Fitch Ratings assigns an 'AA+' rating to the Metropolitan Water District of Southern California (Metropolitan or the district) $137.4 million water revenue refunding bonds, 2008 series B. Fitch also affirms the 'AA+' underlying long-term rating on Metropolitan's $4.1 billion of outstanding water revenue bonds (net of refunding) and 'AAA' long-term rating on Metropolitan's $327.2 million of outstanding general obligation bonds. The current issue will sell via negotiation on or about May 29th. The Rating Outlook is Stable.
The 'AA+' rating on Metropolitan's water revenue bonds reflects credit strengths that include the essentiality of the service provided; Metropolitan's role as the region's wholesale water supplier; a strong financial position even with a recent and projected near-term decline in debt service coverage levels; long-term financial and operational planning practices; and a robust, diverse, and growing service area. Credit concerns focus on recent legal challenges which may significantly reduce Metropolitan's largest water supply, the State Water Project (SWP), and could add sizable operating cost pressures as the district offsets SWP water with other, more expensive sources. These anticipated operating costs pressures have prompted higher rate increases than had previously been expected and are forecasted to cause a sizeable short-term reduction to senior debt service coverage in fiscal 2009 before the effect of rate increases boosts coverage back to historical norms. A rapid improvement in the district's financial metrics will be necessary to maintain the current rating level.
With an estimated population of 18.4 million, Metropolitan provides between 40% and 60% of the service area's water, depending on water conditions, and works on the development and acquisition of the long-term water supply for the region. Metropolitan's supply is derived from two sources -- Northern California's San Francisco Bay/Sacramento-San Joaquin River Delta (bay/delta) water via the SWP, which provided approximately 75% of its water supply in 2007, and the Colorado River via the Colorado River Aqueduct, which provided the remaining 25%.
Following reductions to the Colorado River supply in recent years due to a 2003 settlement among all California parties that use water from the river, the SWP has become an increasingly important component of Metropolitan's overall water portfolio. However, a federal court decision reached in December 2007 is expected to result in a reduction of Metropolitan's allocation from the SWP by up to 30%, at least over the near term. The ruling stipulates reductions in operation of the SWP and the project's compliance with the Endangered Species Act until a new biological opinion is completed by the U.S. Fish and Wildlife Service later this year for the Delta Smelt (required deadline is September 2008). SWP operations may be changed again following release of the new biological opinion.
A second ruling reached in April 2008 by the same federal court overseeing the Delta Smelt case also invalidated the biological opinions for salmonid species spawning in rivers flowing into the bay/delta. These fish species are largely influenced by operations of the federal Central Valley Project (CVP), but because the bay/delta is impacted by both the SWP and CVP, a change in operations to the CVP to accommodate any final determination in the case could impact operations of the SWP and consequently the volume or timing of exports to MWD. A hearing is scheduled for June 2008 to determine if interim remedies should be commenced. These legal cases are occurring within a broader political debate in California over the bay/delta and the numerous environmental impacts that affect it, including urban development, farming practices, deteriorating levy conditions, flood control, and state water consumption demands.
Mitigating Fitch Ratings' concern over the estimated immediate reductions are actions taken by Metropolitan to reduce demand, including curtailment of water sales for groundwater recharge and a 30% reduction in sales to agricultural customers, as well as its efforts to increase supplies from other sources. These other sources include stored reserves, groundwater purchased from the San Bernardino groundwater basin, and water options. Based on these efforts and assuming SWP deliveries continue to be curtailed, Metropolitan estimates that it will have sufficient supplies to meet member demands from 2008-2010. However, by the end of 2010, water storage could be seriously depleted. As a result, it will be critical that a near-term solution be reached among bay/delta stakeholders to maintain the health of the bay/delta ecosystem and ensure operational reliability of the SWP at a level that allows Metropolitan to meet ongoing regional demands.
As a result of this disruption in SWP supplies and the need to find replacement sources, Metropolitan is projecting a substantial rise in its operating cost structure for fiscal years 2008 and 2009, which will temporarily impact ADS coverage levels and cash reserves until rate increases are able to offset the costs. Currently, Metropolitan conservatively projects that senior-lien ADS coverage will fall to 1.7 times (x) in fiscal 2008, followed by a decline to 1.3x in fiscal 2009 before recovering to 2.0x and above, thereafter. While Metropolitan's legal covenants do not include transfers from a rate stabilization fund as revenues for purposes of meeting its rate covenant, the district plans to utilize approximately $150 million of its rate stabilization fund in fiscal 2009 to offset cash flow shortfalls, including ongoing pay-as-you-go capital funding; reserve balances are expected to be replenished by fiscal 2012. ADS coverage including the rate stabilization fund transfer is 1.9x for fiscal 2009.
Metropolitan's fiscal year ends on June 30, but the district implements rate increases in January to allow a reasonable amount of time for members to adopt corresponding adjustments. Previously, Metropolitan had anticipated raising rates in smaller increments through fiscal 2012. However, to restore financial margins in light of rising operating cost pressures, the board approved a rate adjustment in excess of 14% in March of this year for 2009. Metropolitan now forecasts an additional hike of up to 10% in 2010, followed by more modest 3%-5% adjustments annually, thereafter.
Fitch recognizes the timing issues related to Metropolitan's rate-setting process, particularly in relation to events leading up to the rising operating costs now contemplated, and believes management is taking prudent measures to ensure Metropolitan's ongoing financial capacity. However, further deterioration or a prolonged weakening in Metropolitan's operating performance would be viewed negatively, relative to the current rating level, by Fitch.
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