OREANDA-NEWS. July 14, 2015. Fitch Ratings has upgraded its rating on the following obligations of Guam Waterworks Authority (GWA, or the authority) to 'BBB-' from 'BB':

--\\$373.1 million water and wastewater system revenue bonds.

The Rating Outlook is revised to Stable from Positive.

SECURITY
The bonds are secured by a senior lien on the authority's gross water and wastewater system revenues excluding development charges.

KEY RATING DRIVERS

FINANCIAL PERFORMANCE; REGULATORY COMPLIANCE: The upgrade reflects the authority's sustained positive financial performance and forecast, aided by a five-year rate package, as well as substantial progress in complying with all regulatory requirements.

POLITICAL AND REGULATORY RATE SUPPORT: The five-year rate package through fiscal 2018 to support the authority's substantial capital needs demonstrates continued political willingness to raise rates. The regulatory approval process through the Guam Public Utility Commission (PUC) has been supportive of timely cost recovery. Ongoing political and regulatory support for significant additional rate hikes will be necessary, which may ultimately pressure rate affordability.

ELEVATED DEBT AND CAPITAL MANDATES: Debt levels are high and are expected to continue to escalate, since additional debt is the principal funding source for significant capital needs as required in a federal court order. Heavy capital spending extends out beyond the current five-year capital improvement plan.

OPERATIONAL CHALLENGES: Water supplies on the island are adequate but a high approximately 60% water loss rate reflects aging water distribution lines and presents operational challenges for the system.

MILITARY BUILD-UP DELAY CONTINUES: Additional capital projects will ultimately be needed to meet expected military build-up demands, the scope of which has been reduced and timing delayed. However, GWA expects capital costs incurred as a result of the eventual build up will be funded by the U.S. Department of Defense (DOD), including a recent \\$106 million appropriation.

LIMITED ECONOMIC PROFILE: The service territory is isolated and limited and has had a geographic disposition to natural disasters. However, tourism has continued to diversify and recover from the economic downturn, reaching near peak levels the last two years. System rates rely heavily on revenues captured from the commercial/tourism sector (36%).

RATING SENSITIVITIES

CONSISTENT COMPLIANCE AND FINANCIAL PERFORMANCE: The rating is based upon the Guam waterworks authority's continued compliance with regulatory requirements as well as its ability to meet its financial forecast.

CREDIT PROFILE
The authority operates and maintains the water and wastewater systems (the system) for approximately 42,000 water customers and 28,000 wastewater customers on the island of Guam. It is governed by the five-member Consolidated Commission on Utilities (CCU), which also governs the Guam Power Authority. Rates are subject to regulatory approval by the PUC. Bond issuance requires approval from the PUC, the Governor and the Guam legislature.

UPGRADE REFLECTS CONTINUED COMPLIANCE ACTIONS
The system has recently taken a number of actions to bring it into regulatory compliance and ensure stable operations and finances. Structural changes, which began in 2002 when the authority's governance was changed from an appointed to an elected governing board, resulted in the system's full compliance to date with the 2011 USEPA Court Order (the order) and the recent compliance of its two largest wastewater treatment plants for the first time since enactment of the Clean Water Act (CWA) in 1972. Nevertheless, significant operational issues and capital needs persist which will challenge utility operations over the long term.

UPGRADE ALSO REFLECTS FAVORABLE FINANCIAL RESULTS AND FORECAST
GWA has achieved sustained improvement in financial results over the past five years and projections point to continued solid performance. Fiscal 2014 ended better than expected with Fitch-calculated senior lien debt service coverage (DSC), based on audited results and includes accruals, of 2.1x and total DSC of 1.5x. Operating margins were aided by a 10% rate increase effective November 2013 (which was followed by a December 2014 increase of 17.4% or 14.5% on an annualized basis) as well as a 2.8% decline in operating expenses due to lower power purchases and salaries and wages. The increased operating margin was mostly offset by increased debt service payments as the 2010 bonds rolled on. As such, days of operations in cash remained virtually unchanged for the year at a moderate 177.

Fiscal 2015 results are expected to be marginally higher than prior estimates based on estimated results through May 2015 while GWA projections through fiscal 2018 are unchanged. The PUC's policy is to set rates to achieve senior DSC of 1.75x and the authority projects DSC of 1.8x to 2.2x through fiscal 2018 despite rising debt service payments with the inclusion of the approved five-year rate plan.

STRONG HISTORY OF COMMITMENT TO RAISING RATES CONTINUES
Overall, the CCU (and the PUC) have shown a demonstrated commitment to cost recovery needed to stabilize system financial performance, approving cumulative increases of over 95% since fiscal 2007. Residential charges currently exceed Fitch's affordability threshold with combined water and wastewater rates of \\$83.94 per month at 7,500 gallons of usage, equal to 2.3% of median household income (MHI).

