Fitch Rates Dallas, TX's Water & Sewer Revs 'AA+'; Outlook Stable

Fitch Ratings has assigned an 'AA+' rating to the following bonds issued by the city of Dallas, TX (the city):

--Approximately $409 million waterworks and sewer system revenue refunding bonds, series 2016A;

--Approximately $179 million waterworks and sewer system revenue refunding bonds, taxable series 2016B.

Bond proceeds will refund outstanding commercial paper as well as certain outstanding parity bonds of the city's water and sewer system (DWU). The bonds are expected to price the week of June 20, 2016 via negotiation.

In addition, Fitch has assigned an initial rating of 'AA+' to the system's $1.9 billion in outstanding parity debt.

The Rating Outlook on the bonds is Stable.

SECURITY

Bonds are payable from a first lien pledge of net revenues of the system after payment of system operating and maintenance (O&M) expenses.

KEY RATING DRIVERS

FINANCIAL RESULTS TO REBOUND: DWU's key financial metrics have historically been comparable to similarly-rated large systems. Although fiscal 2015 results were relatively weak due to a culmination of sluggish sales and higher operating expenses, particularly with regards to a significant escalation in purchased water costs, the rating reflects Fitch's expectation that rate adjustments and controlled expenditures, will restore financial results to favorable levels in fiscal 2016 and beyond.

ELEVATED DEBT: Debt obligations are relatively high but manageable. Ongoing capital needs are large but are only expected to increase leverage ratios moderately over time. Debt obligations include the Tarrant Regional Water District (TRWD) debt issues related to the city's portion of capital costs to build-out the Integrated Pipeline Project (the IPL) - the city's next major water supply source - which will grow considerably over the next decade or so.

STRONG OPERATING PROFILE: Historical planning and development of water supplies has positioned the system well to meet long-term customer demands, even during drought conditions. Treatment capacity is also sufficient, and a water treatment expansion currently underway should ensure sufficient capacity for the foreseeable future.

GOOD RATE FLEXIBILITY: Rate increases have been regular and measured yet remain low relative to other large utilities both within and outside of the state. Moderate planned adjustments should preserve a favorable degree of flexibility going forward while sustaining strong financial margins.

BROAD AND DIVERSE SERVICE TERRITORY: DWU serves an extensive area that includes the city of as well as much of the neighboring suburban communities on a wholesale basis. The city has a diverse and stable economic base, and headquarters a broad array of corporate entities, serving as a nationally recognized technology, trade, and health service center.

RATING SENSITIVITIES

DECLINING FINANCIALS: Failure to improve its financial results to levels consistent with historical results and current projections, particularly given the scope of anticipated capital needs going forward, could result in downward rating pressure on the city of Dallas water and sewer system.

RISING CAPITAL AND DEBT: Escalation in out-year capital and debt funding and/or material changes in costs related to the Integrated Pipeline project beyond amounts already anticipated could also pressure the rating given the relatively elevated nature of the existing debt profile.

CREDIT PROFILE

The system serves an expansive territory, providing retail water and sewer service to 1.2 million city residents. The system also provides wholesale treated water to 23 municipalities and wholesale sewer service to 11 customer cities in Dallas County (the county) and the contiguous counties. The city is a primary driver of the broad Metroplex, serving as the center of medicine and higher education in the area, as well as home to Southwest Airlines.

Characteristic of a large, older city, wealth levels within the city limits are somewhat low (median household income for the city is around 80% of the state and U.S. average) and poverty rates are relatively high (around 50% higher than the national average). However, county wealth and poverty rates are closer to state and national averages and wholesale customers outside the county generally are quite affluent.

SOLID SUPPLY PORTFOLIO BUT RISING COSTS

Water supply is provided from six reservoirs, Trinity River water and indirect reuse, with diversion rights equal to 1,840 million gallons per day (mgd), or over 4.5x the historical five-year average production needs of the system. The existing and connected diversion rights also provide a current dependable yield (available supplies during a severe drought) of 431 mgd, around 1.1x the five-year average production amounts. Dependable yield will rise to 604 mgd sometime after 2020 when water from a seventh reservoir (Lake Palestine) will be added to the system as a result of the IPL, providing sufficient capacity to meet customer demands through around 2050.

The IPL is a major undertaking, consisting of an integrated water delivery transmission system project done in cooperation with the Tarrant Regional Water District, TX (TRWD) to move approximately 350 mgd of water from Lake Palestine in east Texas to the Metroplex. The project will consist of 150 miles of pipeline, three new pump stations on Lake Palestine and three new booster pump stations. The city has contracted with TRWD to design and build the transmission line that will connect Lake Palestine to the system as well as interconnecting certain TRWD reservoirs to the system. TRWD will own, operate and finance the IPL, with DWU owning 150 mgd of reserved capacity rights in the IPL and TRWD owning 197 mgd of reserved capacity rights.

