OREANDA-NEWS. Fitch Ratings downgrades its rating on the following Garland, Texas (the city) outstanding revenue bonds:

--$132.2 million water and sewer system revenue bonds series 2007, 2008, 2009, 2010, 2011, 2011A, and 2012 to 'AA' from 'AA+';
--$29.4 million water and sewer system revenue refunding and improvement bonds, series 2013 to 'AA' from 'AA+';
--$38.2 million water and sewer system revenue refunding and improvement bonds, new series 2014 to 'AA' from 'AA+'.

The Rating Outlook is revised to Stable from Negative.

SECURITY

All bonds are secured by a pledge of the net revenues of the city's water and sewer system (the system). The outstanding prior lien bonds are senior to the new series 2014 bonds. With the issuance in 2014 of the new lien bonds the prior lien was closed. The new series 2014 revenue bonds are paid subsequent to the prior lien bonds.

KEY RATING DRIVERS

WEAKENED FINANCIAL METRICS DRIVE DOWNGRADE: The downgrade reflects softer financial performance (specifically as it relates to debt service coverage [DSC], days cash and free cash flow [FCF]) driven by escalating purchased water and debt service costs and the expectation that financial results are unlikely to return to previous highs.

WHOLESALER COST AND RATE PRESSURES: The city's dependence on it wholesale water provider North Texas Municipal Water District (NTMWD) creates cost pressure outside of the utility's direct control. Rates hikes generally have been implemented to keep pace with rising water costs, but additional system rate adjustments to keep pace with wholesaler and debt service cost increases could reduce affordability over the medium term.

INCREASING DEBT LEVELS: Direct system debt per customer levels are on par with 'AA' category medians but become elevated above the 'AA' median when taking into consideration planned debt to support capital projects. System debt levels are further pressured when taking into account off-balance sheet debt of NTMWD.

ASSURED SUPPLY: The system has assured water supply through 2030 from its long-term, perpetual contract with NTMWD.

MATURE DALLAS METRO SUBURB: The city is part of the larger Dallas-Fort Worth-Arlington (DFW) metropolitan statistical area (MSA) economy and employment base. Anchored by manufacturing and distribution, Garland's overall economic base remains sound.

RATING SENSITIVITIES
DETERIORATION OF FINANCIAL MARGINS: Weakening financial metrics could negatively impact the rating. Achieving improved financial metrics as outlined in management's system forecasts will be key to maintaining the rating.

CREDIT PROFILE

The water system serves approximately 68,000 city customers and purchases its water on a wholesale basis under a perpetual contract from NTMWD. Existing and projected water supplies from NTMWD reportedly are sufficient to meet all customer demands through 2030. The wastewater system serves around 66,000 customers within the city as well as portions of five other cities, including the city of Dallas.

WEAKENED FINANCIAL PERFORMANCE DRIVES DOWNGRADE

System operations have been pressured by increasing debt service and purchased water costs, and financial metrics are now below Fitch's 'AA' median category medians. Since fiscal 2012 the city's purchased water rate has increased on average 11% annually and NTMWD rates are anticipated to continue increasing by 7%-11% annually through fiscal 2021. Also impacting the system were drought related water use restrictions implemented late in fiscal 2011 which remained in place until May 1, 2015. Reduced water demand in fiscal 2014 and into 2015 led to usage that fell short of projections.

Audited fiscal 2014 results point to senior lien annual DSC declining to 1.8x (1.4x net of transfers out) from a high of 3.0x in fiscal 2011. All-in DSC, which includes about $22 million in outstanding general obligation debt along with $38 million in subordinate lien bonds, dropped to 1.5x (1x net of transfers out) for the year from a good 2.4x in fiscal 2011. These reduced coverage levels fall short of Fitch's 'AA' category median levels of 1.8X DSC on an all-in basis and all-in net of transfers.

Fiscal 2015 estimates point to all-in DSC weakening further to 1.4x, while DSC on the closed senior lien grows to 2.2x due to declining annual requirements. Liquidity, which showed some improvement in fiscals 2012 and 2013, registering at 187 and 172 days of cash on hand, respectively, dipped to 155 days in fiscal 2014. Given capital needs are anticipated to be entirely debt-funded, cash balances, which are weak for the 'AA' category, are expected to remain at similar levels over the forecast period.

