Fitch Ratings affirms the following ratings on outstanding Philadelphia Gas Works (PGW) revenue bonds:
--$188.9 million gas works revenue bonds, various series, (1975 general
ordinance), at 'BBB+';
--$935.2 million gas works revenue refunding bonds, various series (senior 1998 general ordinance), at 'BBB'.
The Rating Outlook is Stable.
The 1975 general ordinance bonds are secured by a first lien on net revenues of the gas works utility. The 1998 general ordinance bonds are secured by net revenues of the gas works utility subordinate to the prior pledge of the 1975 general ordinance bonds.
KEY RATING DRIVERS
IMPROVED FINANCIAL PERFORMANCE: Financial performance continued to improve through fiscal 2011, reflecting the positive impact of multiple rate increases enacted in recent years and a favorable reduction in accounts receivable. Financial metrics are likely to soften somewhat by the close of fiscal 2012 based on weaker than budgeted operating results through the first 10 months of fiscal 2012.
SUPPORTIVE REGULATION: PGW benefits from a supportive relationship with the Pennsylvania Public Utility Commission (PUC), which regulates the utility's retail rates, as evidenced by the trend of timely approval of gas rate adjustments and the utility's recent ability to secure authorization for a weather normalization adjustment.
REDUCED RELIANCE ON DEBT FUNDING: PGW has generated positive cash flow after debt service in recent years and has not issued commercial paper to fund operations since May 2009. Total debt remains high, but PGW has reduced its reliance on short-term and long-term financing to fund capital expenditures and will benefit from the recent implementation of an infrastructure surcharge.
WEAK BUT STABLE DEMOGRAPHICS: Declines in PGW's customer base and related gas usage have generally mirrored the declining population of the city, but recent census data seems to indicate that Philadelphia's population trends may be stabilizing. Wealth indicators throughout the service area remain weak as approximately 19% of PGW's residential customers are enrolled in low-income, customer responsibility programs.
PRIORITY LIEN RECOGNIZED: The 'BBB+' rating on the 1975 general ordinance bonds reflects their priority lien in the flow of funds, which is closed to future bond issues, as well as the distinct separation between the 1975 and 1998 ordinances.
POTENTIAL SALE OF THE UTILITY: Ongoing discussions about a sale of PGW are viewed as credit neutral by Fitch based on the understanding that any potential sale would result in either repayment or defeasance of outstanding PGW bonds.
What Could Trigger a Rating Action
WEAKER CASH FLOW: The inability to fund a share of capital improvements from internally generated cash flow, thereby increasing PGW's reliance on debt funding, would be viewed negatively.
Largest U.S. Municipal Gas Utility
PGW is the largest municipal gas distribution utility in the nation and is owned by the City of Philadelphia (Fitch rates the city's general obligation bonds 'A-' with a Stable Outlook). The system provides natural gas through a diverse mix of supply arrangements as well as its own storage and natural gas liquefaction facilities. Ample storage capacity allows the system to lock in and store a sizeable portion of its winter supply during the less expensive summer months.
Challenging Demographics Compound High Rates
The system's service territory consists of the entire city, which includes a diverse customer base with no meaningful concentration among users. Approximately 77% of the system's 503,000 customer accounts are residential, 20% are commercial and industrial and the balance is comprised of municipal users. The city's unemployment rate remains elevated relative to the state and national averages, and weak income indicators persist. The city's poverty rate stands at 25%, sixth-highest among the nation's 50 largest cities, and overall income levels approximate just 75% of the state and national averages.
Fitch believes PGW's high residential rates and the city's challenging demographics will continue to limit the system's operating flexibility. The typical peak winter month's residential gas bill for PGW customers in fiscal 2012 was about 42% higher than the average bill for distribution systems throughout the state. The high rates are mostly attributable to historically weak collections and extensive utility-sponsored discount programs that benefit low-income customers. Nevertheless, accounts receivable collection rates have shown considerable improvement in recent years following historically substandard levels.
Gas Rates Regulated
Rates and charges of PGW are set by the Public Utilities Commission of the Commonwealth of Pennsylvania (PUC). The PUC's ratemaking methodology is designed to ensure that PGW recovers its costs, meets its strong rate covenant of 1.5x and continues to fund a required $18 million annual utility payment to the city. PGW's relationship with the PUC is reportedly constructive, as evidenced by the trend of timely approval of gas rate adjustments and the utility's recent ability to secure authorization for a weather normalization adjustment.
PGW's most recent base rate filing was approved in July 2010. The approval permitted PGW to maintain virtually all of a $60 million extraordinary rate increase granted by the PUC in 2008, and to receive an incremental rate increase of $16 million annually to fund other post-employment benefit costs. Management does not anticipate a request for another base rate increase for at least the next five years.
Steadily Improving Financial Profile
The system's financial performance continued to show improvement through fiscal 2011, largely due to higher than budgeted sales positively offsetting a modest decline in collections. Sales volumes, including gas transportation deliveries, totaled 74.5 billion cubic feet (Bcf) in fiscal 2011, an 8% increase over the prior year due to increased heating demand and a slight increase in customer accounts. Consequently, coverage of all-in debt service increased to a healthy 1.5x while liquidity improved to 64 days cash on hand.
Volumes for fiscal 2012 have dropped significantly due to warmer weather leading to reduced demand. Interim financial results through the first 10 months of fiscal 2012 show a sizeable negative variance in net operating income relative to budgeted expectations, which is likely to somewhat diminish annual debt service coverage. Multi-year financial projections beyond fiscal 2012 show satisfactory all-in debt service coverage levels of about 1.7x leading up to fiscal 2017.
High Leverage Expected to Improve
Capital needs through fiscal 2017 are manageable. The majority of the system's $420 million capital program will be dedicated towards upgrading the distribution system and replacing aged infrastructure. Almost half of the CIP is expected to be funded with long-term debt, including proceeds from a prior borrowing and a $175 million financing slated for the latter half of (calendar) 2013.
Leverage ratios are expected to remain high, although Fitch views positively management's commitment to reducing its reliance on short-term and long-term financing to fund capital expenditures. The system is considering levying a distribution system improvement charge (DISC) of up to 5% of a consumer's bill in 2013 to help cover infrastructure costs and fund a greater share of capital expenditures from current resources. Despite some improvement in recent years, equity/capitalization (18%) and total debt/funds available for debt service (7.3x) remain weak, but not inconsistent with the given rating category.
Additional information is available at www.fitchratings.com. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
This action was informed by information identified in Fitch's 'Revenue-Supported Rating Criteria' and 'U.S. Public Power Rating Criteria'.
Applicable Criteria and Related Research:
--'U.S. Public Power Rating Criteria', Jan. 11, 2012;
--'Revenue-Supported Rating Criteria', June 20, 2011.
Applicable Criteria and Related Research:
U.S. Public Power Rating Criteria
Revenue-Supported Rating Criteria
Christopher Hessenthaler, +1-212-908-0773
One State Street Plaza
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Dennis Pidherny, +1-212-908-0738
Alan Spen, +1-212-908-0594
Elizabeth Fogerty, +1-212-908-0526