OREANDA-NEWS. February 23, 2016. Fitch Ratings has assigned an 'AA' rating to the following Eastern Municipal Water District, California debt:

--Approximately \\$214.4 million subordinate lien water and sewer revenue bonds series 2016A.

The bonds are scheduled to sell via negotiation on or about March 1, 2016. The proceeds will be used to refund the district's outstanding 2006A revenue certificates of participation (COPs) and certain outstanding state revolving fund loans and to pay cost of issuance.

In addition, Fitch affirms the following ratings on debt issued by the district and the Eastern Municipal Water District Financing Authority:

--\\$426.6 million senior water and sewer revenue bonds and COPs at 'AA+';
--\\$272.7 million subordinate water and sewer revenue bonds at 'AA';
--\\$104.6 million senior water and sewer revenue bonds series 2012A and 2013A (the SIFMA bonds) at 'AA+/F1+';
--\\$97.5 million bank certificates associated with series 2008C and 2008G at 'AA+';
--\\$234.1 million bank bonds associated with series 2014A, 2014B, 2014C and 2015A at 'AA';
--\\$35.5 million Western Riverside Water and Wastewater Financing Authority revenue bonds (Eastern Municipal Water District improvement district general obligation (GO) bond financing) at 'AA'.

The Rating Outlook is Stable.

SECURITY
The outstanding senior revenue bonds and COPs are payable from a first lien on net water and sewer revenues, including rate stabilization fund transfers and connection fee revenues. The subordinate bonds are payable from a second lien on net revenues.

The GO bonds are payable from net system revenues after payment of all revenue bonds and COPs, from available reserves and from ad valorem property taxes. The 'AA' rating reflects the net revenue pledge.

KEY RATING DRIVERS
FINANCIAL PERFORMANCE REMAINS HEALTHY: The utility's financial performance remains healthy despite an extreme multi-year California drought. All-in DSC jumped to a very strong 2.3x in fiscal 2015. Liquidity remains very healthy with 513 days cash on hand on June 30, 2015.

DIVERSE, STABLE REVENUES: Operating revenues have held up well in the face of variable demand for water due to significant rate increases, the district's allocation based rate structure, and very stable sewer and property tax revenues.

CONNECTION FEE EXPOSURE: The utility remains reliant on economically sensitive connection fee revenues. Fitch expects all-in coverage excluding connection fees to remain solid.

STRONG MANAGEMENT PRACTICES: Management practices reflect detailed, multi-year water supply, capital and financial planning processes. Budgeting is generally conservative with actual results regularly exceeding projections and corrective action taken quickly to restore performance during periods of weakness. Elected officials have shown strong rate discipline.

SOLID SUBURBAN SERVICE AREA: The district provides essential water and sewer services to a large and diverse service area in western Riverside County. The region has emerged from a deep cyclical downturn after the collapse of the local housing market and remains fundamentally sound.

SIGNIFICANT DEBT BURDEN: Debt levels are above average and expected to remain elevated with slow amortization and \\$120 million of additional borrowing planned over the next five years. The debt profile is complex with high levels of variable-rate debt and some derivatives exposure.

RATING SENSITIVITIES

CONSISTENTLY HIGHER FINANCIAL MARGINS: Management has stated an intent to improve financial margins from recurring revenues and reduce reliance on debt funding over the next five years. If the district demonstrates consistently improved levels of free cash to depreciation and all-in debt service coverage, coupled with a decreased use of debt to fund ongoing repair and replacement of capital assets, upward rating movement could occur.

PRESSURE FROM STATEWIDE DROUGHT: The rating could come under downward pressure if financial margins fell more than expected due to severe or multi-year water rationing related to the current severe California drought. Fitch believes this is unlikely due to the district's diverse revenue base, self-stabilizing allocation-based rate structure and ample rate flexibility.

CREDIT PROFILE
Eastern Municipal Water District provides water service and sewer service to 785,000 people, or about a third of Riverside County's population, through retail and wholesale accounts. The service area covers 550 square miles and includes the cities of Temecula, Murrieta, Moreno Valley, Hemet, San Jacinto and Perris, as well as unincorporated areas. The formerly agricultural region suburbanized rapidly in recent decades and is close to both Orange and San Diego Counties.

