OREANDA-NEWS. Fitch Ratings has assigned an 'AA' credit rating to the following Santa Clara Valley Water District, California (the district) debt:

--$111.6 million water system refunding revenue bonds series 2016A;
--$75.2 million water system refunding revenue bonds taxable series 2016B;
--$43.3 million water revenue certificates of participation (Water Utility System Improvement Projects) series 2016C;
--$55 million water revenue certificates of participation (Water Utility System Improvement Projects) taxable series 2016D.

The bonds are scheduled to sell via negotiation on or about March 17, 2016. Proceeds of the series 2016 A & B bonds will refund the district's outstanding 2006A bonds for savings and commercial paper notes for re-amortization as long-term debt. The series 2016 C & D COPs will finance the district's ongoing capital improvement program, including seismic improvements to district dams and water treatment plants. Proceeds from all series will also pay cost of issuance.

The Rating Outlook is Stable.

SECURITY

The series 2016 revenue bonds and COPs are payable from a second lien on net water revenues. The senior lien is closed and has about $132.6 million of bonds still outstanding.

KEY RATING DRIVERS

WHOLESALER, STRONG SERVICE AREA: The district provides essential services as groundwater basin manager and imported water provider to Santa Clara County, the center of Silicon Valley and the U.S. technology industry. The service area is large, diverse in terms of ultimate payers and wealthy.
RISING DEBT BURDEN: Debt will be low at $257 per capita after the current transaction but is expected to rise significantly if the utility completes a proposed expansion of its recycled water system.

STRONG FINANCIAL PERFORMANCE: All-in debt service coverage (DSC) varies with water sales, but has remained strong across business and weather cycles, averaging 3.8x over the three fiscal years ended June 30, 2015. Coverage is expected to decrease with upcoming debt issuance and drought pressures, but remain adequate in the near term and strong in the later years of the district's financial forecast. Liquidity is strong with 420 days of unrestricted cash and investments on hand at the end of fiscal 2015.

DUAL RESPONSIBLITIES REDUCE VOLATILITY: The district benefits from a solid business model that allows it to charge local water retailers for both groundwater extractions and imported water. However, revenues do vary significantly as weather and business cycles affect final demand.

GOOD RATE FLEXIBILITY: The district has a solid history of raising rates to preserve financial margins. The area's high incomes and the district's wholesale business model provide heightened rate flexibility. Rates are moderate compared to other wholesale water providers in California, but quite expensive compared with wholesalers nationwide.

RATING SENSITIVITIES

DOWNSIDE RISK ON FINANCIAL PERFORMANCE: Fitch may downgrade the rating if Santa Clara Valley Water District's financial performance weakens more than projected as new debt is issued. A worsening of drought pressures could also put downward pressure on the rating.

CREDIT PROFILE

The district is the local importer of water supplies from the federal Central Valley Project and the California State Water Project to Santa Clara County, California. The district also provides groundwater basin management, recycled water and flood control services to the 1.9 million county residents. The economically vital county includes California's third largest city (San Jose) and is home to major technology companies such as Apple Inc., Google Inc., Intel Corp., HP Inc., Cisco Systems Inc. and Ebay Inc.

STRONG FINANCIAL PERFORMANCE

Historical financial performance has been sound through stressful periods of recession, drought and wet weather. All-in DSC dropped to a still strong 2.4x in fiscal 2015 from 4.8x in in fiscal 2014, as sales fell and expenses rose as conservation efforts intensified in reaction to a severe California drought. Operating revenues fell 10.4% to $155.2 million as the volume of water sold dropped 16.9%. Operating expenses jumped 11.8% as the district increased spending for turf replacement, conservation programs and open market water purchases. The district's financial forecast shows DSC declining to a merely adequate 1.4x in fiscal 2016 as drought pressures continue, but rate increases are forecast to push coverage back toward 2x in fiscal 2017 even with the planned issuance of additional bonds.

Fitch's rating incorporates expectations that the utility will manage its finances to achieve its goal of all-in coverage near 2x on average over time. Short-term deviations from the goal are unlikely to pressure the rating, but sustained changes in underlying long-term performance could pressure the rating. A sustained decline in free cash flows relative to depreciation could also pressure the rating. Free cash to depreciation has averaged a strong 158% over the past five years, but fell to just 40% in fiscal 2015.

The district's volumetric rate structure creates a good deal of short-term revenue volatility as water sales revenues fluctuate with weather and economic conditions. In the long term, the district's strong rate discipline has kept revenues on a rising trajectory with gains that averaged 5.2% annually over the past two decades despite gradual conservation that reduced consumption by an average of 0.2% annually. The district's board has shown solid rate discipline, raising treated water rates an average of 10% annually over the past five years.

Liquidity is strong, allowing the district to withstand near-term fluctuations in coverage without deteriorations in credit quality. The utility had $149.9 million of unrestricted cash and investments, or 420 days cash, on its balance sheet at the end of fiscal 2015. Cash has averaged a strong 419 days of operating expenses over the past five years. Fitch expects liquidity to remain strong if the utility continues to set rates to comply with robust internal financial planning targets.

BROAD RESPONSIBILITIES, DIVERSITY OF SUPPLIES

The district's broad responsibilities for water supply management reduce revenue volatility somewhat. Unlike a wholesaler that only imports water, the Santa Clara Valley Water District manages both imported supplies and the county's large and productive groundwater basin. The arrangement allows the district to recover fixed costs regardless of whether local retailers rely more heavily on groundwater or imported supplies in a given year. The utility remains exposed to variations in final demand for water, which varies significantly due to the local climate.

Santa Clara Valley's supply position is sound and likely to improve meaningfully with investments in potable reuse that could add up to 45,000 acre feet (a.f.) of recycled water to its supply portfolio over the next decade. The district's available supplies equal about 320,000 a.f. in a typical year (including groundwater) compare with average usage of about 280,000 acre feet over the past twenty years. The utility expects to import 108,100 a.f. of water from the Central Valley Project and 64,000 a.f. from the State Water Project in a normal year, while collecting about 84,720 a.f. of surface water. These supplies vary widely depending on precipitation levels in northern California and in the Sierra Nevada Mountains.

The district manages the variability of its supplies through conservation, storage programs, conjunctive use (storing water in the ground in wet years and relying more on groundwater in dry years) and open market purchases of water from farmers and other agencies. All told, supplies are adequate given stable demand, but variable enough to require significant cuts in water use during droughts. The proposed expansion of recycled water production would harden supplies and could eventually lead to less revenue volatility and water rationing in drought periods.

LARGE CAPITAL PLANS, RISING DEBT

The district is embarking on a major capital improvement plan (CIP) that would increase debt levels from low levels after the current deal to fairly high levels for a wholesaler. Debt will remain low at $500.9 million, or $257 per capita, after the current transaction. Debt per capita is projected to rise to about $650 as the district issues $1.1 billion of debt to fund a $1.4 billion CIP.

The district's capital plan is driven by plans to expand recycled water production and potable reuse of wastewater. The plan also includes significant investments to seismically retrofit district dams. The current capital plan includes $568 million of costs associated with a potable reuse strategy that could cost as much as $1.6 billion to fully complete. Policymakers have not yet made a final decision on the timing and scope of the district's full potable reuse plan. Debt could rise to very high levels if the district undertakes the full plan over the next decade. While the current rating takes account of all debt included in the current capital plan, the rating could come under downward pressure if debt ratios continue to rise thereafter.