Fitch Affirms Memphis, TN's Sanitary Sewer Revs at 'AA-'; Outlook Stable

Fitch Ratings affirms the following ratings for Memphis, TN (the city):

--Approximately $100 million sanitary sewer system revenue bonds at 'AA-'.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a senior lien pledge of the net revenues of the city's sanitary sewerage system (the system), including system development charges.

KEY RATING DRIVERS

VOLATILE FINANCIAL PERFORMANCE: Financial results have significantly improved as result of the large rate increase implemented in fiscal 2011. However, Fitch expects finances to continue to remain volatile, with periods of declining and weak results followed by large rate increases.

LONG-TERM CAPITAL NEEDS: The system's significant historical deferred maintenance has led to large and continuing capital needs. Capital investment primarily related to sanitary sewer overflows (SSO), a result of a consent decree, and system renewal and replacement will be funded by state revolving fund (SRF) loans and pay-as-you-go resources.

RISING, AFFORDABLE DEBT BURDEN: Fitch projects the debt burden will rise but remain manageable with over the next five years. Strong financial margins and affordable rates provide flexibility, potentially limiting the amount and trajectory of long-term debt issuances.

LARGE INDUSTRIAL CUSTOMER PRESENCE: The customer base is concentrated with the 15 largest industrial users accounting for 31% of total revenues. While Cargill, Inc.'s announcement to close its Memphis operations will result in the system's loss of its second leading sewer customer by revenues, Fitch projects the impact on financial performance to be manageable.

BROAD REGIONAL ECONOMY: The city's role as the employment center for a three-state, four-county metropolitan statistical area remains a stabilizing credit factor. The economy is broad and diverse with employment spanning the distribution, warehousing, health care, higher education, government, and tourism sectors. The city's unemployment rate remains elevated and wealth indicators are low.

RATING SENSITIVITIES

RATING STABILITY EXPECTED: The rating is sensitive to shifts in various credit fundamentals including financial performance, customer and employment base characteristics, debt levels and long-term capital needs. The Stable Outlook assumes such shifts are unlikely over the next several years.

CREDIT PROFILE

LARGE CUSTOMER BASE WITH INDUSTRIAL CONCENTRATION

The city of Memphis (GO bonds rated 'AA-' by Fitch) owns and operates the system, providing sanitary sewer collection, treatment, and disposal services to a large customer base of approximately 262,000 retail accounts. The service area is large, covering 442 square miles in total, and includes the city, as well as a portion of the surrounding suburban communities of Shelby County (GO bonds rated 'AA+'). The total population served is estimated to be 900,000, and it remains stable.

The customer base, while large, is somewhat concentrated with the top 15 industrial customers comprising approximately 31% of total system revenues, with the leading five comprising about 20%. Cargill Inc., a large multinational food and agricultural production company and the second largest system customer, recently announced plans to close its corn milling facility in the city over the next several months. Cargill's departure means a loss of approximately 400 jobs and nearly $6 million in annual revenues to the sewer system (5% of total revenues).

The expected revenue loss is notable but not projected to significantly impact financial performance given the sizable cash flows and debt service coverage (DSC), and strong system liquidity. The customer base is stable and the city reports no other material changes in its largest customers, many of which are related to the food processing and production industry.

LARGE RATE INCREASE REVERSES WEAK FINANCIAL PERFORMANCE

The system reversed a trend of weak financial performance with a large rate increase adopted for fiscal 2011. The increase nearly doubled operating revenues in fiscal 2011 over the prior year and led to a strengthening of the system's well below average DSC of 1.4x in fiscal 2010, and poor liquidity (72 days cash on hand in fiscal 2010).

The system ended fiscal 2011 with roughly $62 million in net revenues (after paying operating expenses), producing very healthy 3.6x. Along with the fixed costs associated with debt, the system transfers millions annually to the city's general fund (GF) in the form of PILOT and return-on-equity payments. The transfers have been steady at about $6 million annually. Including these additional fixed costs, total coverage has been 3.2x or greater since fiscal 2011.

The generation of sizable excess revenues over the past three years has allowed the system to re-establish a strong cash position. At fiscal end 2013, the system's $61 million in available resources, which includes unrestricted cash and investments and renewal and replacement funds, provided over 560 days cash on hand. Fitch projects the currently high cash balances will decline based on the system's large capital program, roughly 40% of which is anticipated to be funded from existing cash and excess annual cash flows.

Estimated financial results for fiscal 2014 are similar to results for fiscal 2013, with DSC topping 3.4x all-in net of transfers. Cash is also expected to improve in fiscal 2014, although going forward Fitch expects liquidity will decline with roughly 40% of the system's capital plan funded from pay-as-you-go resources, including available cash balances. Financial projections were not available as the city is currently undergoing a formal rate study for the system.

The fiscal 2015 budget includes a slight decline in operating revenues due to a 2013 city council approved change in the rate structure lowering the maximum bill during the summer months to $35 (from $50). The pending loss of revenues related to Cargill's departure is not included as the budget was passed prior to Cargill's announcement. If included, DSC would still be solid at 2.4x on an all-in basis, and 2.0x net of transfers (note, capital depreciation and amortization expense is assumed to be $0).

