Fitch Rates Southern CA Wtr Replenishment Dist, CA's Rev Assessment Bonds 'AA+'; Outlook Stable
--Approximately $160 million replenishment assessment revenue bonds, series 2015
The bonds are expected to be sold via negotiation the week of December 7. Proceeds will finance acquisition, construction and installation of capital improvement projects of the Southern California Water Replenishment District (the district), refund the district's outstanding series 2004, 2008 and 2011 certificates of participation, and pay cost of issuance.
In addition, Fitch affirms the 'AA+' ratings on the following district certificates:
--$99.1 million revenue certificates of participation (COPs) series 2004, 2008 and 2011.
The Rating Outlook is Stable.
SECURITY
The bonds are issued by the authority and payable from installment payments made by the district from its system net revenues, including replenishment assessments. The district's obligation to make installment payments is absolute and unconditional as governed by the installment purchase agreement between district and the authority. The district will not establish a reserve fund for the bonds.
KEY RATING DRIVERS
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. After this transition, the district will no longer be pressured by the increasing cost of imported water, although it will substitute wholesaler risk for operational risk by running its own recycled water facility.
STABLE FINANCES FORECAST: Senior lien debt service coverage (DSC) is forecast to be a sound 1.4x to 1.5x from fiscal years 2017 - 2020. Cash levels are also expected to remain healthy at over a year of operations through the forecast period.
SUBSTANTIAL RATE FLEXIBILITY: The district maintains substantial rate flexibility relative to competing supplies from imported water from the Metropolitan Water District of Southern California (MWD; rated 'AA+', Stable Outlook by Fitch). Imported water costs are 4x higher than the district's price per acre foot of water.
ESSENTIAL SERVICE TO LARGE POPULATION: 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 with an approximate population of 4 million.
RISING CAPITAL NEEDS: The district's capital needs are focused on reducing reliance on costly imported water in favor of recycled water. The district's debt profile will grow significantly as the project will be largely debt-financed. However, given the magnitude of its resource base and the modest incremental cost of the debt to the customer base, the district has the financial flexibility to set assessments at a level to adequately cover rising debt service costs.
RATING SENSITIVITIES
STABILITY THROUGH TRANSITION: Maintenance of stable, healthy financial margins will be key to maintaining the currently high 'AA+' rating as the district transitions away from imported water, taking on more operational and capital risk. 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 manage 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 compared to the cost of MWD imported water; the latter is $1,240 per af for fiscal 2015 compared to the district's assessment of $268 per af.
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.
REDUCED RELIANCE ON COSTLY IMPORTED WATER
The district's five-year, $119 million, capital improvement plan (CIP) focuses on independence from costly imported MWD water in favor of increased use of recycled water through the district's groundwater reliability program (GRIP) facility which will produce 21,000 af of recycled water. While Fitch believes this strategy will facilitate more consistent financial performance over the long term, the district's debt burden will increase by 60% with the current offering. The CIP will largely be debt-funded, with just over $69 million in financing associated with the current offer. The remainder of the plan ($49 million) is expected to be funded from district revenues, grants or low-interest state revolving fund loans. The current offering also refunds all of the district's currently outstanding COPs.
Projects included in the CIP 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. In 2013 the district entered into a long-term contract with the Los Angeles County Sanitation District to purchase a minimum of 25,000 af of recycled water and to supply the district recycled water for its GRIP facility.
Capital expenses peak in fiscal 2018 at just over $43 million with the construction of the GRIP facility. After completion of the GRIP facility, 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.
STABLE FINANCIAL OPERATIONS FORECAST WITH TRANSITION
The district will lose some financial flexibility related to their ability to adjust the timing of imported water purchases. However, they will no longer be pressured by the rising cost of imported water and will gain operational stability by running their own facility.
Forecasted senior lien DSC hovers at a sound 1.4x-1.5x once the full impact of the new issuance rolls in. The district's anticipated coverage levels are not atypical for a wholesale water provider. 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.
Unaudited financial results for fiscal 2015 report a weaker debt service coverage levels of 1.1x (including purchased water costs) due to a one-time legal settlement expense of $8.5 million. Management reports DSC would have been over 2x without the one-time expense.
STRONG LIQUIDITY AND RESERVES
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 ($11.9 million in September 2015) and water purchases/rate stabilization reserve fund (over $36.8 million in September 2015), adding to the district's already solid cash position. The cash levels maintained by the district are currently on par with 'AA' rated credits.
CHANGE IN INDENTURE COVERAGE CALCULATION
In the existing COPs indenture, purchased water costs were treated as capital outlay and were excluded from pledged net revenues. With the transition away from purchasing imported water, the new revenue bond indenture's definition of pledged net revenues has been updated to include water purchase costs as part of operating and maintenance expenses.
While indenture coverage (exclusive of purchase water costs) has historically been very strong, including 7.9x for fiscal 2014, Fitch's analysis has focused on DSC generated on a traditional net revenue basis. DSC 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.
RESOLUTION OF LEGAL CHALLENGES
Two lawsuits challenging the district's compliance with Proposition 218 in setting the replenishment assessments have been resolved. 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 about $9 million to be paid by the district to the cities. 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 has been dropped. It was filed by the Central Basin Municipal Water District on behalf of all property owners in its jurisdiction and sought 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.
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