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

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Long-Term Issuer Rating of the Autonomous Region of the Azores (Azores) at BBB (low) and its Short-Term Issuer Rating at R-2 (low). The trends on all ratings have been changed to Stable from Negative.

KEY RATING CONSIDERATIONS

The change in the trends on the ratings to Stable from Negative are underpinned by the upgrade of the Republic of Portugal (A (low), Stable) on 26 August 2022 and reflects DBRS Morningstar’s view that SATA Group's short-to-medium term solvency and liquidity risks have receded, reducing the region's potential risks related to the airline, following the approval by the European Commission (EC) of a EUR 453 million restructuring aid to SATA to support the company’s restructuring plan. The support includes a EUR 318 million equity injection by the region notably through the conversion in equity of a EUR 82.5 million direct loan from the region to SATA as well as the take-over by the region of EUR 174 million of SATA’s debt which was guaranteed by the region. Moreover, DBRS Morningstar understands that SATA’s financial performance has improved in the first half of 2022, thanks to growing revenues supported by the strong recovery of the hospitality sector in the Azores as well as the implementation of cost saving measures, which should allow the company to be in line or even exceed the targets for 2022 set in its restructuring plan.

The Azores’ ratings remain underpinned by (1) sound operating results and an overall stable financial performance over the five years prior to the COVID-19 pandemic and the regional government's willingness to consolidate its public finances in the coming years; (2) a high and, historically, a relatively stable debt ratio which increased noticeably from 2020 but is expected to start stabilizing in the near term and; (3) the region's geographical location, as an Archipelago in the Atlantic Ocean, classifying it as an outermost region in the European Union (EU) which reinforces the Azores' relationship with the Republic of Portugal as well as the support stemming from the national government.

RATING DRIVERS

The Azores’ ratings could be upgraded if any or a combination of the following occur: (1) the region materially reduces its indebtedness and risk exposure to loss-making regional companies; (2) Azores’ economic outlook outperforms current expectations; (3) there are indications of a further strengthening of the relationship between the region and the central government; or (4) the Portuguese sovereign rating is upgraded again.

The Azores' ratings could be downgraded if (1) SATA's, or other regional companies' financial and liquidity profile deteriorates, prompting guarantee calls or a marked weakening of the region’s already high debt metrics; (2) the region fails to consolidate its financial performance prompting a substantial and structural rise in its debt ratio; (3) indications that the relationship between the region and the central government would be weaker than currently considered; or (4) the Portuguese sovereign rating is downgraded.

RATING RATIONALE

The approval by the EC of a Restructuring Aid to SATA and the Implementation of SATA’s Restructuring Plan Should Reduce Short-to-Medium Term Financial Risks for the Region

DBRS Morningstar considers that regional companies in the Azores, some of which continue to post weak financial results, weigh on the region’s creditworthiness. In particular, the Azores’ 100% ownership of the loss-making regional airline group, SATA, has been in the last years a key concern for DBRS Morningstar. The COVID-19 outbreak has exacerbated the strains on the regional company and its financial results have prompted the regional government to provide SATA with liquidity support in the form of explicit guarantees and a loan in 2020 and 2021.

In June 2022, the EC has approved a EUR 453 million restructuring aid to SATA to support the company’s restructuring plan. The support will take the form of: (1) a EUR 318 million equity injection by the region notably through the conversion in equity of a EUR 82.5 million direct loan from the region to SATA as well as the take-over by the region of EUR 174 million of SATA’s debt which was guaranteed by the region; and (2) a guarantee of the region until 2028 on EUR 135 million of SATA’s debt funding. The restructuring plan includes operational-efficiency measures and the divestment by SATA of its controlling shareholding (51%) of its subsidiary and international routes’ arm, Azores Airlines, which was historically accounting for the largest share of the airline group’s losses.

