Fitch Upgrades Great Lakes Water Authority, MI's Water and Sewer Revs; Outlook Stable
--Approximately $132 million sewage disposal system revenue refunding senior lien bonds, series 2016B 'A';
--Approximately $296 million sewage disposal system revenue refunding second lien bonds, series 2016C 'A-';
--Approximately $87 million water supply system revenue senior lien bonds, series 2016A 'A';
--Approximately $162 million water supply system revenue second lien bonds, series 2016B 'A-';
--Approximately $470 million water supply system revenue refunding senior lien bonds, series 2016C 'A';
--Approximately $202 million water supply system revenue refunding second lien bonds, series 2016D 'A-'.
The bonds are scheduled to price the week of Oct. 10 via negotiated sale. Proceeds will be used to refund certain GLWA sewer system and water system (the systems) debt for interest savings, fund certain water system capital expenditures, and pay costs of issuance.
In addition, Fitch also upgrades the following GLWA bonds previously issued by the city of Detroit (the city) and the Michigan Finance Authority, MI on behalf of the Detroit Water and Sewerage Department (DWSD) and assumed by GLWA:
--$1.9 billion in senior lien sewer revenue bonds to 'A' from 'BBB';
--$902 million in second lien sewer revenue bonds to 'A-' from 'BBB-';
--$1.6 billion in senior lien water revenue bonds to 'A' from 'BBB';
--$608 million in second lien water revenue bonds to 'A-' from 'BBB-'.
The Rating Outlook is Stable.
SECURITY
Senior lien water and sewer bonds are separately secured by a first lien on net revenues of each respective system. Second lien bonds are separately secured by a second lien on the net revenues of each respective system after payment of senior lien bonds.
KEY RATING DRIVERS
UPGRADE ON IMPROVED FUNDAMENTALS: The rating upgrade reflects improved operating fundamentals, including enhanced revenues and reduced operating costs, that generated audited 2015 and unaudited 2016 results that were stronger than expected. The higher rating and Stable Outlook further reflect Fitch's expectation that the authority's improved debt service coverage and liquidity will be sustained through the forecast period (2017-2021).
ENHANCED REVENUE AND LIQUIDITY: Changes in rate setting practices as well as accumulation of reserves under the master bond ordinances should enhance prospects for achieving forecast expectations and also help to adequately insulate GLWA from high city retail delinquencies.
LEASE REINFORCES SEPARATE OPERATIONS: All system funds and accounts are separate and distinct from other city funds including the city's general fund. The lease of the systems by GLWA provides further assurance that system operations will remain independent of the city.
HIGHLY LEVERAGED DEBT PROFILE: The systems' debt load is expected to remain elevated for the foreseeable future as a result of legacy issuances and ongoing borrowings. Over the longer term, it is envisioned that a greater use of pay-go capital funding will prevail and alleviate debt pressures to some degree.
EXPANSIVE SERVICE TERRITORY: The systems provide essential services to a broad area. The water system covers almost 40% of Michigan's population, with over 75% of operating revenues coming from wealthier suburban customers. The sewer system includes around 30% of Michigan's population, with over 50% of operating revenues coming from suburban customers.
STRONG RATE-ADJUSTMENT HISTORY: The governing bodies have instituted virtually annual rate hikes in support of financial and capital needs. Continued annual adjustments are included in the forecast and will be needed to meet rising debt service obligations and sustain financial performance.
RATING SENSITIVITIES
SUSTAINED FINANCIAL AND OPERATING GAINS: The Great Lakes Water Authority's failure to sustain the improved operational and financial performance of its water and sewer utilities due to substandard rate setting practices or higher than expected operating costs could lead to downward rating pressure. Alternatively, further operating enhancements, improved liquidity and moderating leverage could lead to further upward rating movement over time.
CHANGES TO DEBT PROFILE: Increases in debt issuance levels due to revisions in the capital plan or reductions in operating cash flow would be viewed unfavorably given the already high leverage of both systems.
CREDIT PROFILE
The newly-created GLWA entered into 40-year leases of DWSD's respective water and sewer systems (except for the local city infrastructure) as well as a water and sewer services agreement (combined the lease agreements) with the city in June 2015. The lease agreements became effective on Jan. 1, 2016 at which point GLWA assumed operational control of all leased assets of the respective regional water and sewer systems and also conveyed an interest in all revenues of both the water and sewer systems (including both the regional and local city retail systems). At the same time, GLWA assumed all liabilities of the respective water and sewer systems, including all outstanding indebtedness of the city related to the respective systems.
DWSD continues to own and operate the city retail water and sewer systems and also serves as GLWA's agent with regards to rate setting, billing and collection of city retail accounts, although GLWA can terminate DWSD's agent responsibilities in the event of nonperformance by DWSD. Fitch believes the leases and supporting documents effectively codify the legal separation between the systems and the city and insulate the systems from being included in any future city bankruptcy proceedings, if one were to occur.
Key terms of the agreements, which are embedded in GLWA's financial projections, include a $50 million annual lease payment to the city, although such monies may only be used at the city's option to fund pay-go capital improvements related to the city's local water and sewer systems or DWSD-related debt service associated with the local systems and/or GLWA regional systems. A $4.5 million assistance program is also being funded and replenished annually as part of GLWA's budget for low-income customers throughout GLWA's service territory. In addition, a budget stabilization fund is being funded from city retail customers (initially over a three-year period) to ensure monies are available to meet the city's portion of GLWA's annual revenue requirement. Deposits required to fund the lease payment and other created accounts like the assistance account occur subsequent to payment of debt service, although these are added costs that ratepayers must absorb.
