OREANDA-NEWS. Fitch Ratings has assigned its 'AA-' rating to the following city of Annapolis, MD (the city) bonds:

--$13.4 million water and sewer system revenue bonds, series 2015A (tax-exempt);
--$17.4 million water and sewer system revenue bonds, series 2015B (taxable).

The bonds are expected to sell via negotiation on Dec. 10. Proceeds will be used to finance certain water and sewer capital projects, refund and restructure portions of certain general obligation bonds of the city, provide working capital for the water and sewer systems, make deposits to the debt service reserve funds and pay issuance costs.

The Rating Outlook is Stable.

SECURITY
The bonds are payable from a senior lien pledge of the net revenues of the city's water and sewer systems, including connection fees and investment earnings. The bonds are the first debt issuance directly secured by system revenues.

KEY RATING DRIVERS

IMPROVED FINANCIAL PERFORMANCE: The city implemented a large rate increase in 2012 for the systems, greatly improving financial metrics from very weak levels previously. Coverage of general obligation debt (allocated to water and sewer) was solid at 1.7x in fiscal 2014 and fiscal 2015 (unaudited).

LIQUIDITY ENHANCED WITH BOND PROCEEDS: Liquidity has been modest despite stronger margins as the systems have repaid general fund (GF) loans over the past several years. Liquidity is expected to be re-established from $4 million in series 2015B taxable bond proceeds and projected excess cash flows in fiscals 2015 and 2016.

ADEQUATE PRO FORMA: Management's financial projections anticipate strong senior debt coverage over 2.0x through fiscal 2021. Coverage of total debt service is more limited at just 1.2x beginning in fiscal 2017 when the full debt service payments for all outstanding debt occurs.

MANAGEABLE CAPITAL PROGRAM: The system is fairly old, although a new water treatment plant (WTP) is expected to come online next year. The city is committed to funding system-wide renewal and replacement projects at roughly $5 million annually, addressing a backlog of deferred maintenance in collection and distribution assets in approximately 10 years.

ELEVATED DEBT BURDEN: After issuance, the systems will have approximately $70 million in total debt outstanding consisting of the 2015 bonds and subordinate, non-refunded general obligation debt and state revolving fund loans. Capital improvements will be funded with $20 million of additional revenue bonds planned over the next five years.

STRONG SERVICE AREA: The local economy is anchored by a solid employment base featuring government, military, tourism and maritime industries. Proximity to large employment centers, a highly educated work force, strong wealth indicators and low unemployment also indicate economic stability.

RATING SENSITIVITIES

FINANCIAL PERFORMANCE: Expectations for annual rate increases and manageable capital needs point to a stable financial profile going forward. While not expected, given historical results, the rating is sensitive to a weakening in financial performance and metrics.

CREDIT PROFILE
Annapolis is located approximately 25 miles from both Baltimore and Washington, D.C. with an estimated 2013 population of 38,722.

MOSTLY RETAIL CUSTOMER BASE, STABLE OPERATING PROFILE
The city provides retail water and sewer services to approximately 12,500 water and 11,500 sewer accounts located predominantly within the city's limits. The water and sewer systems are accounted for as separate enterprise funds but combined for bonding purposes.

The customer base is mostly residential and stable. Customer concentration is limited and collections are typically strong. Wholesale sewer service is also provided to the U.S. Naval Academy through long-term contractual arrangement since 1976. A new 10-year agreement is expected to be finalized soon.

The operating profiles for both the water and sewer systems are solid and both are in compliance with regulations regarding drinking water quality and sewer discharge. The water system draws its supply from local aquifers and capacity at the city's WTP is ample. A new 8 million gallons per day (mgd) water plant is under construction adjacent to the existing plant that has reached then end of its useful life (originally built in 1929). The new plant, which is expected to improve and streamline operations, will be completed by mid-2016. Water demand is less than half of the new plant's design capacity.

The city's joint ownership in a 13 mgd sewer treatment facility with Anne Arundel County provides it with 6.7 mgd of allocated treatment capacity, which exceeds average daily flows (approximately 5 mgd). Under a joint use and operating agreement that expires in 2022, the county operates the plant. The city pays for its proportionate share of the operating and maintenance costs as well as a portion of the capital expenses and related debt service.

SOLID FINANCIAL PERFORMANCE AIDED BY RATE INCREASES
Historically weak financial results led to sizable rate increases (approximately 90%) and rate structure changes in 2012. Prior to 2012, rates had been relatively unchanged for many years as weak margins led to inter-fund borrowing in some years to meet system expenses, including loans from the city's general fund (GF).

