As part of its continuous surveillance effort, Fitch Ratings takes the following actions on Puerto Rico Aqueduct and Sewer Authority, Puerto Rico (PRASA or the authority):
--$1.3 billion of outstanding revenue bonds, series A (senior lien), downgraded to 'BBB' from 'BBB+';
--$22.4 million of outstanding revenue bonds, series B (senior lien), downgraded to 'BBB' from 'BBB+'.
The Rating Outlook is Stable.
RATING RATIONALE:
--The downgrade to 'BBB' from 'BBB+' reflects the weakened financial performance of PRASA's combined water and sewer system (the system) in recent years and forecasted revenue shortfalls that could pressure PRASA's ability to be a self-supporting enterprise without ongoing commonwealth assistance.
--Major improvements in operations and financial performance have occurred since the change in governance structure in 2004, although financial margins are weak and bad debt levels have increased.
--The capital improvement program (CIP) is substantial and fairly rigid over the near-term.
--PRASA's management is solid and the system also benefits from the Government Development Bank for Puerto Rico's (GDB) advisory capacity and interim funding sources.
--The service territory is diverse, although weak economic conditions have been protracted and customer wealth levels are limited.
--The system provides an essential service.
KEY RATING DRIVERS:
--Failure to implement needed rate increases could impair financial performance without future commonwealth assistance.
--Successful implementation of operating initiatives will be critical to boosting financial performance, particularly with regards to reducing bad debts and electricity costs.
--Effective management of a large and complex CIP while limiting additional capital costs and meeting regulatory milestones remains a key rating driver.
--Continued strong leadership and employment of capable management will be essential to steady improvement in system performance.
SECURITY:
The bonds constitute senior lien obligations of the system, secured by net system revenues after payment of operations and maintenance expenses.
CREDIT SUMMARY:
PRASA provides water service to virtually the entire island, including the estimated 4 million residents and 5 million annual tourists; sewer service is limited to around one-half of the island. Over the last couple of decades, system performance has been lacking, resulting in numerous lawsuits regarding repeated violations of regulatory requirements. From 1995 until 2004 operations were handed over to the private sector with the goal of improving performance, but with marginal success. In 2004 operations were transitioned back to the public side and the commonwealth reorganized PRASA's board and executive management with the goals of limiting political interference, improving the organizational structure, and returning the authority to financial viability without commonwealth subsidization. Since this change, operating, financial, and regulatory performance have improved overall, although significant challenges persist.
To enhance the system's ability to fund capital projects and boost operating performance, PRASA's board passed a two-step rate hike in 2005 totaling a cumulative 128% over fiscals 2006 and 2007 (the first adjustments since 1987) and provided a mechanism for additional moderate rate hikes beginning in fiscal 2010 without further public hearings. As a result of the fiscal 2006 and 2007 rate hikes, PRASA's financial results improved dramatically and PRASA posted positive margins in fiscal 2007 as well as annual debt service (ADS) coverage on all debt of 1.6 times (x). Despite the fiscal 2007 results, financial performance deteriorated substantially in fiscal 2008 and has remained weak through fiscal 2010, although margins have shown improvement in each subsequent year.
Beginning in fiscal 2008, water sales declined over 8%, attributable largely to the recession. As conditions worsened on the island (Puerto Rico has been in recession since the fourth quarter 2006), bad debts rose to 7% of billings from 5% the prior year, accounts receivable from commonwealth agencies increased, and developer contributions declined. On the expenditure side, management held payroll costs largely in check, but various other operating expenses rose for the year, including electrical costs, which were up nearly $23 million due to fuel adjustment pass-through costs from Puerto Rico Electric Power Authority (PREPA); electrical costs account for around 20% of PRASA's operating expenses. The net result of these conditions was a drop of over 70% in net revenues available for debt service from fiscal 2007 levels and failure by PRASA to meet the 1.0x rate covenant of all debt. Nevertheless, senior lien ADS coverage was 1.4x for the year and PRASA was able to fulfill all of its debt obligations from available resources without assistance from the commonwealth.
For fiscal 2009, consumption levels increased slightly as a result of customer growth, which helped to improve operating revenues somewhat even as bad debts rose to 8% of billings. On the expenditure side, management cut staffing and other operating costs and electricity expenses were relatively flat from the prior year. While revenues available for debt service increased substantially as a result of these actions, financial margins remained negative and total debt service coverage again failed to meet the 1.0x rate covenant. However, senior lien ADS coverage improved to 2.6x and PRASA continued to meet its debt obligations, but largely because payment on certain accrued expenses were deferred until fiscal 2010. In addition, to cover necessary operating and capital costs PRASA drew down the entire $150 million of the indenture-required operating reserve that was covered by a line of credit (LOC) from the GDB; PRASA fully repaid the outstanding draws on the operating reserve in fiscal 2010 so that the entire $150 million LOC is once again available.
