Fitch Affs Louisville & Jefferson County Metro Sewer Dist, Kentucky's Revs at 'A+'; Outlook Stable

In the course of routine surveillance, Fitch Ratings affirms its 'A+' rating on Louisville and Jefferson County Metropolitan Sewer District, Kentucky's (the district) $994.6 million of outstanding sewer and drainage system revenue bonds, consisting of the following series:

--$159.1 million, series 1998A;

--$285.1 million, series 1999A;

--$291.9 million, series 2001A;

--$100 million, series 2004A;

--$60.1 million, series 2005A;

--$98.4 million, series 2006A.

The Rating Outlook for all bonds is Stable.

The 'A+' rating reflects the district's adequate financial performance, demonstrated willingness to raise rates, sizeable capital improvement program (CIP), elevated debt burden, and diverse and growing service area. The district is in the midst of a major capital investment cycle, driven predominantly by a regulatory consent decree on the wastewater side. Capital costs, which are significant over the next three years, are expected to require ongoing borrowing. This will put increased fixed cost pressure on the system's financial performance over the near-term, but with expected steady increases in the rate base, margins should improve by the end of the forecast period and be more in line with the current rating level.

The district provides wastewater collection, treatment, and disposal service as well as stormwater drainage service to around 720,000 people within the boundaries of the Louisville/Jefferson County Metro Government (Metro) and certain outlying areas. Like many large urban wastewater utilities, the district's wastewater system has encountered periodic sanitary sewer overflows (SSOs) and combined sewer overflows (CSOs) during wet weather events, which has led to regulatory action against the district. These actions have culminated with the district entering into an amended consent decree in 2009 with the U.S. Environmental Protection Agency (EPA), which superseded a prior consent decree and which outlines various actions for the district to accomplish in order to achieve compliance with its discharge permits.

The consent decree provides the framework of actions by the district over a 19-year period and is estimated to require capital spending of around $800 million. Upon completion of the consent decree milestones, the district expects to capture and treat 96% of all CSOs and eliminate a significant amount of SSOs. The bulk of all capital projects associated with the consent decree are expected to be implemented over the next three to five years. As the district completes major projects, capital expenditures are expected to decline significantly and be much more manageable.

For fiscals 2010-2014, the district's CIP calls for capital spending and project management of around $600 million, most of which is directly related to consent decree projects. Funding for these outlays is anticipated to be derived primarily from future borrowings ($550 million), including an upcoming sale. This will increase the district's already high debt levels and necessitate ongoing rate hikes to offset the rising debt carrying costs.

In an effort to ensure ongoing resources for capital spending, the district's board has raised both wastewater and drainage charges almost continuously since 1991. In addition, to elevate the wastewater rate base sufficiently to fund required regulatory capital items, the board (with the approval of the Metro council) implemented a special surcharge in fiscal 2008, effectively boosting charges by 34%. Since that time the board has adopted additional hikes of 6.5% for both fiscals 2009 and 2010. Despite the continuous increases in rates, combined wastewater and drainage charges remain relatively affordable. This should provide the district sufficient flexibility for future adjustments needed to service a rising fixed cost structure.

As the district's debt service costs have increased in recent years financial margins have narrowed. In fiscal 2003 annual debt service (ADS) coverage was over 1.8 times (x), but by fiscal 2007 ADS coverage had fallen to the district's 1.1x rate covenant. However, with the implementation of the rate surcharge in fiscal 2008 and subsequent hike in fiscal 2009 ADS coverage has stabilized and improved somewhat, rising to over 1.3x for unaudited fiscal 2009. Liquidity and cash flow margins similarly have benefited from the board's recent rate actions. The district's financial margins are expected to remain relatively narrow over the next few years as the additional planned debt comes online. However, results should show improvement subsequent to these issuances from steady anticipated rate adjustments and Fitch believes that these improvements, coupled with a reduced level of ongoing capital pressures, ultimately will allow the district to generate even better financial results over the medium and long term.

The district currently has nine swaps outstanding and initially entered into swaps in order to hedge its exposure to variable-rate debt and take advantage of a lower cost of funds. But with the market volatility over the last year and the rising cost of liquidity, the district has moved towards decreasing its exposure to variable-rate debt instruments. With this transition in debt structure, the district has sought effectively to offset its fixed-payor swaps with a series of fixed-receiver and basis swaps, thereby extending the cost of the termination payments instead of eliminating the original swaps altogether and paying a termination fee at once. Apart from Fitch's concern related to the ongoing fixed costs now resulting from the district's mirror swaps, Fitch believes that the district has mitigated much of its interest rate exposure and also limited some of its counterparty risk.

Metro (general obligation bonds rated 'AA+' by Fitch) serves as the major economic engine of the state. The area's job base has diversified over the last decade from primarily manufacturing to include a strong service component. Wealth levels are above the state average but about 10% lower than the nation's. Unemployment, characteristic of the recession nationwide, has spiked year-over-year and was 10.6% for August 2009, slightly higher than the national average of 9.6%.

Additional information is available at www.fitchratings.com.

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