The rate increases led to a near doubling of operating revenues to roughly $15 million (combined) in fiscal 2012 from the prior year, providing positive cash flows and strong DSC on the outstanding general obligation (GO) bonds issued for the systems. Financial performance was strong in fiscal 2013 (DSC was 2.3x) but declined in fiscal 2014 due to lower revenues and a rise in debt service, although coverage was still solid at 1.7x. Unaudited results in fiscal 2015 show results similar to 2014. Rates were held constant from 2012-2015.

The city passed a rate increase for fiscal 2016. Along with the rate increase, city ordinance included a provision allowing management to raise rates as necessary up to 5% annually without further city council approval. Rates are affordable and the discretion provided to management to increase rates without council approval provides financial flexibility and the framework for stable future financial performance.

FINANCIALS EXPECTED TO REMAIN ADEQUATE
Pro forma results provided by the city's rate consultant are presented on a cash basis, consistent with the city's budgeting process. The projections assume 4.9% annual rate increases, annual 3% growth in operating expenses, approximately $20 million in additional bonds to fund capital needs, no growth in the customer base and a slight decline in customer usage through the forecast period (2016-2021).

Overall, these assumptions appear reasonable and the results show strong senior DSC of 2.5x in fiscal 2017 (the first year annual debt service is paid for the senior bonds) dropping slightly in subsequent years to about 2.1x by fiscal 2021 as new debt is issued. On an all-in basis, DSC including the GO debt and state loans will be slimmer but adequate at 1.2x beginning in fiscal 2017 through the forecast.

LIQUIDITY ENHANCED WITH BOND PROCEEDS
Liquidity has been modest despite the excess cash generated from positive operating results for the past four years as most of the cash flows were used to repay GF loans. The loans have been fully repaid (in fiscal 2015), and Fitch expects liquidity will improve with a $4 million cash infusion from bond proceeds and positive margins anticipated in fiscal 2016. After issuance, liquidity is projected to be above 300 days cash on hand, which is solid although still below the median for the 'AA' category.

ELEVATED DEBT BURDEN, CAPITAL NEEDS MANAGEABLE
The 2015 bonds will represent the city's inaugural issuance of senior lien revenue bonds for the water and sewer systems under a new master trust indenture. Future debt is expected to be issued as senior lien bonds with level debt service, allowing rate increases to match future debt carrying costs (as well as incremental increases in operating costs) and preserve financial coverage ratios.

Prior to this issuance, the entirety of the debt associated with the systems ($33 million) consisted of a portion of the city's long-term fixed rate public improvement GO bonds. In fiscal 2014, outstanding debt was 94% of net plant, which is high (Fitch 'AA' category median is 50%) but not unusual for older systems that have depreciated a substantial portion of their asset base. Debt per customer was just $1,289 per customer in 2014, below Fitch's 'AA' category median of $1,934.

However, the debt burden will rise with the 2015 bonds and $28.5 million of low interest state revolving fund (SRF) loans used to fund the new WTP. Debt service for the SRF loans and GO debt is subordinate to the 2015 bonds (and any future parity bonds issued under the indenture). SRF debt will begin amortizing once the treatment plant is completed in 2016. After issuance, the systems will have approximately $70 million in debt outstanding. Debt per customer will rise to approximately $3,000, which is elevated relative to similarly-rated systems.

The city has already completed upgrades to the jointly owned sewer plant, which along with the nearly completed WTP leaves the largest projects facing the systems already done. However, water distribution and sewer collection assets require fairly substantial repair and replacement that will keep leverage elevated.

The capital improvement plan (CIP) is manageable, totaling just $31 million over the next six years. Expectations are for similar projects to continue beyond the current CIP as the city is committed to dealing with the backlog of deferred maintenance. Approximately 80% of the planned spending will come from additional revenue bonds (including a portion of the 2015 bond proceeds), although expectations are for pay-as-you-go sources to increase somewhat over time.

STRONG SERVICE AREA ECONOMY
The city is the capital of Maryland and the seat of Anne Arundel County (GO bonds rated 'AA+' with a Stable Rating Outlook by Fitch). The local economy is anchored by federal, state, and local government employment (approximately 25% of labor force), with added depth from tourism and maritime industries due to the city's location on the Chesapeake Bay.

While government centers and the United States Naval Academy generate significant year-round visitation, the marinas and the historic district attract leisure travelers from around the region. Annapolis' population is highly educated with 45% of its residents having completed a bachelor's degree or higher, compared to 37% in the state and 29% nationwide. Annapolis' August 2015 unemployment rate remains low at 4.1%, reflecting the stable employment environment. Median household income is also well above the state and nation.