Fitch U.S. Muni Surveillance: Guam Waterworks Authority Revs Affirmed at 'BB': Outlook to Positive.

NEW YORK -- In the course of routine surveillance, Fitch Ratings affirms the 'BB' rating on Guam Waterworks Authority's (GWA; or the authority) $99.3 million in outstanding water and wastewater system revenue bonds, series 2005. The bonds are secured by a senior lien pledge of net revenues of the authority's combined water and wastewater system (the system). The Rating Outlook has been revised to Positive from Stable.

The revision in Rating Outlook to Positive from Stable reflects GWA's substantial progress to date in meeting regulatory requirements stemming from a stipulated order (the order). The Outlook revision also reflects the progress management has made with regards to capital and financial planning, which provide a blueprint for continued success in returning the system to regulatory compliance and ensuring financial integrity.

The 'BB' rating reflects the system's adequate financial performance, demonstrated management capabilities, and sizeable amount of capital costs and rate pressure related to system regulatory compliance and basic infrastructure needs. Historically, the system has been plagued with weak financial performance and violations of the federal Clean Water Act (CWA) and Safe Drinking Water Act (SDWA), which necessitated involvement at the federal regulatory level. However, since 2002 when the authority's governance was changed from an appointed board to an elected governing board, significant strides have been made towards returning the system to regulatory compliance and ensuring stable operations. Nevertheless, capital costs for necessary repairs remains significant and will continue to pressure operations. An upgrade to the authority's rating will be dependent on the timeliness of rate recovery and the authority's ability to effectively execute its capital improvement program (CIP) while maintaining adequate financial performance.

From 1997-2002, the authority was a semi-autonomous agency of Guam whose board members were appointed by the governor, and prior to that was an agency of the government. Over the last two decades, deferred maintenance, along with natural disasters, has affected operations, hindering the system's ability to comply with regulatory requirements and leading to two consecutive consent decrees from the Environmental Protection Agency (EPA), as well as substantial fines. Coupled with inadequate regulatory performance, the system faced continued negative operating results during this period, due in large part from lack of rate relief as well as sizeable bad debt write-offs. By 2001 the authority's financial dilemma peaked with a $9 million judgment lodged against the authority for failure to pay water services provided by the Navy, a restructured $3.5 million line of credit through a private vendor, and around $12 million in repayment obligations to the Guam Power Authority (GPA, revenue bonds rated 'BB+' with a Positive Outlook by Fitch) for cash flow borrowings and power costs in arrears.

The U.S. EPA initiated legal proceedings to place the system in receivership for failure to comply with outstanding consent decrees in December 2002, immediately before a newly elected five-member Consolidated Commission on Utilities (CCU) took office in January 2003. From 2003-2005 when the authority sold the bonds, the CCU settled litigation related to the authority's debt and became current in repayment of these obligations, petitioned and received sizeable rate relief from the Public Utility Commission (PUC), hired an experienced management team, reduced labor and operating costs by over 20%, and began the process of bringing the system's operations back to profitability. In response to the EPA lawsuit, the CCU negotiated the order with the EPA in June 2003 that establishes definitive milestones for improving the authority's management and organization, operations, financial administration, facility construction and rehabilitation, and staff training that will bring the system back into regulatory compliance with the CWA and SDWA.

Since 2005, GWA management has made substantial progress in meeting the milestones required under the order. Operational issues largely have been completed, and most of the major capital projects have been or are expected to be completed by the end of calendar 2009. The schedule for some of the major capital items required under the order have been delayed to varying degrees from original timeframes established in the order, but fines have been limited (around $250,000 since January 2004) and all fines have been paid within 30 days of assessment. In total, over $80 million has been invested in capital assets from fiscal 2003-2008, with around $69 million in construction completed over the last three fiscal years.

Pursuant to the order, GWA also commissioned a water resources master plan (WRMP; approved by the CCU in January 2007), which provides a framework for continued improvement by detailing basic system capital needs over a 20-year period ending in calendar 2026. It is expected that the EPA will extend or create a new stipulated order at a later date that will include priority items contained in the WRMP. In total, base case capital needs identified in the WRMP are sizeable at an estimated $894 million in 2007 dollars through 2026 or $744 million under a minimum case (priority needs), with $154 million in projects deferred to years 21-30. WRMP capital costs are expected to be largely debt-financed.

