OREANDA-NEWS. November 11, 2015. Fitch Ratings has affirmed its 'A+' rating on the following Kalamazoo, MI (the city) revenue bonds:

--\\$3.7 million water revenue and refunding bonds, series 2006 and 2007.

The Rating Outlook is Stable.

SECURITY

The bonds are payable from a senior lien pledge of the net revenues of the system.

KEY RATING DRIVERS

ADEQUATE FINANCIAL PERFORMANCE: Financial results have been somewhat volatile in recent years but have remained at levels consistent with Fitch's 'A' category medians. Customer rates are affordable relative to median household income (MHI), lending management financial flexibility.

CAPITAL NEEDS LIKELY TO INCREASE: Management expects to spend about \\$5 million annually in its five-year capital improvement plan (CIP), nearly double that of prior plans. About 30% of the CIP is expected to be debt-funded.

MANAGEABLE DEBT POSITION: Debt metrics are currently very low and should afford the system sufficient capacity to issue additional debt in order to meet growing capital needs.

AMPLE SYSTEM CAPACITY: The system has adequate treatment capacity and reliable water supply derived from groundwater. Capital needs will primarily focus on infrastructure renewal and replacement as opposed to expansion and capacity needs.

LIMITED ECONOMY: The service area economy is somewhat limited, with below-average income levels and above-average unemployment.

RATING SENSITIVITIES

DECLINES IN FINANCIAL MARGINS: Maintenance of the rating will depend on management's ability to meet financial projections while funding the system's expanded capital improvement program and ongoing annual costs attributable to the system's other pension employee obligation (OPEB) program.

CREDIT PROFILE

Kalamazoo is located in the southwestern quarter of Michigan's Lower Peninsula, approximately 50 miles south of Grand Rapids. The drinking water system provides retail water pumped from the Kalamazoo-Portage Aquifer to customers within the city as well as to nine neighboring townships and villages. All but one of the system's franchise service contracts with the townships and villages have expired. However, the townships and village abide by the continuation clauses of their agreements and the system retains the exclusive right to deliver water to those communities. Alternative treated water supplies for the franchise communities are limited.

The service area population of about 121,000 is nearly evenly split between in- and out-of-city customers. Water supply is ample with daily average consumption rates of only 50% of available resources.

SATISFACTORY FINANCIAL RESULTS

Financial results have remained within the 'A' rating category over the past five years despite some fluctuation in debt service coverage (DSC) and liquidity levels over this time. DSC in fiscal 2014 fell to a modest 1.3x, below fiscal 2012 and 2013 coverage levels of 1.8x and 2.3x, respectively. The decline in coverage was due to lower water sales and higher operating expenses in fiscal 2014. DSC in fiscal 2014 including annual payments in lieu of taxes (PILOTS) to the city's general fund (legally paid after debt service) was slim at just 1.0x. Favorably, fiscal 2014 debt service costs consumed a low 19% of gross revenues.

Management's financial forecast shows improved coverage levels through fiscal 2018 of between 1.8x and 3.1x as revenues are supported by planned rate increases and expenses resume normal growth. Including PILOT payments, prospective coverage levels range between 1.4x and 2.1x. These coverage levels include additional debt service from an expected late calendar year 2015 bond issue of \\$3.1 million.

Liquidity also declined in fiscal 2014; unrestricted cash of \\$5.9 million fell 13% from the year prior and equated to a still healthy 220 days cash on hand (down from over 270 days in fiscal 2013). Management expects liquidity to continue to decline as much of the system's capital needs will be cash-funded over the next five years; however, intermittent debt issuances should support continued modest cash levels. Free cash flow (FCF) relative to depreciation has been negative three out of the past five fiscal years, indicating weak cash flow generation that is inadequate to fund system renewal absent external financing.

FLEXIBLE RATES

The city has implemented moderate rate increases of 3% and 6.4% in fiscals 2014 and 2015, respectively. Management plans to increase rates by between 6%-8% annually through fiscal 2019, which appears reasonable in light of the system's strategy to cash-fund much of its CIP. Fitch projects that these rate increases are not likely to significantly impact the system's rate-raising flexibility. The average system monthly bill of \\$50 in 2014 equated to only .6% of MHI. This cost indicator is below Fitch's 1% of MHI threshold for a single utility cost, indicating there should be rate-raising flexibility.

MODERATE DEBT LOAD INCLUDING PROJECTED DEBT

The city's \\$25 million CIP includes significant renewal and replacement projects to bring the system's aging infrastructure into a state of good repair, as well as targeted water-main rehabilitations and reservoir upgrades to support system redundancy. The CIP is not driven by regulatory requirements.

Management plans to fund at least 30% of its capital needs from additional debt. Based on several years of weak FCF, Fitch expects that substantially more debt will be required to support capital spending. Favorably, the system's key debt metrics are very low, enabling management to secure additional debt if required. In fiscal 2014 total debt comprised only 20% of the system's net assets and equated to about \\$450 per customer and \\$285 per capita. Existing debt amortization is rapid with principal payout at 51% and 90% in the next 10 and 20 years, respectively.

In addition to the late fiscal 2015 debt issue of \\$3.1 million, the system is also responsible for the repayment of its \\$16 million share of a \\$90 million OPEB bond issued by the city. The system's annual payments will approximate \\$552,000 and be paid as an operating expense, although legally subordinate to debt service.

STABLE CUSTOMER BASE, IMPROVING ECONOMY

Customer accounts have experienced modest annual increases of about 1.2% on average since fiscal 2008 and management's expectation for continued stable growth appears reasonable. The system's service area is a regional economic and population center for south-west Michigan. Pfizer Corp. is the city's largest taxpayer and a significant employer (3,200 personnel). The city's economy is further stabilized by Kalamazoo College and Kalamazoo Community College.

The local economy remains highly dependent on manufacturing but is stabilized by the presence of higher education and healthcare. Socioeconomic indicators have shown some improvement; city unemployment has declined from 8.7% in August 2013 to 5% in August 2015; however, MHI levels remain somewhat low, equating to only 66% and 60% of the state and national averages, respectively.