Fitch Rates Southern California Metro Water District $200MM Revs 'AA+'; Outlook to Negative

SAN FRANCISCO--(BUSINESS WIRE)--Fitch Ratings assigns its 'AA+' rating to Metropolitan Water District of Southern California's (Metropolitan) $200 million water revenue bonds, 2008 authorization, series A. The Rating Outlook is Negative. Metropolitan expects to price the series A bonds on or around Jan. 14, 2009 via negotiated sale.

Fitch also affirms Metropolitan's $4.16 billion of outstanding water revenue bonds at 'AA+' and revises the Rating Outlook to Negative. In addition, Fitch affirms its 'AAA' rating on Metropolitan's outstanding $327.2 million general obligation bonds. The Rating Outlook is Stable.

The change in Outlook to Negative from Stable on Metropolitan's water revenue bonds reflects increasing pressure on Metropolitan's water supply and cost structure. While initially this trend appeared to be temporary, Fitch now believes that increases in water supply costs and the potential for decreased water sales revenues could result in even greater declines in financial margins than those previously anticipated. Rating triggers that could prompt a downgrade include:

--Continued declines in financial performance, including annual debt service and reserves;

--Inability to procure replacement water supplies sufficient to meet projected sales levels;

--Difficulty adopting rates that accomplish cost recovery in a timely manner.

Fitch notes that Metropolitan continues to exhibit its traditional credit strengths that include an extremely large and diverse customer base of 18 million in southern California, strong management and planning practices, a high degree of political support for Metropolitan's regional role as the wholesale water provider, and strong Board leadership as evidenced by actions taken to date to develop additional long-term water supplies. Various projects at Metropolitan, the California Department of Water Resources (DWR) which operates the State Water Project (SWP), and the member level are underway to increase existing supplies or develop new ones. The upcoming two to three years appear to be the period of the greatest water supply challenge until such time as certain new projects become operational. The Negative Outlook reflects the credit pressures discussed below which are significant such that the rating, in the event of the rating triggers, may be more appropriately reflected by a 'AA' rating than the current 'AA+' rating.

Fitch anticipates reviewing the rating again in the spring of 2009 when the final SWP allocation will be known, the 2010 budget and associated rate increases will be developed, available water and prices from the drought bank (a mechanism used periodically by the state to encourage water sales between parties during periods of critically dry conditions) should be announced, and Metropolitan may have a better idea of the conservation achieved through voluntary measures and whether or not mandatory rationing will be implemented.

Legal environmental challenges and operating constraints at the SWP have significantly reduced Metropolitan's largest water supply source in the past year. These operating constraints are expected to continue to limit the amount of water delivered to Metropolitan from the project in the near-term and possibly longer if interim structural solutions or alternative operating regimes currently under consideration are not successful. This development, combined with ongoing critically dry hydrological conditions, is adding sizable operating cost pressures to offset lost SWP water with more expensive supply sources.

The cost increases are being passed through to members through sizable rate increases: 14% effective Jan. 1, 2009 and a projected rate increase of between 20% and 25% in 2010. Rate pressure is occurring at a time when the economic and political environment may make needed rate increases difficult for Metropolitan's member to implement. However, the Board has not passed the full cost through to members, relying instead on financial reserves in the rate stabilization fund. Although the rate stabilization fund reserves were used for their intended purpose, to balance the rate impact to members, initial projections for fiscal 2010 indicate that Metropolitan may fully deplete the rate stabilization fund and begin to use reserves in the Water Revenue Remainder Fund, which has historically been the fund that represented the minimum reserve threshold for the district. Given the pressure on water supplies, it may be difficult for Metropolitan to replenish these financial reserves in the short-term.

Uncertainty regarding water supplies in calendar year 2009 may prompt Metropolitan to curtail deliveries to its members as outlined in a recently adopted Water Supply Allocation Plan (WSAP). The reduced sales would result in lost revenues to Metropolitan, which would occur at a time when its financial position has already experienced recent and projected near-term declines in annual debt service coverage. Fitch expects that an enactment of the WSAP would be accompanied by a corresponding rate action to protect bondholders.

Metropolitan ended fiscal 2008 with $1.1 billion in operating revenues. Debt service coverage in fiscal 2008 (June 30 year end) was 1.76 times (x), which is in line with projections reviewed by Fitch in the June 2008 credit review. Currently, Metropolitan projects that senior-lien ADS coverage will fall to 1.50x in fiscal years 2009 and 2010. More importantly, fixed charge coverage is projected to decline to 1.03x in fiscal 2009 and 0.98x in fiscal 2010 before recovering to levels above the Board policy of 1.2x in fiscal 2011. Transfers from reserves are expected to fund the difference between revenues and expenditures in fiscal 2010. Fixed charge coverage includes amounts paid to DWR for capital costs associated with the SWP. Fitch focuses on the fixed charge coverage because it more accurately reflects a true cash flow debt service coverage since the 'capital costs' paid to DWR are paid from annual revenues. The declines in coverage are resulting from higher costs at the SWP and costs associated with water transfers. As noted previously, there are a number of assumptions that could change and have a significant impact on debt service coverage levels.

Metropolitan provides between 40-60% of the service area's water, depending on water conditions, and is responsible for the development and acquisition of the long-term water supply for the region. The district consists of 26 member public agencies, including 14 cities, 11 municipal water districts, and one county water authority. Member agencies purchase water from Metropolitan to supplement local supplies and then resell it on a wholesale or retail basis to more than 300 cities and numerous unincorporated communities in the district's service area. Metropolitan's supply is derived from two sources: Northern California's San Francisco Bay/Sacramento-San Joaquin River Delta water via the SWP,which provided approximately 75% of its water supply in 2007, and the Colorado River via the Colorado River Aqueduct, which provided the remaining 25%. The SWP supply source, as noted above, has dropped considerably in 2008, supplying only 30% of Metropolitan's water sales. The remaining water supply was provided by the Colorado River (33%); storage (18%); and transfer, exchanges, and water banking agreements (19%).

Fitch issued an exposure draft on July 31, 2008 proposing a recalibration of tax-supported and water/sewer revenue bonds ratings which, if adopted, may result in an upward revision of this long-term rating (see Fitch research 'Exposure Draft: Reassessment of the Municipal Ratings Framework'). Fitch has deferred its final determination on municipal recalibration due to market conditions and plans to revisit the recalibration in the first quarter of 2009 (see press release 'Fitch Defers Final Determination on US Municipal Ratings.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.