OREANDA-NEWS. Fitch Ratings affirms at 'AA' the ratings on the following Killeen, Texas (the city) revenue bonds:

--\$11.1 million waterworks and sewer system revenue refunding bonds, series 2011;
--\$28 million waterworks and sewer system revenue refunding and improvement bonds, series 2013;
--\$7.9 million waterworks and sewer system revenue refunding bonds, taxable series 2013.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by net revenues of the city's waterworks and sewer system (the system) on a basis subordinate to the system's outstanding senior lien bonds, series 2007; Fitch does not rate the series 2007 bonds (\$1.6 million outstanding).

KEY RATING DRIVERS

SOLID FINANCIAL PROFILE: Financial results are solid with total debt service coverage (DSC) in excess of 2x in each of the last three audited fiscal years. Near-term projections indicate reduced coverage levels that remain adequate for the rating, but a recent increase in transfers to the general fund will produce very low DSC net of transfers out. DSC, including net of transfers, is expected to return to more historically favorable norms relatively quickly.

FAVORABLE DEBT PROFILE: System debt levels are low even when taking into consideration off-balance sheet debt of Bell County Water Control & Improvement District No. 1 (the district, the system's wholesale water and sewer provider), which are supported by the system. Debt levels should remain below average even after the system's entire near-term capital program is debt funded given the system's rapid amortization schedule.

ADEQUATE RATE FLEXIBILITY: The system maintains sufficient rate flexibility but rates could be pressured over time to support wholesale pass-through costs and additional system debt issuances. Rates are projected to remain affordable over the next five years even with the adopted and planned rate hikes.

WHOLESALER COST PRESSURES: The city is susceptible to operating cost pressure from its wholesale water and wastewater providers.

MILITARY DRIVES LOCAL ECONOMY: While economic indicators are sound, the service area economy is strongly linked to Ft. Hood (the base), the largest U.S. Army base in the nation.

RATING SENSITIVITIES

CONTINUED HEALTHY FINANCIAL METRICS: Maintenance of financial margins consistent with the rating level despite rising operating and fixed costs is key to retaining the current rating level.

GROWING TRANSFERS: Increasing transfers out to the general fund could pressure liquidity to a level inconsistent with the current rating.

CREDIT PROFILE

The system provides retail water and sewer service to city residents, which includes a population of around 137,000 persons. Water and wastewater treatment are provided through separate long-term contracts with the district that extend to 2029 and 2024, respectively. Costs paid to the district, including debt service costs related to the district's own borrowings for capital assets that serve the city, are an operating and maintenance (O&M) expense of the system payable from revenues on a lien superior to that of the bonds.

ADEQUATE FINANCIAL RESULTS EXPECTED

System financial performance has been strong, recording annual DSC in excess of 2x for fiscals 2011-2013. For fiscal 2013, as previously projected, audited coverage was a solid 2.3x all-in (1.5x net of transfers out). However, unaudited fiscal 2014 results point to a decline to a still strong 1.8x due to a bump in debt service requirements outpacing the modest 3% rate increase for the year. Of concern though, for the same period DSC was below 1x net of transfers out.

Transfers out have steadily increased to \$5.7 million (or 16% of operating revenues) in fiscal 2014 from \$3.3 million (or 11%) in fiscal 2009. Slightly lower DSC at a still adequate 1.5x is projected for fiscal 2015 before larger rate increases planned for fiscal years 2016 and 2017 combined with a descending debt service schedule are projected to produce higher DSC levels closer to historical results. Fitch will monitor the impact these transfers have on the system credit fundamentals.

Liquidity increased over the last two years and for fiscal 2013 days cash increased to a five year high at 426 days. However unaudited results for fiscal 2014 point to a material reduction in liquidity in large part due to a \$5 million cash contribution to the district for the system's share of capital for the new water treatment plant, as well as transfers out to the general fund.

MANAGEABLE CAPITAL NEEDS AND AFFORDABLE RATES

The system completed an update to its 20-year water and sewer master plan (the plan) in 2012. Projects incorporated into the plan include an increasing proportion of renewal and replacement (R&R) of existing system assets (45% of project costs) compared to just 10% with the last update of the plan in 2007. The master plan is updated every five years.

The city is in year three of the master plan and construction continues with bond proceeds from prior issuances. The projects for fiscals 2015-2019 total \$47 million of which \$29 million will be completed with funds available from prior bond sales. Approximately \$3 million will be funded with cash reserves and the remaining \$15 million in projects will be completed with future bond sale proceeds expected sometime in fiscal 2018. In addition to the city's capital needs, the district projects total \$34 million for the construction of a water treatment plant and wastewater plant upgrades which will be funded through the district and repaid by the system as an operating expense. To offset the increase in operating expenses in future years, the system advanced \$5 million to the district as a cash contribution in fiscal 2014.

The city commissioned a rate study to evaluate funding options for capital needs beyond fiscal 2015. Annual rate increases of 3% were implemented for fiscal years 2014 and 2015. An additional 5% annual rate increase is planned for fiscal 2016 and 2017 followed by another 2% in fiscal 2018. Residential rates currently equal a moderate 1.6% of median household income (MHI), providing the system sufficient rate flexibility to address future operating and capital cost pressures.

FAVORABLE DEBT PROFILE

Given the system's limited operations, direct system debt levels are low. For unaudited fiscal 2014 debt per customer was just \$519 while debt per capita was \$425, both well below the 'AA' category medians. Including district obligations supported by the system, system debt levels roughly double but remain favorable relative to the medians. The system's debt profile is expected to diminish somewhat over the coming years despite capital costs to construct facilities by either the district or another wholesale provider to meet future system water consumption demands. It is possible that some, if not all, of the capital needs beyond fiscal 2015 will be debt funded. However, based on the system's current debt profile the likely increases in direct and indirect borrowings over the next few years are not expected to push system debt levels beyond those of comparably-rated credits.

MILITARY-RELIANT SERVICE TERRITORY

Killeen (general obligation bonds rated 'AA' by Fitch) is located in central Texas, approximately 60 miles north of Austin. Adjacent to the city is Ft. Hood, the largest Army post in the U.S., with over 50,000 military and 5,500 civilian personnel. Prospects for future growth are favorable due to the city's affordable housing market, transportation infrastructure improvements and close proximity to the base.

The unemployment rate in the city typically is marginally higher than the state but has fared better than the nation in recent years given the level of federal military funding. City unemployment for November 2014 trended lower year-over-year and was 6.1% compared to the state and national averages of 4.6% and 5.5%, respectively. Wealth levels in the city are moderately low, with MHI 10%-15% below the state and nation.