Fitch Rates Hampton Roads Sanitation District, VA's Wastewater Revs 'AA+'; Outlook Stable

Fitch Ratings assigns an 'AA+' rating to the following Hampton Roads Sanitation District, VA (HRSD) revenue bonds:

-- Approximately $120 million wastewater revenue bonds, refunding series, 2014A.

The bonds are expected to sell via negotiation on Oct. 29. Bond proceeds will be used to advance refund a portion of the district's outstanding series 2008, 2011, and 2012A bonds for interest savings. Savings are expected to be taken annually.

In addition, Fitch affirms the ratings on the following district bonds:

-- $620 million (pre-refunding) in outstanding wastewater revenue bonds at 'AA+';

-- $22 million in outstanding subordinate wastewater revenue bonds, series 2012 at 'AA';

-- 25 million in outstanding subordinate wastewater revenue bonds, series 2011 at 'AA'/'F1+'.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by the net revenues of the district. The senior bonds have a first lien on net revenues and the subordinate bonds have a second (junior) lien on such revenues. The 'springing' debt service reserve fund for the senior bonds was activated in 2014, resulting in a $45 million deposit for the benefit of senior bondholders. The subordinate bonds do not require a debt service reserve.

KEY RATING DRIVERS

LARGE REGIONAL SERVICE PROVIDER: HRSD provides sewer treatment and disposal services to Virginia's Hampton Roads region and its 1.7 million residents through 462,000 retail accounts. The service territory encompasses 670 square miles and includes nine cities, eight counties and several large military installations.

SOLID FINANCIAL PERFORMANCE: Strong financial management continues to produce solid excess cash flows, adequate debt service coverage (DSC) and ample liquidity. Near-term pro forma projections show coverage and liquidity staying solid; however, longer-term projections point to a decline in all-in DSC driven by expectations for additional subordinate lien debt.

LARGE LONG-TERM CAPITAL PROGRAM: Capital needs over the next five years are manageable. However, substantial long-term mandated spending for regional sanitary sewer overflow (SSO) mitigation projects is expected to lead to much higher leverage over the long term.

AFFORDABLE RATES, INCREASES EXPECTED: Rates remain affordable despite sizable increases over the past several years. Consistent annual rate increases going forward will be necessary to service planned debt.

FAVORABLE INTERNAL LIQUIDITY: The 'F1+' short-term rating on the series 2011 bonds reflects the district's strong overall credit fundamentals and its ability to cover the maximum potential liquidity demands by at least 1.25x from internal resources, including cash and highly liquid, highly rated investments.

RATING SENSITIVITIES

DETERIORATING FINANCIAL PROFILE: Maintenance of strong financial performance - particularly debt service coverage (DSC) and liquidity - will be key to preserving the rating given the expected pressure to the district's debt profile from the SSO program in the outer years.

SIGNIFICANT RISE IN CAPITAL COSTS: Escalation of current SSO cost estimates and or compression or acceleration of the SSO program would be viewed negatively.

CREDIT PROFILE

LARGE REGIONAL PROVIDER, SOLID SYSTEM FUNDAMENTALS

The district, created by referendum in 1940 to abate water pollution in the Hampton Roads region, plays an important role as the region's wastewater interception, treatment and disposal provider. Capital and financial planning efforts are robust and include extensive long-range forecasting for capital needs and user charges, with an emphasis on exceeding various formal financial and debt policies approved by the district's board in 2009.

The sewer system consists of nine major treatment plants and several smaller treatment facilities located throughout the service area. Total average daily flow in fiscal 2014 was approximately 60% of total capacity, leaving plenty of treatment capacity for the long term. The customer base is mostly residential and there are no concentration concerns.

DEBT MANAGEABLE BUT CAPITAL PROGRAM TO EXERT PRESSURE

A nearly five-fold increase in debt since fiscal 2007 has led to a larger but still manageable debt burden. As of fiscal 2014, outstanding debt totaled approximately $775 million, which is slightly lower than total debt recorded in fiscal 2013. Debt to net capital assets remains a somewhat elevated 76% in 2014, but at $1,678 debt per customer is below the median for 'AA' category water and sewer utilities. Amortization of existing debt is a somewhat slow 35% over the next 10 years but improves with a more rapid 75% retired over 20 years.

