OREANDA-NEWS. Fitch Ratings has affirmed the following rating on bonds issued by the Semitropic Improvement District of the Semitropic Water Storage District, California:

--$83.3 million water banking revenue bonds, series 2012A and 2012B at 'AA-'.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross pledge on water banking contract revenues received from five water banking customers of Semitropic. If banking revenues are insufficient, Semitropic has pledged any available revenues for payment of the bonds. Bondholders also have a lien on the proceeds from the sale of a water-banking customer's stored water in the event that the customer terminates its contract with Semitropic.

KEY RATING DRIVERS

VALUABLE WATER-BANKING CONTRACTS: Semitropic provides valuable water-banking services to five State Water Project (SWP) customers, who in turn provide water to the majority of California's population. Water-banking provides customers flexibility in managing the variability of supplies in California's tightly constrained water market, particularly during periods of drought.

STRONG CREDIT QUALITY OF CONTRACTORS: The collective credit quality of the five pledged water-banking contracts is strong and at the high end of the 'AA' rating category. The contracts have been in place since 1995-1999 and 2008 (San Diego County Water Authority; SDCWA) and terminate at bond maturity in 2035.

CONTRACT TERMINATION RISK: Water contractors have the ability to terminate their water-banking agreements with one-year's notice. Contract termination is a risk to bondholders, since remaining revenues could be insufficient to repay bonds. However, the water-banking program is a key water resource in the long-term water supply plan of each of the contractors, and Fitch believes the risk of terminations is very low.

VARIABLE BANKING REVENUE COVERAGE: Pledged water-banking contract revenues are quite variable. Pledged revenue coverage has averaged 1.3x over the past four years, but can fall below 1.0x in periods with minimal usage by the Metropolitan Water District of Southern California (rated 'AA+'/Stable Outlook), the largest contractor. Coverage rose to 1.5x in fiscal 2015 as Metropolitan and other program participants withdrew water to meet drought needs, but coverage is expected to decline in 2016 with drought easing and storage withdrawals reduced.

BACK-UP PLEDGE OF SEMITROPIC: The back-up pledge of any available district revenues provides cash flow support during years of lower banking revenues. Semitropic's minimum cash reserve policy is to maintain at least $15 million in its emergency and contingency reserve. Unrestricted cash and investment equaled $18.5 million, or 153 days cash, at the end of 2015, providing adequate protection against short-term shortfalls in banking revenues.

RATING SENSITIVITIES

DECREASE IN METROPOLITAN USAGE: Maintenance of cash reserves at Semitropic Water Storage District is viewed as key for the rating given the inherent risk to bondholders of a change in usage of the program, particularly the Metropolitan Water District of Southern California. Multiple years of no usage by Metropolitan could prompt a rapid rating decline.

CONTRACT TERMINATION: In the event of a contract termination by one or more of the water banking contractors, the rating would likely experience significant downward movement.

DECLINE IN CONTRACTOR CREDIT QUALITY: A material change in credit quality of the water contractors could result in a rating change to the water banking revenue bonds.

CHANGES IN DEBT PROFILE: The rating would come under downward pressure if the district issued additional debt backed by the pledged water banking revenues. It could also come under downward pressure if further leveraging of other revenue streams reduced overall financial performance.

CREDIT PROFILE

Semitropic Water Storage District is located in central California, about 20 miles northwest of Bakersfield. The district provides supplemental surface water to farmers in order to reduce the impact of pumping on the region's groundwater basin, and it provides water banking services to other water agencies. Semitropic's surface water supplies are provided by the SWP via the California Aqueduct that traverses the state from north to south.

The bonds are backed by a pledge of Semitropic's water-banking revenues from five large, urban water providers. The five pledged water contractors are the Metropolitan Water District of Southern California (rated 'AA+'/Stable Outlook); Santa Clara Valley Water District (rated 'AA+'/Stable Outlook); Alameda County Water District; Zone 7 Water Agency; SDCWA; (rated 'AA+').

LOCATION WELL SUITED FOR GROUNDWATER BANKING

Semitropic benefits from a large, porous groundwater basin and a location on the California Aqueduct south of the Sacramento-San Joaquin River Delta. Its location south of the Delta allows Semitropic to serve SWP customers that are vulnerable to supply disruptions in the Delta and periodic droughts. Semitropic began selling capacity in its local groundwater aquifer to urban SWP customers in 1994. The combination of SWP imports and banking water deposits have allowed the district to stabilize groundwater levels, increasing supply reliability and reducing costs for its agricultural users.

Banking customers bank (or store) water with Semitropic in high water years and withdraw it during low SWP allocation years, providing water supply stability to those customers in droughts. Banking customers are able to recall 90% of their banked water in future years, subject to the physical transport limitations of Semitropic's system to pump groundwater storage back to the California Aqueduct.

