New York, October 18, 2016 -- Summary Rating Rationale
Moody's Investors Service today downgraded the ratings on the outstanding Vernon (City of) CA (Vernon Electric) Electric System Revenue Bonds to Baa3 from Baa1. The rating outlook is negative. The ratings downgraded to Baa3 from Baa1 are Series 2008A, Series 2009 A and Series 2012 A and B. Today's rating action concludes the review on Vernon Electric debt that was initiated on August 19, 2016.
The two notch downgrade to Baa3 from Baa1 takes into consideration chronically weak financial metrics including very low adjusted debt service coverage ratios, limited capacity to improve the metrics given the utility's size and the nature of the customer mix, as well as the continued and substantial reliance by the city's General Fund on the utility for transfer payments. The downgrade acknowledges the risks associated with a natural gas prepay contract that becomes a direct obligation of the utility should the supplier and the guarantor not perform. While there is a low probability of these events occurring the existence of this potential risk is unique among municipal issuers with prepay arrangements and the implications for Vernon Electric are material should parties not perform.
The rating considers the city's small size and unique characteristics as the majority of its fixed costs are borne by commercial and industrial customers, and the inherent governance challenges due to the city's small size. After a controversial period stretching close to a decade, with ethics charges brought against the city and certain individuals and attempts by the state to disenfranchise the city, an Independent Reform Monitor was appointed in 2012 and remains in place today. Reform progress is evident with a comprehensive state audit being implemented and a new management team and a newly elected city governing board attempting to bring fiscal stability and reform to various management practices. Over 97% of the items identified in the state audit have been corrected. While progress at local government reform is being made, we understand that the Independent Reform Monitor term, which was to expire at the end of 2016, will continue as the contract was extended to 2017.
With respect to financial metrics, Vernon's fixed obligation charge coverage as calculated by Moody's was below one times between FY 2013-2015, and the fixed obligation charge coverage in FY 2015 was 0.67 times. These financial metrics include the debt associated with the natural gas prepay obligations given the recourse nature of this obligation. Additionally the General Fund transfer is treated as an operating expense of the utility. Even if one excludes the debt service associated with the natural gas prepay, Vernon Electric's metrics were weak. On an indenture basis, Vernon Electric bond ordinance debt service coverage is in compliance with its bond covenants.
Unaudited fiscal year 2016 financial metrics improved somewhat aided by a debt restructuring with the issuance of Series 2015 Electric System Revenue Bonds, 2015 Taxable Series A (unrated), which helped to improve liquidity through capital reimbursements and by delaying the first principal payment to 2023. Forecasted adjusted debt service coverage (after General Fund transfers) are at or below one times coverage. The median for a Baa rated US public power electric utilities that owns generation in FY 2015 was 1.36x.
A major reason for the weak financial metrics has been the large General Fund transfer, which has increased and is needed each year to fund the city's General Fund accumulated deficit. We calculate that the transfer payment represents about 27% of the city's General Fund, and that the city would have a substantial deficit each year without such transfer. For these reasons, we believe that the amount of the transfer will continue at recent historical levels for the foreseeable future. As a further indication of the city's reliance on the utility, we observe that at June 30, 2016, the city's owes the utility approximately $30 million under a City Council Resolution which has been amortizing and is scheduled for repayment in 2021 but can be extended for five years at the city's option.
The city is unique having only a total population of 211, but in the city there is a private sector work force of over 55,000 employees which is evidence of the city's role as a location for industrial and commercial enterprises adjacent to the City of Los Angeles. The 5 square mile city is almost exclusively industrial and commercial including 1,700 customers largely in manufacturing, metalworking, and significant warehouse space. Major highway and commercial rail access are key factors in its growth. A positive consideration is the industrial vacancy rate in the second quarter of 2016 was 3.2% and county unemployment rates have been at their lowest level for past several years. Exide Technologies, recently one of the city's largest industrial firms, lead contamination exposure issue, while not a direct impact to local government is requiring state testing and cleanup in a 1.7 mile radius of the former facility located in this small city of 5 square miles.
Over the past several years, Vernon Electric's strong competitive commercial and industrial rate advantage worsened relative to its adjacent peers as it has had to increase rates annually to maintain even its weak financial position. Higher electricity rates is a problem because of the need for Vernon Electric to remain competitive with the region and particularly versus neighboring Los Angeles Department of Water and Power (Aa2) and Southern California Edison Company (A2).
Given Vernon Electric's history concerning managing risk, a rating consideration is how the utility's governance and risk tolerance may be affected when the Independent Reform Monitor leaves in 2017, if the term is not extended. For example, a major portion of the utility's outstanding debt is related to a natural gas prepay transaction entered into during 2006 that holds significant risk to Vernon Electric and its utility ratepayers in a termination event. The risks associated with the transaction has thus far been somewhat mitigated by a guarantee by Citigroup Inc. (Baa1) and a natural gas sales contract with Sacramento Municipal Utility District (SMUD: Aa3). Additionally, Citi has also posted an $83 million letter of credit agreement reducing nonperformance risk. The original intention of the transaction was to provide a source of economic natural gas below the spot price supplied to the Malburg Generating Station (Malburg), a 134 MW natural gas fired unit located in the city. Vernon Electric constructed the station but then sold it to Bicent Energy, a taxable entity through a sale/leaseback arrangement. However, Vernon Electric could no longer sell the prepaid natural gas to the Bicent station, since it had to be sold to a tax-exempt entity. While the natural gas sales contract with SMUD satisfies the tax-exempt status of the transaction, Vernon Electric now has to purchase natural gas on the market to satisfy the fuel needs under the tolling agreement with Bicent. The prepaid natural gas purchase agreement expires in FY2021.
Vernon Electric's negative outlook reflects the expectation for continued weak financial metrics, a constrained ability to appreciably raise electric base rates given current base rates among C&I customers, and an expectation that transfer payments to the city will continue to be material. Additionally, the negative outlook acknowledges the utility's risk tolerance and uncertainty about how the organization will be managed without external oversight.
Factors that Could Lead to an Upgrade
Improved and steady fixed obligation coverage of all debt and satisfactory internal liquidity on a sustained basis
Reduction in risks related to the Natural Gas Prepay agreement
Demonstration that governance improvements are sustainable
Improved competitive retail rates
Reduction in General Fund balance deficit
Factors that Could Lead to a Downgrade
Worsening fixed obligation charge coverage
Multi-notch downgrade of counterparty rating of Natural Gas Prepay supplier and guarantor
Any weakening in the terms of the SMUD natural gas purchase contract
Security provisions are satisfactory with net revenues of the electric system being the main revenue pledge in the bond security. The rate covenant requires that rates are set to provide net revenues equal to 1.1 times debt service. Parity obligations may be issued if historical net revenues adjusted for rate increases are in place and additions to the system are funded by the new bonds, equal to 1.25 times maximum annuals debt service. The debt service reserve fund is required to be funded at an amount equal to the least of 10% of the initial offering price of the bonds; the greatest amount of debt service on the outstanding bonds due at 125% average annual debt service as adjusted. A Reserve Financial Guaranty policy can be used in place of cash with the Trustee.
Use of Proceeds
Vernon is located 5 miles south of downtown Los Angeles and is unique with a population of only 210 people, but an employment force of 55,000. The 5 square mile city is almost exclusively industrial including manufacturing, metalworking, and significant warehouse space. Major highway and commercial rail access are key factors in its growth. 99% of the electric system revenues are derived from commercial and industrial customers.
The principal methodology used in this rating was US Public Power Electric Utilities With Generation Ownership Exposure published in March 2016. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.
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