OREANDA-NEWS. Fitch Ratings has affirmed the 'AA+' ratings on the following Southern California Water Replenishment District, CA (the district) certificates:

--$99.1 million revenue certificates of participation (COPs) series 2004, 2008 and 2011.

The Rating Outlook is Stable.

SECURITY

The COPs represent an absolute and unconditional obligation of the district, payable from the district's net revenues, and are not subject to annual appropriation. Pledged net revenues, as defined in the indenture, exclude water purchase costs.

KEY RATING DRIVERS

ROBUST FINANCIAL FLEXIBILITY: The district has considerable financial flexibility due to its ability to defer water purchases or pre-purchase water and has substantial rate flexibility relative to alternate water supply costs.

TRANSITIONING TO RECYCLED WATER: The district is in the process of transitioning to producing recycling water and away from purchasing costly imported water for aquifer replenishment. This transition will result in the district no longer being pressured by the increasing cost of imported water, although they will be substituting wholesaler risk for operational risk by running their own recycled water facility.

ESSENTIAL SERVICE: The district plays a unique and essential role as groundwater manager to southern Los Angeles County and its customer base of 43 municipalities and large private water companies.

RISING CAPITAL NEEDS: The district's capital needs are significant as it focuses on reducing reliance on costly imported water in favor of recycled water and the district's debt profile will grow significantly as the project will be largely debt financed. However, the district's has the financial flexibility to set assessments at a level to adequately cover rising debt service costs.

SOUND COVERAGE: Indenture coverage is very high due to the exclusion of purchased water costs. While debt service coverage (DSC) measured on a more traditional basis declines dramatically in years when large water purchases are made, Fitch views these as akin to pay-go capital costs. Coverage levels calculated on a tradition basis have remained above 1.3x since fiscal 2011.

RATING SENSITIVITIES

RATING STABILITY EXPECTED: The rating is sensitive to shifts in the fundamental credit characteristics, including financial and operating performance, along with debt and capital management. The Stable Outlook reflects Fitch's expectation that such shifts are unlikely.

CREDIT PROFILE

LARGE UNIQUE DISTRICT

Established by popular vote in 1959 to counteract the over pumping of water from the Central and West Coast groundwater basins, the district covers approximately 420 square miles within Los Angeles County and serves 43 cities, including Los Angeles and Long Beach. The district serves as the groundwater manager for the basins by enforcing the terms of adjudications stemming from a series of lawsuits between municipalities in the 1960s. The district replenishes groundwater resources by purchasing recycled or imported water and, to a lesser extent, through the capture of storm water runoff. Water is injected into the aquifers or spread on the surface to percolate down to the basins. In 2001, a court upheld the legal status of the district's responsibilities after they were challenged by a group of the district's groundwater pumpers.

Users of the aquifers pump about 244,000 acre-feet (af) of water per year from the two basins. The district derives the majority (95%) of its annual revenues through a replenishment assessment on each of the users based on their annual extraction. The top 20 users account for about 89% of overall pumping and include the Golden State Water Company (16%), the city of Long Beach (13%), the city of Downey (8%) and California Water Services Company (7%). The assessment is established by approval of the district's board of directors at the beginning of the district's fiscal year based on the total estimated amount of water expected to be extracted from the basins. Once approved, the rate may not be changed until the following fiscal year.

In fall of 2014 the governor signed the Sustainable Groundwater Management Act, highlighting the state's desire to more effectively manage the state's groundwater resources. The purpose of the bill is to develop plans to management groundwater basin throughout the state that are not currently adjudicated. The legislation specifically exempted the Central and West basins, which are managed by the district.

ASSESSMENTS TO INCREASE BUT REMAIN AFFORDABLE

District assessments have seen significant increases over the last decade to address the rising cost of imported water from the Metropolitan Water District of Southern California (MWD; revenue bonds rated 'AA+', Stable Outlook by Fitch). The district increased replenishment assessments by 18.5% in fiscal 2010, 13.1% in fiscal 2011, 19% in fiscal 2012 and 9.8% in fiscal 2013. Assessments have remained flat since fiscal 2013 but are anticipated to increase further, albeit at a more modest 3% to 5% annually through 2021. Despite the historically large assessment increases, the fee remains extremely affordable when compared to the higher cost of MWD imported water at $1,240 per af for fiscal 2015 compared to the district's assessment of $268 per af.

Per state legislation, the district's rate stabilization reserves are limited to $10 million adjusted each year based on the percentage change of the blended cost of water. The law allows amounts above the limit to be used to reduce the replenishment assessment or purchase water in the succeeding fiscal year. The district assesses its cash needs annually and has thus far not requested a change in the law.