RATES REMAIN AFFORDABLE, RATE FLEXIBILITY LIKELY LIMITED

The city has independent rate setting authority, although rate setting policies have been somewhat inconsistent to date; after years of flat rates since the 1980's, the city implemented somewhat large one-time increases in fiscals 2005 (49%) and in 2011 (115%). The decision to keep rates low provides rate relief to customers, but comes at the expense of needed capital reinvestment and sound financial margins. Prior to the 2011 rate hike the city passed two consecutive 9.5% rate increases in fiscals 2009 and 2010. However, the increases were not enough to improve the preceding weak financial results.

Rates remain affordable despite the 2011 rate hike. Rates have not been increased since then, and no increases are anticipated by the city for at least another few years (likely in advance of the SRF loan repayments). Fitch notes the large projected long-term capital expenditures and associated SRF loans totaling $200 million through fiscal 2019 will erode the currently strong financial margins over time, likely leading to the need for additional rate increases in the future. However, Fitch is concerned by the infrequency and unevenness of historical rate increases and expects financial margins may erode significantly before additional rate hikes are implemented. In addition, while the city will begin aggressively marketing the Cargill facilities to find a new tenant, the level to which the revenues associated with Cargill are replaced, and when, is currently unknown.

The average residential customer pays $17 per month for service, which is just 0.6% of median household income (MHI). The low and affordable monthly residential rates imply rate raising flexibility is present, although the city council's recent decision to lower the maximum rate charged to residential customers during the summer is consistent with management's historical practice of prioritizing rate relief over strong financial margins.

DEBT BURDEN IS LOW, INITIAL STAGES OF A LARGE CAPITAL PROGRAM

The sanitary sewer system is operated under the purview of the Division of Public Works (DPW). DPW is responsible for the billing and collections of the system's large industrial users, while residential/commercial customers are billed by the city's electric utility - Memphis Light, Gas & Water (Fitch rated 'AA+'; Stable Outlook).

The system contains 2,400 miles of sewer mains, 25 miles of interceptors, 100 pump stations, and two wastewater treatment plants with a combined capacity to treat 225 million gallons per day (mgd). Plant capacity is adequate with average daily flows totaling 167 mgd in 2013. The treatment plants discharge effluent under recently extended National Pollution Discharge Elimination System (NPDES) permits granted by the state.

Solid system infrastructure capacity is somewhat offset by the system's age and long-term capital rehabilitation needs. In response to a consent decree to address SSO's, the system anticipates spending roughly $250 million over the next 10 years to assess and improve existing infrastructure to eliminate sewer overflows. In addition, management expects to spend $12 million annually (average) on ordinary system upkeep and repair not related to the consent decree. Fitch will continue to monitor the city's progress in meeting consent decree requirements, which are in the beginning stages.

Overall, capital needs are fairly significant totaling $360 million over the next five years. The city expects to fund the CIP with the $200 million in SRF loans ($120 million recently approved) through fiscal 2019 and a sizable amount of pay-as-go resources. While the system's low and rapidly amortizing debt burden, low rate structure and strong margins provide a solid framework to meet these long-term capital pressures, these attributes result from of a lack of significant investment in the system over many years. At 27 years, the average age of plant is more than 2.0x the median age of water and sewer utilities Fitch rates.

As of fiscal 2013, debt carrying costs were just 16% of gross revenues, and debt per customer was $528 (and $160 per capita). Debt ratios are projected to rise to about $1,100 per customer and approximately 24% of gross revenues over the next five years, which are still manageable and close to the medians for similarly rated systems.

STABLE REGIONAL EMPLOYMENT BASE, WEAK SOCIO-ECONOMIC INDICATORS

The city's stable economy is anchored by transportation and health care and plays a vital role as the major employment center for a three-state, four-county metropolitan statistical area (MSA) encompassing jurisdictions in Arkansas, Mississippi, and Tennessee. Along with healthcare and transportation, employment in distribution and warehousing, higher education, government, tourism, and agri-business provides broad and diverse employment options.

Distribution and warehousing are supported by a solid intermodal network including Memphis International Airport (Memphis-Shelby County Airport Authority, Fitch rated 'A' Outlook Stable), one of the world's busiest cargo airports and Federal Express (FedEx) headquarters, the Port of Memphis, freight rail, and an array of interstate highways.

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 and Related Research:

--'Revenue-Supported Rating Criteria' (June 2014);

--'U.S. Water and Sewer Revenue Bond Rating Criteria' (July 2013);

--'2014 Water and Sewer Medians' (December 2013);

--'2014 Outlook: Water and Sewer Sector' (December 2013).

Applicable Criteria and Related Research:

U.S. Water and Sewer Revenue Bond Rating Criteria

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

Revenue-Supported Rating Criteria

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

2014 Water and Sewer Medians

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724358

2014 Outlook: Water and Sewer Sector

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724357

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=902655

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