SOLID FINANCIAL PERFORMANCE
The utility performed well in very difficult operating environments in recent years, including periods of surging imported water costs, drought and very weak connection fee revenues. Fitch calculated all-in DSC, which includes the district's general obligation bond revenues and debt service, was solid at 1.8x in fiscal 2014 and strong at 2.3x in fiscal 2015. All-in DSC has averaged 1.8x over the past five years. Free cash to depreciation, a key measure of the utility's ability to maintain its existing assets from revenues, averaged a modest 45% over the five year period but has been increasing gradually. The measure rose to 56% in 2015. Free cash to depreciation remains significantly below the median of 91% for 'AA' category credits.

The senior lien bonds are rated a notch above the subordinate working lien debt due to the additional bondholder protection provided by priority of payment and higher debt service coverage. Senior lien DSC was strong at 2.2x in fiscal 2014 and rose to 2.7x in fiscal 2015. While the excess coverage margin on the senior debt is currently modest, senior DSC is expected to rise fairly rapidly over the next few years as debt is refinanced into the subordinate working lien. The current transaction will refund about \\$214 million of debt into the working lien, boosting future senior lien coverage to very high levels.

The utility's revenues are reasonably diverse, but somewhat volatile. Connection fees have traditionally been the main source of revenue volatility for the utility and are currently on the upswing. Connection fees have averaged \\$29.2 million over the past two years, about three times the level seen at their recent low in fiscal 2011. Non-connection fee revenues are fairly diverse and stable, with sewer charges, fixed water meter charges and stable property taxes providing more than half of revenues. Coverage excluding connection fees rose from a narrow 1.2x in fiscal 2014 to 1.6x in fiscal 2015.

The utility's very strong financial reserves mitigate concerns about revenue volatility in the near term. Unrestricted cash and investments equaled \\$180.9 million, or 346 days of operating expenses, at the end of fiscal 2015. The district has an additional \\$87.2 million of construction and other somewhat flexible reserves that are restricted on its balance sheet but available for appropriation for debt service or operations if the district's board chooses to remove restrictions.

IMPROVED FINANCIAL PERFORMANCE IN FORECAST
The issuer's financial forecast shows a positive financial trend. Fitch-calculated all-in DSC is projected to average a strong 2.2x over the next five fiscal years if results meet the forecast, while senior coverage would jump to an average of 4.4x across the period. All-in coverage excluding connection fees would average an adequate 1.3x. Free cash to depreciation would improve to healthier but still low levels of about 70% at the end of the period.

The gains are driven by policymakers' desire to increase pay-go funding of capital investments and by increasing connection fee revenues. The forecast appears reasonable, but gains in connection fees are dependent on broader macroeconomic conditions. The issuer projects connection fee increases based both on higher rates and rising connections due to increasing development and housing permit activity in the area. While the assumptions underlying this forecast appear plausible, connection fee revenues remain a vulnerability to the forecast. The forecast is also sensitive to refunding assumptions, particularly in regard to the level of future senior DSC. Market conditions will dictate the amount of the proposed refunding that is completed.

DROUGHT CONSERVATION MANDATE
The California State Water Board has ordered the district to reduce water use 28% from 2013 levels. Recent regulatory changes are likely to reduce the conservation requirement closer to 20%. The utility appears well positioned to withstand the revenue pressures associated with either of the standards. The district's allocation based rate structure is designed to recoup lower revenues as drought measures push sales volumes down. When the district needs to conserve water, policymakers declare a higher drought stage, which reduces the amount of water allocated to residents at low rates for indoor and efficient outdoor use. The rate structure stabilizes rates by pushing use into more expensive tiers, effectively increasing the average price of water sold. The district also benefits from reductions in purchased water costs as demand declines. About 30% of operating costs (excluding depreciation) went to water purchases in fiscal 2015.

