on hand and just over 14 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 2013, the GPF had a balance of $508 million, more than double the $250 million in fiscal 2011.
The system's updated projections, through fiscal 2018, reflect that all-in annual debt service coverage will hover between 1.3x and 1.4x, which is marginally lower than the forecast from December 2013 due to lower than previously projected rate hikes tied to the regional inflation factor. 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.
SUBSTANTIAL BUT MANAGEABLE CIP
The system's 2014-2018 CIP is large due to the age of the infrastructure, expected growth, and the city's strategy shift to make 'best practices' improvements from a regulatory and health standards compliance approach. The $2 billion CIP is forecasted to be partly funded on a pay-go basis (about 17% of total funding sources), compared to prior years' plans that entirely debt-financed capital improvements. Nevertheless, the amount of additional debt required to meet the CIP funding requirements is a risk considering the system is already highly leveraged.
The high leverage was driven partly by ground subsidence issues that forced the system to shift its water reliance from ground water to surface water. The city has ample water supplies and was well positioned during the drought of 2011. Subsequent heavy rainfalls have restored lake levels to normal, and the city remains in a good position regarding water supply.
INCREASING SERVICE RATES
The 2004 master ordinance provides for automatic rate adjustments based on regional inflation, which requires no council action. Based on this provision, water and sewer rates increased an average of 2.5% annually from fiscal 2006 to 2009, and a 5.1% increase, which also included an adjustment for population growth within the city, was implemented for fiscal 2010.
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 bill has increased nearly 58% from fiscal 2009 levels as a result. Despite the large rate hikes, average residential bills remain very affordable at 1.4% of the MSA median household income (MHI) level, well below the Fitch 2% MHI affordability threshold. The city is planning another rate study in fiscal 2015 to ensure rates remain in line with rising service costs.
DECLINING SUPPORT FOR DRAINAGE
In 2010 city's voters approved a charter amendment that provides for improvements to the city's drainage system by imposing separate charges on property owners receiving drainage services; revenues from water and sewer rates had previously funded drainage needs. The city began assessing and collecting the drainage fee in fiscal 2011.
Transfers from water and sewer operations remained sizable in fiscal 2011 to support start-up costs of the drainage system, but a declining trend in the transfers is evident in fiscal years 2012 and 2013. The drainage transfers will continue for a number of years to support debt service of previously issued bonds and some operational support, but the establishment of a dedicated fund evidences a commitment to discontinue the subsidy in the long term.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in Fitch's U.S. Municipal Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope.
Applicable Criteria and Related Research:
--'Revenue-Supported Rating Criteria' (Jun. 3, 2013);
--'U.S. Water and Sewer Revenue Bond Rating Criteria' (Jul. 31, 2013);
--'2014 Water and Sewer Medians' (Dec. 12, 2013);
--and Sewer Sector' (Dec. 12, 2013).
Applicable Criteria and Related Research:
2014 Outlook: Water and Sewer Sector
2014 Water and Sewer Medians
U.S. Water and Sewer Revenue Bond Rating Criteria
Revenue-Supported Rating Criteria