Fitch Rates San Luis Obispo, CA's Water Revs 'AA'; Outlook Stable

Fitch Ratings assigns its 'AA' rating to the following San Luis Obispo, CA bonds:

--$6.3 million series 2012 water revenue refunding bonds.

The bonds are scheduled to be sold via competitive sale the week of Jan. 18. The proceeds will be used to refund the series 2002.

In addition, Fitch affirms the following rating:

--$21.6 million outstanding water revenue bonds at 'AA'.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by net revenues of the water system after payment of operating and maintenance expenses.

KEY RATING DRIVERS

STRONG HISTORICAL FINANCIAL PERFORMANCE: Financial performance has been very strong historically, with debt service coverage (DSC) averaging 3.0 times (x) over the three years ended fiscal 2010, the most recent audited financial results. Liquidity remained extraordinarily strong at greater than 600 days cash and has averaged 667 days over the past five years.

TEMPORARY WEAKNESS TO BE ADDRESSED: Fitch expects the utility to post weak coverage of about 1.0x from fiscal 2011 to 2013, as it adapts to a sharp rise in expenses due to the acquisition of a major new water supply. However, the utility has adequate reserves to allow it to transition to higher rates gradually during this period. Fitch's rating assumes that additional rate increases will be implemented to provide healthy coverage approaching 2.0x by 2015.

STRONG MANAGEMENT AND OPERATIONS: System operations are sound, led by an experienced forward-looking management team and policymakers who have implemented disciplined rate hikes. Water resources are diverse and independent, and treatment capabilities are more than sufficient to meet projected demand.

HEALTHY CUSTOMER BASE: The utility provides an essential service to the cultural and economic center of California's Central Coast region. The customer base is mostly residential, growing very gradually, and reasonably diverse.

HIGH DEBT, SIGNIFICANT INVESTMENTS: The utility's debt burden is very high at over $7,000 per customer and $2,300 per capita. This concern is partially mitigated by the city's development of a diverse, reliable, and independent water supply, and the lack of additional debt plans.

WHAT COULD TRIGGER A RATING ACTION

FAILURE TO IMPLEMENT ADEQUATE RATE INCREASES: Fitch believes the city's exemplary financial planning and long history of implementing disciplined rate increases provide comfort that it will implement the rate increases needed to return coverage to levels approaching 2.0x by 2015. Fitch is likely to downgrade the rating if the utility fails to authorize an adequate rate package for 2014 and beyond in 2013.

CREDIT PROFILE

The water system serves the entire city of San Luis Obispo and several users outside the city, including California Polytechnic University (Cal Poly), which enrolls roughly 15,000 students. The system serves 14,875 retail connections in a developed, stable service area. About 84% of customer accounts are residential. The top 10 customers provide about 12% of revenues, which is above average, but the concentration is largely related to the university, a large, stable governmental employer that presents limited risk.

The utility's traditionally very strong financial performance has been eroded by a large increase in supply expense due to its participation in a project that brings the utility significant new water supplies from the Nacimiento Lake 40 miles to the north. DSC is expected to hover close to 1.0x until the city's next rate package is implemented beginning in 2014. The utility's fiscal 2012 performance is expected to be particularly weak.

The pipeline project, which significantly improves the utility's supply position and long-term prospects, adds a large fixed-cost burden that the utility planned for with a series of large rate increases. Rate hikes averaged 12% over the five years ended fiscal 2011. A rate hike of 10% has already been implemented for fiscal 2012, and a 9% increase has been approved for fiscal 2013. The utility experienced minimal community opposition to rate increases. By raising rates in anticipation of the project, the utility accumulated significant reserves before it began taking delivery of Nacimiento water, allowing it to smooth rate increases over a period of several years.

The rate increases have yielded less revenue than expected due to temporary weather phenomena, conservation efforts, and a cutback in use due to higher prices. Precipitation was above the city's long-term average of 24 inches of rain at 33 inches in 2011, the third consecutive year with rainfall above 30 inches. Water sales volumes dropped by 18.4% over the period, blunting the impact of rate increases. The weather-related aspects of the demand are likely to be transitory, and such volatility is not a credit concern for utilities with sufficient reserves.

However, some of the drop in demand appears to be related to conservation efforts and the city's big rate increases. Management plans to offset the decline in demand by adjusting rates to a level that provides adequate coverage and ongoing investment in the system at current usage levels. It plans to raise rates by 8% in 2014, 7% in 2015 and 4% in 2016, returning coverage to healthy levels at 1.9x in 2015. Fitch believes the city's strong financial planning and long history of implementing disciplined rate increases indicate it will implement the necessary increases. Fitch is likely to downgrade the rating if performance declines further or if the utility fails to implement a rate package that returns coverage to healthy levels.

The water fund's reserves are adequate to withstand this period of weak financial performance. Indeed, the utility prepaid a significant portion of its 2012 debt service during fiscal 2011 to maintain the minimally adequate 1.0x coverage in 2012. The prepayment does not mitigate the underlying need for rate increases, but it shows the flexibility that reserves provide. Days cash was extraordinarily strong at 634 days at the end of fiscal 2010, and liquidity is forecast to remain above the median for the 'AA' rating category even after this payment at better than 300 days cash.

The system's debt burden is well above average for Fitch-rated water and sewer utilities. Total debt exceeds $107 million, including the city's share of the Nacimiento project bonds, water revenue bonds and state revolving fund loans outstanding. The utility has no further debt plans, which will lead to improving debt ratios over time as debt is amortized.

The current high debt levels are largely related to the Nacimiento project, which is expected to provide the utility with adequate water supplies through its full build-out. The water reliability and independence provided by the project position the utility to perform well after it has fully digested the additional cost of the Nacimiento water. The utility's supply position is a significant offsetting credit strength. (The cost of debt service on the Nacimiento bonds is paid as an operating expense as part of the cost of the water provided by the project, effectively making that debt senior to the rated bonds.)

San Luis Obispo is located approximately 10 miles inland of California's central coast, approximately midway between San Francisco and L.A. The city serves as the region's economic and cultural center. The local economy is anchored by Cal Poly and has outperformed the state over many years with an annual unemployment rate below the statewide average for 10 consecutive years. While the local economy remains weak due to the lingering effects of the recent recession, it appears to have good long-term prospects with significant governmental, public utilities, tourism, and agricultural sectors. The region's moderate climate and scenic Central Coast location have been strong draws for residents and businesses over many years. The city also benefits from a small high-tech industry supported by engineering and business departments at Cal Poly. The unemployment rate was elevated at 9.7% in October 2011, but well below the state's 10.9% rate and down by 1.4 percentage points over the past year.

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 the Revenue-Supported Rating Criteria, this action was informed by information from CreditScope, IHS Global Insights, the financial advisor and disclosure counsel.

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria', dated June 20, 2011;

--'U.S. Water and Sewer Revenue Bond Rating Criteria', dated Aug. 10, 2011;

--'2012 Water and Sewer Medians', dated Dec. 8, 2011;

--'2012 Outlook: Water and Sewer Sector', dated Dec. 8, 2011.

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=637130

2012 Outlook: Water and Sewer Sector

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=657110

2012 Water and Sewer Medians

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=657111

U.S. Water and Sewer Revenue Bond Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=647331

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