Fitch: Revises Milwaukee sewer revs outlook to negative; affirms ratings at ‘A+’

Fitch Ratings has affirmed the ‘A+’ rating on the following Milwaukee, WI (the city) obligations:

–Approximately $151 million sewerage system revenue bonds series 2021 S2 and series 2016-S7′

In addition, Fitch has assessed the sewer system’s standalone credit profile (SCP) at ‘a+’. The SCP represents the standalone credit profile of the system on a stand-alone basis irrespective of its relationship with and the credit quality of the city (Issuer Default Rating [IDR] A/Negative).

The Rating Outlook has been revised to Negative from Stable.

ENTITY / DEBT  

RATING  

PRIOR  

Milwaukee (WI) [Sewer]

  • Milwaukee (WI) /Sewer Revenues/1 LT

LT

A+ 

Affirmed

A+ 

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VIEW ADDITIONAL RATING DETAILS

ANALYTICAL CONCLUSION

The Negative Outlook reflects Fitch’s view that leverage, measured as net adjusted debt to adjusted funds available for debt service (FADS), will rise and exceed 10.0x on a sustained basis. Increasing leverage is driven by lower than previously expected FADS, reflecting current estimates for revenue growth to lag the rate of expenditure growth over the five-year horizon.

The ‘a+’ SCP assessment and ‘A+’ revenue bond rating reflect the system’s historically stable financial performance, which had shown improvement through 2021 (FYE Dec. 31), viewed in the context of its strong revenue defensibility and very strong operating risk profile.

The city maintained its sewer rates into 2022, but raised rates in 2023. Moderate rate increases are anticipated going forward that will continue to be offset by moderate volume declines. Growth in operating expenditures, in part reflecting recent inflationary pressures, is projected to outpace revenue growth. The city also supports general fund expenditures that benefit stormwater operations; Fitch assumes these costs will increase in line with other expenses. As a result, FADS is expected to be lower through the five-year horizon, moving leverage higher through this period.

Revenue defensibility, assessed at ‘a’, reflects the provision of monopolistic services to the city of Milwaukee along with the common council’s independent ability to adjust rates. The service area is generally stable, although the median household income (MHI) is significantly below the national median. The system’s operating cost burden remains very low, and the life cycle ratio reflects capital spending that has consistently outpaced depreciation, supporting the ‘aa’ operating risk assessment.

Leverage approximated 9.1x in 2021, continuing its downward trend over the past several years. Current estimates indicate a reversal in this trend, with leverage approaching 11.0x by 2026. Leverage incorporates the system’s capital spending that is predominantly debt funded.

CREDIT PROFILE

Sewer system operations consist of collection and conveyance of sanitary and stormwater flows within the city of Milwaukee. Sanitary flows are conveyed for treatment to the Milwaukee Metropolitan Sewerage District (MMSD; IDR AAA/Stable). Milwaukee is located on the western shore of Lake Michigan in southeastern Wisconsin. The city is the hub of the metropolitan area and is the state’s largest city with a population approaching 580,000. The system serves around 140,000 primarily residential sewer customers.

Fitch considers the system a related entity to the city for rating purposes, given city’s oversight of the system, including the authority to establish rates and the city-wide approach to liquidity management. Notably, liquidity for the system is supported by the general government of the city, both from an operating cash perspective, as well as the ability to make advances for construction. The city’s credit quality influences but does not currently constrain the system’s rating. However, as a related entity, the issue rating could become constrained by a material further decline in the general credit quality of the city.

KEY RATING DRIVERS

Revenue Defensibility ‘a’

Midrange Service Area Characteristics; Supportive Rate Flexibility

The revenue defensibility assessment reflects the monopolistic nature of the service and city’s independent legal ability to establish rates. Sewer rates remain affordable for the vast majority of the population, despite median household income levels that approximate 66% of the nation.

Operating Risks ‘aa’

Very Low Operating Cost Burden; Robust Capital Plan

The system’s very strong operating risk profile incorporates the very low operating cost burden, consistent with the system’s collection only operations. The very low life cycle ratio is supported by capital spending which significantly outpaces the level of annual depreciation.

Financial Profile ‘a’

Solid Financial Profile; Currently Neutral Liquidity

Leverage of 9.1x in 2021 is anticipated to increase and approach 11.0x in the current five-year horizon. Increasing leverage reflects generally stable but lower FADS to support ongoing debt issuance in support of capital spending. Fitch currently considers the liquidity profile neutral to the assessment, but notes it has shown variability.

Asymmetric Additive Risk Considerations

No asymmetric additive risk considerations affected this rating determination.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

–Increased FADS, driven by the convergence of revenue and operating growth rates and stable capital spending could stabilize the Outlook;

–Sustained leverage ratios below 8.0x in Fitch’s base and stress cases, in the context of current revenue defensibility and operating risk assessments.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

–Leverage sustained above 10.0x in Fitch’s base and stress cases;

–A reduction in overall system liquidity as evidenced by current cash levels below 30 days cash on hand and coverage of full obligations (COFO) that is below 1.0x;

–Material deterioration in the city’s IDR and/or liquidity position.

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

SECURITY

The bonds are secured by net revenues of the system and a mortgage lien on the system. Additionally, the city has pledged legally available funds, subject to annual appropriation, to subsidize any revenue shortfall, although the city is not obligated to make such an appropriation over and above the reasonable cost and value of services rendered to the city, as defined in the bond resolution.

Revenue Defensibility

Revenue defensibility is strong, as reflected by the ‘a’ assessment. The system provides an essential service to a large and economically diverse service territory within the city of Milwaukee, and all revenues are derived from the system’s monopolistic business line to provide retail sewer services. The city’s common council is able to adopt rate increases without external oversight.

