Fitch Expects to Rate Detroit, MI Water & Sewer Revs
AUSTIN, Texas--(BUSINESS WIRE)--Fitch Ratings expects to assign the following ratings to the Michigan Finance Authority, MI (the authority) local government loan program revenue bonds issued on behalf of the city of Detroit, MI (the city) for the Detroit Water and Sewerage Department (DWSD):
--$152.2 million DWSD sewage disposal system revenue senior lien local project bonds, series 2014C1 and C2 'BBB-';
--$683.5 million DWSD sewage disposal system revenue refunding senior lien local project bonds, series 2014C3, C4, C5 and C6 'BBB-';
--$99.8 million DWSD sewage disposal system revenue refunding second lien local project bonds, series 2014C7 and C8 'BB+';
--$774.3 million DWSD water supply system revenue refunding senior lien local project bonds, series 2014D1, D2, D3, D4 and D5 'BBB-';
--$80.7 million DWSD water supply system revenue refunding second lien local project bonds, series 2014D6 and D7 'BB+'.
The bonds are expected to price the week of Aug. 25. Proceeds will be used by the authority to purchase certain DWSD obligations and pay costs of issuance. Proceeds from the sale of the DWSD obligations will be used by the DWSD to make certain improvements to its sewer system as well as refund certain DWSD sewer system and water system debt.
At this time, Fitch also places the following outstanding DWSD bonds (pre-refunding) on Positive Watch from Negative Watch:
--$1.1 billion senior lien water revenue bonds 'BB+';
--$565 million second lien water revenue bonds 'BB';
--$1.6 billion senior lien sewer revenue bonds 'BB+';
--$788 million second lien sewer revenue bonds 'BB'.
The Positive Watch indicates that at the time of conversion of the 2014 expected ratings to final ratings, Fitch anticipates revising its ratings on DWSD's respective senior lien and second lien system outstanding bonds to 'BBB-'/'BB+' and assigning a Stable Outlook to all bonds.
The final ratings on the series 2014C1-C8 and series 2014D1-D7 (the 2014 bonds) are contingent upon the receipt by Fitch of: (i) executed documents and legal opinions conforming to information already received and reviewed; (ii) the final pricing of the 2014 bonds; and (iii) legal actions by the city and bankruptcy court (the court) overseeing the city's bankruptcy case authorizing the 2014 bonds (including granting a perfected security interest in and liens upon pledged assets) and approving a settlement between the city and various parties (the DWSD settlement parties) that, among other things, resolves certain objections by DWSD creditors to the city's proposed plan of adjustment (the POA).
Senior lien water and sewer bonds are separately secured by a first lien on net revenues of each respective water and sewer system (the systems). Second lien bonds are separately secured by a second lien on the net revenues of each respective system after payment of senior lien bonds.
KEY RATING DRIVERS
NEAR-TERM UPGRADE EXPECTED: The expected ratings on the 2014 bonds and change in Watch status to Positive from Negative on the outstanding system bonds reflects the city's tender offer to DWSD bondholders, which is anticipated to yield certain economic benefits for the systems and simultaneously resolve contentious legal issues relating to the city's attempted impairment of certain DWSD bonds. The expected ratings on the 2014 bonds and change in Watch also reflect ongoing DWSD actions as well as recent revisions to system baseline financial assumptions that Fitch believes are more likely to achieve steadily improving financial margins going forward.
WEAK FINANCIAL OPERATIONS: The systems exhibit weak financial results, having historically missed forecast expectations on a regular basis and for various reasons.
SEPARATE OPERATIONS: All system funds and accounts are separate and distinct from other city funds including the city's general fund. Excess system funds are invested by the bond trustee for and at the direction of DWSD.
HIGHLY LEVERAGED DEBT PROFILE: The systems' debt load is expected to remain elevated for the foreseeable future. With the downward revision in baseline financial assumptions, management has included higher near-term borrowing estimates in its capital improvement plans (CIPs). Over the longer term though it is envisioned a greater use of pay-go capital funding will prevail and alleviate debt pressures to some degree.
EXPANSIVE SERVICE TERRITORY: The systems provide essential services to a broad area. The water system covers roughly 43% of Michigan's population, with over 70% of operating revenues coming from wealthier suburban customers. The sewer system includes roughly 30% of Michigan's population, with over 50% of operating revenues coming from suburban customers.
STRONG RATE-ADJUSTMENT HISTORY: The governing body has instituted virtually annual rate hikes in support of financial and capital needs.
COMPLETION OF TENDER REFUNDING: Fitch expects to rate the 2014 bonds and upgrade DWSD's outstanding respective senior and second lien bonds to 'BBB-'/'BB+' and assign all bonds a Stable Outlook upon closing of the proposed 2014 bonds coupled with the actions detailed above, including the issuance by the court authorizing the 2014 bonds and approving certain agreements between the city and certain DWSD objectors to the city's POA.
