TEXT- Fitch affirms Puerto Rico Aqueduct & Sewer Auth 'BBB' revs
Jan 30 - Fitch Ratings affirms the following ratings on Puerto Rico Aqueduct and Sewer Authority, Puerto Rico (PRASA, or the authority): --Approximately $3.5 billion of outstanding revenue bonds, series A, B, 2012A and 2012B (senior lien), at 'BBB'. The Rating Outlook is Stable. SECURITY The bonds are secured by a gross lien of all authority revenues related to PRASA's combined water and sewer system (the system), as defined in the amended master agreement of trust (MAT), senior to all other debt or expenses of PRASA. Authority revenues include operating revenues, as defined in the amended MAT (e.g. user charges and impact fees), as well as governmental funds available to pay current expenses; amounts from the Commonwealth of Puerto Rico (the commonwealth) for payment of commonwealth guaranteed indebtedness (CGI) or commonwealth supported obligations (CSO); and any amounts transferred from the budgetary reserve fund (BRF), as created in the amended and restated Fiscal Oversight Agreement (FOA) between PRASA, the commonwealth and the Government Development Bank for Puerto Rico (GDB). The authority revenues received from the commonwealth for CGI and CSO are not subject to lien of the MAT and are not available to pay debt service on the bonds. SENSITIVITY/RATING DRIVERS MARGINAL FINANCIAL RESULTS: Major improvements in operations and financial performance have occurred since the change in governance structure in 2004. However, financial margins remain minimal and there are significant revenue and expense challenges that could pressure results over the next several years. EXTENSIVE CAPITAL NEEDS: The capital improvement program (CIP) is substantial and fairly rigid over the near term. Resulting borrowing demands are sizeable and will continue to pressure PRASA's debt profile over the long term. SOLID MANAGEMENT AND COMMONWEALTH SUPPORT: PRASA management is strong and the system also benefits from GDB advisory support and interim funding as well as historical support from the commonwealth. WEAK BUT EXTENSIVE SERVICE AREA: The service territory is diverse, although weak economic conditions have been protracted and customer wealth levels are limited. ESSENTIAL UTILITY: The system provides an essential service to the residents of Puerto Rico. WHAT COULD TRIGGER A RATING ACTION CHANGE IN THE COMMONWEALTH RATING: Any deterioration in the commonwealth's credit quality would likely affect the rating on the bonds given the historical and expected support of the system by the commonwealth, both directly and through GDB. INABILITY TO ELIMINATE BUDGETARY SHORTFALLS: Failure to identify and enact revenue solutions to meet forecasted budgetary gaps beginning in fiscal 2014 would have negative rating implications. LACK OF COMMONWEALTH SUPPORT: A reduction or elimination of commonwealth support, either from direct appropriations or support from the GDB, that jeopardizes PRASA's current operating capacity would negatively affect the rating. GROWTH IN CAPITAL COSTS: Acceleration or escalation of the large and complex CIP without accompanying financial improvement could add negative rating pressure. CREDIT SUMMARY PRASA provides water service to virtually the entire island, including the roughly 4 million residents and 5 million annual tourists; sewer service is limited to around one-half of the island. After a decade of privatization, operations were transitioned back to the public side in 2004 and the commonwealth reorganized PRASA's board and executive management with the goals of limiting political interference, improving the organizational structure, and returning the authority to financial viability without commonwealth subsidization. Since this change, operating, financial, and regulatory performance have improved overall, although significant challenges persist and are expected to be ongoing for the foreseeable future. RECENT FINANCIAL RESULTS CHALLENGING For fiscal 2010, net revenues based on audited figures (consistent with prior MAT requirements) provided senior lien debt service coverage (DSC) of a reasonable 1.6x. However, PRASA was unable to meet its obligation to pay debt service on the commonwealth-supported Superaqueduct bonds (PRASA's fifth lien debt) in July 2009 given PRASA's depleted balance sheet position. Instead, debt service on these bonds (around $27 million) was paid by the commonwealth; failure by PRASA to pay CGI or CSO does not constitute an event of default under the MAT. For fiscal 2011, senior lien DSC from net revenues improved to 2.5x based solely on funds from operations. But again, PRASA was reliant on the commonwealth and GDB for sufficient funding to pay subordinate debt service. In total, PRASA received $105 million from these two sources. For unaudited fiscal 2012, net revenues improved by $9 million despite operating expenses rising 14% for the year. Increased operating expenses were driven by rising power and personnel expenses (up $44 million and $25 million respectively), but were offset by$70 million in commonwealth appropriations and $95 million in draws on the BRF. Nevertheless, PRASA experienced a $20 million increase in total debt service costs for the year, which