MINIMAL DROUGHT IMPACT ANTICIPATED

On May 5, as a response to the Governor's recent executive order to reduce annual water usage in the state by 25%, the State Water Resource Control Board adopted rules requiring mandatory reductions in water usage for all of California's retail water providers. While the mandate does not directly apply to the district, as it is not a water retailer, it does apply to the cities within the district (district pumpers). Most district pumpers obtain their individual supplies from a combination of imported water and groundwater. Given the affordability of the groundwater replenishment assessment compared to imported water, management does not anticipate a significant decline in assessment revenues due to reduced pumping. Rather, district pumpers will be more likely to reduce the amount of their purchased imported water to meet the state mandated drought conservation requirements.

SUBSTANTIAL FINANCIAL FLEXIBILITY

The district has a great deal of financial flexibility due to its ability to delay purchase of or pre-purchase water. Purchased water costs are akin to capital outlay and pledged net revenues, as defined in the indenture, exclude water purchases. Under the indenture definition of pledged net revenues, the district generates substantial coverage, including 7.9x for fiscal 2014. Increasing debt service costs have reduced indenture coverage below the historical double digit coverage the district has known in the past. Debt service coverage on a traditional net revenue basis, which includes purchased water expense as an operating expense, resulted in a lower 3.1x DSC for fiscal 2014.

The district anticipates issuing around $100 million in debt this fall to finance additional recycled water facilities within the district. It is expected that annual debt carrying costs following this issuance will grow to over $13 million starting around fiscal 2018, 2.4x more than fiscal 2014 annual debt service. Forecasted DSC as defined by the indenture remains healthy based on the district's five-year financial projections for fiscals 2016 - 2021 with indenture DSC dropping to no lower than 4.9x (fiscal 2018). Traditional DSC for the forecast period hovers at 1.4x once the full impact of the new issuance rolls on.

The district's unrestricted cash balance for fiscal 2014 registered a robust $57 million, or the equivalent over 1,100 days cash on hand (DCOH) when treating water purchases as capital expenses. This ratio drops to a still healthy 477 DCOH when purchased water is treated as an operating expense, higher than the 'AA' median of 442 days. The district also maintains strong restricted cash reserves in the form of an operating reserve ($7 million in February 2015) and water purchases/rate stabilization reserve fund (over $49 million in February 2015), adding to the district's already solid cash position.

As the district moves away from imported water purchases, traditional coverage and financial health will take on added importance for the rating. The district's anticipated traditional coverage levels are not atypical for a wholesale water provider and the cash levels maintained by the district are currently on par with 'AA' rated credits. Maintenance of stable, healthy financial margins will be key to maintaining the currently high 'AA+' rating as the system transitions away from imported water, taking on more operational and capital risk.

REDUCED RELIANCE ON COSTLY IMPORTED WATER

The district's capital projects focus on independence from costly imported MWD water in favor of increased use of recycled water. While Fitch believes this strategy will facilitate more consistent financial performance over the long term, debt levels will increase significantly over the next five years. The district's five-year capital plan totals $159 million with $100 million to be debt financed. Projects included will complete the final phase of recycled water projects and complete the district's Water Independence Now initiative, eliminating the need to purchase imported water. The $100 million debt financing expected in fall of 2015 and is $62 million less than previously estimated due to lower than anticipated costs associated with wastewater treatment. After completion of the recycled water project capital needs are expected to be minimal and the additional capital risk associated with running the facilities is manageable. The district's primary capital risk in its role as groundwater manager for the two basins is groundwater contamination; however, the district has a number of programs in place to monitor for groundwater contamination to manage this risk.

RESOLUTION OF LEGAL CHALLENGES

The district was facing two lawsuits challenging its compliance with Proposition 218 in setting the replenishment assessments. The first suit filed by the cities of Cerritos, Downey and Signal Hill, which combined make up about 11% of total assessment revenues, came to a close with a negotiated settlement of $9.1 million to be paid by the district to the cities, which includes the cities related legal fees. The cities were required to pay past due assessments and the district agreed to assist the cities in accessing additional groundwater sources. The second suit was filed by the Central Basin Municipal Water District (CBMWD) on behalf of all property owners in its jurisdiction and seeks up to $100 million in overcharges based on non-compliance with Proposition 218 and a rate structure that it claims favors the West Coast Basin pumpers. This suit has since been dropped by CBMWD.