SOME IMPROVEMENT IN FINANCES ANTICIPATED

Through the fiscal 2016-2019 forecast period, all-in DSC gradually improves from 1.6x in 2016 to 1.8x by 2018 before dropping to a still adequate 1.5x in fiscal 2019. The forecast incorporates increased debt carrying costs associated with financing the capital plan, rising operating expenses, and water rate increases of 9%-15% as well as more modest 1.5%-2.0% sewer rate adjustments.

Senior lien DSC over the forecast period grows from 2.6x to 2.9x as a result of declining annual debt service. The senior and subordinate bonds are rated on par, reflecting the small amounts of subordinate bonds outstanding (16% of total debt burden) and the nominal distinction in coverage between the two liens. The ratings may diverge in the future if these factors change.

ABOVE AVERAGE TRANSFER TO GENERAL FUND

Fitch notes that transfers out of the system are high (averaging 11% over the past five fiscal years) and are projected to increase to about 14% over the forecast period. Transfers out of the system combined with limited surplus cash from operations after payment of operating and debt service costs have left a minimal amount of free cash available to cover depreciation expense. FCF for fiscal 2014 fell to just 5%, down from 91% in fiscal 2011 and well under the 'AA' median of 94%.

INCREASING WHOLESALE WATER RATES

Water costs associated with the NTMWD contract increased 14% in fiscal 2013 and 10% fiscal years 2014 and 2015. NTMWD rates are expected to rise from 7%-11% annually through 2021, driven by the need for regulatory upgrades. The city has raised their own water rates in an effort to keep up with rising purchased water costs, increasing rates by 9% in fiscal 2013, and by 10.8% in fiscal years 2014 and 2015. Purchased water costs make up approximately 40% of fiscal 2014 operating expenses and this figures is expected to grow to 52% by fiscal 2019. Despite raising user charges, operating revenues only increased by 4% and 2% in fiscal years 2013 and 2014, respectively, while operating expenses grew by 6.3% and 5% over the same period.

RATE FLEXIBILITY DIMINISHING

The monthly bill at $78.8 (assuming usage of 7,500 gallons per month for water and 6,000 gallons per month for sewer) is among the highest in the Dallas/Fort Worth Metroplex and currently registers at around 1.8% of median household income (MHI). Rates still fall under Fitch's 2% of MHI affordability threshold but are forecasted to grow to 2.4% of MHI by 2019 with planned rates increases.

GROWING DEBT BURDEN

The system's fiscal 2015-2019 capital improvement plan (CIP) totals $173 million and will be entirely debt financed, a negative credit consideration. The city plans to initiate a $90 million commercial paper (CP) program in 2015 to finance a significate portion of the CIP, followed by a $125 million CP program in 2018. Approximately 70% of the CIP addresses sewer system improvements that will ensure compliance with new and enhanced regulatory and operational standards while the remaining 30% is for water system improvements.

Direct system debt per customer of $1,823 aligns closely to the 'AA' category median of $1,934, but debt to net plant is high at 59% compared to the 'AA' median of 50%. Debt levels grow to $2,232 within five years, exceeding the 'AA' median of $2,049. Further, system debt levels increase by approximately 44% when off-balance sheet debt of NTMWD is included, pushing system debt levels well-above category 'AA' rating median. Positively, the system benefits from very rapid amortization, with principal payout at 74% and 100% in 10 and 20 years, respectively.

MATURE, STABLE ECONOMIC BASE

Garland (general obligation bonds rated 'AAA' by Fitch with a Stable Outlook) benefits from its location within the DFW MSA. Manufacturing and distribution remain the city's primary economic engines, and the city's industrial market reportedly is the second largest in the DFW metroplex. City wealth levels are on par with state and national levels. April 2015 unemployment is favorable at 3.8%, compared to the state's 4.2% and the nation's 5.4%. The individual poverty rate of 16.2% is just slightly higher than the U.S. and lower than the state.