AUSTIN, Texas--(BUSINESS WIRE)--Fitch Ratings has assigned its 'AA+' rating to the following bonds issued by the Metropolitan Water District of Southern California (Metropolitan):
--Approximately $250 million water revenue refunding bonds, 2016 series A.
Bond proceeds will refund outstanding bonds for savings and pay costs of issuance. Bonds are expected to price on June 22, 2016.
The Rating Outlook is Stable.
Bonds are payable from net water revenues of the district.
KEY RATING DRIVERS
WHOLESALE SUPPLEMENTAL WATER SUPPLIER: Metropolitan is the supplemental wholesale water supplier to 26 member agencies who provide water to 18.7 million people in southern California. Revenues are provided from member agencies that rely on water purchased from Metropolitan to supply their retail and wholesale customers, although there are no minimum annual purchase or payment amounts.
LOWER FINANCIAL MARGINS IN 2016: Financial margins are expected to dip in fiscal 2016 (June 30 year-end) as water sales are below budgeted levels. Debt service coverage is expected to dip to 1.37x on revenue bonds or 1.23x fixed charge coverage (FCC). Metropolitan has spent down its robust reserves but levels remain adequate.
VARIABLE SALES DRIVE FINANCIAL MARGINS: Financial performance exhibits a high degree of cyclicality as compared to retail water utilities as a result of Metropolitan's role as the supplemental wholesale supplier and its highly volumetric rate structure. Financial margins rely on the volume of water sales achieved in any given year, which have fluctuated considerably in the past 10 years.
RATE FLEXIBILITY EXISTS: Fitch views Metropolitan's rate flexibility as relatively strong given the large increases between 2008 and 2013 and continued modest annual increases in recent years. Nevertheless, rate sensitivity and limitations exist given the varied reliance on Metropolitan by its purchasers and an ongoing lawsuit with San Diego County Water Authority (SDCWA) regarding Metropolitan's rate structure.
WATER SUPPLY FLUCTUATIONS: Water is primarily provided from two independent supply sources. Supply fluctuations occur for both sources - the State Water Project (SWP) and the Colorado River. Metropolitan's substantial storage facilities help balance this risk.
SUSTAINED FINANCIAL MARGIN DECLINE: Fitch's 'AA+' rating and Stable Outlook anticipate a degree of cyclicality in Metropolitan's coverage and reserve levels. However, multiple years of sustained lower coverage and/or reserve levels could pressure the rating.
Metropolitan is a wholesale water supplier in southern California to 26 member agencies, many of whom have some form of local water supply. The largest three member agencies (54% of water revenues in fiscal 2015) are the San Diego County Water Authority (senior lien revenue bonds rated 'AA+'), Municipal Water District of Orange County (revenue bonds rated 'AAA'), and Los Angeles Department of Water and Power (LADWP; water bonds rated 'AA').
HIGHLY VARIABLE WATER SALES KEY DRIVER OF REVENUES
Significant developments affecting water supply sources and the demand profile from members have occurred in the past 10 years. Greater variability and uncertainty exists with Metropolitan's in-state water supply, the SWP. Demand level from members has declined from pre-recession levels of over 2 million acre-feet (maf) to low points of 1.63 maf in fiscal 2011 and an expected 1.6 maf in fiscal 2016. Management expects water sales to continue to exhibit a high degree of annual variability although assumed sales have been lowered to between 1.7 and 1.75 maf annually in fiscals 2017-2020.
Metropolitan's members are not required to buy minimum amounts of water from Metropolitan but instead use the imported water supply to supplement their other sources. However, Metropolitan's role in the region is crucial in that it supplies 40%-60% of southern California's water supply. Fitch expects Metropolitan to remain a key water supplier although over the long term there will very likely be further pressure on demand.
Metropolitan absorbs much of the regional demand variability from naturally occurring hydrological conditions that impact the member agencies' local supplies. As drought lowers available local supplies and households have greater outdoor watering demands, members increase their purchases from Metropolitan. Conversely, as one of the highest-cost resources in the region, Metropolitan bears a disproportionate impact of reduced demand, such as from the state-mandated conservation levels; members reduce purchases from Metropolitan before reducing production from their own local supplies.
The biggest swing in historical annual demand exceeded 200,000 acre-feet (AF). With Metropolitan's primarily volumetric rate structure, the district budgets to achieve a strong financial cushion in order to absorb the revenue implications of a potential drop in water sales of this magnitude. A larger decline of 300,000 af is expected to occur in fiscal 2016 with estimates of water sales of 1.6 maf as compared to actual sales of 1.9 maf in fiscal 2015.