STRONG MANAGEMENT PRACTICES, SIGNIFICANT SUPPLY INVESTMENTS
The district's management practices are particularly strong with a long track record of delivering better than forecast financial results, investing to increase the reliability of supplies and raising rates as needed to maintain financial performance. For example, the district began investing in water recycling long before most California water agencies and now produces a very significant 33% of supplies from relatively drought-proof, highly treated wastewater. The district also produces about 16% of supplies from local groundwater, including an increasing amount of desalinated brackish ground water. The district's supply investments do not exempt it from mandatory statewide conservation, but the investments position the utility better than others if the drought is prolonged and significantly reduces the availability of imported water supplies. Eastern imports about half of its water from the Metropolitan Water District of Southern California (Met Water, revenue bonds rated 'AA+'/Outlook Stable by Fitch), down from about 60% in 2002.

SOLID RATE DISCIPLINE
The district's elected board has raised rates as needed to maintain healthy financial performance. The board raised water rates an average of 4.8% annually over the five years through fiscal 2016 and sewer rates by 5.3%. Combined water and sewer rates are currently affordable at just 1.6% of Riverside County's median household income for 10 hundred cubic feet (about 7500 gallons) of water. Actual water usage is significantly higher in this arid, suburban service area, suggesting somewhat less rate flexibility than Fitch's affordability measure suggests. But even with average use of 18 HCF of water per month, combined bills remain moderate. Rates also compare favorably to other local jurisdictions.

SIGNIFICANT DEBT BURDEN
The district's debt burden is somewhat above average. The district's \\$1 billion debt burden at the end of fiscal 2015 was about 131% of the median for 'AA' category water and sewer utilities at \\$2,690 per customer. Fitch expects debt to remain fairly steady as it issues about \\$120 million of additional debt to fund its \\$395 million fiscal 2016 to fiscal 2020 capital improvement plan (CIP) and amortizes a similar amount of debt. Amortization is slow with 65% of bonds repaid in 20 years versus an 'AA' median of 84%.

The utility's physical plant appears well maintained. The district has invested heavily in maintaining and expanding its infrastructure with capital expenditures to depreciation averaging 157% over the past five years. Unaccounted water loss has averaged a moderate 6% over the past five years. Financial average age of plant is below average at 11 years.

The district's debt portfolio is more complex than the typical municipal water and sewer utility with \\$350.7 million, or 34.4% of the district's outstanding debt, as short-term and variable rate debt. About \\$94.7 million of the debt is hedged with interest rate swaps, lowering the percentage of pure variable rate exposure to 25.1%. Management has taken prudent measures to reduce counterparty risk by replacing some variable rate demand obligations with SIFMA index notes with staggered rollover dates and diversifying liquidity providers, while maintaining strong reserves as an asset to hedge variable rate exposure. Fitch expects variable rate exposure to slowly decrease as a percentage of the debt portfolio as the district plans to utilize significant amounts of fixed-rate state revolving fund loans to fund capital over the next few years.

RELATIONSHIPS BETWEEN RATINGS
The district's underlying long-term subordinate revenue bond and GO bond ratings are rated a notch lower than the district's senior bonds due to their lower priority of payment from net revenues. The district plans to gradually shift outstanding debt into the new subordinate working lien over time.

The GO bonds are payable from an unlimited ad valorem property tax revenues from a number of small, concentrated improvement districts. They are rated to the district's covenant to pay debt service from available reserves or net revenues after payment of revenue bond and state loan debt service, which is the stronger of the two pledges. The district does not levy the full legally permissible debt service levy for the GO bonds, choosing instead to pay some GO debt service from net revenues. While the GO bonds have a lower priority of payment from net revenues than the subordinate revenue bonds, Fitch judged the credit quality of the two securities to be roughly equivalent.

The 'F1+' short-term rating on the SIFMA index bonds reflects Fitch's expectation that the highly-rated district will maintain the market access necessary to remarket the debt as necessary.

The bank bond ratings equal the related underlying long-term ratings. Fitch has reviewed the standby bond/certificate purchase agreements and does not believe they would materially affect the district's long-term credit quality. Penalty interest rates would be higher on all series but would be affordable in the short term, and term out provisions provide ample time to refinance debt or secure new liquidity.