WATER CONTRACTS PROVIDE FIXED O&M FEES AND USAGE FEES

Semitropic's revenues include fixed assessments collected on local property tax bills, contract water sales revenues (sales of imported SWP water to irrigators), non-contract water sales (sales of banking water deposits to farmers) and the pledged water banking revenues. Semitropic's irrigation customers are contractually obligated to purchase available banking and SWP water. The price of non-contract water (banked water) is typically priced near the cost of pumping water from the ground to incentivize farmers to participate in the program. Contract water rates include both a fixed charge tied to SWP fixed costs and a volumetric rate tied to pumping charges and other variable costs.

Banking revenues include a minimum O&M fee from users other than Metropolitan and volumetric deposit and withdrawal fees from all users. Non-Metropolitan O&M fees are adjusted annually by inflation and include a commensurate amount of deposits and withdrawals, making Metropolitan the primary payer of volumetric rates. The contracts do not include a take-or-pay provision, and the O&M fee increases are tied to inflation, not Semitropic's actual costs.

VOLATILE REVENUE STREAM

The pledged water-banking revenues provide a solid but variable source of repayment for the rated bonds. Pledged revenues have averaged $10.3 million annually over the past decade, equal to 1.2x coverage of maximum annual debt service (MADS) on the rated bonds and parity swap obligations. MADS occurs in 2035 and equals $8.3 million.

Coverage varies with usage of the banking program, particularly by Metropolitan. A 2003 contract amendment allows Metropolitan to avoid O&M fees as long as its 10-year rolling average of storage and withdrawal amounts of water from the bank is 35,000 acre feet (af) or above. Metropolitan reached this 10-year average beginning in 2010, reducing the district's O&M fee revenue. The change somewhat reduces Semitropic's water-banking fees in the long term, and it significantly changed the timing of payments from Metropolitan while increasing revenue volatility.

Changes in Metropolitan's fee structure agreed to in 2012 further exacerbate concerns about pledged revenue volatility and timing mismatches by reducing near-term storage deposit fees in exchange for raising long-term storage withdrawal fees. No further amendments to the contracts are permitted by the bond indenture without a certification to the trustee that it would not adversely affect payment of debt service. O&M fees from the four non-Metropolitan pledged banking customers equaled $3.8 million in 2015 compared to debt service of $6.7 million.

Metropolitan makes significant use of the banking program in wet years (depositing excess water supplies) and in dry years (withdrawing water), but it uses the program very little in balanced water years when its SWP and Colorado River deliveries roughly equal its needs. For instance, Metropolitan made minimal use of the program in 2012, reducing Semitropic's pledged banking revenues to $4.4 million and debt service coverage to just 0.95x. Performance has since rebounded to more solid levels with pledged banking revenues reaching $10.3 million in 2015. However, 2016 is likely to be another weak year for the pledged revenues.

Typical California water supply conditions (wet years alternating with periods of drought) are likely to keep Metropolitan's water-banking revenues at a level that provide solid coverage on average over time. Metropolitan's combined storage and withdrawals averaged 71,994 af annually over the 10 years ended 2015, providing adequate revenues on average. However, a sustained drop in Metropolitan's usage would create financial stress for the agency and could put downward pressure on the rating. Multiple years with no Metropolitan usage would likely result in a downgrade of more than one notch. Semitropic has experienced three years without Metropolitan usage since 1994, but it has never experienced two consecutive years.

The back-up pledge of Semitropic's other revenues and reserves is key to protecting bondholders during periods of limited use by Metropolitan, and Semitropic's overall financial performance has been adequate. All-in debt service coverage averaged a weak 1.2x over the past three years. Liquidity averages an adequate 147 days of operating expenses. While overall financial performance is judged to be adequate to offset the risk of short-term shortfalls in pledged banking revenue coverage, available resources are only sufficient to withstand a relatively short period of no more than one to three years at the current rating level.

BANKING PARTNER DEPARTURE UNLIKELY

Fitch views the potential for water banking contract termination by one of the five pledged contractors as unlikely given the stability in SWP water supply offered by the water banking arrangement. Increasing water supply scarcity in California and the high cost of procuring equivalent supply security through desalination, dam construction and/or water reuse add to the incentives to participate in the banking program. Banking customers would also forfeit banked water in the event of a termination, and current banking balances total more than 700,000 af of water.

HIGH DEBT BURDEN

Semitropic's debt levels are above average with debt-to-net plant assets of 79% and debt-to-funds available for debt service at 9.8x. Amortization is solid with 42% maturing in 10 years and 89% in 20 years. The district's debt profile includes an unusual off-the-market, forward-starting swap that the district began to make payments on in September 2014. The payments are on parity with the water-banking revenue bonds. The swap had a negative mark-to-market value of $20.5 million as of July 11, 2016. Management says it will consider terminating the swap when mark-to-market values decline, which is not expected in the near term. In the meantime, the district has increased property assessments to cover the payments. This provides a reliable source of repayment, but does not boost legally pledged revenues.

The district currently may issue $25 million of additional debt to fund land acquisitions related to a new conjunctive use project later this year but otherwise management reports minimal capital needs. The district has not decided on the structure or pledged to support the new debt. Any additional leveraging of the pledged water-banking revenues would put downward pressure on the bond rating. The rating could also come under downward pressure if new debt issuance reduces overall financial performance, particularly if cash slipped below the district's reserve target.