Fitch Ratings takes the following rating action on Norfolk, VA's
revenue bonds:
--Approximately $181 million water revenue refunding bonds
series 2012 rated 'AA+'.
The bonds are expected to sell the week of March 19 via
negotiation.
Proceeds of the series 2012 bonds will be used to refund all or
a portion of various outstanding parity bonds for savings, and pay
issuance costs.
In addition, Fitch affirms the following ratings:
--Approximately $115 million in outstanding water revenue bonds
(various series) at 'AA+'.
The Rating Outlook is Stable.
SECURITY
The bonds are secured by a senior lien pledge of the net
revenues of the water system (the system). The existing common debt
service reserve fund will not cover the 2012 bonds.
KEY RATING DRIVERS
LARGE REGIONAL PROVIDER: Norfolk's water system is the primary
service provider for a large, mostly residential, and economically
stable region. The system directly serves over 65,000 retail
accounts, and an additional 196,000 retail customers through
wholesale contracts.
HYBRID SYSTEM; STABLE FINANCIAL MANAGEMENT: Fitch views coverage
levels as adequate despite being below average for retail systems.
Over 50% of operating revenues are derived from wholesale customers
making the system somewhat unique. Fitch is comfortable with
coverage levels more consistent with wholesale systems given the
ability to pass through costs and importantly, the systems strong
liquidity.
STRONG SYSTEM CAPACITY: Ample water supply and treatment
capacity provides operating flexibility and limits short-term
capital needs mainly to repair, replacement, and maintenance
projects.
BELOW AVERAGE DEBT BURDEN: Debt ratios are manageable when
including all of the system's direct retail customers, and the
retail customers it serves on a wholesale basis. A mainly
debt-financed capital plan is expected to only modestly raise the
debt burden.
BELOW AVERAGE LEGAL PROVISIONS: Legal provisions are below
average compared to typical utility systems Fitch rates. The rate
covenant and additional bonds test require just 1.1x debt service
coverage from net revenues.
CREDIT PROFILE
Role as Regional Service Provider a Credit Positive
The city of Norfolk (general obligation bonds rated 'AA+' by
Fitch) is located in the Hampton Roads region of Virginia, along
the Atlantic Ocean. The city covers 66 square miles and has an
estimated current population of 244,000.
The system is the primary water provider for the entire region,
providing retail service to its own roughly 65,500
mostly-residential customers and wholesale service to the city of
Virginia Beach (water and sewer revenue bonds rated 'AAA' by
Fitch), the U.S. Navy, and other nearby communities. The entire
service area covers more than 330 square miles, includes a total
retail customer base of more than 260,000, and serves a population
of about 1,100,000, according to city estimates.
The area is mostly residential in nature; although its favorable
location promotes significant industrial, trade, and tourist
activities. The economy, which is anchored by the presence of the
U.S. military, is beginning to expand with employment gains in
business and other services. A large commercial port and Norfolk
International Airport provide significant employment and trade
opportunities. The unemployment rate remains above historical
levels at 7.1% as of December 2011.
Long-term Contracts Provide Stability and Offsets
Concentration
While customer concentration is moderately high, Norfolk
provides service to several highly rated utility systems in the
region through mainly long-term wholesale contracts. The city of
Virginia Beach is the system's largest wholesale customer,
comprising 35% of total revenues in 2011. Pursuant to the long-term
water services contract, which expires in 2030, Norfolk receives
and treats raw water from Virginia Beach and conveys potable water
back to Virginia Beach up to an average of 45 mgd.
Virginia Beach is charged based on a cost of service approach,
whereby it pays Norfolk a proportionate share of operations and
maintenance expenses, depreciation expense, and a return on assets.
Such payments are designated as operating expenses of the Virginia
Beach water and sewer utility, and therefore are paid ahead of any
debt service.
Norfolk also provides service to the City of Chesapeake (utility
system rated 'AA', with a Stable Outlook), and the U.S. Navy.
Service to Chesapeake consists of a small amount of treated water
(2.2 mgd in 2011) and a larger amount of surplus raw water (7.1 mgd
in 2011) on a take-or-pay basis. Revenues from Chesapeake accounted
for about 9% of total revenues in 2011, while the US Navy comprised
11%. The contract with the US Navy is a short-term contract that
expires later this year. Management expects an extension of this
contract for another three-year term.
System Capacity is Strong
Water supplies are extensive and diverse, consisting of a series
of eight city-owned surface water reservoirs totaling 15.2 billion
gallons in storage capacity. In addition, supply comes from Lake
Gaston, a Virginia Beach-owned water source, and two supplemental
sources consisting of intakes from the Blackwater and Nottoway
rivers. Four deep groundwater wells (located in Suffolk) are also
available during dry periods. The city estimates it has enough
supply to serve the needs of the region for another 50 years. Two
water treatment facilities have a current capacity of 136 mgd,
which is more than twice the average daily demand in 2011.