Total capital costs associated with the IPL are currently estimated at $2.4 billion, with DWU's portion at around $977 million. DWU's portion of the capital costs has been financed through contract revenue bonds issued by TRWD and payable by DWU as an O&M expense of the system. To date, TRWD has issued $474 million in contract revenue bonds on behalf of DWU with $463 million currently outstanding. It is expected that DWU's remaining capital costs associated with the IPL will be funded through future issuances of additional TRWD contract revenue bonds over the next 10-15 years.

ELEVATED BUT MANAGEABLE DEBT PROFILE

System debt obligations (including obligations associated with the IPL) are currently elevated. Debt levels are expected to rise incrementally over time given the scope of capital spending and the city's practice of financing 80% of its capital improvement program with debt. However, increases in the debt burden through fiscal 2020 should be moderate.

Offsetting some concerns relating to the system's debt burden are that debt levels are relatively reasonable for systems with significant wholesale service components like DWU. Also, the system's debt structure is relatively conservative (including the IPL obligations), consisting solely of fixed rate obligations apart from commercial paper outstanding at any given time, thereby limiting interest rate and third party credit risks. Further, maximum annual debt service on direct debt occurs in the current year followed by gradual declines in carrying costs, affording the system a good deal of structuring flexibility, if needed.

Most near-term capital needs are geared towards renewal and replacement of existing infrastructure and maintaining regulatory compliance, with a significant portion of costs devoted to replacing aging water and wastewater mains (around $60 million annually). Total capital costs for fiscals 2016-2020 (not including costs associated with the IPL) are sizeable in terms of total dollars at $1.5 billion, but reasonable in terms of annual cost per customer ($351) relative to the 'AA' category median of $325.

FINANCIAL PERFORMANCE TO REBOUND FOLLOWING CHALLENGES IN FISCAL 2015

Recent financial results have been solid and showed steady improvement through fiscal 2014, marked by increasing debt service coverage, liquidity and surplus cash flows. For fiscal 2015 though, adopted rate hikes were relatively lower than prior years (3.5%) while operations throughout the year were challenged on various fronts, ultimately lowering senior and total DSC to around 1.5x and 1.4x, respectively. Overall consumption rose a modest 1% from the prior year as hot dry conditions in the summer months offset extremely heavy precipitation through the spring, which initially dampened sales. However, fiscal 2014 sales were the low point of what has been a declining trend in consumption for at least a decade.

Personnel services also increased over $15 million (around 18%) from the prior year due mainly to the implementation of GASB 68 and 71 to recognize the changes in the net pension liability as opposed to prior years where pension contribution was expensed. Finally, there was a $30 million increase in supplies and materials costs stemming largely from a dramatic increase in charges from the Sabine River Authority (SRA) pertaining to the city's purchase of Lake Fork water.

At the beginning of fiscal 2015 SRA unilaterally increased purchased water costs nearly 10-fold (to around $27 million per year) following expiration of the city's original contract and unsuccessful negotiations between the city and SRA to arrive at a new price once the contract was renewed. The city appealed SRA's rate to the Public Utilities Commission, contending the new rate violates the Texas Water Code and the contract. An administrative law judge has been assigned to hear the matter, but in the meantime an interim rate for the water has been set at the SRA rate with the city ordered to pay the charges into an escrow account during the pendency of the dispute. Various other lawsuits have been filed both by the city and SRA related to this case, all of which may take several years to resolve.

To account for the additional Lake Fork water costs and other system needs, the city prudently increased its retail service rates for fiscal 2016 for water and sewer by an average of 5.3% while wholesale customers experienced a 13.7% increase in treated water charges and a 50% adjustment for untreated water. Despite the rise in charges, residential charges are a moderate 1.4% of median household income and are relatively low compared to other large utilities across Texas and the nation.

With the rate hikes in place senior and total DSC for fiscal 2016 is expected to rebound to just under 1.9x and 1.8x, respectively. Fiscals 2017-2020 financial performance is expected to remain similarly strong relative to anticipated fiscal 2016 results based on the expectation of continued moderate annual rate adjustments, additional costs associated with the IPL and future direct debt issuances, as well as a continuation of the interim charge for Lake Fork water. Achieving and maintaining such results will be key to the rating going forward in order to provide a solid amount of pay-go capital spending and limit escalation in the system's debt profile.

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

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

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

U.S. Water and Sewer Revenue Bond Rating Criteria (pub. 03 Sep 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869223

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1005287

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