Service area demographics include a generally stable customer base, and an unemployment rate that improved through 2018, but weakened compared to the national rate through the pandemic. The unemployment rate was 6.5% in 2021, compared to 5.3% for the nation. December 2022 figures (not seasonally adjusted) indicate improvement in the unemployment rate, approximating 97% of the nation. The city’s stable MHI approximates two-thirds of the nation, with about 25% of the population below the poverty level.

Sewer rates are based on water consumption during winter months for residential customers and bills are combined with other utility services. When calculated on a monthly basis and utilizing Fitch’s standard usage metric of 6,000 gallons per month, and including the charge from the Milwaukee Metropolitan Sewerage District, bills are considered affordable for more than 80% of the service area population, even in light of the relatively low MHI and the history of regular rate adjustments.

Operating Risks

The system’s operating risk profile is assessed at ‘aa’, with a very low operating cost burden of about $1,600 per million gallons (mg) of flows and a life cycle ratio consistently below 25%. The low cost of operations is largely attributable to the system’s conveyance only nature for sewer and stormwater flows.

Total system costs (operating and non-operating) in 2021 included about $25 million related to street sweeping, leaf collection and similar activities deemed beneficial to the system. When including these additional costs to the system, the operating cost burden is still very low at less than $2,900 per mg. Fitch has assumed these costs will increase at approximately the same pace as other operating costs over the next five years.

The system’s life cycle ratio averaged 23% over the last five years as annual capital expenditures consistently exceed annual depreciation. The system’s capital expenditures are expected to approximate $25 million annually, primarily related to relining and replacement of existing sewer lines. Additional spending supports inflow and infiltration mitigation projects as well as flood mitigation and downspout disconnection. Management expects to fund the significant majority of capital needs with debt, predominantly through the use of state revolving loan funds.

Financial Profile

The financial profile is assessed at ‘a’. Leverage of 9.1x in 2021 reflects a continued decline in leverage over the past five years from a high of 13.4x in 2017, attributable to ongoing rate increases driving FADS growth and, in 2021, capital spending that was below estimates. Fitch-calculated FADS for the system, and resulting leverage, reflect the total reported costs of the system, including recurring non-operating expenses.

The liquidity profile is considered neutral to the assessment but has shown variability. Coverage of full obligations has been above 1.0x since 2019. Reported liquidity has been variable as the system participates in a city-wide cash pooling program. Days cash on hand grew from 30 in 2020 to 272 in 2021, but benefited from funds planned for construction (reflected as unrestricted on the financial statement). Despite this variability, Fitch historically has viewed the system’s liquidity profile as neutral given the participation in the city-wide pool.

As Fitch’s assessment of the city’s credit quality has evolved, Fitch views liquidity provided by the pool program as less of a mitigating factor in the absence of a specific cash policy for the sewer system. Fitch believes the system’s liquidity could be stressed should the city’s overall credit quality or liquidity position weaken.

Fitch Analytical Stress Test (FAST)

The FAST considers the potential trend of key ratios in a base case and a stress case. The stress case is designed to impose capital costs 10% above expected levels and evaluate potential variability in the projected key ratios. The base case was informed by the city’s estimates of system revenues and expenditures, annual capital spending and debt issuance.

Revenues are estimated to increase 2% annually, reflecting moderate rate increases offset by volume declines; expenditures are estimated to increase 4% annually. Capital spending for 2022 through 2026 is anticipated to total $132 million, primarily supported by state loans and revenue bond issuance totaling $103 million through 2026 (about 85% of sources); the remainder is anticipated to be funded through grants for specific purposes. Fitch also assumed that the system’s recurring non-operating costs that support system-related general fund expenditures will continue, and increase at a rate similar to other expenditures.

Using the above assumptions, Fitch’s base case indicates that leverage will increase over the five-year horizon, reaching 10.4x by 2026. The stress case reflects peak leverage of 10.8x in 2026, reflecting the impact of additional debt funded capital for the stress case. The sustained leverage above 10.0x drives the Negative Outlook. The liquidity profile could continue to show variability and could become weaker and risk additive if current days cash drops below 30 days. COFO is expected to remain at 1.1x or higher over the upcoming five years.

Sources of Information

In addition to the sources of information identified in Fitch’s applicable criteria specified below, this action was informed by information from Lumesis.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of ‘3’. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg.

Additional information is available on www.fitchratings.com

PARTICIPATION STATUS

The rated entity (and/or its agents) or, in the case of structured finance, one or more of the transaction parties participated in the rating process except that the following issuer(s), if any, did not participate in the rating process, or provide additional information, beyond the issuer’s available public disclosure.

APPLICABLE CRITERIA

ADDITIONAL DISCLOSURES

ENDORSEMENT STATUS

Milwaukee (WI)EU Endorsed, UK Endorsed

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All Fitch Ratings (Fitch) credit ratings are subject to certain limitations and disclaimers. Please read these limitations and disclaimers by following this link: https://www.fitchratings.com/understandingcreditratings. In addition, the following

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SOLICITATION STATUS

The ratings above were solicited and assigned or maintained by Fitch at the request of the rated entity/issuer or a related third party. Any exceptions follow below.

ENDORSEMENT POLICY

Fitch’s international credit ratings produced outside the EU or the UK, as the case may be, are endorsed for use by regulated entities within the EU or the UK, respectively, for regulatory purposes, pursuant to the terms of the EU CRA Regulation or the UK Credit Rating Agencies (Amendment etc.) (EU Exit) Regulations 2019, as the case may be. Fitch’s approach to endorsement in the EU and the UK can be found on Fitch’s Regulatory Affairs page on Fitch’s website. The endorsement status of international credit ratings is provided within the entity summary page for each rated entity and in the transaction detail pages for structured finance transactions on the Fitch website. These disclosures are updated on a daily basis.

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