FAILURE TO CLOSE TENDER: Failure to close the transactions and subsequently remove the originally proposed impairment of DWSD bonds in an updated city POA would result in a resumption of the legal status quo and financial uncertainty related to the systems. This in turn would lead to maintenance of the existing ratings and a reinstatement of the Negative Watch. Further, Fitch would continue to view the court's confirmation of an impairment as a likely distressed debt exchange, which could ultimately lead to a rating downgrade to as low as 'D'.
TENDER RESOLVES CHAPTER 9 LEGAL QUESTIONS AND BENEFITS SYSTEMS
The city has made an invitation to bondholders to tender all of DWSD's outstanding system bonds, with such tender offer period closing Aug. 21, 2014. The offered tender prices are intended to reflect current market prices, with the city offering to pay par or higher on the vast majority of bonds currently proposed to be impaired under the POA. Subsequent to the closing of the tender period, DWSD's Board of Water Commissioners (BOWC, DWSD's governing body) voted Aug. 22, 2014, to accept water and sewerage system bond tenders of up to $752 million (31% of bonds outstanding) and $715 million (26%), respectively. Monies to fund the BOWC-approved tenders will be derived from a portion of the proceeds of the sale of the Michigan Finance Authority 2014 bonds or a private placement.
As conditions to closing the 2014 bonds, the court is to enter an order authorizing the issuance of the 2014 bonds and granting a perfected security interest in and liens upon pledged assets securing the 2014 bonds, with such liens on parity with existing water and sewer system bonds. Also, the court is to approve a settlement between the city and the DWSD settlement parties whereby water and sewer claims under the city's POA would be treated as unimpaired with the closing of the 2014 bonds. In addition, accrued water and sewer system pension and other post-employment liability benefits will be fixed through fiscal 2023. These legal actions would resolve significant uncertainty that has surrounded DWSD's outstanding bonds in recent months while also eliminating likely substantial future litigation costs related to the proposed POA and providing DWSD cumulative debt service cash flow savings currently estimated in excess of $240 million by refunding tendered bonds at current market rates.
NEGATIVE RAMIFICATIONS OF STATUS QUO IN SPITE OF CHAPTER 9 LEGAL PROTECTIONS
Fitch continues to maintain the view that there is substantial protection provided to the DWSD's system debt even without the proposed tender refunding transactions. DWSD's debt constitutes special revenue obligations under Chapter 9 of the bankruptcy code, and certain legal and practical separations exist between system funds and other city funds. Having said this, failure to achieve the tender refunding and associated legal actions would result in the status quo whereby the city seeks to impair certain DWSD bonds.
Under such a situation, Fitch would expect to maintain the current ratings at 'BB+'/'BB' for the senior and second lien bonds, respectively, and to again place them on Negative Watch. If the POA was confirmed as filed and thereby resulted in impairment to bondholders, Fitch would likely view the action as a distressed debt exchange leading to a ratings downgrade to as low as 'D'. However, Fitch would not take any such rating action prior to resolution of the significant objections filed by bondholders and other creditors.
WEAK FINANCIALS EXPECTED TO IMPROVE
Estimated financials for fiscal year ending June 30, 2014 point to modest margins that were up slightly from fiscal 2013 actuals but below prior forecasts. For the year, total debt service coverage (DSC) on water obligations was a relatively slim 1.17x and 1.18x on sewer obligations. Days cash for fiscal 2014 rose somewhat for both systems, increasing to 136 days cash for water and 138 days for sewer but remained relatively weak compared to other rated utilities.
A major credit concern in recent years has been DWSD's poor financial results and inability to meet forecast results which in turn has led to uncertainty as to ongoing minimum performance levels. Recognizing these projection issues, management recently undertook a systematic reevaluation of underlying forecast assumptions. For the most part assumptions have now been revised to more conservative levels, particularly with regard to sales and bad debts. In addition, certain costs related to proposed POA pension and other post-employment benefit changes have now been included in DWSD's projections. With the assumption changes, lower margins are contemplated through the fiscal 2019 forecast period than previously expected. Nevertheless, current estimates appear more realistic, making meeting forecast results in the future more likely.
With fiscal 2015 serving as the base year of the forecast, total DSC for water obligations is now expected at 1.25x compared to budgeted DSC of 1.37x. On the sewer side, total DSC is currently anticipated at 1.19x as opposed to the 1.30x budgeted. Thereafter, DSC is generally stable or shows modest improvement each year through fiscal 2019. The limited surplus cash flows provide only minor improvement to liquidity, although days cash for fiscal 2015 is estimated to reach around 145 days for water and 170 days for sewer (compared to around 135 days and 140 days, respectively, in fiscal 2014) and then climb annually thereafter.
