Fitch Rates Puerto Rico Aqueduct & Sewer Authority's 2015A Sr. Revs 'CC'; Maintains Negative Watch
--Approximately $750 million revenue bonds, series 2015A (senior lien).
The 2015A bonds are placed on Rating Watch Negative.
In addition, the $3.3 billion of outstanding PRASA parity senior lien revenue bonds currently rated 'CC' are maintained on Negative Watch.
The 2015A bonds are scheduled to sell via negotiation the week of Aug.17. Bond proceeds will be used to (i) finance a portion of PRASA's capital improvement program (CIP) and reimburse the authority for certain capital costs incurred during fiscals 2013-2015; (ii) repay or refinance certain outstanding credit facilities; and (iii) pay costs of issuance.
SECURITY
The bonds are secured by a gross lien of all authority revenues related to PRASA's combined water and sewer system (the system), as defined in the amended master agreement of trust (MAT), senior to all other debt or expenses of PRASA. Authority revenues include operating revenues, as defined in the amended MAT (e.g. user charges and impact fees), as well as governmental funds available to pay current expenses; amounts from the Commonwealth of Puerto Rico (the commonwealth) for payment of commonwealth guaranteed indebtedness (CGI) or commonwealth supported obligations (CSO); and any amounts transferred from the budgetary reserve fund, as created in the amended and restated Fiscal Oversight Agreement between PRASA, the commonwealth and the Government Development Bank for Puerto Rico (GDB). The authority revenues received from the commonwealth for CGI and CSO are not subject to lien of the MAT and are not available to pay debt service on the bonds.
KEY RATING DRIVERS
COMMONWEALTH GO DRIVES RATING AND WATCH: PRASA's 'CC' rating and Negative Watch are driven by and currently capped at the commonwealth's general obligation (GO) rating given the commonwealth's ability to affect PRASA's operations materially both directly and indirectly. Commonwealth officials have indicated that PRASA may not be part of a larger restructuring of commonwealth debt over the coming months. However, until greater clarity is known, Fitch does not believe it is appropriate to distinguish the ratings amongst the various commonwealth securities, including PRASA.
SELF-SUFFICIENT OPERATIONS FROM RATE HIKE: PRASA enacted an average rate increase for fiscal 2014 of over 60% which allowed PRASA to become self-sufficient without assistance from the commonwealth and the GDB. For fiscal 2015 operations generally remained favorable but cash flows were severely and negatively affected by delays in the current financing. Self-sufficient operations are forecasted going forward.
HIGH DEBT; FAVORABLE CAPITAL DEVELOPMENTS: Debt levels are high both in terms of absolute dollars as well as the relative percentage of carrying costs to revenues. Costs will also continue to increase as the system pushes forward with its ongoing CIP funding, but ongoing negotiations with regulators are expected to lead to a material reduction in required annual spending.
HIGH UTILITY RATES: The rate hike for fiscal 2014 pushed residential charges well above Fitch's 2% of median household income (MHI) affordability measure and increased bad debt levels. However, limited additional increases in user charges are expected through the fiscal 2019 forecast period.
WEAK BUT EXTENSIVE SERVICE AREA: The service territory is diverse, although weak economic conditions have been protracted, the population has been declining, and customer wealth levels are limited.
ESSENTIAL UTILITY: The system provides an essential service to the residents of Puerto Rico.
RATING SENSITIVITIES
CHANGES IN COMMONWEALTH RATING: Ratings on the Puerto Rico Aqueduct and Sewer Authority's revenue bonds will continue to be influenced by movement of the Commonwealth of Puerto Rico's GO rating for the foreseeable future given the commonwealth's historical actions and ability to expose PRASA to potential fiscal and operational challenges.
FULL AND TIMELY PAYMENT: Any debt restructuring initiated by the commonwealth that does not result in full and timely payment of PRASA's bonds according to the original terms would likely result in a downgrade to 'D'.
NEGOTIATED RESOLUTION: Any negotiated resolution to the challenges facing the commonwealth that incorporates PRASA's bonds would be evaluated for its effect on bondholders.
CREDIT PROFILE
PRASA provides water service to virtually the entire island, including the roughly 3.5 million residents and 5 million annual tourists; sewer service is limited to around 60% of the island.
PRASA RATING AND WATCH TIED TO COMMONWEALTH GO
PRASA's rating is currently capped at the commonwealth's GO credit (currently rated the same as PRASA's revenue bonds) given the commonwealth's ability and history of directly or indirectly impacting PRASA's operations. In addition, resolution of the commonwealth GO's Negative Watch is also critical to resolution of PRASA's Negative Watch.
The commonwealth's GO bonds, and correspondingly PRASA's bonds, have been downgraded and placed on Negative Watch in recent months as a result of willingness to pay concerns, liquidity issues and market access impediments. The most recent downgrade to 'CC' on June 29, 2015 was precipitated by public comments made by the governor supporting the broad debt restructuring strategy included in the release of an external report (the Krueger report). The Krueger report detailed economic and financial issues plaguing the commonwealth and recommended various measures to improve commonwealth financial results and reduce expenditures, including a comprehensive restructuring of commonwealth-related debt.
Following release of the Krueger report the governor also issued an executive order to create a working group that would consider measures necessary to remedy the commonwealth's economic and fiscal crisis, including the recommendations detailed in the Krueger report. The working group is tasked with presenting a draft of its proposals in a fiscal adjustment plan to the governor by Aug. 30, 2015, and filing the necessary legislative measures to implement the plan with the commonwealth legislature by Oct. 1, 2015. Because of the uncertainty surrounding the path the commonwealth may take in pursuing debt restructuring and how PRASA's debt may factor into such a restructuring, Fitch currently does not believe it is appropriate to distinguish the ratings among the various securities of the commonwealth and its instrumentalities.