GWA's five-year rate proposal that covers fiscals 2014-2018 was approved by the PUC on Oct. 29, 2013. Remaining base annual rate increases range from 4% to 16.5% along with additional surcharges. As such, rates based on usage of 7,500 gallons per month will increase to about 2.6% of MHI by fiscal 2018, which is well above Fitch's affordability threshold, assuming an increase in income of 2% per year from 2010 levels. Despite GWA's ratemaking bodies' continued commitment to necessary rate recovery, the level of service charges could limit future rate flexibility that will be needed to address ongoing capital needs.

SIGNIFICANT IMPROVEMENT IN REGULATORY COMPLIANCE; CONTINUED CAPITAL NEEDS SEVERELY WEAKEN DEBT PROFILE

In 2003 the authority negotiated a stipulated order (SO) with the USEPA as a result of violations to the CWA and Safe Drinking Water Act (SDWA). To cure system-wide deficiencies, the SO was subsequently amended and superseded by the order, which added several major projects to be constructed. Projects included in the order are expected to cost \\$269 million over the next five years. To date, GWA has completed or has programmed into the fiscal 2014-2018 CIP all but one of the 100 projects required under the order.

The USEPA also issued a notice of Findings of Significant Deficiencies for the water system in 2012 and for the wastewater system in 2013. Notably, the authority has addressed 36 of the 40 items identified for water, and four are long-term continuing actions. The authority has addressed 86 of the 89 items identified for wastewater and is on track to address the remaining within the allowed timeframe.

GWA's progress in addressing regulatory requirements is a positive development, but the authority faces significant capital needs to meet remaining requirements. The fiscal 2015-2018 CIP totals \\$321 million, with the order accounting for 73% of expected expenditures. Funding will be derived largely from additional debt, consisting of an estimated \\$161 million in fiscal 2016 and \\$90 million in fiscal 2018, along with remaining 2013 bond proceeds (85% of sources).

With the additional debt incurred in fiscal 2014, GWA's debt-to-net plant increased to 118%, as compared to Fitch's median of 43%. GWA's currently high debt ratios will rise even higher, to nearly \\$8,000 per customer, or 4x-5x Fitch's median for investment grade credits. GWA's financial flexibility will decrease as debt service accounts for an increasing percentage of system revenues (22% in fiscal 2014 and expected to climb to 29% by 2018). A similar level of capital needs and debt funding extends beyond the five-year CIP, indicating further escalation of the system's leverage position.

SECONDARY TREATMENT NOT ADDRESSED IN CIP
The authority's two largest wastewater treatment plants (WWTPs) have historically operated under secondary treatment variances issued by the USEPA under the CWA, allowing the authority to discharge primary effluent into the Philippine Sea. As part of their June 1, 2013 renewals, the discharge permits for both WWTPs include increased secondary treatment requirements.

The authority estimates the cost of upgrading both treatment plants at \\$279 million and is currently negotiating a schedule for compliance with the USEPA. The authority expects to receive approval to delay implementation until after completion of projects required under the current order and notes that other agencies have negotiated extended compliance schedules of 20-25 years. However, if a shorter timeframe is required, there would likely be significant pressure on the system. The CIP through fiscal 2018 does not include the secondary treatment upgrade projects or the appropriations from the federal government.

MILITARY BUILD-UP DELAYED
Currently, the DOD build-up is expected to result in an increase of 7,400 military and civilian personnel after 2018. This compares to previous estimates of an ultimate increase to the island's permanent population of around 32,000 people (approximately a 20% increase from the current level) as part of its relocation of troops from the nation of Japan.

Positively, the federal government recently appropriated \\$106 million for civilian water and sewer improvements on the island associated with an expected military build-up, the first time the federal government has actually appropriated money towards such action. Receipt of the monies is uncertain, but GWA expects to use the monies to bring one of the WWTPs up to secondary treatment. GWA continues to expect that any additional costs incurred as a result of the build-up will be borne by the military.

LIMITED ECONOMY
The island's economy is driven by the military and tourism sectors. Most tourists are Japanese citizens, although there has been an increasing percentage of South Koreans visiting the island. The year 1997 was the peak year for visitors to the island before a series of setbacks from the Asian economic decline throughout the last decade and various natural disasters, continuing through the recent worldwide economic downturn. However, a recovery continues with fiscal 2014 marking the second highest year for visitor arrivals and hotel occupancy rates at 75% the past several years, the highest in more than a decade; fiscal 2015 is on track to meet or exceed these numbers.

Unemployment on the island is mixed depending on the source, ranging from historically very high (in excess of 20%) to only moderately above average (7.4% as of March 2015). Wealth levels are low, with estimated MHI around 75% of the U.S. average.