June 6, 2006
Fitch Downgrades Lodi Electric Utility to 'BBB-'; On Watch Negative
Fitch Ratings-New York-06 June 2006: Fitch Ratings downgrades the outstanding $78.6 million of the City of Lodi (CA) electric system's certificates of participation notes to 'BBB-' from 'BBB+' and has placed the notes on Rating Watch Negative. The downgrade reflects deterioration of the utility's projected fiscal 2006 financial results from levels indicated to Fitch in March 2006 and concerns that fiscal 2007 results might not show much improvement. Based on discussions with City Council and utility management, there does not appear to be the likelihood of another rate increase in 2006 that would significantly improve the utility's current financial position. The Negative Watch reflects Fitch's view that if the city and utility fail to bolster the utility's liquidity position or if unexpected costs arise that are not met with increased revenues, the rating may be further at risk.
On Jan. 24, 2006 Fitch revised the Outlook to Negative on Lodi Electric Utility's bonds reflecting increasing concern over deteriorating financial measures caused by past power supply strategies related to purchasing the utility's full open position in the short-term market that left the utility highly vulnerable to volatile natural gas prices and wholesale energy markets. The utility has since hedged a portion of its near-term forward power supply. In its March 30, 2006 report, Fitch stated that deterioration of cash and coverage measures could lead to further negative rating action. Lodi's revised projections show $1.7 million of available cash for fiscals 2006 and 2007, which is approximately $2 million less than previous forecasts. Fitch believes the utility's projected working capital level of $1.7 million, or 11 days of operating expenses, is exceptionally thin and places the system at greater risk.
The reduction in cash and operating margin in projected fiscal 2006 results primarily from lower than forecast retail power sales and an additional $1.6 million in transmission costs. For the remainder of fiscal 2006, Lodi will utilize cash reserves from its rate stabilization fund as well as reserves held at the Northern California Power Agency on behalf of Lodi, to meet its 1.1 times (x) rate covenant and to make the annual required transfer payment to the city's general fund ($6 million in 2006). Going forward, Lodi is exploring the use of an outside bank facility to provide additional working capital. The Negative Watch is indicative of Fitch's view that Lodi's continual use of reserves to meet operating expenses or annual general fund transfers is unsupportive of an investment grade rating.
Fitch is concerned not only with the low financial measures but also the city's and utility's lack of response at this time to the less than expected financial margins. With no additional rate increases planned, partly reflecting a sensitive political climate and reluctance by the community to pay higher rates, current projections for fiscal 2007 indicate just adequate cash flow to meet operating expenses, debt service, and the utility's transfer to the city. Consequently, Lodi forecasts that cash reserves will remain around $1.7 million through the end of fiscal 2007 (June 30, 2007). Fitch views this level of liquidity as insufficient for the current rating given that projected annual expenses are approximately $54 million, the utility's operating margins will likely retain some volatility even with the new power supply strategy, and that the utility remains heavily reliant on natural gas prices and the regional wholesale market to meet its energy requirements beyond fiscal 2007.
At present, the 'BBB-' investment grade rating is supported by Lodi's new power supply strategy adopted earlier this year that resulted in over 95% of the utility's open power supply position being hedged for the following fiscal year (2007) as compared to 0% in previous years. Further supporting the rating are the recently created risk oversight committee, which has increased reporting efforts between utility management and City Council, and that following the 17% rate increase implemented last year, revenues are forecast to be sufficient to meet the utility's forecasted expenses in fiscal 2007.
Fitch believes that the new power supply strategy should allow for greater hedging of future energy costs (e.g. the utility is almost entirely hedged for energy costs through 2007). As part of that strategy, the utility expects to hedge most of its energy costs for fiscal 2008 over the next year. While this strategy is intended to introduce greater cost stability than past energy procurement practices, Fitch remains concerned that cost volatility will not be entirely eliminated. Given the lack of response to the recent financial developments, Fitch has concerns as to how the city and the utility will respond if the cost of hedging turns out to be higher than current forecasts.
Fitch is also concerned about additional cost pressure introduced by Lodi's debt portfolio. Lodi's variable-rate debt of $42 million represents a large portion of the utility's total debt portfolio, and dwindling cash reserves provide a limited hedge against rising interest rates. Fitch is also concerned about liquidity pressure that could arise if the utility received below investment grade ratings from either Fitch or Standard & Poor's, which may trigger the termination of Lodi's three outstanding swap agreements. If any of the swaps have a negative termination value, a termination payment from Lodi to the counterpary would be required.
The Lodi electric utility serves as an enterprise system for the city of Lodi, CA, and provides retail electric service to a customer base of approximately 27,558 customers in the city of Lodi, which is located in CA's San Joaquin Valley, 35 miles south of Sacramento. Revenues by customer class include residential (33%), commercial (43%), and industrial (24%). Income levels are below those of the state and national levels.
Contact: Hiran Cantu +1-212-908-0371, New York; or Kathy Masterson +1-415-732-5622, San Francisco.
Media Relations: Christine Pollak, New York, Tel: +1 212-908-0526.