SAN FRANCISCO--()--Fitch Ratings downgrades the following rating of Lomita, CA (the city):
--$7.275 million water revenue bonds, series 2008 to 'A' from 'A+'.
The bonds are placed on Rating Watch Negative.
The bonds are secured by net revenues of the water system.
DELAYED PRODUCTION; LOWER COVERAGE: The downgrade reflects primarily a delay of more than two years in the production of local water due to water quality issues. The delay resulted in increased water purchasing costs and lower debt service coverage levels, which fell to less than 1.0x in fiscal 2012.
MANAGEMENT DELAY OF RATE STUDY: The rating action also factors in a delay in consideration of a rate study from 2010 to 2012, during which cost escalation exceeded revenues. Although rate hikes have recently been adopted, they were delayed at the expense of deterioration in finances.
LOWER LIQUIDITY: Cash balances have fallen over the past several years, further limiting financial flexibility.
RELIANCE ON IMPORTED WATER: The city is 100% reliant upon costly water from Metropolitan Water District of Southern California (MWD; water revenue bonds rated 'AA+' by Fitch), the cost of which has increased nearly 70% per acre-foot since 2009.
MODERATE DEBT; CAPITAL NEEDS REMAIN: The system has moderate debt per customer but extremely slow amortization and sizable remaining capital needs due to its old distribution system.
PRESSURED RATE BASE: The recently implemented five-year rate package should improve revenues to match expenditures and provide adequate debt service coverage, but it will increase rates that are already above Fitch's affordability threshold.
WHAT COULD TRIGGER A RATING ACTION
CONTINUED WATER PRODUCTION DELAY: Continued delay in the production of local water - resulting in greater than anticipated purchased water costs and lower coverage levels - could result in further negative rating action.
The city is a bedroom community located about 20 miles south of Los Angeles. The system serves a population of approximately 21,000 through 4,200 connections.
DELAYED LOCAL WATER PRODUCTION
Local water production, which was expected to begin in 2010, was delayed more than two years, resulting in higher than anticipated purchased water costs in fiscals 2011 and 2012. Series 2008 bond proceeds were used to rehabilitate one of the city's wells to provide a local groundwater source in order to reduce imported water costs. However, the well was taken off-line shortly after it began distributing water in summer of 2010 due to complaints from the community about odor, taste, and hardness.
The city subsequently replaced various water lines and added a dedicated blending pipe. According to management, the city spent about $134,000 to correct the problems. Results of testing in fall 2012 showed the well water meeting all state water quality requirements, and blind taste tests by residents were positive. The city plans to begin distribution of well water blended with MWD water by February 2013, and expects to save $300,000-$400,000 annually once the blending commences.
LOWER DEBT SERVICE COVERAGE
Debt service coverage fell from 1.4x in fiscal 2010 to 1.3x in fiscal 2011 and 0.87x in fiscal 2012. The decline was due to the higher than anticipated water purchases and the delay in increasing user rates. Due to regional supply issues, lower sales and increasing water costs across the state, water costs from MWD via West Basin Municipal Water District increased 68% to $1,024 per acre-foot from 2009 to 2013.
Projections estimate coverage ranging from 1.3x to 3.0x from fiscal year 2013 through 2015 as the rate increases are implemented. However, any delays in distribution of the blended water would increase costs and likely pressure coverage.
Fitch views some of the forecast assumptions as reasonable; they include 0.25% annual customer growth rate and 3% annual increases in operating expenses (excluding personnel costs, which are expected to increase 2% annually). However, the forecast includes imported water cost increases of only 2% per year - versus 14% average annual increases over the past five years. This concern is potentially mitigated given the city's ability to pass through MWD increases through its rate structure.
LOWER LIQUIDITY LEVELS
Liquidity has declined over the past several years from a combination of increased outlays for imported water and capital spending. At fiscal 2012 year-end available cash totaled $922,000, or roughly 78 days of operations (as compared to 102 days in fiscal 2009). The system also had $3.5 million in restricted capital funds at year-end fiscal 2012.
RECENT INCREASES PUSH RATES HIGHER
The city demonstrated its willingness to raise rates, albeit after its expenditure increases, by passing a five-year rate package for fiscal 2013 through 2017. The residential water rates consist of a bi-monthly meter charge and a tiered volumetric charge. The council last adopted a five-year rate structure that increased rates through fiscal 2010. In 2010, the City Council suspended consideration of a water-rate study until 2012.
The five-year rate structure passed by Council in 2012 includes a 15% increase in fiscal 2013, followed by 7% annual increases in 2014 and 2015, and 6% annual increases in 2016 and 2017. Rates, which are already above Fitch's affordability threshold, will be pressured even further with the increases. However, they are currently lower than several comparison cities, including Manhattan Beach, Palos Verdes, and Gardena.
MODERATE DEBT; CONTINUED NEEDS
Debt per customer of $1,830 is average but debt amortization is very slow with only 44% of principal paid out in 20 years. Free cash to depreciation is -14%, indicating the system is not generating sufficient cash to fund reinvestment. The city has additional capital needs, as the majority of the system's pipelines are more than 50 years old and in need of repair and replacement. It plans to spend $3 million over the next five years on these projects from current resources and does not anticipate additional debt in the near term.
STABLE SERVICE AREA
County population growth has been less than 1% per year in the five years ending 2012. County-wide unemployment of 10.3% as of October 2012 is higher than state and national averages. City wealth indicators are on par with state and national averages. As the city is primarily residential, customer concentration is low with the top 10 generating about 6% of revenues.
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 Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope.
Applicable Criteria and Related Research:
--'Revenue-Supported Rating Criteria' (June 12, 2012);
--'U.S. Water and Sewer Revenue Bond Rating Criteria' (Aug. 3, 2012);
--'2013 Water and Sewer Medians' (Dec. 5, 2012);
--'2013 Outlook: Water and Sewer' (Dec. 5, 2012).
Applicable Criteria and Related Research:
2013 Outlook: Water and Sewer Sector
2012 Water and Sewer Medians
U.S. Water and Sewer Revenue Bond Rating Criteria
Revenue-Supported Rating Criteria