RATE HIKE LEADS TO POSITIVE OPERATIONS BUT CHALLENGES IN FISCAL 2015
Aside from PRASA's connection to the commonwealth's fiscal and market access difficulties, the most pressing weakness for PRASA over the last few years has been a significant budget gap that had developed and was growing from lack of rate action. The gap had required commonwealth and GDB support as well as deficit financing. For fiscal 2013, a $145 million budget gap was met from 2012 bond proceeds. But starting with fiscal 2014, projections pointed to the budget gap widening to $342 million and escalating annually thereafter. PRASA had received both direct and indirect commonwealth support in prior years to balance operations, but the commonwealth determined not to provide an appropriation for PRASA for fiscal 2014, requiring PRASA's governing board to revise its rate structure in accordance with the rate covenant under the MAT securing the bonds.
The approved rate hike, which became effective at the beginning of fiscal 2014, resulted in an average increase in user charges of over 60%. The adjustment was designed to provide self-sufficient operations not only for fiscal 2014 but for several subsequent years as well. On the negative side, residential charges which were already on the high side jumped to around 3.3% of MHI as a result of the rate increase, above Fitch's 2% affordability benchmark.
Because of the adjustment, system revenues greatly exceeded operating and debt service expenses in fiscal 2014, generating debt service coverage (DSC) on senior lien bonds at 4.9x (per the MAT calculation) or over 1.4x on a more traditional net revenue basis that Fitch applies to all its utility credits. In addition PRASA was able to generate sufficient surplus revenues at the end of the year to deposit $93 million into the rate stabilization fund (RSF).
Fiscal 2015 revenues continued to be positive but delays in the current sale severely impacted PRASA's capabilities to meet all funding requirements for the year. DSC on senior lien bonds reached 4.4x per MAT calculations and over 1.7x on a net revenue basis. However, PRASA failed to make its $1.6 million CSO note payment as operating revenues were diverted to capital projects.
Failure to make the CSO note payment is not considered an event of default under the MAT but does evidence the financial strain faced by PRASA during the fiscal year. Overall, PRASA was forced to defer and/or delay operating expense payments; cancel, delay or terminate capital contracts; and pledge the bulk of its cash reserves ($90 million in the RSF) as collateral for a term loan due Aug. 31.
Proceeds of the current sale should provide significant cash flow relief as a portion of the proceeds will be used repay the upcoming term loan, thereby releasing the $90 million escrow back to PRASA. Further, $288 million of the proceeds will be used to reimburse PRASA for prior capital expenditures made from operating revenues. With these additional monies, PRASA expects to be able to make all flow of funds requirements for fiscal 2016 (including the payment of its CSO obligation), produce 3.3x senior lien DSC per MAT calculations (1.6x on a net revenue basis), provide $85 million in pay-go capital funding, and generate a surplus sufficient to deposit an additional $140 million to its RSF for the year. A variety of factors could reduce financial results for the year, including a prolonging of the drought which is built into PRASA's forecasts through October but could reduce net margins by an estimated $13 million for each additional month the drought continues thereafter without offsetting actions by PRASA.
Operations through the remainder of the fiscal 2019 forecast are expected to narrow somewhat given rising operating and debt service costs from this and additional borrowings. Draws on the RSF are scheduled to begin in fiscal 2017. Also, PRASA is projecting moderate 4.5% rate hikes in fiscals 2018 and 2019 to support operations which will place added pressure on PRASA's rate base. PRASA's consulting engineer generally finds the authority's projections feasible but does note certain assumptions as being aggressive. Consequently, additional rate adjustments beyond those currently contemplated and/or a reduction in the amount of programmed pay-go capital (currently $285 million during fiscals 2016-2019) may be necessary if forecast assumptions are not realized.
ELEVATED DEBT BURDEN BUT FAVORABLE CAPITAL DEVELOPMENTS
Central to PRASA's challenges has been the scope of needed capital investment to achieve regulatory compliance and renew system assets given the limited historical investment in the system's infrastructure and the resulting pressure this places on operations. The system traditionally has relied on borrowable resources to meet its capital demands and this has resulted in an elevated debt profile. For fiscal 2014, the authority's debt per customer of $2,661 was 45% higher than Fitch's published sector median, while debt to net plant for the same period was 1.5x greater.
For the five-year period covering fiscals 2015-2019, CIP costs remain elevated at $1.45 billion, which will lead to an additional weakening in PRASA's debt profile given total borrowings to support the CIP are around $1 billion. However, PRASA is in the final stages of negotiating a new consent decree (CD) with regulators that should have a significant positive effect on PRASA's ongoing operations and its ability to plan and deploy capital assets beyond the current CIP horizon.
The proposed CD is expected to realign existing CD requirements by utilizing a prioritization system. The proposed CD is also expected to contain a list of base high-priority mandatory projects in the first years of the CIP as well as a revision of timing and priority of certain projects previously included in prior CIPs. If approved as envisioned, PRASA's ongoing capital spending is expected to fall to around $200 million to $250 million annually, significantly below the $380 million average annual capital spending during fiscals 2009-2014.
While the proposed CD has yet to be finalized, negotiations with regulators are reportedly positive, with the result that PRASA's current CIP has been adjusted to conform to expected costs related to the proposed CD. Consequently, failure to enact the proposed CD would lead to a material escalation in capital requirements for the current CIP period (around $285 million), which would pressure PRASA's operations beyond that currently contemplated.
For more information related to other commonwealth ratings, please see 'Fitch Downgrades Puerto Rico's GO and Related Ratings to 'CC'; Maintains Rating Watch Negative' dated June 29, 2015.
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