Fitch Rates Houston, Texas' CUS First Lien Revs 'A+' Underlying; Outlook Stable

2008-04-29 23:51:12 -

- Fitch ratings assigns an 'A+' underlying rating to Houston, Texas' combined utility system first lien revenue refunding bonds as follows:

--$200 million series 2008A-1;

--$49.1 million series 2008A-2 (series 2008A bonds).

In addition, Fitch affirms its underlying rating on the city's outstanding $3.95 billion of parity first lien revenue bonds (net of this refunding) including $274 million series 2004C subseries C-1, C-2A, C2-B and 50% of C2-E at 'A+', which are being converted into a term rate mode. Fitch also affirms its underlying rating on the city's $786.8 million of outstanding junior lien water and sewer system revenue bonds, which are senior to the first lien revenue bonds at 'AA-'.

The series 2008A bonds are being issued to convert the system's outstanding first lien revenue refunding auction rate securities, series 2004C subseries C-2C, C-2D, and 50% of C-2E to variable rate demand bonds secured with a direct pay letter of credit. Fitch is not assigning credit enhanced ratings to the series 2008A bonds which are scheduled to be sold via negotiation as early as May 7, 2008. The 2004C auction rate securities will be reoffered in term rate mode the week of May 12, 2008. The Rating Outlook is Stable.

The ratings reflect the improved financial position resulting from a 2004 rate increase and subsequent annual rate adjustments specifically mandated by the first lien revenue bond master ordinance, as well as projected revenue growth from recently implemented rate increases to wholesale customers. Concerns regarding revenue growth limitations previously reflected in the rating are somewhat mitigated with voter approval of Proposition G, which essentially lifts the revenue generation limitation of Proposition 2 on the city's enterprise systems. Also reflected in the ratings are the service area's healthy underpinnings, the sufficiency of the combined utility system's water resources until 2035, and the adequate debt service coverage and anticipated improvements in the system's projections. The sizeable system capital improvement plan (CIP), which will be exclusively debt financed, and the expectation that operations and maintenance (O&M) costs will continue to grow as the city shifts to increased surface water usage are additional factors considered in the rating.

The utility system's undertaking of the 2004 debt restructuring and modifications to the master ordinance featuring automatic rate adjustments and some tightening of uses in the general purpose fund with the limitation on the annual transfers for the drainage utility purposes facilitated the system's improvement of its financial margins. On an all-in basis, coverage levels improved to 1.7 times (x) in fiscal 2006 from 1.3x in fiscal 2004. More notably and reflective of the system's service rate increases, its liquidity improved markedly to 210 days cash-on-hand and 571 days of working capital (excluding the general purpose fund), compared with 99 days cash-on-hand and 115 days working capital in fiscal 2004.

Financial results for fiscal 2006 were favorable with operating revenue growth of 7.3% over the prior year. System liquidity remained healthy, with working capital increasing by nearly three months. Junior lien coverage under the previous ordinance was 6.5x and first lien coverage was 1.9x. These levels exclude an estimated $250 million balance in the general purpose fund that, as allowed by the combined utility indenture, may be available for payment of debt service; unaudited fiscal 2007 statements points to similar results. Through fiscal 2012, all-in annual debt service coverage is expected to range between 1.25x (2011) and 1.48x (2008).

The master ordinance provides for automatic rate adjustments based on the Consumer Price Index, absent council action. Based on this provision, 3.6% and 2.8% water and sewer rate increases became effective on April 2006 and April 2007, respectively. Another 1.8% automatic adjustment will become effective in April 2008. Prior to the June 2004 rate increases, the city had not raised its service rates since 1993. Houston's water and sewer rates are moderate compared with a peer group of large U.S. cities, providing some future rate flexibility.

One of the risk factors considered in the rating is the sizeable capital plan for the combined system. The FY2009-2013 CIP totals $1.3 billion and is expected to be entirely debt financed adding to an already highly leveraged system. The CIP is predominantly weighted towards system repair and replacement needs, due to the focus of previous capital spending on securing surface water supplies and constructing associated treatment facilities. This spending, which contributed greatly to the system's highly leveraged position, was the result of the subsidence issues in the region and requirements to reduce groundwater withdrawals. The system has now secured ample water rights and constructed large water treatment facilities.

The combined system will continue to rely on water and sewer rates as a financing mechanism for drainage operations and infrastructure. The need for further drainage improvements was highlighted by past severe flooding. Under the master ordinance, utility fund transfers out for nonsystem purposes are now limited to 8% of gross revenues from the immediately prior year and dedicated solely for drainage functions. Under the prior water and sewer system indenture surplus revenues were available for any lawful purpose.

Two charter amendment initiatives (Proposition 1 & 2) relating to limiting the overall revenue-generating flexibility of the city were approved by voters in November 2004. Proposition 1, which received more favorable votes than Proposition 2, applies only to the city's ad valorem taxes and water and sewer rate increases, while Proposition 2 pertains to substantially all revenues of the city. Based on the city charter, which provides that an initiative receiving the highest number of votes will prevail in instances in which inconsistent measures are approved by voters at the same election, the city attorney opined that Proposition 1 is binding.

In response to the city attorney's opinion, supporters of Proposition 2 filed a petition in state district court alleging that there is no inconsistency between the two propositions or, as an alternative, the propositions should be harmonized. A district court judge has ruled that both propositions were effective, but the city has filed an appeal and subsequently returned to the voters in November 2006 at which the voters approved Proposition G, a City Charter amendment that excludes the enterprise fund revenues from the Proposition 2 revenue limitations. A state district court recently dismissed an action by a city voter that sought to invalidate Proposition G, and the plaintiff has appealed the ruling. Fitch Ratings will continue to monitor the potential credit implications of Proposition 1, as well as the current legal challenge and the potential effects to implementing Proposition 2.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Fitch Ratings
Gabriela Quiroga, +1-512-215-3731 (Austin)
Steve Murray, +1-512-215-3729 (Austin)
Cindy Stoller, +1-212-908-0526
(Media Relations, New York)