AUSTIN, Texas--(BUSINESS WIRE)--Fitch Ratings upgrades the following city of Detroit (the city) and Michigan Finance Authority bonds issued for the Detroit Water and Sewerage Department (DWSD):
--$1.2 billion in senior lien water revenue bonds to 'BBB' from 'BBB-';
--$585 million in second lien water revenue bonds to 'BBB-' from 'BB+';
--$1.8 billion in senior lien sewer revenue bonds to 'BBB' from 'BBB-';
--$698 million in second lien sewer revenue bonds to 'BBB-' from 'BB+'.
The Rating Outlook is Stable.
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
UPGRADE ON CONTINUED OPERATIONAL IMPROVEMENT: The one-notch upgrade reflects DWSD's ongoing actions to produce greater revenue stability and improve operational efficiencies, including improvement in current collections. As a result, financial results are largely on target despite above average precipitation during fiscal 2015. Forecasted results beyond fiscal 2015 have been revised upward modestly.
LEASE REINFORCES SEPARATE OPERATIONS: All system funds and accounts are separate and distinct from other city funds including the city's general fund. The planned lease of the systems by Great Lakes Water Authority (GLWA) provides further assurance that system operations will remain independent of the city.
HIGHLY LEVERAGED DEBT PROFILE: The systems' debt load is expected to remain elevated for the foreseeable future as a result of relatively high near-term borrowing. Over the longer term, it is envisioned a greater use of pay-go capital funding will alleviate debt pressures to some degree.
EXPANSIVE SERVICE TERRITORY: The systems provide essential services to a broad area. The water system covers about 38% of Michigan's population, with over 70% of operating revenues coming from wealthier suburban customers. The sewer system includes roughly 28% of Michigan's population, with over 50% of operating revenues coming from suburban customers.
STRONG RATE-ADJUSTMENT HISTORY: The governing bodies have instituted virtually annual rate hikes in support of financial and capital needs. Continued annual adjustments are included in the forecast but the pace of growth should be less than in prior years.
CONTINUED FINANCIAL AND OPERATING GAINS: Demonstration of consistent and steady improvement in the financial and operating profiles of the respective water and sewer systems could lead to additional upward rating movement over time.
OPERATIONS AND FINANCIALS IMPROVING
Ongoing organizational improvements should continue to help improve revenue levels and reduce costs. On the revenue front, DWSD has been working extensively to reduce retail delinquencies by stepping up outreach to customers and pursuing service cutoffs. As a result, current collections have improved considerably year-over-year and were near DWSD's goal of 95% for fiscal 2015 compared to 81% in fiscal 2014.
DWSD also adopted changes with its wholesale water customers beginning in fiscal 2016 to revise purchase estimates and shift to an increasing amount of fixed monthly charge recovery. These changes are similar to the implementation of 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 expense front, management continues to implement its organizational optimization, which has entailed cutting the number of job classifications in recent years and reducing by nearly 40% DWSD's workforce from 2011 to 2015 as well as leading to increased automation, with some additional gains possible in the future. As a result, operating expenses have trended downward over the last several years, although the systems will face cost escalations over the next several years (fiscals 2015-2023) in light of $409 million in costs associated with the DWSD's share of the city's prior general retirement system negotiated as part of the city's bankruptcy process.
These combined revenue enhancement and expenditure control efforts helped to offset an 8% reduction in water sales in fiscal 2015 from an extremely wet spring/summer. The result is that total estimated water DSC of 1.08x for the year (as adjusted by Fitch to include non-operating pension and pension certificate payments to the city) was somewhat close to DWSD's previous forecast (as adjusted by Fitch) of 1.17x. Sewer DSC of 1.25x actually beat the prior adjusted estimates of 1.13x.
A major credit concern in recent years has been DWSD's poor financial results and inability to meet its forecasts which in turn led to uncertainty as to ongoing minimum performance levels. Recognizing these projection issues, management last year undertook a systematic reevaluation of underlying forecast assumptions. For the most part assumptions were revised to more conservative levels, particularly with regard to sales and bad debts and also included certain costs related to the city's bankruptcy plan of adjustment, particularly those surrounding pension costs.
The assumption changes resulted in lower forecasted margins but appear to provide a greater measure of certainty as to baseline results and the ability to absorb negative budget variances. DWSD's latest projections (as adjusted by Fitch to include non-operating and pension certificate payments) point to water DSC of 1.24x for fiscal 2016, rising gradually each year to 1.39x through the fiscal 2020 forecast period. Similarly, total sewer DSC (per Fitch's adjustment for non-operating and pension certificate payments) is 1.22x in fiscal 2016, climbing to 1.47x by fiscal 2020. Assuming DWSD is able to continue meeting or exceeding these figures additional positive credit action could ensue.
ASSET LEASE REINFORCES SEPARATION
The newly-created GLWA entered into 40-year leases of DWSD's respective water and sewer systems as well as a water and sewer services agreement with the city in June 2015. The leases become effective after completion of certain conditions, including consent by the majority of bondholders, receipt of various legal opinions, contract assignments, permit transfers, and the adoption of a master bond ordinance relating to the respective systems' debt. The estimated completion of the conditions is January 1, 2016.
Fitch views the transition of systems to GLWA control as detailed in the agreements and supporting documents as a credit positive for bondholders, principally because it codifies the legal separation between the systems. DWSD has operated with increasing independence from the city in recent years (including a separation of staff and financial accounts) and Fitch expects this would continue without the leases becoming effective. However, despite DWSD's operating independence from the city, DWSD was still included as part of the city's recent bankruptcy proceedings which cost the systems around $28 million in professional and insurance fees during fiscal 2015 alone as well as requiring significant staff efforts. With the leases, all DWSD regional assets will be conveyed to GLWA along with a right and title to all system revenues thereby insulating the system from being included in any future city bankruptcy proceedings, if one were to occur.
Key terms of the agreements include a $50 million annual lease payment to the city, although such monies may only be used at the city's option to fund pay-go capital improvements related to the city's local water and sewer systems or debt service related to the city's local systems and/or GLWA. A $4.5 million assistance program will also be funded and replenished annually as part of GLWA's budget for low-income customers throughout GLWA's service territory. In addition, a budget stabilization fund will be funded from city retail customers (initially over a three-year period) to ensure monies are available to meet the city's portion of GLWA's annual revenue requirement. Deposits required to fund the lease payment and other created accounts like the assistance account will occur subsequent to payment of debt service, although these are added costs that ratepayers will absorb.
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 $3,952 for sewer and moderately high $2,113 for water for audited fiscal 2014. Principal payout is relatively typical for sector credits at around 80% over 20 years for both water and sewer.
The systems' 2016-2020 capital improvement plans (CIPs) increased from last year's estimates to $794 million (an 18% increase) on water and $594 million on sewer (7%). Along with these increases, additional borrowings are also expected, although transition to more pay-go funding is expected over time. For water, planned borrowings through the CIP period are up around $65 million after more than doubling in last year's CIP; planned sewer borrowings have stayed relatively flat over the last few CIPs.
The rise in projected water capital costs and borrowings stem from the recent completion of the updated water master plan, the first since 2004. 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 results 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 3.8 million people or about 38% of Michigan's population, including the city's population of around 680,000. The system serves the city on a retail basis and 127 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 around 28% 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.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in the U.S. Municipal Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope and Citibank (underwriter).
Revenue-Supported Rating Criteria (pub. 16 Jun 2014)
U.S. Water and Sewer Revenue Bond Rating Criteria - Effective July 31, 2013 to September 3, 2015 (pub. 31 Jul 2013)
Dodd-Frank Rating Information Disclosure Form