OREANDA-NEWS. Fitch Ratings has affirmed its rating on the city of Houston, TX's $1.6 billion in airport system subordinate lien revenue bonds at 'A'. The Rating Outlook is Stable.

The airport system also has approximately $93 million in series 2010 subordinate lien revenue bonds and $450 million of series 2009A senior lien revenue bonds outstanding which are not rated by Fitch.

The rating affirmation reflects a large dual-hub airport system which has exhibited robust traffic growth in recent years as the result of a thriving metropolitan service area. The rating is constrained by the future direction of the airport system's leverage, which is expected to evolve upwards as the Houston Airport System (HAS) embarks on a sizable capital program to redevelop several terminals at Houston Intercontinental Airport (IAH). To the extent the capital plan moves forward, coverage levels on total debt obligations may evolve down towards the 1.5x level.

KEY RATING DRIVERS
Revenue Risk Volume - Stronger
STRONG SERVICE AREA: HAS's broad economic base supports over 26 million annual enplanements, with strong demand for air carrier service at both IAH and William P. Hobby (Hobby) airports. The system's traffic base has experienced robust growth in recent years, which is expected to rise further as United expands at IAH and international traffic at Hobby develops. The desirability of HAS's service area as well as its growing O&D base partially mitigate the high levels of carrier concentration by United at IAH and Southwest at Hobby.

Revenue Risk Price - Midrange
HYBRID USE AGREEMENT WITH COST-RECOVERY EXPOSURE: The airport system's hybrid agreements have allowed Houston to maintain relatively competitive costs at both airports, with revenue-sharing currently implemented at Hobby and expected in the future at IAH. Adjustments to airline revenues may be limited during periods of flat or negative traffic growth due to the compensatory nature of the system's terminal cost center. Despite this exposure, key metrics have not materially deteriorated during periods of economic downturn.

Infrastructure Development/Renewal - Midrange
SIZABLE CAPITAL PROGRAM: The system has a $2.25 billion capital improvement program (CIP), with the largest project being the Intercontinental Terminal Redevelopment Project (I-TRP) at IAH. Expected funding for the 2016-2020 CIP primarily consists of 63% borrowing, 33% internal liquidity, and the remainder in the form of federal funds and grants. Management expects to issue approximately $350 million in early 2016 as part of the financing plan for capital improvements, but other specifics regarding this and expected additional future issuances have not yet been determined.

Debt Structure - Midrange
CONSERVATIVE DEBT STRUCTURE: The airport system has a relatively conservative debt structure, with a majority of debt in fixed-rate mode and no swap exposure. Moreover, management intends to refund some of its currently unhedged variable rate debt with fixed rate debt in fiscal 2016. HAS's amortization profile is flat overall, with rated debt maturing in 2032. Rate covenants of 1.25x for senior debt and 1.1x for subordinate debt are generally consistent with other major U.S. airports, and the airport system has a history of greatly exceeding these levels.

Financial Metrics
ADEQUATE COVERAGE, RISING LEVERAGE: Historically, the airport system had debt service coverage ratios (DSCR) generally in excess of 1.75x. 2014 saw a return to these levels at 1.96x, up from 1.58x in 2013. Despite the rise in 2014, Fitch expects lower margins and coverage levels in the near term projection period, due to increasing debt service requirements for the upcoming capital program. The airport system's current debt levels are moderate at 6.5x net-debt-to-cash flow available for debt service in 2014, though leverage is expected to rise over the next few years as debt for the CIP comes online. Leverage is partially offset by a strong liquidity position, at approximately 747 days cash on hand at fiscal year-end 2014.

Peers
Peers for Houston Airport System include Chicago O'Hare (rated 'A-', Positive Outlook by Fitch), and Metropolitan Washington Airport Authority (MWAA, rated 'AA-', Stable Outlook by Fitch), given their roles as large hub, international gateway airports. All airports have elevated leverage and large capital needs to support ongoing operations, with the size of Houston's capital plan falling in between that of O'Hare and MWAA. MWAA is also comparable in that it operates a two-airport system like HAS, with a stronger O&D base and greater carrier diversification.

RATING SENSITIVITIES
Positive: Stronger than anticipated operational performance and ability to maintain coverage metrics consistent with recent historic performance may be supportive to a higher rating.

Negative: A deterioration in coverage metrics below the anticipated 1.50x range in conjunction with the capital program and its planned financings may pressure the rating.

Negative: Weaker than expected execution of the capital program or inability of management to manage its cost profile could negatively affect the rating.

