Fitch Affirms Sonoma County Water Agency, CA Water Revs at 'AA'; Outlook Stable

As part of its ongoing surveillance efforts, Fitch Ratings has affirmed its 'AA' rating on Sonoma County Water Agency, CA's (SCWA) outstanding $27.2 million water revenue bonds, series 2003 and 2006. The Rating Outlook is Stable.

The 'AA' rating reflects stable financial performance, wholesale contracts that provide timely cost recovery through annual rate setting and an unconditional obligation to pay by the eight wholesale customers, significant changes to water supply in the past year, and capital needs that are expected to be manageable. Credit concerns relate to discord among wholesale customers regarding the pursuit of additional water supply rights and some uncertainty regarding the capital costs and operational changes needed to comply with a new Biological Opinion released in 2008.

SCWA operates under the control of a Board of Directors comprised of the Sonoma County Board of Supervisors. The agency provides wholesale water supply to eight primary water contractors along with several other customers to whom the agency delivers water on a subordinated basis. The water contractors include the cities of Santa Rosa, Petaluma, Sonoma, Rohnert Park, Cotati, the Town of Windsor, the Valley of the Moon, and North Marin Water Districts. This enterprise is known as the 'transmission system' and net revenues from this enterprise secure the bonds. SCWA has other enterprises, such as water supply, flood control, wastewater treatment, that are not pledged to bondholders. The wholesale customers are unconditionally obligated, under a restructured agreement, to pay costs of SCWA, including debt service on the bonds, regardless of water deliveries. SCWA sets its budget annually and the water rates to the eight wholesale customers are based on expected water deliveries and budged expenditures that need to be recovered in that year. This budgeting process has been timely in that it has adjusted the budgeted rates to recover sufficient revenues even with the significant declines in water sales experienced by SCWA.

The agency experienced mandatory reductions in water distribution of approximately 25% to its customers between June 15, 2009 and Oct. 2, 2009. The cutbacks were needed to preserve water levels in Lake Mendocino, a critical part of the agency's and region's water supply network, and to comply with Federal Endangered Species Act requirements for lower flows in Dry Creek, through which SCWA conveys water from Warm Springs Dam for water supply. SCWA has applied to the Water Quality Control Board for permanent flow changes, similar to the order they received this year, which also required reduced water diversions. The result is expected to be a reduction in annual water sales of around 15% compared to years past. However, financial performance is expected to remain consistent since all costs are passed through to the wholesale customers on an annual basis, including much higher rates for the water sold in order to recover essentially unchanged expenses.

Due to various factors, SCWA has decided to abandon the construction of a transmission system expansion project. This decision was made in September 2009, but the agency's largest customer, the City of Santa Rosa, applied for a temporary restraining order to stop SCWA from taking this action, although this application was denied. It appears there is not consensus among the eight wholesale customers as to whether or not to continue to pursue the transmission system expansion project. There has been regional environmental opposition to the expansion and there would be significant additional costs (estimated in the range of $600 million) to construct the project.

Assuming the transmission system expansion project does not move forward, capital needs will relate primarily to projects needed to comply with the Biological Opinion released by National Marine Fisheries Service in 2008 governing the Russian River. SCWA is in the process of reviewing its capital plan and cost estimates in light of the Biological Opinion and the decision to discontinue pursuit of additional water rights and the transmission projects that would have been needed. Fitch expects capital spending to ramp up in the next few years related to the Biological Opinion. SCWA has 15 years to comply with the required changes that relate primarily to fish protection measures.

Historical financial performance has been strong with some decline, as expected, in fiscal 2008 with higher operational costs related to the Biological Opinion and higher debt service costs. Debt service coverage was adequate for a wholesale entity at 1.68 times (x) in fiscal 2008. Liquidity was strong with $29 million in unrestricted cash reserves, or 377 days operating cash. Unaudited financials for fiscal 2009 indicate similar financial performance.

Additional information is available at www.fitchratings.com.

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