Fitch Rates City of Philadelphia, Pennsylvania’s $300MM Airport Revs ‘A’, Outlook Stable

Fitch Ratings assigns an underlying ‘A’ rating to City of Philadelphia’s (the city) airport revenue bonds, as follows:

–$174 million airport revenue bonds, series 2007A (subject to Alternative Minimum Tax[AMT]);

–$41 million airport revenue refunding bonds, series 2007B (non-AMT);

–$85 million airport revenue refunding bonds, series 2007C (AMT);

Fitch also affirms the city’s $1.2 billion outstanding airport revenue bonds. The Rating Outlook is Stable.

The series 2007 bonds collectively are scheduled to price via negotiation on or about Aug. 8, 2007 via a syndicate led by UBS Investment Bank. While planned to price as fixed rate bonds, depending on market conditions the issuer may price series 2007C bonds at a later date as auction reset securities with a corresponding variable to fixed interest rate swap agreement to achieve desired savings. While the final structure of the swap has not yet been determined, Fitch has examined the preliminary structure and found it to be consistent with industry standards. The long-term ratings on the series 2007 bonds are expected to be ‘AAA’ based on a guarantee of debt service under an insurance policy with a monoline insurance company whose insurer financial strength is rated ‘AAA’ by Fitch. Proceeds of the series 2007A will fund various capital projects contained in Philadelphia department of aviation capital improvement program, while proceeds of the series 2007B and 2007C will refund existing debt for interest rate savings. Net operating revenues at Philadelphia International Airport (Philadelphia or the airport) secure the bonds.

The Stable Rating Outlook reflects the airport’s critical role in providing air service to a stable and highly populous service area that generates a solid base of origination & destination traffic. The ‘A’ rating incorporates the airport’s sound base of passenger demand, recent gains in low-fare service, including the introduction of service by market leader Southwest Airlines, and a sound financial profile characterized by competitive airline costs and moderate levels of leverage. Credit concerns center on the large portion of traffic generated by a single carrier and the significant portion of connecting traffic. Additionally, an increasingly congested airfield may necessitate a significant capital program to enhance runway capacity and efficiency in the next 5 to 10 years, with a corresponding increase in debt.

The entry of Southwest Airlines to the airport in 2004 furthered a trend to a more diversified marketplace, with low cost carriers Southwest, AirTran Airways and Frontier Airlines now representing 14% of total enplanements, compared to 2% in fiscal 2002, when AirTran Airways was the sole low cost carrier. However, the airport remains a US Airways’ stronghold, as that airline enplaned 63% of fiscal 2006 passengers. The significant portion of connecting traffic (35%) also represents a concern, as US Airways could opt to route that traffic through other east coast airports such as Charlotte-Douglas International. Mitigating the potential shift in connecting traffic is the much stronger base for international service at Philadelphia, which serves as US Airways’ largest international gateway.

In contrast to the ramp-up in enplanements seen in fiscal 2005, reflecting the 2004 entry of Southwest Airlines, traffic grew at modest rates in fiscal 2006 and fiscal 2007 due to a combination of US Airways service reductions and a national trend toward higher airfares. Total airport enplanements were little changed from fiscal 2005 to fiscal 2006, and have shown a 1.7% increase through the first 11 months of fiscal 2007. Fitch notes that the airport’s operating structure should enable the maintenance of current financial and operational margins even if enplanements over the medium term were to grow at rates below the 2-3% forecasted through fiscal 2012 by the airport’s consultant.

Through the end of fiscal 2007 the airport utilized a hybrid lease which, in combination with sound financial management, resulted in stable operating margins despite recent changes in the air service market. Revenues and expenses both increased at a 9% rate on average annually since fiscal 2002 to achieve a net revenue total of $77 million in fiscal 2006. The airport’s fiscal 2006 operating margin of 35% was comparable to the average margin experienced over the past five years. The cost basis at the airport was moderate for an international gateway, equaling an estimated $6.64 in fiscal 2006.

The airport recently implemented a new lease agreement which is set to run from fiscal year 2008 through fiscal 2011. Under the terms of the prior lease, the airport was required to set airline rates to ensure that airport revenues were sufficient to meet the required rate covenant of 1.50 times (when excluding the net impact of cost centers such as parking and rental car concessions), or a 1.00 times (x) rate covenant when substantially all airport cost centers were included. The exclusion of passenger driven revenues such as automobile parking and rental car concessions from the rate setting mechanism and from the legal bond holder pledge historically resulted in lower levels of liquidity and debt service coverage that would be expected from a comparably facility operating under a hybrid lease. In fiscal 2006 the airport generated 1.77x coverage under the first requirement and 1.12x coverage under the second requirement.

Under the new lease which took effect at the start of fiscal 2008, all airport terminal and passenger revenues are pledged to bondholders before first being shared with the airlines, as was done under the initial lease. Forecasted coverage levels through fiscal 2012 (including an additional $240 million of debt expected in 2009) are expected to be at or above 2.30x under test one and at or above 1.65x under test two. Fitch believes that the new lease modernizes the airport’s rate setting structure and adds additional bondholder security to bring the airport’s rate setting mechanism in line with those existing for comparable facilities.

The airport’s current capital improvement plan (CIP) calls for some additional debt through the 2012 forecast period. Management anticipates issuing approximately $240 million in fiscal 2009 which, in addition to the series 2007A and previously issued bonds, will fund approximately 55% of a $1 billion CIP that runs from 2008-2012. Even with the additional series 2009 debt the airport will still have a moderate debt burden, currently at $73 per enplaned passenger as of fiscal 2006. The 2008-2013 CIP emphasizes terminal upgrades and additions and also funds the lengthening of a runway to 6,500 feet from 5,460 feet. Other funding sources include passenger facility charge pay-go (18% of total sources), state and federal grants (24%) and airport reserves (3%). In addition to its CIP, the Federal Aviation Administration (FAA) is currently conducting and environmental impact study (EIS) regarding the airport’s plans for the future redesign of the airfield. The airport anticipates completion of the EIS in late 2008 and a record of decision in 2010. While the costs and timing of the program are dependent on the plan eventually approved through the EIS process, and the level of federal funding offsets are unknown at this time, based on the airport’s current plan Fitch believes that such a significant capital program will likely result in the use of additional leverage within the next five to ten years.

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