Stable Financial Performance and Management
The system's stable financial profile is evidenced by strong
historical financial margins and good debt service coverage.
Operating margins ranged between 47% and 55% over the past five
fiscal years, which is considered strong. However, the system
annually transfers over $8 million to the city's general fund as an
annual return on investment, which limits the amount of free cash
flow available for capital spending. The annual transfer, while not
unusual for a utility system, is high at roughly 10% of annual
revenues.
Management expects to update various financial and other
policies over the next 12 months; however a change to the annual
transfer is not anticipated. For the past five years the system has
generated between 1.5x and 1.8x coverage on the senior bonds, which
is below average for the rating. However, Fitch is comfortable with
these coverage levels given the hybrid nature of the system, its
regional importance, and strong liquidity.
Including subordinate lien GO bonds, all-in coverage has been
slightly lower. Rate increases have helped improve revenue
performance over the past two fiscal years, leading to slightly
better coverage in FY 2010 of 1.8x. In FY 2011 coverage was closer
to 1.7x due to a slight increase in debt service.
The system's balance sheet resources (liquidity) are strong
despite large annual transfers to the general fund. Including
operating reserves, repair and replacement fund balances, rate
stabilization funds, and the unrestricted general reserve, the
system had 442 days cash on hand as of fiscal end 2011. Other
important liquidity ratios (such as working capital and current
ratio) are also above average. A strong liquidity profile provides
significant financial flexibility, which in addition to the
partially wholesale nature of the system, helps mitigate below
average debt service coverage.
Manageable Debt Position Expected to Continue
After issuance, the system will have approximately $300 million
in senior lien parity debt outstanding. The refunding is expected
to provide significant net present value savings of over 20% of the
refunded par. Most of the savings will occur over the next five
years, and maturities are not being extended.
Debt as a percentage of net plant assets is 77% for fiscal 2011;
however, debt per capita, which takes into account the entire
service area population served by Norfolk, is roughly $350, and is
in line with the rating level. In addition, when including the
retail customers Norfolk serves indirectly through its large
wholesale contracts, debt per customer was just $1,319 in 2011,
which is slightly below the median ($1,615) for 'AA' rated
systems.
Principal amortization is average, with 40% of principal
retiring within 10 years and 82% retiring in 20 years. The
approximately $100 million five-year capital program is expected to
be mainly funded with additional debt; however Fitch projects the
debt burden will remain manageable. Projects will focus on water
line replacement and rehabilitation and treatment plant upgrades.
Management expects to issue bonds in fiscal 2013, and again in
fiscal 2015.
Competitive Rates Expected to Continue to Rise Automatically
Retail rates are set by the city council and are reviewed
annually during the budget process. After double-digit rate
increases in 2004 and 2005, rate increases have been moderate at
approximately 3.5% annually. In 2011, residential rates for 1,000
cubic feet of use per month (about 7,500 gallons) were competitive
relative to other regional utilities at $40, which is roughly 1.1%
of median household income. Rates are expected to remain
competitive despite automatic annual increases designed to provide
for baseline revenue growth.
Legal Provisions are Below Average, Changes to Reserve
Funding
The city covenants to establish, fix, charge, and collect rates,
fees, and charges, and revise such rates fees and charges when
necessary so that in each fiscal year net revenues are at least
equal to the greater of 1.1x annual debt service for senior bonds
plus 1.0x coverage for subordinate bonds, or 1.0x the funding
requirements for the various funds of the indenture, including the
bond fund, debt service reserve, and renewal and replacement. To
issue additional bonds, adjusted net revenues received during any
12 consecutive of the previous 24 months must meet the rate
covenant.
The city will make a change to the requirement for the funding
of debt service reserve funds with the issuance of the 2012 bonds.
The original debt service reserve fund is common to all outstanding
bonds (and will remain intact as long as the parity bonds are
outstanding). The current cash balance in the existing debt service
reserve is about $8 million.
Going forward debt service reserve funds will be series-specific
and the city will have the option whether or not to fund a reserve
for a particular series of bonds, and to what level. For the 2012
bonds, the city has determined it will not fund a debt service
reserve. While this weakens already below average covenants, the
system retains a sizable cash position, has the ability to raise
rates, and is generally well managed. As a result, Fitch does not
believe the exclusion of a debt service reserve for the 2012 bonds
materially weakens the system's strong overall credit profile.
Additional information is available at 'www.fitchratings.com'.
The ratings above were solicited by, or on behalf of, the issuer,
and therefore, Fitch has been compensated for the provision of the
ratings.
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 20, 2011);
--'U.S. Water and Sewer Revenue Bond Rating Criteria' (Aug. 10,
2011);
--'2012 Water and Sewer Medians' (Dec. 8, 2011);
--'2012 Water and Sewer Sector Outlook' (Dec. 8, 2011).
Applicable Criteria and Related Research:
Revenue-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=637130
U.S. Water and Sewer Revenue Bond Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=647331
2012 Water and Sewer Medians
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=657111
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