Fitch Rates Indiana Finance Auth CWA Project 1st and 2nd Lien Wastewater Revs 'A'; Outlook to Stable

AUSTIN, Texas--()--Fitch Ratings assigns an 'A' rating to the following Indiana Finance Authority (IFA) bonds issued on behalf of CWA Authority, IN (CWA):

--$193.8 million first lien wastewater utility revenue bonds, series 2016A (CWA Authority Project);

--$38.6 million second lien wastewater utility refunding revenue bonds, series 2016B (CWA Authority Project).

The 2016A bonds are being sold to fund various CWA wastewater system (the system) capital improvements; to repay draws under a line of credit; fund a surety debt service reserve; and pay costs of issuance. The 2016B bonds will be used to refund CWA second lien bonds, series 2011C; fund a debt service reserve; and pay costs of issuance. The bonds are expected to sell via negotiation the week of Sept. 5.

Fitch also affirms the 'A' rating on the following outstanding IFA bonds issued on behalf of CWA:

--$229.5 million in outstanding first lien wastewater utility revenue bonds, series 2014A (CWA Authority Project);

--$156.3 million in outstanding first lien wastewater utility revenue bonds, series 2015A (CWA Authority Project).

CWA has other first and second lien debt outstanding that is not rated by Fitch.

The Rating Outlook is revised to Stable from Positive.

SECURITY

IFA's series 2016A bonds are secured by CWA's first lien wastewater revenue bonds, series 2016A, which are senior lien obligations of CWA's system, payable from net system revenues. IFA's series 2016B bonds are secured by CWA's second lien wastewater refunding revenue bonds, series 2016B, which are second lien obligations of the system, payable from the system net revenues after the senior lien obligations.

KEY RATING DRIVERS

OUTLOOK TO STABLE ON STEADY EXPECTATIONS: First and second lien debt service coverage (DSC) remains solid but subordinate obligations related to city general obligation (GO) debt service and increasing payment-in-lieu-of-taxes (PILOT) limit upward financial potential. Financial projections point to a continuation of existing performance.

SUBSTANTIAL CAPITAL REQUIREMENTS: CWA's capital program is driven by regulatory requirements and relies on significant annual debt issuance over the next five years. As a result, debt will continue to increase above already high levels.

IMPROVEMENTS TO LENGTHY RATE REGULATION: CWA has maintained a good track record of achieving positive outcomes of its rate cases filed with the Indiana Utility Regulatory Commission (IURC), albeit through a lengthy process averaging 350 days since 2010. Recent legislation and an expedited filing process for consent decree related debt costs should help to decrease timing delays between incurred costs and rate recovery.

LIMITED RATE AFFORDABILITY: Continued rate increases will result in rate pressure, with the average monthly wastewater utility bill currently above Fitch's affordability threshold of 1% of median household income (MHI). However, user charges are currently comparable to other large systems near the region.

FAVORABLE SERVICE TERITORY: The city of Indianapolis (the city) has a large and well diversified economy. The consistent steady gains in employment bolster the system's ratepayer base.

LACK OF NOTCHING: The lack of notching between the first lien and second lien bonds reflects Fitch's view that the risk profile for second lien bondholders is largely the same as for first lien bondholders. Second lien debt accounts for only 16% of current total debt and is expected to decline in the future given all additional debt is anticipated to be issued as first lien obligations, limiting the differential in senior and second lien DSC.

RATING SENSITIVITIES

IMPROVED FINANCIAL RESULTS: Financial projections indicate financial margins and liquidity should remain in a similar range to fiscal 2015, and the regulatory mechanism of a revenue requirement true-up is likely to provide a higher degree of consistency in financial performance. However, a sustained multi-year trend of improving financial margins that outperforms current projections, including improved coverage of all obligations and surplus cash flows could result in a rating upgrade.

ESCALATION IN CAPITAL NEEDS: Substantial increases to the current size and scope of the capital program would be viewed negatively.

CREDIT PROFILE

On Aug. 26, 2011, CWA acquired the system assuming most assets and certain liabilities of the city's sanitary district. The system is largely a retail provider of sanitary sewer service to nearly the entire consolidated city (Indianapolis-Marion County). The system has approximately 236,000 customer accounts, including seven wholesale customers.

FINANCIAL RESULTS SOUND; STEADY RESULTS EXPECTED

Following outperformance of projections in fiscal 2014, financial results in fiscal 2015 were in line with expectations. Senior lien DSC for the year was just under 2.0x while combined senior and second lien DSC was a little less than 1.6x. Including GO debt service associated with system improvements prior to CWA's acquisition, total DSC was less than 1.5x; the GO debt fully amortizes in fiscal 2018. Liquidity improved slightly in fiscal 2015 from the prior year with days cash rising to 235 days. The system's overall liquidity is bolstered by CWA's $145 million available line of credit (the full amount of which will be available after the series 2016A bonds are issued), but the credit line is available to be used only to finance capital expenditures.

CWA's forecast for fiscals 2016-2020 anticipates relatively similar DSC over the next several years. Fitch believes material improvement in financial results, including liquidity and surplus cash flows, is unlikely given pressures associated with the sizeable capital program and increasing PILOT payments, which equaled $17 million in fiscal 2015 (8% of operating revenues) and which are scheduled to increase annually through the forecast to over $28 million by fiscal 2020.

