Fitch Affirms Garland, TX's Water & Sewer Revs at 'AA+'; Outlook Remains Negative

Fitch Ratings affirms the rating for the following Garland, Texas (the city) revenue bonds:

--$206.3 million water and sewer system (the system) revenue bonds at 'AA+'.

The Rating Outlook remains Negative.

SECURITY

The bonds represent senior obligations of the combined system, payable from net system revenues.

KEY RATING DRIVERS

UNCERTAINTY IN FINANCIAL POSITION: The Negative Outlook incorporates the likelihood of diminishing financial flexibility, reduced debt service coverage (DSC), and weak results in other key financial metrics based on current declining trends.

INCREASING DEBT LEVELS: System debt levels are moderately high, especially when taking into consideration off-balance sheet debt of the North Texas Municipal Water District (NTMWD) (the district, the system's wholesale water provider). Debt levels are expected to increase given the bulk of the system's capital program is anticipated to be debt-funded.

DIMINISHING RATE FLEXIBILITY: Existing rates are considered reasonable relative to median household income (MHI) but higher than surrounding area providers. Additional increases to keep pace with higher wholesaler costs and debt service could reduce affordability over the medium-to-long term.

ASSURED WATER SUPPLY: The system has assured water supply through 2030 under a perpetual contract with the NTMWD. The terms of purchase are somewhat disadvantageous due to the service area's weather fluctuations, but management has implemented rate hikes to keep pace with rising water costs.

ESSENTIAL SERVICE, DIVERSE ECONOMY: The system provides an essential service to a mature service area that is part of the large and diverse Dallas area economy. The city has low unemployment and slightly above-average wealth levels.

RATING SENSITIVITIES

DIMINISHED FINANCIAL CUSHION: Realization of projected declines in DSC over the course of the forecast period and/or ongoing weak results in other key financial metrics would likely result in a downgrade.

CREDIT PROFILE

The water system serves approximately 70,000 city customers and purchases its water on a wholesale basis under a perpetual contract from NTMWD, of which Garland is a member city. Existing and projected water supplies from NTMWD reportedly are sufficient to meet all customer demands through 2030. The wastewater system serves around 67,000 customers within the city, as well as portions of five other cities, including the city of Dallas.

WEAKENED FINANCIAL PERFORMANCE

System operations have been pressured by fluctuating weather conditions, efforts to conserve water, and a somewhat disadvantageous water supply contract. Due to the Texas Drought water use restrictions were implemented late in fiscal 2011. Reduced water demand during the 2012 summer months led to a loss in operating revenue, resulting in a decline in net revenues available for debt service in fiscal 2012. Audited fiscal 2012 results point to senior lien annual DSC declining to 2.0x (1.5x net of transfers out) from a high of 3.0x in fiscal 2011. Including debt service requirements of about $30 million in outstanding general obligation debt issued for system improvements, all-in coverage dropped to 1.6x (1.2x net of transfers out) for the year from a good 2.4x in fiscal 2011. Unaudited fiscal 2013 estimates are similar with senior lien and total DSC of 2.0x and 1.4x, respectively, but management reports that sales are lagging approximately 10% behind fiscal 2013 volumes as water use restrictions remain in effect due to the drought; total DSC is forecast to come in at a lower 1.4x in fiscal 2014.

Through the fiscal 2018 forecast period all-in DSC is expected to be reduced to between 1.4x and 1.5x, which is well below the category 'AA' rating medians and below the system's historical performance. The city's forecast assumes increased debt service costs from planned debt issuances and increasing purchased water costs (which already account for more than 50% of the water fund's operating expenses). These expense drivers are somewhat tempered by planned annual rate increases and conservative annual operating expense growth assumptions. NTMWD raised its water rate by 11% in fiscal 2014, and the city has been informed that district rate will increase by around 10% in fiscal year 2015, due to necessary upgrades to meet regulatory requirements.

Fitch also notes that transfers out of the system are high, averaging 12% over the past five fiscal years. Transfers out of the system combined with limited surplus cash from operations after payment of operating and debt service costs have left a minimal amount of free cash available to cover depreciation (free cash to depreciation at 24% in fiscal 2012).

Liquidity levels improved modestly for the year increasing to 187 days cash on hand (DCOH) in fiscal 2012 but are estimated to come in at a lower 172 DCOH for fiscal 2013 (unaudited). Given capital needs are anticipated to be predominantly debt-funded, cash balances are expected to remain at similar levels, or within historical norms, over the forecast period.

RATE PRESSURE

Rates have increased consistently since 2009 to provide additional revenue to support increasing operating and debt service costs. The monthly bill at $73.65 (assuming usage of 7,500 gallons per month for water and 6,000 gallons per month for sewer) is the highest in the Dallas/Fort Worth Metroplex and currently registers at around 1.7% of MHI, still falling under Fitch's 2% of MHI affordability threshold. Forecasts provided by management indicate continued rate increases ranging from 6% to 10% annually for water and around 3% annually for wastewater from fiscal 2015 to 2018. Additional increases to keep pace with higher wholesaler costs and debt service could reduce affordability over the medium-to-long term.

GROWING DEBT BURDEN

The system's capital improvement plan (CIP) for fiscal years 2014 - 2018 totals $169 million, which is up by 24% from the prior five-year plan. The CIP is expected to be financed exclusively from debt. Approximately 65% of the CIP addresses sewer system improvements that will ensure compliance with new and enhanced regulatory and operational standards while the remaining 35% is for water system improvements.

Direct system debt levels are above-average. For audited fiscal 2012 debt to plant was 62% while debt per capita was $1,070, both above the 'AA' category medians. Including NTMWD obligations supported by the system, system debt levels increase by approximately 55% and are well-above category 'AA' rating median levels. Given plans to entirely debt-finance the system capital plan, debt levels are expected to increase with debt per capita estimated at around $1,256 in five years.

MATURE, STABLE ECONOMIC BASE

Garland benefits from its location within the Dallas-Fort Worth metropolitan area. Manufacturing and distribution remain the city's primary economic engines, and the city's industrial market reportedly is the second largest in the Dallas-Fort Worth metroplex. The city's unemployment rate, measured at 5.9% in December 2013, is slightly higher than the state (5.6%) and metropolitan statistical area (5.4%) but remains better than the national (6.5%) average. Local wealth levels within the city, as measured by per capita buying income and median household income, are slightly higher than state but are on par with national averages.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's U.S. Municipal Revenue-Supported Rating Criteria, this action was additionally informed by information from Creditscope and the Municipal Advisory Council of Texas.

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria' (June 3, 2013);

--'U.S. Water and Sewer Revenue Bond Rating Criteria' (July 31, 2013);

--'2014 Water and Sewer Medians' (Dec. 12, 2012);

--'2014 Outlook: Water and Sewer Sector' (Dec. 12, 2013).

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=709499

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=827224

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