Palmerston North City Council Outlook Revised To Positive After Similar Action On New Zealand; Ratings Affirmed

OVERVIEW
  • On Jan. 31, 2019, we revised the rating outlook on New Zealand to positive from stable.
  • Consequently, we are revising our outlook on Palmerston North City Council (Palmerston North) to positive from stable because the ratings on the council are constrained by the long-term foreign-currency rating on New Zealand.
  • At the same time, we are affirming the 'AA/A-1+' ratings on the council.
  • Although Palmerston North's stand-alone credit profile is currently higher than New Zealand's, we believe the council could not withstand a default scenario better than the sovereign could, and that the council's credit metrics would deteriorate in line with those of the sovereign in the event of a distress scenario.
RATING ACTION
On Feb. 1, 2019, S&P Global Ratings revised its outlook on New Zealand's 
Palmerston North City Council to positive from stable. At the same time, we 
affirmed our 'AA/A-1+' long- and short-term issuer credit ratings on 
Palmerston North.

OUTLOOK
The positive outlook on Palmerston North reflects that on the sovereign 
because the ratings on the council are constrained by the long-term 
foreign-currency rating on New Zealand. We could raise the ratings on 
Palmerston North within the next two years should the same occur for New 
Zealand. 

Downside scenario
We could revise the outlook on Palmerston North to stable if we take a similar 
action on New Zealand, or if we perceive Palmerston North's financial 
management to be deteriorating significantly, resulting in a substantial rise 
in council spending that leads to a rapid decline in the council's financial 
position.

RATIONALE
The outlook revision reflects a similar action on the New Zealand sovereign 
(see "New Zealand Outlook Revised To Positive On Improving Fiscal Position; 
'AA+' LC And 'AA' FC Ratings Affirmed", published Jan. 31, 2019). Although 
Palmerston North has a stand-alone credit profile higher than the sovereign's, 
we cap our rating on Palmerston North to that of the sovereign's because 
Palmerston North does not meet the conditions to be rated above the sovereign 
in accordance with our criteria. We do not believe any New Zealand local 
council, including Palmerston North, could maintain stronger credit 
characteristics than the sovereign in a stress scenario. 

We expect the council's financial management, institutional settings, and its 
financial position to support its credit profile. We expect after-capital 
account balances to move into deficits on the back of an increase in capital 
expenditure forecasts including previously delayed projects flowing through 
our forecast horizon. 

We continue to cap our rating on Palmerston North at the level of our 
long-term foreign currency rating on New Zealand because we believe the 
council could not withstand a default scenario better than the sovereign 
could, and that the city council's credit metrics would deteriorate in line 
with those of the sovereign in a stress scenario.

--A supportive institutional framework, buoyant local economy, and prudent 
financial management support Palmerston North's creditworthiness--
The institutional framework within which New Zealand local governments operate 
is a key strength supporting Palmerston North's credit profile. The New 
Zealand local government system promotes a strong management culture, fiscal 
discipline, and high levels of financial disclosure among local councils. This 
system allows Palmerston North to support higher debt levels than some of its 
international peers can tolerate at the current rating.

In our opinion, Palmerston North's experienced financial management will help 
it deliver its capital commitments while maintaining prudent financial 
policies. The council prepares a long-term plan every three years, setting an 
important forward-looking approach to prudent financial management and funding 
strategy. Debt and liquidity management policies are sound, with no issuance 
of foreign-currency and interest exposure being mostly hedged. The council is 
accelerating its debt repayment schedule by reducing repayment periods to 20 
years down from 30 years for major capital projects. 

While management is increasing its efforts to improve capital delivery, we 
consider its long-term capital and financial planning to be weaker than its 
peers', especially international peers'. There are larger variations between 
budget forecasts and actual outcomes in capital expenditure than peers. 
Despite efforts to improve capital expenditure monitoring and delivery, 
Palmerston North executed approximately 60% of its capital expenditure program 
in 2017, with little improvement from 2016.

