Fitch Affirms Modesto, CA Wastewater Revs at 'AA-'; Outlook Stable

AUSTIN--(BUSINESS WIRE)-- Fitch Ratings affirms the following bonds issued by the City of Modesto, California (the city):

--$40.43 million wastewater revenue bonds, series 2005A and 2006A, at 'AA-'.

The Rating Outlook is Stable.

SECURITY

The bonds are payable from net revenues of the city's wastewater enterprise system (the system).

KEY RATING DRIVERS

FINANCIAL MARGIN DECLINE EXPECTED: Financial performance is currently very strong as a result of rate increases in advance of known cost increases. Higher operating and capital costs related to the upgraded wastewater treatment plant are expected to result in more modest coverage and cash levels by fiscal 2017.

TREATMENT PLANT CONSTRUCTION ON TIME: The system is required to upgrade its treatment process to year-round tertiary treatment. Construction of upgrades to the treatment plant is on schedule and the city expects to meet the required date of the improvements by its discharge permit in 2016.

INCREASING OPERATING AND CAPITAL COSTS: The city used a low-interest state revolving fund loan to fund construction at the treatment plant. The $125 million loan is on parity with outstanding revenue bonds. Repayment will begin in 2017 and operating costs will increase in fiscal 2016.

RATE ADJUSTMENTS ADOPTED: Rate increases have already been adopted through fiscal 2018, providing funding for the plant upgrade. Rates will remain comparable with the region.

CUSTOMER CONCENTRATION EXISTS: The customer base is concentrated with the top 10 providing 27% of revenues. The customer base has experienced decreased industrial flows due to closures and downsizing since 2008.

CONSTRAINED ECONOMY IN SERVICE AREA: The city's economy continues to demonstrate growing tax revenues and new development. However, it remains somewhat constrained by the agriculture-dominated regional economy and above-average unemployment rate.

RATING SENSITIVITIES

LOWER FINANCIAL MARGINS: Debt service coverage levels are expected to decline in fiscal 2017 with the first year of repayment on the state revolving fund (SRF) loan (parity lien with bonds on net revenues). However, coverage levels are expected to remain healthy. If financial margins slipped to more modest levels, rating pressure could occur.

CREDIT PROFILE

The city of Modesto is located approximately 90 miles east of San Francisco in California's central valley. The city's wastewater system serves approximately 62,000 customers, primarily within the cities of Modesto and Ceres. Customer growth has been flat. The local economy is based on agriculture. As a result, the system has a sizable industrial load (30% of revenues), particularly resulting from the large food processing presence in the service territory. Customer concentration is a concern, with the 10 largest customers accounting for 27% of revenues.

NEARING THE END OF LARGE CAPITAL INVESTMENT CYCLE

The city is in the final phase of major capital investment in its treatment facilities to comply with a regulatory mandate to move to year-round tertiary treatment standards by 2016. The city has completed facilities to date that are providing tertiary treatment to flows in the summer months. Upgrades to the treatment plant will allow for year-round tertiary treatment and comply with stricter ammonia limits, are scheduled to be completed in the summer of 2015. The cost of the system upgrade is approximately $125 million. The project is being funded with a SRF loan on parity with the city's wastewater revenue bonds.

Remaining projects in the capital improvement plan (CIP) total $88.6 million over the next five years and include expansion of main lines, pump stations, and the transportation main between the city's two treatment facilities. The capital plan is currently projected to be funded entirely from surplus revenues. However, the city is in the process of updated its Wastewater System Master Plan, which could generate additional capital needs or some level of debt funding.

CONSISTENT ANNUAL RATE INCREASES

The city has been proactive in their efforts to increase rates in advance of large needed capital spending in order to phase in the additional revenues. Beginning with 30% annual rate increases implemented in fiscal years 2008 and 2009, the city has adopted more modest single digit rate increases in every year since with the exception of 2010. Rate increases of 3%-5% are approved through fiscal 2018 in order to prepare for the hefty increase in operating and debt service.

The monthly residential combined water and wastewater bill is currently moderate at approximately $77, or 2% of median household income. This bill is comparable for the region. Rate flexibility could become a concern, given the service area's high unemployment (10.9% in January 2015). However, Fitch views the approval by city council of consistent annual rate increases as evidence of a strong commitment to fund the needed capital and maintain financial metrics sufficient for the rating.

STRONG FINANCIAL METRICS; DECLINES EXPECTED FISCAL 2017

Financial performance is strong. Debt service coverage has been over 5.0x during the past five years. Management's financial forecast projects debt service coverage will remain at these high levels through fiscal 2016. In fiscal 2017, debt service triples to approximately $12.2 million with the amortization of the $125 million 20 year loan from the SRF. In addition, estimated additional operating costs of year-round tertiary treatment at the plant are another $6 million, beginning in fiscal 2016.

The rate increases adopted to date have positioned the system to continue to provide healthy debt service coverage in fiscal 2017 and beyond. Management's financial forecast through shows coverage declining in fiscal 2017 to 1.4x.

Debt levels more than doubled with the $125 million loan. Debt levels remain comparable within the region, where similar regulatory needs are pressuring the debt levels of surrounding utilities as well.

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.

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. 31 Jul 2013)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715275

Additional Disclosures

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=985770

Endorsement Policy

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

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View source version on businesswire.com: http://www.businesswire.com/news/home/20150602007011/en/

Fitch Ratings
Primary Analyst
Kathy Masterson, +1-512-215-3730
Senior Director
Fitch Ratings, Inc.
111 Congress Avenue, Suite 2010
Austin, TX 78701
or
Secondary Analyst
Yueping Liu, +1-415-732-5629
Associate Director
or
Committee Chairperson
Douglas Scott, +1-512-215-3725
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
[email protected]
Sandro Scenga, +1-212-908-0278
[email protected]

Source: Fitch Ratings

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