SUMMARY OF CREDIT

Houston's overall traffic base has experienced robust growth in recent years, rising 3.7% in fiscal 2015 over 3.2% growth in fiscal 2014. IAH saw growth of 4.2% in fiscal 2015, mainly due to the expansion of international service. Management indicates that HOU's traffic base growth has slowed from experiencing 8.6% growth in fiscal 2014 to 2.0% growth in fiscal 2015, as a result of the expiration of the Wright Amendment, which has shifted some of Southwest's traffic away from Hobby to Dallas Love Field. However, future traffic growth is still anticipated at Hobby due to the opening of its international terminal in October 2015, which currently serves seven destinations in Latin America. In fiscal 2015, IAH generated approximately 78% of HAS's traffic, where Hobby generated 22%. Roughly 24% of IAH's traffic was international in fiscal 2015, where Hobby's traffic base was entirely domestic. Fitch expects that the airport system will continue to generate moderate growth over the near term.

Fiscal 2014 operating revenues grew 4.4% over the prior year, mostly attributed to an 11% growth in concession revenues. The airport system experienced robust growth on the parking, rental, and ground transportation fronts as a result of rate increases, the implementation of a toll collection agreement with Harris County Toll Road Authority, and an influx of passenger volume. In fiscal 2014, airline revenues increased marginally due to a 3.2% decline in landing fees as a result of lower operating costs, and a 3.2% increase in terminal rents due to United's expansion in Terminal B South. The revenue split between IAH and HOU was 80% and 20% in fiscal 2014, which is consistent with historical trends and not expected to shift in the future. Operating expenses grew a robust 6.3% in fiscal 2014 due to rising personnel benefit costs, increased wages, and consulting fees, though the airport system has set a hard cap for operating expenses in order to contain costs in the future.

HAS's hybrid use and lease agreements (AULs) have provided limited cost-recovery protection during periods of flat or declining passenger growth, as a result of a large portion of airline costs being recuperated on a compensatory basis. In fiscal 2014, use and lease agreements covered approximately 55% of the airport system's operating costs. IAH currently has different AULs for each of its terminals, with terminal C recently being net leased to United, making United responsible for all operating costs but able to retain a portion of the concession revenues. At Hobby, 91.9% of passengers are covered under a 25-year lease, 6.6% under a 5-year lease, and 1.5% are non-signatory. Revenue sharing has been implemented at Hobby and is expected at IAH so long as financial targets are met. Cost-per-enplanement (CPE) levels, at $10.61 for IAH and $6.19 for Hobby in 2014, are considered favourable given each of the airports respective market positions.

The airport system's five year CIP totals approximately $2.25 billion, constituting a $1.04 billion increase from the prior plan. This increase is mostly due to the inclusion of IAH's Intercontinental Terminal Redevelopment Program (I-TRP) in its entirety, whereas only design costs for the project had previously been included. The I-TRP is expected to run alongside United's construction of Terminals B and C, and will result in the complete rebuilding of the Mickey Leland International Terminal, which will be able to accommodate up to 15 wide-body aircraft. Other projects include expansion of parking capacity in the East Terminal, reconstruction of taxi-ways, expansion of Terminal A, apron work on Terminal B, and the lease buyout from Southwest's international terminal at Hobby.

Funding for the capital plan is expected to comprise of 63% borrowing, 33% internal liquidity, and the remainder in the form of federal funds and grants. Bonds are expected to be issued as major I-TRP components are completed. The airport system plans on issuing approximately $350 million in Spring 2016, though specifics regarding the issuance have not yet been determined. Additionally, HAS successfully increased its PFC for both airports to $4.50 from $3 in March 2015, and anticipates using these funds to accelerate payoff of PFC-approved projects on either a pay-go or debt service basis. The airport system expects to provide interim financing via the use of a forward bond purchase agreement, alongside commercial paper supported by a letter of credit. Management indicates that a feasibility report will be provided during the system's upcoming debt issuance, which Fitch plans to review at that time.

Historically, the airport system had coverage ratios in excess of 1.75x. Fiscal 2014 saw a return to these levels at 1.96x on an indenture basis, and 1.6x when PFC and grant offsets are treated as revenues. Coverage is estimated to be 1.75x on an indenture basis in fiscal 2015, albeit Fitch expects DSCR will narrow down towards the 1.5x level as HAS proceeds with its capital plan. Additionally, leverage is moderate at 6.5x in fiscal 2014, but is expected to migrate towards the 8x-10x range in both Fitch's base and rating cases as borrowing for the capital program comes online. The base case assumes modest 2% annual traffic growth while the rating case provides a sensitivity scenario of an overall 8% traffic loss followed by recovery over the following 2-3 year period.

SECURITY
The bonds are secured by a subordinate lien on the net revenues generated from the operations of the airport system that includes the two primary commercial aviation facilities, IAH and Hobby airports.