DBRS Morningstar Confirms the 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

The possible consequences of the Coronavirus Disease (COVID-19) on the regional economy will remain a focus point in coming months for DBRS Morningstar. The rating agency currently considers that any impact would largely be concentrated over a few quarters, but lasting effects on tourism or other sectors that translate into weaker fiscal outcomes would be credit negative. DBRS Morningstar considers that ongoing support from the national government to navigate through the current heightened challenges will be critical for the Azores' economy and the region overall credit profile.

The Azores’ ratings are underpinned by (1) the region’s sound operating results and its overall stable financial performance over the last five years; (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 key concern for DBRS Morningstar. The recent COVID-19 outbreak will likely exacerbate the strains on the regional company and DBRS Morningstar considers that further financial support is likely to become necessary in coming months. DBRS Morningstar points out that the national government's support in addressing this structural challenge currently heightened by the COVID-19 outbreak will be critical to avoid a deterioration in the region's credit profile. The Azores’ geographical location, as an archipelago in the Atlantic Ocean, is also a challenge to its overall credit profile.

RATING DRIVERS

The Azores’ ratings could be upgraded if any or a combination of the following factors occur: (1) the Portuguese sovereign is upgraded; (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.

The Azores' ratings could be downgraded if any or a combination of the following factors occur: (1) the Azores’ underlying 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, 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 Supported Steady Financial Performance

The region delivered solid real gross domestic product (GDP) growth between 2015 and 2019, at an average annual rate of 2.3%, therefore entering into 2020 on a solid footing. The economic growth was supported by steady expansion of the tourism sector within the region’s territory, which is now expected to be the severely hit by the COVID-19 pandemic. While DBRS Morningstar expects considerable economic disruption in 2020, the full impact of the coronavirus on regional output will depend on the depth and duration of the shock, two parameters which remain uncertain at the moment.

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 5% 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) trailing 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 as capex tend to support productivity growth over the long-term and are generally easier to reduce compared with operating expenditure. DBRS Morningstar considers that reducing capex could be one of the initial response taken by the region to answer potential adverse effects related to the current turmoil and therefore limit their overall impact on its financial results.

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 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 it 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 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. Given the current COVID-19 outbreak, any private sector capital injection in the company appears unlikely in the short-term. DBRS Morningstar will monitor any additional financial support provided to the company and the possible involvement of the national government to assess its impact on the region's creditworthiness.

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.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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 COVID-19 outbreak and its potential impact on the regional economy, 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: http://www.dbrsmorningstar.com/research/358292.

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 methodology is Rating European Sub-Sovereign Governments (September 6, 2019) : https://www.dbrsmorningstar.com/research/350151/rating-european-sub-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include the 2015-18 financial statements and monthly budgetary execution from the Autonomous Region of the Azores, quarterly debt metrics from the Bank of Portugal, economic indicators (unemployment, GDP metrics) from the 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.

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 12-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.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/358939/.

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

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions and Sovereign Ratings Group
Initial Rating Date: July 12, 2019
Last Rating Date: October 11, 2019

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