Apart from forecast assumption changes, ongoing organizational improvements should help to improve or stabilize revenue levels and reduce costs. On the revenue front, DWSD has been working with its wholesale customers to revise water purchase estimates and shift to an increasing amount of fixed cost recovery. DWSD also implemented a rate simplification initiative for wholesale sewer customers effective for fiscal 2015 that identifies each customer's proportionate costs based on historical average shares, with such shares billed monthly and locked in for three years before being subject to recalculation.
On the retail side, DWSD has been working to reduce delinquencies through service cutoffs, although DWSD implemented a voluntary moratorium on residential shut-offs from July until Aug. 26 in order to address enforcement concerns from customers. Nevertheless, DWSD and the Mayor remain supportive of collection efforts and significant reductions in past-due amounts have occurred recently, with further improvement expected over the coming months. Specifically, the city paid over $10 million in past-due amounts (or 12% of outstanding retail delinquencies 60-days past due) to DWSD on Aug. 14, 2014, bringing its account current. Also, around 1,500 residential customers turned out at a pay-your-bill fair on Aug. 23, 2014, which further reduced delinquencies.
With regard to operating expenses, management continues to implement its organizational optimization, which has entailed cutting the number of job classifications in recent years and reducing by around 30% DWSD's workforce from 2011 to 2014. As a result, operating expenses have trended downward over the last three fiscal years and further savings are expected as DWSD expects to eliminate an additional 30% of positions by fiscal 2019.
Offsetting reductions in personnel costs are rising expenses associated with POA assumptions regarding the city's prior general retirement system plan, in which DWSD employees participate. The POA - as agreed upon between the city and the DWSD settlement parties and with the closing of the 2014 bonds - envisions that DWSD will contribute a total of $409 million during fiscals 2015-2023 to reduce associated DWSD-related accrued liabilities on an accelerated basis. Based on negotiations with creditors, annual contributions of the systems paid as operations and maintenance expenses will be limited to $24 million with all remaining costs paid after DWSD debt service. Positively, after fiscal 2023 DWSD pension benefit costs should drop significantly and be reflective of normal annual pension costs.
SYSTEM LEVERAGE REMAINS HIGH
Fitch expects leverage for both systems to remain high for the foreseeable future. DWSD's system long-term debt per customer totaled a high $3,480 for sewer and moderately high $2,150 for water. Principal payout is relatively normal compared to other sector credits at just under 80% over 20 years for both water and sewer.
The systems' 2015-2019 CIPs increased recently to $674 million (a 34% increase) on water and $553 million on sewer (9%). Along with these increases, additional borrowings are also expected given the narrower financial margins. For water, planned borrowings more than doubled, up 67% from original estimates; sewer borrowings are staying relative flat compared to last year's estimates. The dramatic rise in projected costs and borrowing on the water side stem from the near-completion of the updated water master plan. One major consideration of the update was to evaluate the feasibility of reducing or repurposing certain water treatment plants as well as distribution mains in order to more actively match asset capacity to needs over the next 20 years. The updated master plan will result in significant near-term investment but these costs are expected to moderate over time. These additional capital costs are factored into DWSD's projections.
BROAD SERVICE AREA ENHANCES SYSTEM STABILITY
The water system is a regional provider serving around 4.2 million people or nearly 43% of Michigan's population, including the city's population of over 700,000. The system serves the city on a retail basis and 124 communities through 84 wholesale contracts. The service territory consists of 138 square miles in Detroit and 981 square miles in eight counties.
The sewer system is a regional provider serving around 2.8 million people or nearly 30% of Michigan's population, including the city. The system serves the city on a retail basis and 76 communities through 22 wholesale contracts. The service territory consists of 138 square miles in Detroit and 850 square miles in three counties.
Population and customer growth for both systems have experienced modest annual declines for a number of years. Detroit's population in particular has experienced continuous decline, but suburban areas have picked up most of the migration.
CONSISTENT SYSTEM RATE INCREASES
BOWC has consistently raised rates to meet financial and capital needs. However, unfavorable operating conditions (including very high delinquencies) and rising fixed costs have muted the positive revenue impact. With the change in assumptions, DWSD expects that revenue increases will be limited to 4% annually.
For more information on DWSD, see Fitch's non-rating action commentary, 'Fitch: Detroit Water/Sewer Tender Would Not be a Distressed Debt Exchange', dated Aug. 21, 2014, available at www.fitchratings.com.
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, Citigroup (underwriter), and Foster Group (feasibility consultant).
Applicable Criteria and Related Research:
--'Revenue-Supported Rating Criteria' (June 2014);
--'U.S. Water and Sewer Revenue Bond Rating Criteria' (July 2013);
--'2014 Water and Sewer Medians' (December 2013);
--'2014 Outlook: Water and Sewer' (December 2013).
Applicable Criteria and Related Research:
Revenue-Supported Rating Criteria
2014 Outlook: Water and Sewer Sector
2014 Water and Sewer Medians
U.S. Water and Sewer Revenue Bond Rating Criteria