Fitch Ratings takes the following actions on Puerto Rico Aqueduct and Sewer Authority, Puerto Rico (PRASA, or the authority):
--Up to $1.8 billion revenue bonds, series 2012A (senior lien), rated 'BBB';
--Up to $350 million revenue bonds, series 2012B (senior lien), rated 'BBB'.
At this time, Fitch also affirms the following rating on the authority's outstanding parity bonds:
--$1.4 billion of outstanding revenue bonds, series A and B (senior lien), at 'BBB'.
The Rating Outlook is Stable.
The bonds are secured by a gross lien of all authority revenues related to PRASA's combined water and sewer system (the system), as defined in the amended master agreement of trust agreement (MAT), senior to all other debt or expenses of PRASA. Authority revenues include operating revenues, as defined in the amended MAT (e.g. user charges and impact fees), as well as governmental funds available to pay current expenses; amounts from the Commonwealth of Puerto Rico (the commonwealth) for payment of commonwealth guaranteed indebtedness (CGI) or commonwealth supported obligations (CSO); and any amounts transferred from the budgetary reserve fund (BRF), as created in the amended and restated Fiscal Oversight Agreement (FOA) between PRASA, the commonwealth and the Government Development Bank for Puerto Rico (GDB) to the trustee. The authority revenues received from the commonwealth for CGI and CSO are not subject to lien of the MAT and are not available to pay debt service on the bonds.
Key Rating Drivers
Solid Management and Commonwealth Support: PRASA management is strong and the system also benefits significantly from the GDB advisory and interim funding support as well as financial support from the commonwealth.
Marginal Financial Results: Major improvements in operations and financial performance have occurred since the change in governance structure in 2004. However, financial margins remain deficient and there are significant revenue and expense challenges that could pressure results over the next several years.
Extensive Capital Needs: The capital improvement program (CIP) is substantial and fairly rigid over the near term. In addition, there is the possibility that significant additional capital costs could be required by regulators at some point in the future.
Weak But Extensive Service Area: The service territory is diverse, although weak economic conditions have been protracted and customer wealth levels are limited.
New Legal Structure Credit Neutral: Amendments to the MAT, including the gross revenue pledge, provide some enhancement to bondholders. However, Fitch views the overall changes as credit neutral given net financial requirements remain sum sufficient.
Essential Utility: The system provides an essential service to the residents of Puerto Rico.
What Could Trigger a Rating Action
Change in the Commonwealth Rating: Any deterioration in the commonwealth's credit quality would likely affect the rating on the bonds given the historical and expected support of the system by the commonwealth.
Inability to Eliminate Budgetary Shortfalls: Failure to identify and enact revenue and expenditure solutions to meet forecasted budgetary gaps beginning in fiscal 2014 would have negative rating implications.
Growth in Capital Costs: Acceleration or escalation of the large and complex CIP without accompanying financial improvement could add negative rating pressure.
PRASA provides water service to virtually the entire island, including the roughly 4 million residents and 5 million annual tourists; sewer service is limited to around 60% of the population. After a decade of privatization, operations were transitioned back to the public side in 2004 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 and are expected to be ongoing for the foreseeable future. Complete independence from the commonwealth is not expected for at least the near term.
Early Actions Boosted Performance
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 2011 as poor economic conditions on the island have persisted and subsequent rate hikes have not occurred.
Recent Financial Results Challenging
For fiscal 2010, net revenues based on audited figures covered senior lien ADS by a reasonable 1.6x. However, PRASA was unable to meet its obligation to pay debt service on the commonwealth-supported Superaqueduct bonds (PRASA's current fourth lien debt) in July 2009 given PRASA's depleted balance sheet position. 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 MAT. For fiscal 2010, operating revenues increased approximately 1% 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 to cut operating costs, with the aggregate result that operating expenses declined 1% even as electricity costs rose over 10%. For fiscal 2011, senior lien ADS coverage from net revenues improved to 2.5x based solely on funds from operations. But again, PRASA was reliant on the commonwealth and GDB for sufficient funding to pay subordinate debt service. In total, PRASA received $105 million from these two sources.