STRONGER FINANCIALS ON IMPROVING OPERATIONS
Audited fiscal 2015 financial results yielded total debt service coverage (DSC) for the water system of just under 1.3x (as adjusted by Fitch to include non-operating pension and city B/C pension notes) and strong liquidity of 266 days cash, ahead of previous forecasts despite an 8% reduction in water sales during the year from an extremely wet spring/summer. For the same period, total sewer DSC was also just under 1.3x and liquidity improved to a robust 369 days cash from 206 days in fiscal 2014.
Preliminary fiscal 2016 financial results point to continued solid performance, with total DSC (as adjusted by Fitch to include non-operating pension and city B/C pension notes) for water of 1.3x and sewer of 1.2x, both slightly ahead of prior forecasts. Projections for fiscals 2017-2021 appear reasonable and point to maintenance or slight improvement in total DSC. Liquidity levels should also increase through the forecast period based on required deposits under the master bond ordinances. GLWA's recent actual results, coupled with expectations of future performance are supportive of the 'A' category system ratings.
Financial results have stabilized and improved over the last few years from previously poor levels, including years where total DSC for both systems was below 1.0x. Gains in financial results are attributable to GLWA's and DWSD's efforts both to enhance revenues and cut operating costs. On the revenue front, GLWA adopted changes with its suburban water customers beginning in fiscal 2016 to revise purchase estimates and shift to an increasing amount of fixed monthly charge recovery (60% versus 40% the prior year). These changes are similar to the implementation of a rate simplification initiative for suburban sewer customers effective for fiscal 2015 that identifies each customer's proportionate costs based on historical average shares, with such shares billed monthly and locked in for three years before being subject to recalculation.
DWSD also has been working extensively to reduce retail delinquencies through outreach and aggressively pursuing shut-offs, which has strengthened the level of revenues flowing into GLWA. While retail delinquencies remain elevated for the industry (14% excluding customers not on payment plans), DWSD's budgeting of 90% collections and GLWA's accumulation of reserves equal to 40% of city retail bad debts in the budget stabilization fund adequately mitigates GLWA's exposure to delinquent city customers.
On the expense front, management continues to implement its organizational optimization, which has entailed cutting the number of job classifications in recent years and reducing the organization's workforce by nearly 40% from 2011 to 2015 as well as leading to increased automation, with some additional gains possible in the future. As a result, operating expenses have trended downward over the last several years, although the systems face cost escalation over the next several years (through fiscal 2023) in light of $409 million in total costs associated with GLWA's and DWSD's share of the city's prior general retirement system liability negotiated as part of the city's bankruptcy process.
SYSTEM LEVERAGE REMAINS HIGH
Fitch expects leverage for both systems to remain high for the foreseeable future. GLWA's system long-term debt per capita totaled a high $1,272 for sewer and moderately high $667 for water for fiscal 2015. For the same period, debt to net plant assets was also elevated for both systems at 129% and 123% for water and sewer, respectively. Principal payout is relatively typical for sector credits at around 80% over 20 years for both water and sewer.
The consolidated GLWA regional and DWSD local 2017-2021 capital improvement plans (CIPs) total $979 million for water and $779 million for sewer. While GLWA's CIPs for the regional water and sewer systems total just $752 million and $657 million, respectively, GLWA revenues fund the DWSD CIPs through the lease payments and debt issued for the local projects so the consolidated CIPs are factored into Fitch's analysis. Funding for the consolidated CIPs is expected to be provided from around 50% debt financing and 50% pay-go.
Projected capital costs have risen following recent completion of the updated water master plan in 2015, the first since 2004. One major consideration of the update was to evaluate the feasibility of reducing or repurposing certain water treatment plants as well as distribution mains in order to more actively match asset capacity to needs over the next 20 years. The updated master plan results in significant near-term investment but these costs are expected to moderate over time.
Additional costs of $71 million are also preliminarily programmed into GLWA's sewer CIP in fiscal 2021 related to possible costs arising from an update to the wastewater master plan, expected to be completed in the 2018-2019 timeframe. Further costs may be identified once the plan is completed. These additional water and sewer capital costs are factored into GLWA's projections.
BROAD SERVICE AREA ENHANCES SYSTEM STABILITY
The water system is a regional provider serving around 3.8 million people or almost 40% of Michigan's population, including the city's population of around 680,000. The system serves the city via DWSD on a retail basis and 127 communities through 87 wholesale contracts. The service territory consists of 138 square miles in Detroit and 981 square miles in eight counties.
The sewer system is a regional provider serving around 2.8 million people or around 30% of Michigan's population, including the city. The system serves the city via DWSD on a retail basis and 76 communities through 18 wholesale contracts. The service territory consists of 138 square miles in Detroit and 850 square miles in three counties.
Population and customer growth for both systems have experienced modest annual declines for a number of years. Detroit's population in particular has experienced continuous decline, but suburban areas have picked up most of the migration. Wealth levels in the city are low while poverty and unemployment levels are high, although figures for the metropolitan area overall, which includes the city as well as the suburban customers, are generally in line with state and national averages.
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