Fitch Affirms Oakland, CA's Sewer Revenue Bonds at 'AA-'; Outlook Revised to Positive
Fitch Ratings affirms an 'AA-' rating on the following Oakland, California sewer revenue bonds:
--$48.7 million series 2004A.
The Rating Outlook is revised to Positive from Stable.
The bonds are secured by a first lien on net sewer revenues.
KEY RATING DRIVERS
OUTLOOK POSITIVE ON FINANCES: The sewer enterprise's debt service coverage remains very strong, and liquidity has improved markedly after a series of rate increases. Liquidity gains have proven more durable than previously expected.
LARGE, DIVERSE SERVICE AREA: The enterprise provides an essential service to a large and diverse service area in the San Francisco Bay Area's third-largest city.
LIMITED OPERATIONS: The enterprise is a collection-only sewer system that owns no treatment plant, reducing the operational complexity of the system.
ONGOING CAPITAL NEEDS: The sewer system's infrastructure is quite old, and regulators have forced the city to undertake significant but manageable capital upgrades to reduce sewer overflows into the San Francisco Bay as well as infiltration of rainwater into the sanitary sewer system during wet weather.
DISCIPLINED RATE SETTING: The Oakland City Council has consistently imposed rate increases to cover the increasing costs of upgrading the aging system, while preserving healthy financial performance.
LOW DEBT BURDEN: The debt burden is very low, and the system has no further debt issuance plans. The system's strong margins and free cash flow support plans to finance capital needs on a pay-go basis.
STRONG FINANCES, LOW DEBT: Fitch expects to upgrade the rating over the next two years if the sewer system's strong financial performance continues and the city imposes a significant rate increased planned for fiscal 2014. The increase was delayed from 2013 to give ratepayers relief during a time of economic stress, but will likely be necessary to meet increasing regulatory capital requirements.
MANAGEABLE REGULATORY PRESSURES: Fitch expects regulatory capital demands to increase but to remain manageable. An unexpectedly large increases in capital spending as part of the renewal of the city's discharge permit in 2014 would lessen the likelihood of an upgrade.
The enterprise provides sanitary sewer services to a stable, older city of about 400,000 people and 102,000 customer accounts on the eastern edge of the San Francisco Bay. The customer base is diverse and 75% residential. The service area also includes a large downtown that's a regional employment hub with a healthy mix of commercial, industrial and governmental ratepayers. Customer concentration is low with the top 10 ratepayers providing less than 2% of revenues.
While the Oakland economy is large and diverse with strong ties to the broader Bay Area employment market, the city's economy is weaker than many of its San Francisco Bay area neighbors. The unemployment rate tends to run above regional, state and national averages, and it was quite elevated at 11.3% in June. Median household income is 83% of the state median and 97% of the national level.
STRONG FINANCIAL PERFORMANCE
The city's sewer enterprise has performed well financially despite the economic challenges and the burden of maintaining its aging infrastructure. The enterprise is a collection-only sewer system with no treatment plant, reducing the operational complexity, and its rate revenue comes primarily from fixed charges, providing a great deal of revenue stability.
Debt service coverage has been very strong with net revenues available for debt service averaging 3.6 times (x) senior debt service over the three fiscal years ended 2012. Coverage is expected to continue to remain quite strong, improving over the five-year forecast horizon in a reasonably conservative city forecast that includes no demand increases and inflationary cost increases.
Liquidity has improved markedly, ending fiscal 2012 with a very strong 440 days cash on hand. The city has not traditionally kept very robust reserves because it invested almost all of its free cash flow back into the aging system, but in recent years it has built up and maintained large reserves as rate collections got ahead of capital spending. This is a typical pattern for water and sewer utilities with large capital programs. While the funds are earmarked for capital, they are not legally restricted and provide a strong liquidity position that protects bondholders and system financial health.
Fitch expects Oakland's cash balances to vary with its capital spending cycle, but the practice of cash funding most capital needs suggests the utility will have significant, revolving capital reserves for the foreseeable future. Oakland also maintains a small, but adequate, operating reserve in the form of a rate stabilization fund that equals about 50 to 60 days operating cash.
ONGOING CAPITAL NEEDS
The utility's financial profile is driven by the need to revitalize an aging system and a practice of cash funding renewal and replacement projects. Oakland's sewer system includes pipes dating from the 1800s, and the average age of infrastructure plant is quite elevated at 18 years. The aging infrastructure has contributed to sanitary sewer overflows, which have drawn heightened regulatory and public scrutiny amid efforts to protect the San Francisco Bay.
Regulators forced the city to undertake a 25-year, $260 million upgrade of system capacity that the city expects to complete in 2014. Its 2009 National Pollutant Discharge Elimination System permit required further significant investments in the city's pipe replacement and renewal program. The city plans to spend a manageable $60.3 million on sewer capital spending over the next five years with much of the capital program dedicated to preventing rainwater from flowing into the sanitary sewer system in order to comply with regulatory requirements. The utility is likely to face further regulatory capital requirements when its permit comes up for renewal in 2014.
GOOD RATE DISCIPLINE
The Oakland City Council has imposed large rate increases to cover the increasing costs of upgrading the system, allowing the utility to meet most of these requirements on a pay-as-you-go basis. Policymakers have already approved a series of 16% rate increases effective fiscal 2011, 2012 and 2014 to fund the capital program. The rate hikes elicited few protests from ratepayers and no dissenting votes from elected policymakers, suggesting strong political support for the capital program. Still, the rate increases pushed Oakland residents' combined sewer collection bill (paid to the Oakland enterprise) and treatment bill (paid to East Bay Municipal Utility District) to slightly above Fitch's 1% affordability threshold for sewer bills, suggesting that rate flexibility may be diminishing in the face of continued significant increases. Indeed, the city council delayed the final increase from 2013 to 2014 to give rate payers some relief during difficult economic times. The utility's growing cash balances suggest the city could afford to wait, but ongoing capital needs will likely require increased rates. Fitch expects the city to continue with its rate plan in 2014 but does not expect to upgrade the rating until the plan is back on track.
LOW DEBT BURDEN
The consistent use of pay-go capital funding yields a very low debt burden for the enterprise. Debt is quite low on both a per capita ($128) and per customer ($501) basis and declining due to rapid amortization. All of the city's outstanding sewer bonds amortize within 20 years. The city currently has no plans to issue additional debt over the near term, suggesting debt ratios will remain a positive credit factor.
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 informed by information from CreditScope and IHS Global Insights.
Applicable Criteria and Related Research:
--'U.S. Water and Sewer Revenue Bond Rating Criteria', dated July 31, 2013;
--'2013 Water and Sewer Medians', dated Dec. 5, 2012;
--'2013 Outlook: Water and Sewer Sector', dated Dec. 5, 2012.
Applicable Criteria and Related Research:
U.S. Water and Sewer Revenue Bond Rating Criteria
2013 Water and Sewer Medians
2013 Outlook: Water and Sewer Sector
Andrew Ward, +1-415-732-5617
Fitch Ratings, Inc.
650 California Street
San Francisco, CA 94108
Alan Gibson, +1-415-732-7577
Michael Rinaldi, +1-212-908-0833
Elizabeth Fogerty, New York, +1 212-908-0526