Fitch Downgrades Kauai County, HI's, GOs to 'AA-'; Outlook Stable

News Release from Fitch Ratings, April 24, 2014

SAN FRANCISCO--Fitch Ratings has downgraded Kauai County, Hawaii's, $188 million general obligation (GO) bonds to 'AA-' from 'AA'.

The Rating Outlook is Stable.

SECURITY

The bonds are absolute and unconditional general obligations, supported by the full faith and credit of the county and an unlimited pledge of ad valorem property tax.

KEY RATING DRIVERS

PERSISTENT OPERATING IMBALANCE: The downgrade to 'AA-' is based on the county's reduced financial flexibility following a substantial reduction in reserves over the past several years. Expenditure growth has repeatedly outpaced revenue gains, resulting in recurring operating deficits and drawdowns in fund balance.

PROSPECTS FOR REVENUE GROWTH: The county has responded to operating deficits with property tax rate increases and may also benefit from recent growth in assessed values (AV) and proposed state legislation to eliminate a cap on counties' share of transient accommodation tax. Such increases may help restore operating balance but do not appear sufficient to raise reserves to previously high levels.

LIMITED EXPENDITURE FLEXIBILITY: General fund expenditures rose steadily throughout the downturn. Recent salary increases resulting from state-level negotiations exceeded management estimates and have contributed to ongoing budget challenges.

NARROW ECONOMIC BASE: Kauai's economy remains highly dependent upon tourism, which continues to show improvement from sharp declines during the downturn. Tourism indicators have risen steadily since 2010 but in general remain below pre-recession peaks.

MIXED LONG-TERM OBLIGATIONS: Debt levels are low due to the absence of overlapping jurisdictions and state government's responsibility for funding public education, but liabilities for retiree benefits are substantial.

RATING SENSITIVITIES

An inability to restore general fund structural balance after fiscal 2014 would likely add downwards rating pressure.

CREDIT PROFILE

Kauai County is the smallest of the four Hawaiian counties in terms of size, population, and operating budget. It occupies the two northern inhabited islands of the Hawaiian Archipelago and has a population of approximately 68,000.

OPERATING IMBALANCE CONTINUES

The downgrade to 'AA-' from 'AA' reflects the county's diminished financial position and prospects for further declines. Unrestricted fund balances fell by more than half between 2010 and 2013, from 62% to 27% of general fund spending, and appear likely to decline further in 2014 and 2015 based on management projections. Fitch considers unrestricted fund balance a key credit factor for the county given its narrow economic base and vulnerability to declines in discretionary consumer spending. Reduced reserves also leave the county less well-equipped to manage future budgetary pressures.

Fund balance drawdowns have resulted from an ongoing imbalance between general fund revenue and spending trends which remains unresolved. General fund expenditures increased at a compounded annual growth rate of 3% between 2009 and 2013 compared to annual revenue declines of 2.8%. In addition, general fund subsidies for the county's solid waste, sewer, and golf enterprises remain significant despite recent efforts to raise user fees, accounting for 5% of general fund spending in 2013.

POTENTIAL REVENUE GAINS

The county is highly dependent upon property taxes, which comprised 79% of general fund revenues in 2013 and tend to lag behind the economic cycle. Property tax revenues fell by 12% between 2009 and 2012, contributing to the county's operating challenges, before returning to growth in 2013. Tax rate increases adopted for the 2014 budget are expected to raise $11 million in new revenue, with a further $4.3 million increase proposed for 2015. A 6.5% increase in 2014 AV will likely boost 2015 property tax receipts further.

Additional revenue gains for 2015 may arise from the proposed elimination of a cap on transient accommodation tax (TAT) imposed by the state during the recent recession. TAT is the county's second largest source of general fund revenue and the state's adoption of the proposal, currently before a legislative conference committee, could add $5-10 million in new funding for 2015 and beyond. Such increases could help restore the county's operating balance but do not appear sufficient to raise reserves to the county's previously high levels.

LIMITED EXPENDITURE FLEXIBILITY

The county's general fund expenditures rose steadily throughout the downturn and show no signs of abating. Public safety increases, which accounted for 37% of general fund spending in 2013, have been notably high, rising at a 7.8% compound annual growth rate between 2009 and 2013.

Labor negotiations for Hawaii's counties are managed jointly with the state, and recent settlements have exceeded budget estimates. The county has also opted to minimize the use of potential labor cost control measures such as furloughs, layoffs, or temporary salary reductions.

NARROW ECONOMIC BASE

Tourism is the mainstay of the county's economy and has shown steady growth since mid-2010 after sharp declines during the recession. Total visitor arrivals remain below pre-recession peaks despite these gains, while visitor expenditures have only recently surpassed previous highs. Hotels and resorts account for a majority of the county's major employers and taxpayers, underscoring the importance of the visitor industry to its economy.

The county's unemployment rate of 5.1% as of December 2013 was above the state average of 4.2% but compared favorably to the national average of 6.5%. Employment levels have seen modest recent growth but remain well below pre-recession peaks.

MIXED LONG-TERM OBLIGATIONS

County debt levels are low at $1,774 per capita and 0.7% of market value, in part due to the absence of overlapping jurisdictions, as well as the state's responsibility for school funding under Hawaii's unique division of municipal responsibilities. Amortization is rapid with 77% of governmental debt repaid in 10 years. The county is a participant in the state-sponsored employee retirement system and will likely face ongoing contribution rate increases to address a low funding ratio. Carrying costs for debt service and retiree benefits are elevated at 26% of governmental spending, about half of which is attributable to pension costs.

The county's unfunded liability for other post-employment benefits (OPEB) is substantial at $156.6 million as of 2011, but the county has shown notable fiscal responsibility in fully funding its actuarially determined annual required contribution for such benefits between 2008 and 2014. Management has proposed a reduction in OPEB funding for 2015 but may elect to return to full funding if potential revenue gains are achieved.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from Creditscope and Zillow.com.

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