DBRS Morningstar Confirms Autonomous Region of the Azores at BBB (low), Stable Trend

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Long-Term Issuer Rating of the Autonomous Region of the Azores (the Azores) at BBB (low) and its Short-Term Issuer Rating at R-2 (low). The trend on all ratings remains stable.

KEY RATING CONSIDERATIONS

While DBRS Morningstar points out that the upgrade of the Republic of Portugal’s rating to BBB (high) from BBB on 4 October 2019, affects positively its assessment of the region’s credit profile, it is insufficient to prompt a rating upgrade of the Azores’ ratings. DBRS Morningstar considers that the economic and fiscal improvements at the national level were already largely factored in the BBB (low) rating of the region when it was assigned in July 2019.

The Azores’ ratings are underpinned by (1) the region’s sound operating results and its overall stable financial performance over the last five years, supported by favourable economic conditions in the region and in Portugal as a whole; (2) the region’s high but only marginally increasing debt ratio and; (3) the recentralisation over the last 24 months of several public services – healthcare, urban and housing rehabilitation – previously carried out by regional companies, onto the regional administration’s own budget and the related efficiency gains expected from these operations. DBRS Morningstar also views the relationship between the region and the Republic of Portugal as key for its assessment of the Azores’ credit profile.

The region also faces structural challenges. DBRS Morningstar considers that regional companies in the Azores, most of which continue to post weak financial results, still weigh on the region’s creditworthiness. In particular, the Azores’ 100% ownership of the loss-making regional airline group, SATA, remains a concern for DBRS Morningstar. In line with the Autonomous Region of Madeira, the Azores’ geographical location, as an archipelago in the Atlantic Ocean, is also a challenge to its overall credit profile.

RATING DRIVERS

Upward rating pressure on the Azores’ ratings could materialise if any or a combination of the following factors occur: (1) the Portuguese sovereign is upgraded further; (2) the Azores materially reduces its indebtedness and risk exposure to loss-making regional companies; (3) the region’s economic indicators continue to improve and the Azores manages to enhance its economic resiliency; or (4) there are indications of a further strengthening of the relationship between the region and the central government.

Downward rating pressure could materialise if any or a combination of the following factors occur: (1) the Azores’ operating performance deteriorates and the region incurs large deficits that prompt a substantial rise in its debt ratio; (2) a significant deterioration in the regional companies’ financial performance occurs, potentially prompting guarantee calls or a marked weakening of the region’s debt metrics; or (3) indications that the relationship between the region and the central government would be weaker than currently considered.

RATING RATIONALE

Solid Economic Growth Boosted by Tourism Supports a Sound and Steady Financial Performance

The region has delivered solid real gross domestic product (GDP) growth since 2015, at an average annual rate of 2.5%, marginally outperforming the 2.2% Portuguese average over the same period. The economic growth was supported by steady expansion of the tourism sector within the region’s territory. For example, air passenger arrivals to the region doubled from 465,000 in 2014, to 935,000 in 2018. This substantial growth reflected the liberalisation of several airline routes between the region and the Portuguese mainland in 2015. Tourist arrivals should stabilise as the market matures, but DBRS Morningstar will monitor their evolution to assess for any indication of a reversal in the positive trend recorded since 2015.

The Azores’ financial performance has been relatively stable in the last five years, with the region recording solid operating results and small, albeit recurring, financing deficits. Taking into account capital revenues and expenditure, deficits have averaged around 6% of the region’s operating revenues. This stable performance reflected a slow but steady growth in operating revenues, largely driven by higher tax collection (particularly value added tax) following solid economic growth. Good control over regional operating expenditure despite relatively flat transfers from the central government also supported stable fiscal outcomes. Sound operating performance allowed the region to allocate more than a quarter of its budget to capital expenditure programmes, a positive feature in DBRS Morningstar’s view. Continued economic growth in Portugal and in the region should support a further strengthening of the region’s performance, with the expectation of near-balanced budget positions.

Recentralisation of Debt is Expected to Enhance Cost Control but Regional Companies Remain a Credit Challenge

The Azores’ adjusted debt stock as calculated by DBRS Morningstar, which includes direct debt and also indirect and guaranteed debt of several regional companies, represented 227% of the region’s operating revenues at the end of 2018. While this ratio has only marginally increased since 2014 when it was close to 200%, it is high by international comparisons and upward trending, a negative credit feature for DBRS Morningstar. Nevertheless, the fact that part of the recent debt increase was driven by the implementation of capital expenditure programmes rather than operating deficits somewhat mitigates that risk. The region’s debt ratio also compares very favourably on a national basis, as its debt-to-operating revenue ratio remains substantially lower than that of Madeira (498% in 2018).

DBRS Morningstar also views positively the changes implemented in the last 24-months to recentralise part of the regional companies’ debt onto the region’s own balance sheet. These operations were concomitant with the dissolution of two regional companies managing urban and housing rehabilitation and healthcare, respectively. This recentralisation of public services should enhance the region’s control over service provision and rationalise some of the related costs, especially concerning debt service.

Some challenges regarding the overall regional public sector remain. DBRS Morningstar views in particular the 100% regional ownership in the loss-making SATA Group as a key challenge. The group includes two airlines, two tour operators, and an airfield management division. While the region is currently considering reducing its stake to 51% in one of the companies of the group (SATA Internacional), DBRS Morningstar considers that concluding any operation would take time and might include a recapitalisation, which could add to the region’s indebtedness. DBRS Morningstar would see the involvement of a credible private investor that strengthens SATA’s financial performance, as positive.

Sovereign Support Remains Key to the Azores’ Ratings

While the Azores does not benefit from any explicit guarantee from the central government, DBRS Morningstar does consider that any assistance provided to Madeira by the Portuguese government would be available to the Azores if ever necessary. This assessment is supported by the fact that the region did benefit from the central government’s debt financing in 2012, at the peak of the European sovereign debt crisis

RATING COMMITTEE SUMMARY

DBRS Morningstar’s European Sub-Sovereign Scorecard generates a result in the BBB – BB (high) range. The main points discussed during the Rating Committee include the Azores’ financial performance, its debt levels and the debt related to public companies, and the region’s relationship with the Portuguese government.

For more information on the Key Indicators used for the Republic of Portugal, please see the Sovereign Scorecard Indicators and Building Block Assessments: https://www.dbrs.com/research/351339/

The national scorecard indicators were used for the sovereign rating. The Republic of Portugal’s rating was an input to the credit analysis of the Autonomous Region of the Azores.

Notes:
All figures are in euros (EUR) unless otherwise noted.

The principal applicable methodology is Rating European Sub-Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include the Autonomous Region of the Azores, Bank of Portugal, Instituto Nacional de Estatística (INE). DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This rating included participation by the rated entity or any related third party. DBRS Morningstar had no access to relevant internal documents for the rated entity or a related third party.

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings GmbH are subject to EU and US regulations only.

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer – Global FIG and Sovereign Ratings
Initial Rating Date: July 12, 2019
Last Rating Date: July 12, 2019

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