Recent downgrades of Puerto Rico’s general obligation debt to the brink of speculative grade have caught the municipal market’s attention, but in the case of the commonwealth its “essential services” utility credits don’t appear to offer investors a safe alternative.
The utilities’ struggles were highlighted most recently by Fitch Ratings’ Thursday downgrade of the Puerto Rico Aqueduct and Sewer Authority’s senior revenue bonds to BBB-minus.
PRASA and the Puerto Rico Electric Power Authority are no small potatoes. Together the commonwealth’s two major utilities have about $12.8 billion of debt, compared to Puerto Rico’s $10.6 billion in general obligation debt outstanding.
All three rating agencies have dropped PRASA’s senior-lien debt in the last four months, Fitch’s action being the most recent.
Moody’s Investors Service downgraded PREPA’s revenue bonds in December. Fitch put the agency’s revenue bonds on review for a downgrade in March.
The authority is the largest municipal power provider in the United States, both in terms of customers and revenues. But in this case big does not mean strong.
PREPA is rated BBB-plus by both Standard & Poor’s and Fitch and Baa2 by Moody’s. It has about $8 billion in outstanding debt, according to Moody's.
Among PREPA’s problems is that it has high accounts-receivable levels. The net accounts receivables as a percent of total revenues was 26.7% in fiscal 2011, according to Fitch. That compares to an 11.5% average for Fitch-rated retail electric systems. The other rating agencies and Janney Capital Markets managing director Alan Schankel agree that this is a problem for PREPA.
Though PREPA has not drawn as much money from the Puerto Rican government over last several years as PRASA, in fiscal 2011 it did get subsidies from the government and Government Development Bank of Puerto Rico, Robert Donahue, managing director at Municipal Market Advisors, said in a phone interview.
After adjusting for contributions in lieu of taxes and other related charges, Fitch calculated that for fiscal 2011 funds available for debt service failed to cover debt service.
A Bank of America Merrill Lynch analysis published April 12 calculated that unaudited fiscal 2012 net revenues would provide 1.1 times coverage of maximum annual debt service and 1.2 times coverage of fiscal year 2013 debt service.
When Fitch put PREPA on review for a downgrade in March, managing director Dennis Pidherny wrote that the authority’s preliminary fiscal 2012 data “suggests declining operating margins and cash flow, declining electricity usage, higher leverage, higher fuel costs and growing account receivables for the fiscal year.”
“Perhaps PREPA’s strongest headwind is the island economy, with its weakness contributing to increased delinquencies and falling residential customer usage,” Schankel wrote in early April.
The authority has not increased its base rates since 1989. In fact, in 2012 it instituted a temporary 5% to 10% rate reduction for certain residential customers.
However, PREPA has a fuel adjustment surcharge that allows it to adjust electrical rates monthly. Currently, PREPA’s rates are higher than those of most U.S. electric utilities but comparable to the rates charged by other island utilities, such as those of Hawaii, Guam and Long Island, N.Y., analysts say.
Prior to 2000 PREPA relied on oil for 99% of its energy. Since then it has added natural gas, renewable and other generating capacity. In fiscal 2011 PREPA had reduced its oil-fired generation to 69% of the total. The authority hopes to bring this down to 41% by fiscal 2016. Pidherny wrote that this could save the authority $660 million in fuel costs by 2016.
As of March 2012 PREPA planned to spend at least $1.7 billion on capital projects from 2012 to 2016, financed largely through debt. This would put pressure on the authority’s debt metrics, Pidherny wrote.
PREPA’s executive director Juan F. Alicea Flores took charge at the start of this year. He said he was too busy preparing a strategic plan for the authority to grant an interview.
The agency’s rating will probably converge with that of the Puerto Rican government, Donahue said. The government’s GO debt is rated Baa3 by Moody’s and BBB-minus by both Fitch and S&P. Because of the anticipated lowering of PREPA’s rating, Donahue said he would be wary of buying the debt right now. The audited 2012 results will be important in judging the authority, he said.
PRASA, already in junk-bond territory, supplies water service to nearly the entire island and provides sewer service to 60% of the island’s 3.6 million residents.
As of December 31, 2012, PRASA reported $4.8 billion in debt outstanding. Of this $3.5 billion is senior revenue, $1.2 billion is commonwealth-guaranteed and $162 million is backed by the government.
The big three rating agencies downgraded PRASA in the last four months. Its senior revenue bonds are rated Ba1 by Moody’s and BB-plus by Standard & Poor’s. After Thursday’s downgrade, Fitch is the only agency to keep PRASA investment grade, with its senior revenue bonds at BBB-minus. The authority’s government-guaranteed bonds are rated triple-B-minus by all three agencies.
PRASA has historically received substantial subsidies from the commonwealth government, so a weakening in its financial strength necessarily implied a weakening in the authority’s strength, the rating agencies said.
One of PRASA’s biggest problems has been non-revenue-producing water. More than 62% of the authority’s water produced from fiscal 2007 to fiscal 2012 was not paid for, Fitch analyst Doug Scott said in a report. That compares to a sector average of about 11%. Most of this loss is due to physical losses in pipes and connections, but a substantial amount is due to theft, billing errors and inaccurate meter readings. Since 2008 the authority has pursued a program to replace obsolete meters, collect overdue accounts, properly classify accounts for proper billing and address theft.
The authority says this has netted about $20 million a year in recent years and expects it to grow to $60 million annually in the next few years, out of total operating revenues around $700 million a year.
The PRASA board has proposed a 67% rate increase. Public hearings will be held on the proposal soon. The board will make the ultimate decision. A rate increase would go into effect sometime from July 1 to Aug. 31.
While the rate increase would be a credit positive for PRASA, Scott wrote that there is a concern that the rate increase may increase bad debt rates among its customers.
Additionally, Scott wrote that PRASA’s financial margins are minimal. In fiscal 2011, senior-lien debt service from net revenues was 2.5 times based solely on funds from operations. However, for subordinate debt service PRASA relied partially on funds from the government and the Government Development Bank of Puerto Rico.
According to unaudited fiscal 2012 figures, PRASA had senior debt service coverage of 8.1 times and total debt service coverage of 1 time.
Scott and S&P analyst Theodore Chapman point to formidable capital needs in PRASA’s near future. Authority officials expect to have to spend $1.5 billion for capital needs in the next five years, according to Chapman. That would be primarily for compliance projects and other critical improvements. External sources may be used for up to $1.2 billion of the projects. Further hefty capital spending is anticipated beyond 2017.
On the plus side, PRASA’s management is strong, Scott wrote. The system also benefits from GDB advice and short-term loans.
PRASA is seeking $350 million in loans from four Puerto Rico banks and from Bank of America, director Efraín Acosta said, which will be enough for the coming year’s capital spending needs. For the time being, “it will be tough to access the [bond] markets,” he said.
After the authority increases its rates and bond investors take note of such a serious action, PRASA will return to the bond market, Acosta declared.
Funding the agency’s capital needs will be tough given its limited access to the capital markets, Schankel wrote.
The office of the budget and the GDB have told PRASA that it will get no government financial support in the coming fiscal year, which starts July 1, Acosta said. The rate increase should provide financial stability to PRASA through 2017 or 2018, he said.