Fitch Rates San Diego County Water Authority, CA's Water Rev Bonds 'AA+'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings assigns its 'AA+' rating to the following bonds issued by the San Diego County Water Authority, CA (the authority):

--Approximately $285 million water revenue refunding bonds, series 2013A.

Proceeds of the series 2013A bonds will refund outstanding fixed-rate bonds for savings and pay costs of issuance. The 2013A bonds will not have debt service reserve funds; released debt service reserve funds from the refunded bonds will be used to reduce the par amount of the refunding bonds. Savings provided by the refunding will be level over the remaining life of the bonds. Bonds are expected to price on Feb. 12, 2013.

In addition, Fitch affirms the following outstanding ratings:

--$1.07 billion outstanding water revenue certificates of participation (COPs), series 1998A, 2002A, 2004A, 2005A, and 2008A at 'AA+';

--$624.63 million water revenue bonds, series 2010A and series 2010B (taxable) issued by the San Diego County Water Authority Financing Agency on behalf of the authority at 'AA+';

--$234.5 million water revenue bonds, series 2011A and 2011B at 'AA+';

--$86.6 million subordinate lien water revenue refunding bonds, series 2011S-1 at 'AA'.

The Rating Outlook on all bonds is Stable.

SECURITY

San Diego County Water Authority's COPs and revenue bonds, as well as the revenue bonds issued by the San Diego County Water Authority Financing Agency, all have a parity lien on net revenues of the San Diego County Water Authority. The subordinate lien 2011S-1 bonds and the authority's commercial paper program have a subordinate lien on net revenues.

SENSITIVITY/RATING DRIVERS

STABLE FINANCIAL PERFORMANCE: The financial performance of the authority has remained stable even with the significant declines in water sales experienced in previous years. Financial margins are expected to decline in fiscal 2013 with increased debt service costs but should remain adequate.

BROAD SERVICE AREA: The authority provides wholesale water service to 24 member agencies across a large and diverse service area in San Diego County.

WATER SUPPLY DIVERSITY: Water supplies have been diversified as a result of significant capital investments made in the last decade. Water purchases from the development of the Carlsbad Project, a 50 million gallon a day desalination project, should continue to provide further supply diversity.

MEMBER SUPPORT FOR RATES: Fitch anticipates that continued member support for costs associated with supply diversification, including the Carlsbad Project, will facilitate rate increases to preserve financial margins at consistent levels.

RATE STRUCTURE STABILITY: The structure of the authority's revenues, with a high use of fixed charges, has provided stability through a period of significant water sales declines.

PRUDENT FINANCIAL MANAGEMENT: The authority adheres to prudent financial management practices and engages in comprehensive long-term planning aimed at securing a diverse and reliable future water supply.

HIGH DEBT: Capital spending has been substantial in recent years, primarily funded by debt. As a result, the authority's debt levels are high and amortization slow.

WHAT COULD TRIGGER A RATING ACTION

RATE PRESSURE: The authority's ability to continue to achieve timely cost recovery through rates is key to the rating. Fitch views community rate support as favorable for the authority's strategic direction but rate fatigue, given the pace of rate increases to date, could lower financial margins as costs continue to increase, which would put pressure on the rating.

CREDIT PROFILE

SDCWA imports around 70% of the region's water supply annually on behalf of its 24 member agencies, which provide water to a population of over three million residents across the county. Water sales declined 24% from 2007 through 2011, consistent with other regional utilities. Reductions in 2008 and 2009 were the result of drought conditions, mandated reductions from Metropolitan Water District (MWD), and local investments in conservation and efficiency.

Low sales in 2010 and 2011 were attributed to abundant rainfall and continued low economic conditions. However, the authority adjusted its estimates and rate accordingly and began to plan for low sales or 'the new normal'. Actual sales in 2011 exceeded budget estimates and sales in 2012 rebounded by 5%, exceeding estimated sales once again. The authority continues to plan conservatively for future sales.

METROPOLITAN WATER DISTRICT AND SUPPLY DIVERSIFICATION

A major portion of the district's water supply is provided by the Metropolitan Water District of Southern California (MWD), the regional wholesale provider of imported water to communities that do not have sufficient local water resources, such as the district. The authority is the largest purchaser from MWD and expects to remain so, although it has worked to diversify its supply.

Metropolitan's supplies are provided by the State Water Project (SWP) and Colorado River. Both sources have been under pressure from drought conditions and regulatory changes resulting in lower water availability over the past decade. These pressures are expected to continue. The cost of MWD supplies has been increasing. Overall, MWD has raised its rates 75% on a cumulative basis over the last six years.

The purchase contract with MWD does not require a minimum amount or a fixed payment, so the authority is able to reduce its purchases in response to lower sales, which was advantageous during the years of declining sales since the district was able to offset the revenue loss with lower purchased water costs.

Following significant investments after California's drought in the early 1990's, the authority reduced its water supply from MWD at 95% of its supply in 1991 to 44% in 2012. Other supplies include purchases from Imperial Irrigation District (27%), conservation (11%), surface water (11%), groundwater (4%), and recycled water (3%).