HRSD's updated five-year $600 million capital improvement plan (CIP) through 2019 is roughly 17% greater than last year's CIP but still considered manageable. The updated CIP is expected to be approximately 40% debt-funded with the remainder funded from existing bond proceeds ($100 million) and pay-as-you-go resources. While the district's debt burden is projected to rise, it is expected to increase only modestly over the next five years with key debt metrics remaining close to the medians for similarly-rated systems.

The district's 10-year $1.3 billion CIP is sizable and will focus on both regulatory requirements associated with nutrient reduction standards and sanitary sewer overflows (SSOs) as well as fund system-wide renewal and rehabilitation of aging infrastructure. New debt associated with the 10-year plan totals roughly $600 million through 2024, still leaving the district's debt profile manageable in Fitch's estimation.

However, longer-term capital spending (beyond the current 10-year plan) remains very significant with SSO mitigation projects accelerating in size and in scope relative to the earlier five and 10 years capital forecasts. From 2025-2034, management anticipates capital needs will total an additional $2.8 billion (for a total 20-year CIP of around $4 billion), roughly half of which will be funded with new debt, raising concerns over the district's ability to manage its future long term fixed cost obligations. In total, the district anticipates issuing $2 billion in new debt through 2034, with the majority of future issuances occurring over the last 10 years (2025-2034).

SOUND FINANCIAL OPERATIONS, LIQUIDITY A CREDIT POSITIVE

Overall financial performance remains solid despite a weakening of several key financial metrics over the past six years, including DSC and free cash to depreciation. DSC has declined from very high levels in fiscal 2007 (more than 7.0x on the senior bonds and 3.0x all-in) on rising debt service costs, although the district implemented regular rate increases in anticipation of the higher debt service.

The district ended fiscal 2013 with $71 million in net cash flow after operating expenses, providing 1.9x coverage of senior lien bonds and 1.5x coverage of all debt service. The rate increases also enhanced the district's liquidity, which more than doubled from fiscal 2008-2014. Cash flows were slightly better for fiscal 2014, but an increase in annual debt service caused DSC to decline to 1.7x on the senior bonds and a somewhat narrow 1.3x all-in. While not expected over the intermediate term, a trend of low DSC margins would be viewed negatively, especially if accompanied by a significant drop in liquidity.

The fiscal 2015 budget anticipates improved DSC from 2014 results due to a rise in operating revenues from an 8% rate increase and a slight decline in operating expenses. When including the projected interest savings from the 2014 bonds, DSC rises to 2.0x on the senior bonds and 1.6x all-in. Updated pro forma financials provided by the district show DSC coverage improving further as additional proposed annual rate increases outpace new debt issuance.

HRSD ended fiscal 2013 with a sizable amount of unrestricted cash and available investments totaling $153 million, or near 400 days cash on hand (DCOH). When including the approximately $68 million of renewal and replacement fund balances, liquidity was an ample 558 DCOH. Liquidity declined somewhat in fiscal 2014 but remains strong at 495 DCOH.

INDEPENDENT RATE-SETTING, LONGER-TERM AFFORDABILITY CONCERNS

The district maintains sole rate-setting authority, with charges resulting only from the provision of wastewater interception and treatment services. Rates currently are moderate but will continue to rise to offset recent and expected increases in debt. Rates were increased by more than 70% between fiscals 2008-2014, coinciding with a roughly 100% increase in debt over that time. Service charges are higher when including monthly charges for sewer collection provided by each of the local municipal utility systems, but appear manageable overall.

HRSD user charges are expected to rise roughly 80% over the next 10 years based on the district's long-range forecast which points to 5%-10% adjustments annually. Despite rate escalation concerns, Fitch views favorably the district's approach to implementing manageable incremental rate increases over time, thereby allowing customers to adapt to the changes more easily.

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:

Revenue-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Water and Sewer Revenue Bond Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=715275

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=907334

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