Increasing Budgetary Gap
Throughout the financial challenges PRASA has faced over the last several years, management has actively identified and implemented targeted revenue enhancements and expenditure reductions and continues this process with favorable results. Continuation and enhancement of these initiatives will be important to the ongoing financial health of the utility. However, even with these initiatives, management continues to forecast sizeable additional revenues that will be needed to meet all operating and increasing debt service obligations.
While the funding of the BRF will alleviate immediate cash flow pressures through fiscal 2013, PRASA is forecasting significant budget deficits beginning in fiscal 2014 that greatly exceed prior year appropriations by the commonwealth for such purposes. Fitch is concerned that these deficits would place a significant financial strain on commonwealth resources. Alternatively, if PRASA were to fund these shortfalls entirely through increased user rates, required increases would be substantial and may be difficult to fully achieve given the currently elevated utility rates and the high poverty level on the island.
Fitch has developed a stress scenario to evaluate the rate hikes necessary to recover these unidentified revenues based on a bad debt rate of 10%, forecasted operating revenues, and planned debt issuances. Based on these assumptions and no commonwealth appropriations in fiscals 2014-2016, rates would need to increase by approximately 50% for fiscal 2014 followed by smaller annual hikes in the 4%-6% range for fiscals 2015-2016, respectively, to generate the $335 million-$425 million of annual unidentified revenues projected by PRASA; it would be expected that additional rate hikes would also be necessary beyond fiscal 2016.
Fitch will closely monitor the identification and implementation of revenue sources and could take negative rating action in the future if budgetary deficits escalate and/or clear plans for the generation of such revenues is lacking. PRASA's rating would also likely be negatively affected by any deterioration in the commonwealth's credit quality as Fitch expects additional commonwealth support will be necessary over the next several years to sufficiently offset the projected revenue shortfalls.
Capital Needs Remain Sizeable
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 PRASA's management has successfully executed key components of the CIP, particularly those required by regulators, projected capital spending over the fiscal 2012-2016 CIP period remains sizeable at $1.56 billion. Spending is expected to remain elevated well beyond fiscal 2016 as PRASA carries out improvements related to its 2011-2030 master plan. Furthermore, capital costs could escalate, potentially rapidly, depending on changes to or identification of projects related to existing regulatory agreements or additional regulatory requirements imposed, particularly if PRASA is required to implement a repair plan relating to its wastewater collection system.
Rising Debt to Keep Margins Low
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 CIP progresses and place increasing pressure on the authority's already weak financial margins. Overall, PRASA expects total revenues, as well as the unidentified revenues previously mentioned, to cover all flow of fund requirements by around 1.0x-1.1x through fiscal 2016. Senior lien ADS coverage is expected to be higher (particularly given the new gross revenue pledge) but is projected to diminish over the forecast, reflecting this and other planned parity offerings. Given the rising debt burden, debt carrying costs are expected to increase from 20% of gross revenues experienced in fiscal 2009 to around 34% by fiscal 2015.
Amendments to Legal Covenants Credit Neutral
Recent amendments to the MAT which elevated the priority of payment of senior lien bonds to a gross revenue pledge, as well as amendments to the FOA that created the BRF and formalized mechanism for the commonwealth financial support, are viewed as credit positives. However, given PRASA's extensive operating and capital pressures, which are forecasted to continue generating sum-sufficient coverage of all flow of funds requirements, Fitch does not view the changes as material to enhancing overall credit quality.
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.
In addition to the sources of information identified in Fitch's U.S. Municipal Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope.
Applicable Criteria and Related Research:
--'Revenue-Supported Rating Criteria', June 20, 2011;
--'U.S. Water and Sewer Revenue Bond Rating Criteria', Aug. 10, 2011;
--'Tax-Supported Rating Criteria', Aug. 15, 2011;
--'U.S. Local Government Tax-Supported Rating Criteria', Aug. 15, 2011.
Applicable Criteria and Related Research:
Tax-Supported Rating Criteria
U.S. Local Government Tax-Supported Rating Criteria
U.S. Water and Sewer Revenue Bond Rating Criteria
Revenue-Supported Rating Criteria
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