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 September 18, 2015 - 3:02 PM EDT
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Fitch Downgrades Palo Pinto Co. Muni Water Dist No.1, TX Rev Rfdg Bnds to 'A+'; Outlook Stable

Fitch Ratings takes the following rating action on Palo Pinto County Municipal Water District No. 1, Texas (the district):

--$4.4 million revenue refunding bonds, series 2011 downgraded to 'A+' from 'AA-'.

Fitch also downgrades its implied rating on the water and sewer system of the city of Mineral Wells, Texas (the city) to 'A+' from 'AA-'.

The Rating Outlook on both is Stable.

SECURITY

The bonds are special obligations of the district and secured solely from a first lien on net revenues from the district's waterworks system. Pledged revenues specifically include payments received by the district from the city. The city's implied rating assumes a net revenue pledge of the city's water and sewer system.

KEY RATING DRIVERS

GROWING DEBT DRIVES DISTRICT DOWNGRADE: The downgrade of the district's revenue bonds is due to significant planned leveraging on the part of the district to finance the design, acquisitions and construction of a new reservoir, along with associated softening of district financial margins.

LONG-STANDING RELATIONSHIP WITH CITY: The district rating is closely linked to the credit quality of the city's water and sewer system (the system), which provides the majority (86%) of district revenues. Long-term contracts between the district and the city provide strong legal protection. The water charge from the city that covers district debt service as well as operations is treated as an O&M expense, payable prior to any of the city's water and sewer debt.

PRESSURED CITY'S FINANCES: As a result of weather-related pressures the financial profile of the city's utility system has deteriorated recently, resulting in the downgrade of the implied rating. Debt service coverage (DSC) notably weakened in fiscal 2014, dropping to just 1x on an all-in basis. Despite continued rate hikes, which included a 60% drought rate increase, mandated water restrictions resulted in reduced water demand. In the last three years the city has also experienced the loss of its largest system user and its largest taxpayer.

AGREEMENT WITH BEPC: A contractual agreement with the Brazos Electric Power Co-Operative (BEPC) is expected to provide significant support (39%) for the district's new reservoir project. Failure to extend the BEPC agreement past the current 2020 period would put significant additional pressure on the district and city to fund the construction of the reservoir and could result in further downward rating action.

EXTENSIVE CAPITAL PROJECT: The construction phase of the district's new $95 million reservoir is anticipated to begin around fiscal 2020. The reservoir is expected to provide water to the district and city sufficient to meet needs beyond 2050.

RATING SENSITIVITIES

DETERIORATION OF THE CITY OF MINERAL WELLS' FINANCIAL PROFILE: Maintenance of adequate financial operations while balancing reduced water demand and increasing contributions to Palo Pinto County Municipal Water District No. 1 (the district) for the reservoir project will be of paramount importance to maintaining the current ratings.

MANAGEMENT OF DISTRICT DEBT: Maintenance of adequate coverage levels and a manageable debt load as the district begins construction of the reservoir will be a key rating consideration. Further leveraging by the district beyond what is currently expected or erosion of financial margins beyond what is currently forecast could pressure the rating.

CREDIT PROFILE

The district owns Lake Palo Pinto (the lake) and a diversion reservoir with a combined capacity of approximately 27,500 acre-feet. The district also owns the Hilltop Water Treatment Plant, which treats all water provided to the city and has an operating capacity of 14 million gallons per day.

The city's water utility provides retail service to more than 6,200 city customer accounts and wholesale service to six rural water supply corporations serving a total population of approximately 32,000. The sewer utility provides collection, treatment, and disposal services to approximately 5,800 customers within the city limits and certain areas outside the city. The combined service area is stable, experiencing only modest growth over the last several years.

PERSISTENT DROUGHT PRESSURES

The region was severely impacted by the prolonged state drought, with Lake Palo Pinto levels dropping to less than 9% of capacity. The city consistently implemented water restrictions, enacting stage 3 restrictions (one-day-a-week watering) in December 2012, followed by stage 4 restrictions (no outdoor water) in October 2014. As a result of these measures water demand contracted sharply, dropping 15% in fiscal 2012 and 14% in fiscal 2014. Favorably, a series of heavy rain events in April and May of 2015 returned the lake to 100% capacity and the city eased water restrictions effective May 1, 2015.

WEAKENED CITY FINANCES

Reduced water demand since fiscal 2012 resulted in weakened financial metrics for the city's utility, despite rate increases to offset the revenue shortfalls. The city boosted both water and sewer rates by 6% in fiscal 2014, on top of the 4% increase adopted in fiscal 2013. To counter the severe financial impact of the drought, council adopted a 60% drought rate on water bills as of Jan. 1, 2015. In addition, in July of 2013 the state did not renew its contract with a private jail that was the system's largest user, providing approximately 17% of system revenues.