STORED WATER SUPPORTS SALES DURING INITIAL YEARS OF DROUGHT
MWD made substantial investment in its physical storage facilities and inter-agency water storage agreements in the past 20 years. Storage capacity is nearly four times what it was in 1994. Metropolitan currently has 5.83 MAF in storage capacity. Strong hydrological conditions allowed Metropolitan to build its stored water reserves in 2011-2013. Storage reached a high point of 3.37 MAF on Jan. 1, 2013 before declining to 1.54 MAF as of Jan. 1, 2016.
Metropolitan's substantial stored water position allowed it to meet the increased water demand of members during the initial years of the drought. Financial performance in fiscals 2014 and 2015 exceeded budget expectations and debt service coverage equaled 2.5x and 2.7x, respectively. FCC in those years was over 2.0x, in excess of Metropolitan's internal target for rate-setting of 1.2x.
Fitch uses FCC as the key financial metric for Metropolitan (a proxy for total debt service coverage) and Metropolitan uses this calculation for internal rate-setting as well. The FCC calculation includes the amount of SWP costs that are a capitalized expense as if they were paid as debt service. This expense is paid to the state for SWP expenses and is a cash outflow, much as principal on debt-financed assets is paid but not considered an 'operating expense' of the system in its accounting treatment.
FINANCIAL MARGINS IN 2016 WILL BE LOW
Expected water sales in fiscal 2016 are 1.6 maf, which is well below the 1.75 maf assumed in the budget. In addition, SWP costs are above budget even with the power cost savings from pumping a lower allocation from the project. Management projects debt service coverage of 1.37x and FCC of 1.23x.
The sizable decline in financial margins was driven by the state's very quick implementation of mandatory conservation requirements on Metropolitan's purchasers. Fitch expects financial margins in fiscal 2017 to rebound, given the easing of drought conditions in recent months and water rates to be implemented Jan. 1, 2017. Sales could remain constrained in 2017 but the rates implemented on Jan. 1, 2017 (mid-year fiscal 2017) will reflect the lower water sales budget assumption of 1.7 maf as compared to the 1.75 maf in the fiscal 2016 budget.
RESERVES BOLSTERED IN 2014 and 2015; SPENT DOWN IN 2016
The healthy water sales in the initial years of the drought bolstered unrestricted cash and investments as shown on the balance sheet to over $1 billion at the end of fiscals 2014 and 2015 (days cash on hand of 389 and 385, respectively). In the past year, overall cash reserves have been spent down to fund $450 million of conservation programs and to purchase property and related water rights as an opportunity became available.
Fitch views the rapid spenddown in reserves as reasonable from a credit perspective, given the starting point of Metropolitan's reserves in excess of the maximum unrestricted reserve target level, the extreme nature of the current drought and the governor's executive order that requires each of Metropolitan's members to significantly reduce water sales. Metropolitan's historically strong reserves have provided a high degree of financial flexibility.
Metropolitan put in place two $200 million liquidity facilities in April 2016 with RBC Municipal Products, LLC and U.S. Bank for a total of $400 million. These facilities can be drawn for any purpose, compared to the $180 million dedicated revolving credit agreement that Metropolitan has in place to pay the purchase price of its self-liquidity bonds, if needed. Metropolitan has drawn $250 million on these two new facilities to bolster its cash reserves.
Metropolitan operates with a reserve policy that is a subset of its overall cash position. The reserve policy is designed to protect against the revenue loss associated with a multi-year wet weather period; the reserve policy has a minimum of approximately $200 million and target of approximately $480 million. Metropolitan projects its unrestricted reserves will be approximately $408 million at the end of fiscal 2016, including the benefit of the liquidity facility borrowing and no longer including the disputed amount related to rate litigation with SDCWA.
Until April 2016, a sizable portion of Metropolitan's unrestricted cash reserves had been designated for the litigation with SDCWA, although the timing of a final judgement payment to SDCWA is uncertain. A judgement in SDCWA's favor was filed in 2015 but Metropolitan has appealed the decision. In April 2016, Metropolitan segregated the disputed amount into an exchange agreement set-aside fund. As of May 31, this set-aside fund totaled $250.2 million.
For additional information on the issuer, see Fitch's Report, 'Metropolitan Water District of Southern California', dated March 24, 2016.
The rating committee relevant to this rating action convened on Dec. 1, 2015.
Additional information is available at 'www.fitchratings.com'.
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