Fitch U.S. Muni Surveillance: Vallecitos Water District, California COPs Affirmed at 'AA'.

AUSTIN, Texas -- In the course of routine surveillance, Fitch Ratings affirms the 'AA' rating on Vallecitos Water District, California's (the district) $62.5 million of outstanding certificates of participation (COPs). The COPs are payable from a senior lien on and pledge of the net revenues of the district. The Rating Outlook is Stable.

The 'AA' rating reflects the system's strong financial performance, rate flexibility, and manageable capital plan. Additionally, district actions to secure additional water should assist in ensuring long-term supply reliability. Financial operations could face pressure in the near-term from continued reductions in connection fees and increases to water supply costs. Significant increases in user charges will be necessary over the next several years to maintain stable financial operations. However, the district has managed well to date, and Fitch expects the district will take necessary actions to preserve sound financial metrics.

Financial performance has been very good, although results for the most recent couple of years have been reduced somewhat from highs in the earlier part of the decade. Senior annual debt service (ADS) coverage levels averaged an extremely high 9.9 times (x) over the fiscal 2004-2008 period, including capacity fees. While ADS coverage for fiscals 2007-2008 continued to be strong, it dropped to the 2.2x-2.8x range as connection fees fell from slowing development; for fiscal 2008 connection fees were just $2.6 million compared to the high of $8.8 million in fiscal 2005. Projected ADS coverage over the next few years is anticipated to be good, but margins are forecasted to be somewhat less than historical norms given rising water purchase cost pressures and a continued dampened pace of development.

The district has taken prudent steps to establish reserves for operations and capital replacement funding and has historically maintained sound unrestricted cash and investment balances. For fiscal 2008, these balances equaled 253 days of operating expenditures. Given that 100% of the district's $55 million fiscal 2010-2014 CIP is expected to be cash funded, cash and investment balances may decline. However, Fitch expects that reserve levels overall will remain favorable.

As with most southern California credits, user charges are expected to see steady increases, but district rates are favorable and residential charges are currently estimated to be among the lowest in the area. The district has adopted rate increases through fiscal 2011, with residential users experiencing a combined monthly bill increase of $15.55 and $10.08 for FY2010 and FY2011, respectively. However, most water hikes are direct pass-through increases from the San Diego County Water Authority (SDCWA). Based on the current rate structure, the district's combined average monthly bill is very affordable at 1.1% of median household income and user charges should continue to compare favorably to other area retailers.

The district recently entered into a contract with Poseidon Resources to purchase 7,500 acre-feet per year of available desalinized water. Poseidon's plant is expected to break ground later this year and be operational in 2012. The contract term is for 30 years from the plant operation date, along with the option for two 30-year extensions. With continued dry weather, water supply shortages and increases in wholesale water costs, desalinized water provides the district with a sustainable and reliable alternative source of supply.

The district is centrally located in northern San Diego County between the cities of Los Angeles and San Diego. The district provides water, wastewater, and water recycling services to over 80,000 people in the city of San Marcos, portions of the cities of Escondido and Carlsbad, as well as unincorporated parts of San Diego County. The district currently purchases its entire water supply from SDCWA (COPs rated 'AA' by Fitch). Wastewater is treated both at the city's own water reclamation facility as well as the Encina Water Pollution Control Facility, in which the district owns a 20% stake.

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