Rates for the city have historically been high. For fiscal 2014 the average residential bill (based on 5,000 gallons of usage) was $66 or 2.2% of median household income (MHI). Taking into account the drought rate, user charges climb to $90 or 3.1% of MHI, well above Fitch's 2% MHI affordability threshold. City council voted to remove the drought rate increase effective Jan. 1, 2016.

For fiscal 2014, the city's DSC dropped to just 1x on the system-supported certificates of obligation (COs), significantly weaker than the 'AA' median of 2x. Cash balances also declined but remain sound at $3.3 million or the equivalent of 172 days of cash on hand (DCOH); at this level they fall short of the 'AA' median of 442 DCOH. A credit positive is that the COs are the only system debt obligation beyond the commitment to the district, and will fully mature in February 2016.

The water charge paid by the city to the district has been increasing recently, further straining finances. The payment increased from $1.86 million in fiscal 2012 to $2.36 million by fiscal 2014. The city's contribution was reduced to just over $2 million for fiscal 2015 in response to the drought pressures. It is expected to return to $2.3 million as the district will require additional support for debt scheduled in late 2015.

DISTRICT LEVERAGING GROWS: COVERAGE SOFTENS

Total costs associated with the new reservoir total $95 million. The district issued $8 million in subordinate lien bonds and received a grant from the Texas Water Development Board (TWDB) for planning and design costs associated with the project. The district has been approved by TWDB for an additional $17 million to finance the acquisition and design phase, to be issued through the TWDB this fall.

District's financial performance has remained stable for the last three fiscal years, with DSC averaging 1.8x over that time. However, forecasts point to DSC declining to just 1.3x with the addition of the $17 million TWDB loan.

Fiscal 2014 debt per capita is very low at $275 and currently outstanding debt is fully amortized in 15 years; the district front loaded repayment of its outstanding debt to add capacity that would be needed for the new reservoir in future years. The addition of the $17 million in TWDB debt will boost debt per capita to $773, above the 'AA' median of $520.

Cost estimates associated with the final construction phase of the reservoir total $70 million. The district currently anticipates issuing the debt through the TWDB around 2020 to complete the project; this plan assumes continued participation from BEPC. The additional debt would increase debt per capita levels to a very high $2,800, 5x higher than the 'AA' median of $520.

AGREEMENT WITH BEPC CRUCIAL

The district has a contractual agreement BECP for a 39% option on water from the new reservoir, which is currently set to expire in 2020. If BECP elects not to renew the agreement, the district would need to consider alternative financing options for the construction phase of the project. District management stated they may also consider postponing the project if BECP elects not to participate.

DISTRICT RELATIONSHIP WITH CITY

The district was created in 1961 to provide a source of water supply within Palo Pinto and Parker Counties. Currently, the district provides potable water to the city and two other entities as well as lake residents. Revenues from the sale of water to the city are by far the largest source of district income, accounting for over 80% of all water revenues. The district is therefore highly dependent on the city's continued financial health to maintain its credit quality.

Pursuant to a water purchase contract and an O&M contract between the city and the district, the city operates and maintains all district facilities. In addition, the city makes equal monthly payments to the district as a water charge sufficient to pay its share of district O&M costs, the annual debt service requirements on district revenue bonds, and the annual requirements of the district's debt service reserve and contingency funds.

LIMITED, CONCENTRATED ECOMONY

Mineral Wells is the largest city and principal commercial center in Palo Pinto County and is located in the Barnett Shale, the second-largest producing on-shore natural gas field in the U.S. The economic base is dominated by oil/gas interests, with the city's top 10 taxpayers making up over 20% of the total tax base. The single-largest taxpayer is Baker Hughes Inc., an oilfield services company which makes up 4% of the 2015 assessed value and has recently closed its facilities in the city.

Population over the last decade has been flat and was estimated at about 16,900 in 2010. The city's unemployment rate for July 2015 totaled 5.2% and is on par with the nation's 5.3% but slightly higher than the state's 4.2%. Area wealth levels as measured by MHI are approximately 30% below the state and national averages.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope and the Municipal Advisory Council of Texas.

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Water and Sewer Revenue Bond Rating Criteria (pub. 03 Sep 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869223

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=991017

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=991017

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Fitch Ratings
Primary Analyst
Primary Analyst
Teri Wenck, CPA
Associate Director
+1-512-215-3742
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Gabriela Gutierrez, CPA
Director
+1-512-215-3742
or
Committee Chairperson
Steve Murray
Senior Director
+1-512-215-3729
or
Media Relations:
Sandro Scenga, +1 212-908-0278
sandro.scenga@fitchratings.com


Source: Business Wire (September 18, 2015 - 3:02 PM EDT)

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