OREANDA-NEWS. July 14, 2015. Fitch Ratings affirms the following Lake Havasu City, Arizona (the city) wastewater system (the system) revenue bonds outstanding:

--\\$59.7 million senior lien wastewater revenue bonds, WIFA loan, series 2006, 2007, 2009 and 2009A at 'A';
--\\$104.8 million junior lien wastewater revenue bonds (GO tax backed), WIFA loan, series 2006 and 2008 at 'AA-'.

The Rating Outlook is Stable.

SECURITY

The senior lien bonds are secured by a net revenue pledge of the system. The junior lien bonds are secured by a net revenue pledge of the system subordinate to the senior lien bonds and are additionally backed by the general obligation (GO) pledge of the city.

KEY RATING DRIVERS

ADEQUATE FINANCIALS: Debt service coverage (DSC) excluding the rate stabilization fund (RSF) is weak. Robust system liquidity somewhat offsets the low coverage level.

GO SUPPORT: The junior lien bonds benefit from the city's GO pledge and historical financial support of the system. The GO rating is driven by the city's strong fund balance reserve levels, achieved by proactive fiscal management that implemented tight budgetary measures to maintain structural balance during the recession. Also reflected in the GO rating is the city's inherent vulnerability to economic cycles as a recreational, second home community and high dependence on sales taxes.

HIGH LEVERAGE BUT MANAGEABLE NEEDS: Customer debt levels rose to levels that are among the highest in the U.S. as a result of constructing the city's centralized sewer system project (the project) in recent years. However, now that the project is complete and remains relatively new, near to mid-term capital needs are minimal and are planned to be cash-funded, which should allow leverage to decline over time.

HIGH USER RATES LIMIT FLEXIBILITY: Service rates are high due to high fixed costs (mostly debt service requirements) despite the use of the RSF. Moderate rate hikes or an increase in the RSF may be necessary to maintain adequate DSC, although in an effort to mitigate rate increases, the city is in the process of restructuring its existing debt to level debt service requirements and lengthen the amortization schedule.

ESSENTIAL PROJECT: Citizen support for the project has been strong, with the project critical to preserving the city's tourism attractiveness.

RATING SENSITIVITIES

MAINTENANCE OF SYSTEM FINANCIAL METRICS: Material deterioration of liquidity and DSC levels could apply pressure to the senior lien rating, in light of the system's substantial annual requirements and limited rate flexibility.

MAINTENANCE OF STRONG FINANCIAL POSITION: Given the high dependence on volatile sales tax revenues, combined with an economy driven by tourism and hospitality, maintenance of strong general fund reserves is a key rating driver to the GO-supported obligations.

CREDIT PROFILE

The city, which has a population of just over 53,000, is located in the far west-central portion of Arizona along the eastern edge of Lake Havasu (the lake), about 200 miles northwest of Phoenix. The city's economy is centered on tourism and recreation, with a growing retirement sector and accompanying commercial and retail base. Government, construction, and light manufacturing are also significant contributors to the economy. Unemployment rates historically have been below state and national averages, but this trend reversed beginning in 2011, and for April 2015, the unemployment rate was at 6.7%, compared with 5.4% and 5.6% for the state and U.S., respectively.

SEWER SYSTEM EXPANSION PROJECT
Prior to 2001, the system served only a small portion of the city (10% of city residents), with remaining residents served by on-site septic tanks. However, as a result of environmental concerns to the lake in the 1990s, the city commissioned an engineering study to evaluate options for serving the sewer needs of the entire city. Based on the results of the study, voters approved a \\$463 million bond package by over a 75% margin in 2001 to expand the system. With the expansion and retrofitting of existing structures, the project resulted in the decommissioning of around 21,135 individual on-site septic tanks and average connections rose to an estimated 26,370 in 2015 from just 3,450 connections in 2003, at the start of the expansion.

The city completed the project in November 2011, about one year ahead of schedule and about \\$115 million below the \\$463 million voter approved bond package. All debt issued to fund the project has been, and is anticipated to continue being, supported by system revenues, although the city issued the majority of debt as junior lien revenue bonds/loans that are also secured by the city's GO tax pledge. In addition, all of the debt issued to finance the project has been placed with the Arizona Water Infrastructure Finance Authority's federally subsidized state revolving fund program. Given the scope of the project, customer debt levels are substantial and remain among the highest of any water and sewer credits rated by Fitch despite a recent \\$23 million prepayment of loan maturities. The total debt currently outstanding is \\$245 million.

SOUND SYSTEM FINANCES
As previously expected, system operations are pressured by the debt related to the project but remain adequate with the support of the city's general fund and the established \\$6.5 million RSF. The RSF was initially funded from the system's revenue fund and subsequent contributions from the general fund. The RSF may be swept and used for system purposes but must be replenished from city general fund contributions annually.

Since all of the debt was issued in a relatively short timeframe (from 2002 to 2009) and the maximum loan term was for 20 years, the resulting debt service requirements grew rapidly and DSC thinned, as expected. For fiscal year 2014, all-in DSC was 1.2x, inclusive of the \\$6.5 million RSF. Excluding the RSF, all-in DSC was only 0.9x. Liquidity remained robust during fiscal 2014 at \\$36.6 million or 1,875 days cash on hand.

All-in DSC was expected to decline at the last rating review, with a forecast that called for rate increases beginning in fiscal 2014. However, rates remained unchanged in order to provide relief to customers. Further, the city expects to restructure its debt over the near term to extend maturities another six years beyond the existing schedule and thereby provide ongoing debt service and rate relief.

While establishment of the RSF benefits ratepayers, it also enhances the system revenue pledge since an additional revenue stream is available to bondholders for repayment of the debt. Furthermore, bondholders will be protected in the event of future system debt issuances given the RSF is not included in revenues for purposes of calculating the additional bonds test. The city does not currently plan to issue additional debt.

HIGH RATES AND CHARGES DESPITE GENERAL FUND CONTRIBUTIONS
The city's wastewater utility rates are considered high at 1.6% of median household income, above Fitch's affordability level of 1%. In an effort to mitigate future rate increases, the city established the RSF in fiscal 2007 that is included in the rate covenant calculation.

Historically, the city made sizable transfers to the system totaling about \\$35.5 million through fiscal 2014. The system also generated non-recurring revenues totaling about \\$42.3 million in connection fees. The RSF balance at the close of fiscal 2014 remained at \\$6.5 million.

HEALTHY GENERAL FUND POSITION
Unrestricted general fund balance levels are robust at \\$26 million, or 62% of spending at the close of fiscal 2014 (more than double the \\$12 million, or 34% in fiscal 2010). Implementation of tight budgetary measures and net transfers-in accounted for about 60% of this increase with lease proceeds accounting for the remainder. The city is highly dependent on economically sensitive sales taxes which for fiscal 2014 comprised 37% of the general fund revenues, followed by 36% intergovernmental revenues (which also are derived from volatile sources such as state sales and urban revenue sharing). Property taxes made up 11% of fiscal 2014 revenues. Although the city experienced large valuation declines during the recession, these were offset with tax levy adjustments.

For fiscal 2015, projections indicate a modest \\$1 million draw down, primarily due to transfers out for capital projects. The fiscal 2016 proposed budget includes a moderate \\$6 million drawdown on fund balance reserves. The budgeted operating expenditures conservatively assume all authorized positions are filled for the entire year. Proposed adjustments to payroll are also included as well as a \\$1.2 million, one-time deposit to the city's underfunded obligation to the Public Safety Personnel Retirement System.