To fund the remaining capital items required under the order, as well as items detailed under the WRMP's minimum case scenario and certain expansion related to the indirect impact of Guam's near-term military buildup, GWA has prepared a five year capital improvement program (CIP) for fiscals 2009-2013 totaling $363 million. Of this amount, over $320 million (88%) is expected to be derived from future borrowings, including an issuance in calendar 2010 that is estimated at $148 million. Remaining funding is expected to come from surplus system revenues and grants.

Financial performance in recent years has been adequate, but margins are slim. For unaudited fiscal 2008 annual debt service coverage (ADS) on the bonds was 1.3 times (x), while days cash and days of working capital was just 23 and 39 days, respectively. In addition, free cash was just 20% of depreciation for the period. At the time of Fitch's initial rating in 2005, GWA projected ADS coverage of 3.2x in fiscal 2008. Part of the reason for GWA's weaker financial performance from earlier projections has been the result of smaller and less frequent rate adjustments by the CCU and PUC than originally estimated. Overall, rates were projected to rise 8% annually beginning in fiscal 2006 and continuing through fiscal 2010, but instead were only increased 3% in fiscal 2006 and no adjustment was enacted in fiscal 2007. GWA did receive rate relief in fiscal 2008 of over 14% to ensure compliance with the bond rate covenant and has petitioned the PUC for an additional 13% hike for fiscal 2009; the CCU approved the rate increase in July 2008.

To assist ratemakers and the public with an understanding of the need for continued increases to support necessary capital improvements and maintain sufficient fiscal capacity, GWA staff has prepared a five-year financial plan for fiscal 2009-2013 (the financial plan), the first such multi-year financial projections prepared by GWA staff. In addition to the 13% proposed adjustment for fiscal 2009, the financial plan calls for subsequent annual hikes alternating between 2%-8% through the forecast period. Assuming enactment of such rate increases, GWA projects that ADS coverage will range between 1.6x-3.1x through fiscal 2013. Liquidity is also expected to show improvement through the projection period. The financial plan was approved by the CCU in November 2008 and is expected to be acted upon by the PUC by the end of next month; action on the fiscal 2009 rate hike is expected simultaneously with the financial plan. Fitch considers timely rate recovery as critical to any consideration of a rating upgrade.

Guam is the westernmost territory of the U.S. and is the southernmost island of the Marianas archipelago in the Pacific. Because of its strategic location, U.S. military operations historically have been the main economic engine of the island, and over the next six to eight years the military's economic impact is expected to increase substantially more as the island undergoes a massive buildup of military personnel from relocation of troops from other parts of the globe and consolidation of operations. Overall, military personnel are anticipated to increase by more than fourfold to around 44,000. An additional 20,000 civil and dependent personnel are expected to relocate to the island from this buildup as well. While the Department of Defense (DoD) has allocated funding for capital relative to military bases, there are additional capital requirements that GWA will be required to take on in relation to system expansion for which the DoD has not allocated any funding as of yet. These capital costs are currently estimated at $190 million and are outside of the costs identified in the WRMP, although a portion of them are included in the fiscal 2009-2013 CIP in the form of projects to address population growth due to the impact from the DoD relocation.

In addition to the economic impact of Guam's military, the island has developed a sizeable tourism sector over the past few decades, primarily drawing visitors from Asia, and Japan in particular. Since the peak of visitor arrivals in 1997, Guam has experienced a series of economic hardships and natural disasters, including several typhoons, the threat of the SARS disease, worldwide terrorism, and, most prominently, the Asian economic recession that reduced income levels by 11% from 1999-2003. Enplanements and hotel occupancy have been rebounding, although visitor levels declined during calendar 2008 by over 7% from 2007 with the impact of the worldwide financial crisis. Nevertheless, with rising room rates, hotel occupancy taxes were only down 1.7% for the year.

Fitch issued an exposure draft on July 31, 2008 proposing a recalibration of tax-supported and water/sewer revenue bond ratings which, if adopted, may result in an upward revision of this rating (see Fitch research 'Exposure Draft: Reassessment of the Municipal Ratings Framework'.) At this time, Fitch is deferring its final determination on municipal recalibration. Fitch will continue to monitor market and credit conditions, and plans to revisit the recalibration in the first quarter of 2009.

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