AUSTIN, Texas--(BUSINESS WIRE)--Fitch Ratings downgrades the following Indianapolis Local Public Improvement Bond Bank, Indianapolis (the bond bank) bonds as part of its routine surveillance effort:
--$904 million waterworks project revenue bonds to 'A' from 'A+'.
The Rating Outlook is revised to Stable from Negative.
RATING RATIONALE:
--The downgrade to 'A' from 'A+' reflects continued erosion of the waterworks system's (the system) financial metrics resulting from a protracted rate settlement period as well as the expectation that margins will remain thin even with recent rate relief.
--The revision in Outlook to Stable from Negative reflects the passage of the rate order by the Indiana Utility Regulatory Commission (IURC) that should alleviate further deterioration of financial performance.
--Financial margins for the system are weak.
--The system's board of directors has independent rate-setting authority from the city, although rates are subject to approval by the IURC and achieving timely rate relief in recent years has been problematic.
--Moderate capital requirements are expected to keep debt levels elevated but manageable.
--The service area is large and diverse.
KEY RATING DRIVERS:
--Timely implementation of rate hikes to ensure adequate financial margins and sufficient capital funding is critical to maintaining the rating.
--Credit implications associated with the potential sale of the utility to Citizens Energy Group are unknown.
SECURITY:
The bonds are secured by net revenues of the system.
CREDIT SUMMARY:
Financial performance has deteriorated substantially since 2007 largely as a result of the system's exposure to variable-rate debt and downgrades of credit and liquidity providers associated with those instruments. While 2007 annual debt service (ADS) coverage of 1.4 times (x) was relatively weak, it was consistent with historical results. However, for 2008, ADS coverage fell to just under 1.0x as deteriorating market conditions precipitated a rise in interest costs of around $15 million more than budgeted estimates on the system's variable-rate debt. With the rising interest costs, sales declines from wet weather, and ongoing funding of capital expenditures, the city's Waterworks Department (the department) also saw its liquidity position erode, with unrestricted cash falling from around 100 days of operating expenditures in 2007 to less than 30 days in 2008.
In an effort to stabilize and somewhat restore financial margins as well as fund budgeted capital expenditures for the year, the department filed an emergency rate petition with the IURC in February 2009 for roughly a 17.6% rate hike. The department sets rates independently from the city/county government, but any adjustments are subject to approval by the IURC. With the proposed adjustment and assuming a July effective date, ADS was forecast to improve to 1.2x in 2009 followed by an increase to 1.3x in 2010 with a full year of implementation. However, in a rate order dated June 30, 2009, which was highly critical of system management, the IURC limited the rate request to around 12.3%; the rate hike was subsequently reduced to 10.8% by virtue of a true-up of ADS costs associated with the 2009 bonds and which refunded all of the department's variable-rate debt to fixed. As a result of the lower than requested rates and delay in implementation, ADS coverage for the year again fell short of the department's 1.1x rate covenant, generating just under 1.0x ADS coverage. In addition to the poor ADS coverage in fiscals 2008-2009, reserves were completely depleted in fiscal 2009, necessitating a borrowing of $20.8 million from the city's general fund to pay debt service on the bonds and payment-in-lieu-of-taxes expenditures.
Apart from the financial implications of the rate order, another credit concern that emerged was the IURC's prohibition of payments by the department to Veolia Water Indianapolis, LLC (Veolia) for certain contractual costs and the potential ramifications it could pose to system operations. A portion of the department's emergency rate request was to fund a stipulated 5% increase in operating payments above those paid during 2008 as well as reimburse Veolia for prior agreed-upon expenditures by the department of around $1.7 million that were payable in September 2009. However, citing case law supporting the IURC's ability to protect public welfare during emergency events notwithstanding the interference of contracts, the IURC expressly disallowed these costs, forestalling any decision on Veolia's prior expenditures until the permanent rate hike proceedings and mandating that the department work with Veolia to find ways to reduce operational expenditures to 2008 levels.
As part of the emergency rate request, the department also filed a request for a permanent 33.4% increase to fund operating and capital expenditures; the hike would also provide for sufficient working capital and allow the system to repay the city's general fund. While the IURC recently granted approval for an increase, the final order was significantly delayed until February 2011. In addition, the 26% hike approved by the IURC was again below the requested amount, which was partially due to the IURC's formal disallowance of payment of the $1.7 million contractual payment to Veolia. Despite the IURC's actions, Veolia has continued to meet its contractual obligations under the operating agreement.
As a result of the delay in receiving timely rate relief, ADS coverage for fiscal 2010 is projected at just over 1x, with the system's payable to the city's general fund increasing to $22.6 million for borrowed funds. While fiscal 2011 results should show improvement, further rate hikes will be necessary to fund the department's ongoing capital expenditures and Fitch is concerned about the department's ability to achieve timely rate relief in the future. On the positive side, the latest IURC rate order expressly granted a 45-day working capital balance and included funding for fiscal 2011 capital needs of $111 million, including a 50% equity component and forecasted debt service costs associated with a planned sale within 120 days of the order. The approved equity component is important given that the system's debt profile is moderately high and principal amortization of system debt is slow, with just 60% of debt maturing in 20 years. Nevertheless, maintaining a sizeable capital equity-funding component in the future may be difficult to achieve given that the latest rate hike pushes residential charges to a relatively high 1% of median household income.
The department was created by city ordinance in 2001 to facilitate the purchase of substantially all assets of the Indianapolis Water Company and five smaller subsidiaries of IWC Resources, Inc. By enabling legislation, it owns and operates the system, which serves around 980,000 people within the Indianapolis metropolitan statistical area (MSA). Veolia serves as system operator pursuant to a 20-year management agreement executed in 2002 and amended in 2007.
With the city as the state capital, the MSA has a sizeable government sector. The MSA also has a large retail sector as well as a significant manufacturing presence, which includes pharmaceuticals and automotives. The area continues to be affected by the weak economic conditions nationally and has experienced rising unemployment rates year-over-year even as the national rate has improved slightly. Nevertheless, the MSA's 8.7% unemployment rate for November remained below that of the state (9.4%) and nation (9.3%).
Over the last year, the city has initiated a sale of the utility to Citizens Energy Group, a not-for-profit public charitable trust that provides gas and other utility services to the city and surrounding area. While the sale may occur as early as June 2011, details regarding the transaction are still under negotiation. Consequently, the current rating action does not take into consideration the effect such a sale could have with regard to the credit quality of the outstanding bonds.
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.
Related Research:
--'Revenue-Supported Rating Criteria', dated Oct. 8, 2010;
--'Water and Sewer Revenue Bond Rating Guidelines', dated Aug. 6, 2008.
--'2011 Water and Wastewater Medians', dated Jan. 18, 2011.
--'2011 Outlook: Water and Wastewater Sector', dated Jan. 18, 2011.
Applicable Criteria and Related Research:
Revenue-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=564565
Water and Sewer Revenue Bond Rating Guidelines
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=395918
2011 Water and Wastewater Medians
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=593285
2011 Outlook: Water and Wastewater Sector
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=593286
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