CARLSBAD DESALINATION PROJECT

The authority signed a 30-year water purchase agreement with Poseidon Resources in December 2012. The contract represents an effort to further diversify supply and develop water supplies that are drought-tolerant, locally generated, and do not rely on State Water Project or Colorado River hydrology. The agreement obligates the authority to purchase water from the Carlsbad Seawater Desalination Project once construction is complete at a fixed cost. If construction is complete and the plant produces quality drinking water, the authority is required to purchase the minimum output of 48,000 acre-feet, which would provide around 8% of the Authority's water supply. The authority may purchase any water generated above the 48,000 af minimum at its discretion.

The cost of the project water, estimated at around $2,000 per af, is significantly higher than water purchases from MWD, with current Tier 1 treated water rates of $847 per af. The authority views the regulatory and hydrological uncertainty of imported supply as providing a high risk to its customers. It has pursued a strategic direction to develop alternative supplies, even at higher costs, because of the reliability value it feels is provided by those premium sources.

The authority's strategic direction is set by its 36 member Board of Directors, made up of its 24 member agencies, who have supported the rate impacts to fund the water supply diversification strategy. The authority has indicated to its member agencies that a rate increase of 11% is anticipated to be necessary to fund the incrementally higher cost of the Carlsbad project once it comes on line, which is expected to occur in 2016.

The authority is only required to pay for the water and related pipeline delivery costs once water deliveries occur. Therefore, the authority is not at risk of construction delays or technology failures. It could continue to purchase water from MWD. The fixed price contract does include price escalation, power cost risk, and potential cost risk related to regulatory changes.

WATER RATE INCREASES

The authority has implemented sizable rate increases in response to the anticipated lower water sales and increasing water supply and debt service related costs. Rates were increased 11.3% in calendar year 2011 and 18.1% for calendar year 2010. More recent increases have been slightly lower at 7.7% in calendar year 2012 and 9.7% in calendar 2013. Additional rate increases are anticipated and will be needed to preserve financial margins.

Fitch views rate flexibility as good, despite the cost escalation in recent years, based on strong member support for the strategic direction. The reliance on fixed charges is also viewed favorably from a credit perspective. In an era of increased conservation, the authority's rate structure provides a higher degree of revenue stability than a more volumetric rate structure used by many water agencies. The authority's fixed charges collect 75-80% of its fixed expenditures. Discussions are ongoing about how desalination costs will be recovered in the rate structure, which could impact this percentage of fixed cost recovery.

The authority has ongoing litigation with MWD regarding MWD's rate structure. The authority alleges that MWD's transportation rates are too high and reflect water supply costs, which results in overcharging to the authority. The authority continues to pay the disputed rates while the litigation proceeds and it has not assumed any change in rates of settlement proceeds in its financial planning and own rate setting. Although it is not uncommon to have rate disputes at wholesale entities with so many members, Fitch views the increasing tension between the authority and MWD as a potential credit concern.

FINANCIAL MARGINS STABLE; SOME DECLINE IN 2013

SDCWA's financial performance declined in fiscals 2010-2011 as a result of lower sales and increasing costs. However, management protected financial margins with reduced water purchases, lower operating expenditures including staff reductions, and the deferral of non-essential capital spending. Management continued annual rate increases to its member agencies to reflect the cost increases.

Financial performance in fiscal 2012 improved from prior years with SDCWA posting senior lien annual debt service (ADS) coverage as calculated by Fitch of 1.65 times (x) and all-in ADS coverage of 1.54x. Fitch's calculations include the authority's share of the county's 1% property tax receipts as revenues, along with the authority's fixed charges received through the infrastructure access charge and water standby availability charge. System capacity charges to new members are also included as revenues, although these have been much lower in recent years. ADS includes subordinate payments related to the commercial paper and interest on the series 2011S notes that have a bullet maturity due in 2016.

Fitch's expectations for fiscal 2013 are weaker, reflecting the 28% increase in total debt service costs related to full payment of the 2010 debt service (capitalized interest was used in the past two years to cover a portion of the 2010 bond debt service). Even with assumed additional revenues related to the 9.7% rate increase mid-year fiscal 2013 and modest growth in water sales of 2.8%, revenue bond coverage is projected to decline to 1.36x and ADS to 1.24x.

RECOVERY TO FINANCIAL POLICY OF 1.5x COVERAGE BY 2014

Management's projections indicate gradual recovery to its target of 1.5x debt service coverage of revenue bonds by fiscal 2014, with what Fitch views as appropriately conservative projections for water sales recovery. Rates to SDCWA's 24 member agencies are expected to continue to increase annually as a result of cost increases from MWD and capital costs associated with SDCWA's own CIP and could ultimately become an affordability issue. However, Fitch expects that timely cost recovery will allow SDCWA to resume compliance with its financial policies over the near term and that price pressures will be relatively similar for other regional providers.

Liquidity is healthy with operating reserves and rate stabilization funds providing $118 million, or 124 days cash at the end of fiscal 2012. This level of reserves is considered adequate for the authority's wholesale agency risk profile.

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);

--'California Water Agencies: Weathering Recent Storms But Clouds Remain on Horizon' (June 7, 2012).

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=681015

U.S. Water and Sewer Revenue Bond Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684901

California Water Agencies

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=680815

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