OREANDA-NEWS. Fitch Ratings affirms the following ratings on the San Antonio Water System (SAWS) District Special Project (DSP) waterworks system and the debt assumed by the DSP from the former Bexar Metropolitan Water District (BMWD):

--\$102.7 million BMWD waterworks system revenue refunding bonds, series 2006 and 2009 (senior lien) at 'A+';
--\$2.2 million BMWD capital appreciation refunding bonds, series 2006 (senior lien) at 'A';
--\$115 million San Antonio DSP waterworks system flexible-rate revolving notes (subordinate lien) at 'A'/'F1'.

The Rating Outlook is Stable.

SECURITY

The senior lien bonds are secured by and payable from a first lien on and pledge of the net revenues of the DSP waterworks system. The notes are secured by a subordinate lien on net revenues of the DSP waterworks system, which are on parity with the district's outstanding subordinate lien bonds (not rated by Fitch).

KEY RATING DRIVERS

SEGREGATED SYSTEMS: SAWS assumed all interests and obligations of BMWD effective January 2012. The operations are being accounted for separately from the SAWS system and are reported as a component unit of the city of San Antonio as a department of SAWS. The DSP and SAWS systems will remain segregated until certain requirements are met.

STABILIZED FINANCIALS: Debt service coverage (DSC) historically was erratic and even failed to meet the 1.25x covenant level for one year. Under the new management team, DSC improved and has remained stable. This was achieved primarily through a debt restructuring and operating efficiencies. Liquidity has also improved and stabilized but remains below median levels.

HIGH LEVERAGE: The DSP is highly leveraged. Capital needs appear to be manageable given the relative overlap and proximity of the combined DSP and SAWS service areas.

RATES AND CHARGES: The DSP water rates are higher than those of SAWS customers, but they remain affordable relative to wealth levels. With implementation of certain cost savings, synergies, and the recent debt restructuring, management has maintained and expects to maintain level rates over the remaining integration period.

STRONG AND DIVERSE SERVICE AREA: The trend of San Antonio's overall economic activity and diversification remains stable, with the softening in residential building activity partially offset by steady commercial and military expansion.

SHORT-TERM RATING: The 'F1' rating on the DSP flexible-rate revolving notes is based on the long-term credit quality of the security ('A').

RATING SENSITIVITIES

MAINTENANCE OF ADEQUATE FINANCIAL POSITION: The rating is sensitive to shifts in fundamental credit factors. Preservation of the system's sound financial profile is a key consideration given the pressure to maintain level rates during the integration period.

CREDIT PROFILE

SAWS (senior lien debt rated 'AA+' by Fitch) recently took control of the operations of the former BMWD as a result of a public election to dissolve the BMWD. After years of public criticism and numerous complaints regarding service and management of the system, the state passed legislation requiring the public to vote on dissolution of the district. The election was held in November 2011 at which time 74% of the voters approved the dissolution of BMWD and for the operations to be taken over by SAWS.

SAWS took over operations effective January 2012. In order to protect bondholders and maintain credit neutrality, operating revenues and debt obligations of the two systems will remain separate until certain requirements are met for full integration. The legislative timeline for integration is five years with the possibility of extending another three years with the approval of the Texas Commission on Environmental Quality (TCEQ). The San Antonio City Council by resolution adopted an ordinance creating a separate 'District Special Project' and the DSP is reported as a separate discrete component unit of the city of San Antonio beginning with the Dec. 31, 2012 financial statements.

HISTORICAL VOLATILITY

Historical annual DSC of BMWD was somewhat volatile, but generally adequate, ranging between 1.3x and 1.6x since fiscal 2007. However, for fiscal 2010, the BMWD cited lower than budgeted water sales due to extreme wet weather leading to a dip in maximum annual debt service (MADS) coverage to 0.92x, well below the 1.25x legal covenant. Although DSC on MADS was very weak, Fitch notes that actual DSC was better and that the BMWD made timely debt service payments on its bonds. In response to these results, the BMWD implemented a 7% rate increase in fiscal 2011 and improved DSC to 1.6x by the close of fiscal 2011.

IMPROVED AND STABLE FINANCIAL METRICS

Over the last three fiscal years since SAWS' management has assumed control of the DSP financial metrics have improved, with improvement in the metrics due in large part to a 2012 debt restructuring. DSC has ranged from 1.6x to 1.8x from fiscals 2012 to 2014. Liquidity, although still below medians for the rating level, has improved to 156 days cash on hand at the close of fiscal 2014 compared to 101 days in fiscal 2011.

Since taking over the system, SAWS' management team has implemented a number of cost savings that have enabled the maintenance of improved and stable financial metrics without the need for rate increases, positioning the system well to begin planning for full system integration. As stated in the legislation, integration is deemed to be complete when (1) the areas of service located in the former DSP are no longer operated as a special project within SAWS, (2) the rate payers of the former DSP pay the same rates as similarly situated ratepayers of SAWS, and (3) the ratepayers of the former BMWD receive water service that meets the TCEQ requirements. This last requirement is already being met.

To complete the integration, SAWS' current plan is to take out the existing DSP debt with SAWS debt obligations in the first quarter of 2016. The refunding of the obligations would result in the collapse of the DSP and financial results and cash flows will be consolidated, fulfilling the first requirement. However, the rates of the former DSP customers (which are slightly higher than SAWS rates) are planned to remain in place until Jan. 1, 2017. Based on this strategy, the DSP and SAWS will consolidate financially, in early 2016, prior to the full integration date, Jan. 1, 2017, when all customers will be paying the same rate.

HIGHLY LEVERAGED SYSTEM

The DSP is highly leveraged and additional capital needs were large prior to SAWS taking over the system. However, due to the overlap of the two systems' service areas, SAWS was able to curb capital spending on water supply projects by supplying water from its existing sources. A portion of the former BMWD debt was restructured in fiscal 2012 with the issuance of flexible-rate revolving notes secured by a subordinate lien on net revenues of the DSP waterworks system. The initial term was for three years with renewal options and a maximum \$100 million authorization.

SAWS exercised its renewal option, extending the term of the notes another two years and increasing the authorization to \$115 million. Currently \$78.7 million is outstanding under this program. The remaining authorization is available for capital projects, if needed. Since issuance of the notes in 2012, the DSP has only drawn an additional \$10 million for capital projects.

SERVICE AREA

DSP serves a diverse and growing area within the San Antonio metropolitan statistical area (MSA), providing water delivery to a service area that includes portions of Bexar, Atascosa, and Medina counties. The district presently has more than 100,000 connections, the vast majority of which are residential. The service area includes the original south San Antonio segment which still is the largest customer base. However, acquisition of water companies in the west, northwest, north central, and northeast areas of Bexar County coincide with some of the fastest growing areas in the region.