SIZABLE CAPITAL NEEDS DRIVEN BY REGULATORY REQUIREMENTS

The system's substantial capital costs are driven by a consent decree (CD) requiring CWA to implement a $1.8 billion Combined Sewer Overflow (CSO)-Long-Term Control Plan (LTCP) by 2025. CWA has completed around 40% of the program to date. The current five-year capital improvement program (CIP) covers fiscals 2016-2020 and totals approximately $1.1 billion. CSO project costs included in the CIP total approximately $802 million during the next five years and account for roughly 70% of planned spending.

The necessary CSO-LTCP projects include the construction of several deep underground tunnels and storage facilities designed to capture 95%-97% of wet weather CSO and result in no more than two to four overflow events per typical year. Prior to the acquisition, the city had a history of proactively implementing a CSO-LTCP. Upon assuming the city's obligation under the CD, CWA has continued to aggressively implement the LTCP, which Fitch views positively. CWA is currently in full compliance with the CD. Other projects in the current CIP include general system improvements and expansions (25% of spending) and septic tank elimination efforts (5% of spending).

Approximately 80% of the current CIP is expected to be funded with existing and future bond proceeds (including proceeds from the current transaction). The remaining amount will be funded by pay-go. The significant debt is expected to be supported by a combination of annual base rate increases, through the standard IURC filings and/or the Environmental Compliance Plan (ECP) recovery mechanism, an expedited rate-raising process for CWA to recover debt service costs associated with the CD. To date, CWA has not used the recovery mechanism.

The system's debt ratios are very high with debt per customer at $7,109, and debt per capita at $1,786, exceeding twice the 'A' category median for other utility credits. Debt ratios are expected to continue to increase in the foreseeable future as CWA plans to fund its significant CIP with bonds. However, management believes that the level of pay-go will be increased steadily, after fiscals 2019-2020 (peak years for capital costs), with the goal of attaining 100% pay-go by the scheduled end of the CD in 2025. CWA also anticipates a steady improvement in pay-go funding for non-CD capital projects given CWA's allowance to recover the system's depreciation costs through the rate making process. Nevertheless, Fitch expects debt levels to remain significant for several years as principal payout is slow with only 61% of outstanding principal amortizing in 20 years.

STABLE REGULATORY ENVIRONMENT EXPECTED

The IURC maintains jurisdiction over the approval of rates and charges of the system. In the past, the IURC's oversight has hindered timely rate increases for certain other utility systems in the state. However, recent actions point to a less lengthy regulatory environment going forward. First, in 2013, the Indiana Legislature passed Senate Enrolled Act (SEA) 560, which helps to mitigate the effects of regulatory lag by requiring that rate cases take no longer than 300 days from the original filing date. Failure by the IURC to act within the 300-day time frame will result in 50% of the rate request becoming effective immediately, subject to refund if the final order authorizes less than the 50%. While still a lengthy regulatory process, it should reduce the timing lag resulting from the 426 day approval CWA experienced during its 2013 rate petition. The 2015 petition approval, by contrast, was received in 297 days, in compliance with the new 300 day limit.

Secondly, the IURC formally approved the details and the procedures of the ECP recovery mechanism on June 14, 2012, which became applicable beginning in fiscal 2014. This tool is designed to timely recover debt service, debt service reserve funds, and costs of issuance related to CD costs. In addition, in February 2014, utility systems received the authorization (under Indiana House Bill 1132) to petition the IURC for adjustments of basic rates for certain capital costs including wastewater system replacements and upgrades.

Finally, in March 2016, the Indiana Legislature passed SEA 383, which enables regulated utilities to adjust rates to recover IURC-approved, but unearned revenue requirements that may result when, for instance, revenues are affected by weather or other factors that can alter demand, either upwards or downwards. SEA 383 is essentially a revenue requirement mechanism, providing another important offset to previous rate recovery concerns.

RATES LIMIT AFFORDABILITY

Current wastewater user charges at $57 per month, based on Fitch's 6,000 gallon assumption for sewer utilities, amount to almost 1.6% of MHI, above Fitch's 1% of MHI affordability benchmark for individual utilities. Combined water and wastewater utilities charges are also high, exceeding Fitch's 2% affordability benchmark for combined systems. Despite the high wastewater charges, CWA maintains that its rates are in line with other regional systems. CWA plans to increase rates annually either through general rate hikes or the ECP recovery mechanism. Fitch expects such rate hikes to be sizeable over the next several years given debt needs, which could pressure the customer rate base over time.

LARGE AND DIVERSE SERVICE AREA

The city's economy remains well diversified and serves as the economic engine for the surrounding area. The city has a large retail sector as well as a significant manufacturing presence, which includes pharmaceuticals and automotives. The city's economy also includes health services, life and sciences companies and other business and professional service companies.

The county experienced a 1.0% increase in employment from December 2014 to December 2015. Reflective of the ongoing employment growth, the June 2016 unemployment rate of 4.6% fell from 4.9% the prior year and is comparable to those of the state (4.4%) and nation (5.1%). MHI levels in the county are around 12% and 20% lower than state and national levels, respectively.

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 JP Morgan Securities LLC (underwriter).

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/site/re/750012

U.S. Water and Sewer Revenue Bond Rating Criteria (pub. 03 Sep 2015)

https://www.fitchratings.com/site/re/869223

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Contacts

Fitch Ratings
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Doug Scott, +1-512-215-3725
Managing Director
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Andrew DeStefano, +1-212-908-0284
Director
or
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Senior Director
or
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elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Doug Scott, +1-512-215-3725
Managing Director
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Andrew DeStefano, +1-212-908-0284
Director
or
Committee Chairperson
Kathy Masterson, +1-512-215-3730
Senior Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com