Palmerston North's well-diversified economy supports the rating, reflecting 
the role of a service center in New Zealand's North Island. Growth prospects 
are sound after the district's economy grew by 3.65% in 2016. Palmerston 
North's GDP per capita was on average US$35,941 between 2014 and 2016, which 
is higher than previous figures due to new central government data sources. 
The city has about 20% of the workforce commuting daily from elsewhere in the 
Manawatu-Wanganui region, and therefore, contributing to the city's GDP. 
Palmerston North is home to the country's largest army base, and the Manawatu 
campus of Massey University, both contributing to Palmerston North's young 
population (second-youngest city in New Zealand). Further, the commencement of 
Jetstar and Origin Air services have boosted passenger movement to the city, 
and more recently air freight services have begun out of the airport.

--Increased capital expenditure will drive after-capital account balance into 
small deficits and increase debt levels-- 

We expect Palmerston North's after-capital account to move into deficit for 
the first time since 2012 as the council increases its capital expenditure. 
This should see Palmerston North's debt levels rise for the first time since 
2012. We forecast capital expenditure to average about 30% of total 
expenditure between 2018 and 2020, up from about 25% historically, resulting 
in after-capital account balance moving into deficits of about 5.6% and 9.5% 
of total revenues in 2019 and 2020, respectively. A major contributor to these 
deficits is previously delayed capital expenditure projected to commence 
during the next few years. 

Our forecasts reflect our expectation that capital expenditure will be 40% 
less than the council's budget in its 2017-18 annual plan, and 35% less in 
both 2019 and 2020. This is in line with the council's previous results. We 
forecast Palmerston North to spend between NZ$37 million and NZ$46 million per 
year on infrastructure, predominately renewals.

While we expect Palmerston North's operating surplus to remain strong at 17.5% 
of operating revenues in 2019 and 2020, this is weaker than the past when it 
averaged more than 20%. Lower operating balances reflect higher spending on 
employees and suppliers in 2019, and higher interest expense forecasts. Any 
under execution of capital expenditure may reduce interest expenses, as the 
council is likely to reduce borrowings compared with our forecasts, and 
potentially have positive outcomes on operating balances. 

Supporting its budgetary performance is the council's ability to raise 
revenues. Palmerston North is targeting an average rate increase of 6.4% in 
2018 and 5.6% a year over the next 10 years. As with all New Zealand local 
councils, there are no restrictions on Palmerston North's ability to increase 
property rates and user charges each year, other than a political imperative 
to keep increases low. These income streams are the key source of income, 
making up about 90% of operating revenues.

As a result of Palmerston North's after-capital account deficits and higher 
capital spending, Palmerston North's debt metrics would weaken slightly 
through to 2020. We forecast the council's total tax-supported debt to reach 
90% of operating revenues in 2020, up from 81% in 2018. Interest expenses 
reflect this borrowing and are forecast to be about 8% of operating revenues 
between 2019 and 2020. 

Palmerston North's strong financial position has benefited from its solid 
budgetary performance. Since 2011, the council has averaged after-capital 
account surpluses of 4.6% of total revenues. This helped the council to reduce 
its borrowing levels and interest costs. It also reflected a history of under 
execution of capital expenditure, which could result in infrastructure 
backlogs if continued over time. This could hinder the council's budgetary 
flexibility in the future.

We currently estimate that Palmerston North's liquidity sources--average cash 
and available credit lines--will average about NZ$51 million during the next 
12 months, covering about 130% of its upcoming debt service. The council has 
four long-term bonds, totaling NZ$30 million, due in the next 12 months. This 
level of debt maturing within the next 12 months has lowered the debt 
servicing ratio from 195% in our previous assessment. We consider Palmerston 
North's access to external liquidity to be satisfactory. New Zealand's capital 
markets are comparatively liquid, but lack depth because of their small size.

We consider Palmerston North's contingent liabilities to be relatively low. 
They mainly reflect potential expenses for addressing the environmental 
condition of the Manawatu River; potential coverage of increased borrowings by 
its airport, which is currently financially self-supporting; and the risk of 
flooding from a natural disaster. We do not expect the river planning and 
resource consents to be finalized until 2022, and the council will likely be 
required to fund an upgrade of the water treatment plant toward the end of the 
2020s. The council has already incorporated some of these costs in the 
2018-2028 long-term plan, but there is a possibility they could be much higher 
than currently budgeted. In addition, Palmerston North has insurance to cover 
its aboveground and underground assets.
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