continued to pressure DSC for the year. Based on PRASA's amended MAT, which provides for a gross revenue pledge for senior lien bonds, PRASA was able to generate senior and total DSC of 8.1x and 1.0x, respectively, for fiscal 2012, results that were in line with prior expectations and in compliance with PRASA's rate covenants; under the amended MAT, the rate covenant includes revenues on a cash basis and expenditures on an accrual basis net of applicable non-cash reserve adjustments. However, in comparison to prior year coverage calculations, net revenues covered senior lien DSC by just 2.0x while total DSC was below 0.8x, similar to fiscal 2011 results. Despite the net revenue calculation, PRASA was able to pay all debt service and operating costs from available funds given certain expenses included in the net revenue calculation relate to non-cash accruals. INCREASING BUDGETARY GAP Throughout the financial challenges PRASA has faced over the last several years, management has actively identified and implemented targeted revenue enhancements and expenditure reductions and continues this process with favorable success. Continuation and enhancement of these initiatives will be important to the ongoing financial health of the utility. However, even with these initiatives, management continues to forecast the need for sizeable additional revenues to meet all operating and increasing debt service obligations. While the funding of the BRF from 2012 bond proceeds has alleviated immediate cash flow pressures through fiscal 2013, PRASA is forecasting significant budget deficits beginning in fiscal 2014 that greatly exceed prior year appropriations by the commonwealth. Fitch remains concerned that these deficits may place a significant financial strain on commonwealth resources. Alternatively, if PRASA were to fund these shortfalls entirely through increased user rates, required increases would be substantial and may be difficult to fully achieve given the currently elevated utility rates and the high poverty level on the island. Fitch has developed a stress scenario to evaluate the rate hikes necessary to recover these unidentified revenues based on a bad debt rate of 10%, forecasted operating revenues, and planned debt issuances. Based on these assumptions and no commonwealth appropriations in fiscals 2014-2017, rates would need to increase by over 50% for fiscal 2014 followed by additional annual hikes in the 5%-10% range for fiscals 2015-2017, respectively, to generate the $342 million-$485 million of annual unidentified revenues projected by PRASA; it would be expected that additional rate hikes would also be necessary beyond fiscal 2017. Fitch will closely monitor the identification and implementation of revenue sources and could take negative rating action in the future if budgetary deficits continue to escalate and/or clear plans for the generation of such revenues is lacking. Furthermore, given that PRASA's rating is enhanced by the historical support of the commonwealth - both directly and indirectly through the GDB - a reduction or cessation of commonwealth support that would hinder PRASA's ability to generate sufficient revenues for operations would diminish PRASA's credit quality and lead to negative rating action. CAPITAL NEEDS REMAIN SIZEABLE Central to PRASA's challenges are the scope of needed capital investment to maintain regulatory compliance and renew system assets given the limited historical investment in the system's infrastructure and the resulting pressure this places on operations. While PRASA's management has successfully executed key components of the CIP, particularly those required by regulators, projected capital spending over the fiscal 2013-2017 CIP period remains sizeable at $1.5 billion and is expected to remain elevated well beyond fiscal 2017 as PRASA carries out improvements related to its 2011-2030 master plan. PRASA is in the process of renegotiating its existing consent decrees with regulators in an effort to establish a prioritization of projects and smooth the economic impact of the CIP on an annual basis. If approved, this would likely alleviate near-term capital pressures to some extent and provide a longer period with which to meet regulatory milestones but may also include additional required projects over time. RISING DEBT TO KEEP MARGINS LOW With minimal surplus revenues available for equity funding of capital, PRASA anticipates relying almost exclusively on borrowable sources. Consequently, debt levels, which are already elevated, will rise further as the CIP progresses and continue to place pressure on the authority's already weak financial margins. Overall, PRASA expects total revenues, as well as the unidentified revenues previously mentioned, to cover all flow of fund requirements by around 1.0x-1.1x through fiscal 2017. Senior lien DSC is expected to be higher at 2.8x-7.2x based on the new gross revenue for senior lien bonds but a more modest 1.4x-1.9x using the more traditional net revenue basis. Given the rising debt burden, debt carrying costs are expected to increase from 20% of gross revenues experienced in fiscal 2009 to around 34% expected by fiscal 2015.
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