For unaudited fiscal 2010, operating margins continued to improve overall, but PRASA was unable to meet its obligation to pay debt service on the commonwealth-supported Superaqueduct bonds (PRASA's fourth lien debt) in July 2009 given PRASA's depleted balance sheet position and the drawdown of the operating reserve LOC mentioned above. Instead, debt service on these bonds (around $27 million) was paid by the commonwealth; failure by PRASA to pay commonwealth-guaranty and commonwealth-supported debt does not constitute an event of default under the senior lien indenture. For the year, operating revenues were increased approximately 3% from fiscal 2009, but largely from one-time receivables due from prior years, including amounts owed by commonwealth agencies. On the expenditure side, management continued cuts to operating costs, with the aggregate result that operating expenses declined 2% even as electricity costs rose slightly. For the year, net revenues (excluding commonwealth revenues for payment of the Superaqueduct debt) increased over $70 million from fiscal 2009 levels, which offset increased debt service costs of around $46 million and kept senior lien ADS coverage at a strong 2.4x; total ADS coverage rose to 0.9x for the year.
Throughout the financial challenges PRASA has faced over the last several years, management has actively identified and implemented targeted revenue enhancements and expenditure reductions. Through the fiscal 2014 forecast period, management is focusing on three key initiatives which will continue this practice and which will also improve system operations. First, management is seeking to partner with private firms to assume and reengineer the customer service operations and also design-build-operate technologies for remote meter reading and an enhanced database using geo-referencing. This public-private partnership will not only enhance revenues by decreasing the amount of non-revenue producing water (water lost from non-billing, theft, database errors, etc.), which is currently an extremely high 63% of water produced, but will also improve customer service, help reduce personnel costs, and increase the amount of money available for capital investment. Second, management is in the process of automating the majority of its facilities, which also will lead to a reduction in operating costs as well as provide for better protection of water quality. Finally, PRASA is seeking additional public-private partnerships that will enable it to diversify its power supply and lock in lower energy costs as well as invest capital dollars in efficient operating equipment.
However, even with these initiatives, management is forecasting that additional revenues of $150 million to $160 million annually will be needed beginning in fiscal 2012 to meet all operating and increasing debt service obligations. As mentioned above, the commonwealth paid the debt service on the Superaqueduct bonds in fiscal 2010 ($27 million) and for fiscal 2011 commonwealth assistance to PRASA totals $105 million. Commonwealth assistance has grown over the last two years in part because PRASA's board has foregone rate hikes previously expected to resume in fiscal 2010 to provide rate relief to the customer base during the economic downturn. While Fitch has observed other utilities nationwide limiting or foregoing rate hikes and believes it is likely the commonwealth will continue to subsidize PRASA's operations as necessary while economic conditions on the island remain poor, PRASA's growing budget imbalance over the near-term and reliance on commonwealth assistance is a concern as it diminishes PRASA's ability to be fully self-supporting. Furthermore, it potentially exposes PRASA's customers to rate shock should PRASA be forced to implement another sizeable rate hike in a single year to ensure sufficient operating monies in the event commonwealth appropriations cease. This concern is exacerbated by the fact that combined water and sewer costs are already high at 2.3% of median household income (MHI) and the high poverty rates on the island (the MHI on the island is around 35% that of the U.S. average). Fitch has developed a stress scenario to evaluate the rate hikes necessary to recover these unidentified revenues based on a bad debt rate of 13%, forecasted consumption levels, and planned debt issuances. Based on these assumptions and no commonwealth appropriations in fiscals 2012-2014, rates would need to increase by 24% in fiscal 2012 to generate the unidentified revenues of $150 million-$160 million on a recurring basis.
Central to PRASA's challenges are the scope of needed capital investment to maintain regulatory compliance and renew system assets given the limited historical investment in the system's infrastructure and the resulting pressure this places on operations. While capital cost estimates have declined in recent years as PRASA's management has successfully executed key components of the CIP, particularly those required by regulators, projected capital spending over the fiscal 2010-2014 CIP period remains sizeable at $1.57 billion. Capital costs should continue to decrease over the next several years and shift more towards repair and replacement by the end of the current CIP period. However, ongoing needs are expected to remain relatively large and average $200 million-$250 million annually from fiscal 2013 onward.
With minimal surplus revenues available for equity funding of capital, PRASA anticipates relying almost exclusively on borrowable sources. Consequently, debt levels, which are already moderately high, will rise further as the current CIP progresses and place increasing pressure on the authority's already weak financial margins and keep total ADS coverage at 1.0x; senior lien ADS coverage is projected to diminish through fiscal 2014 to the 1.4x-1.5x range as a second lien bank loan and third lien GDB interim financing debt are refinanced to a senior position. Given the rising debt burden, debt carrying costs are expected to increase from 20% of gross revenues experienced in fiscal 2009 to over 35% expected by fiscal 2014.
Applicable criteria available on Fitch's website at 'www.fitchratings.com' include:
--'Revenue-Supported Rating Criteria,' dated Dec. 29, 2009.
--'Water and Sewer Revenue Bond Rating Guidelines,' dated Aug. 6, 2008.
Additional information is available at 'www.fitchratings.com'.
Related Research:
Revenue-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=493154
Water and Sewer Revenue Bond Rating Guidelines
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=395918
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