DBRS Morningstar consider that the EC approval of the restructuring aid and the implementation of the restructuring plan should reduce in the short-to-medium terms the region's potential financial risks related to the airline, especially because the company had a large exposure to short-term debt which was largely guaranteed by the Region. As of 1st September 2022, the region's guarantee exposure to SATA amounts to EUR 105 million versus EUR 267.5 million at year-end 2021, and is currently only related to long-term debt maturing in 2028. DBRS Morningstar understands that SATA’s financial performance has improved in the first half of 2022, thanks to growing revenues supported by the strong recovery of the hospitality sector in the Azores as well as the implementation of cost saving measures, which should allow the company to be in line or even exceed the targets for 2022 set in its restructuring plan. Moreover, DBRS Morningstar notes that the EC has closed its investigation related to past public support measures provided to SATA, given that those capital injections have been reimbursed to the region, including interests.

After A Sharp Contraction in 2020, the Recovery Is Under Way, Supported by the Favorable Momentum for the Hospitality Sector from the Spring of 2021, but Uncertainties Remain Given Inflationary Pressures

On the economic front, the region delivered solid real gross domestic product (GDP) growth between 2015 and 2019, at an average annual rate of 2.4%, supported by steady expansion of the tourism sector within its territory. However, the economic disruption was considerable in 2020, with an economic contraction estimated at 9.2%, versus 8.4% nationally. COVID-19 has triggered a severe blow to the hospitality sector, which suffered a 71% decline in overnights stays in 2020 compared to 2019. The hospitality recovery nevertheless started in the spring of 2021 and accelerated in Q4 2021, with overnights stays accounting for 94% of their Q4 2019 level during that last quarter. The positive momentum in the hospitality sector was confirmed in the first half of 2022. Overnight stays in H1 2022 accounted for 98% of their H1 2019. This contributed to the decline in the unemployment rate which reached 5.9% in Q2 2022 versus 8.2% in Q4 2020. Going forward, the full recovery of the tourism sector will remain exposed to uncertainties related to inflationary pressures and the complete resolution of the healthcare situation but may be supported by the opening of new airline routes to the Azores in 2022. DBRS Morningstar will also monitor the potential uplift in the economic recovery linked to additional funds expected to be received by the region from the European Union (EU, AAA, Stable). On top of traditional EU operation programs, the region could receive up to EUR 580 million in grants related to the Recovery and Resilience Facility (RRF).

The Region’s Financial Performance, Although Strengthening in Recent Years, Was Strongly Hit in 2020 and 2021, but Should Improve from 2022

The Azores’ financial performance, while it has been relatively stable in the previous five years, with solid operating results and small, albeit recurring, financing deficits, it deteriorated markedly in 2020 and 2021. The operating results-to-operating revenues ratio stood at -5.7% in 2020 and -5.6% in 2021, versus a surplus of 8.5% on average in the five years prior to the pandemic. Similarly, the financing deficit represented 30% of operating revenues in 2020 and remained close to 10% in 2021 (17% excluding SATA's capital reimbursement) compared with a deficit of 5.5% between 2015 and 2019. Those very large budgetary shortfalls were mainly due to COVID-related higher expenditures, particularly in healthcare and education (both responsibilities of the region). DBRS Morningstar expects these large deficits to remain concentrated in 2020 and 2021 and understands that the region is targeting re-balancing its accounts by 2023. A structural weakening of the region's financial performance would potentially have a negative impact on its ratings.

As a consequence, the Azores’ adjusted debt stock as calculated by DBRS Morningstar, which includes direct debt and indirect and guaranteed debt of several regional companies including SATA's, has reached 302.9% of the region’s operating revenues at the end of 2021, versus 241% at the end of 2019, mainly due to higher regional financing needs due to the COVID-19 pandemic, but also due to the large increase of SATA's debt. From an international perspective, this debt level is very high. The medium-term debt trajectory of the region will, therefore, remain one of the key focuses of DBRS Morningstar's analysis.

DBRS Morningstar views also positively the changes implemented in the last years to re-centralise part of the regional companies’ debt onto the region’s own balance sheet. These operations were concomitant with the dissolution of several regional companies.. This re-centralisation of public services should enhance the region’s control over service provision and rationalise some of the related costs, especially concerning debt service. The region has also decided to take over hospitals' debts which are part of its direct debt from 2020 and will take over EUR 174 million of SATA’s debt in 2022. This did not have and will not have any impact on DBRS Morningstar's debt metrics as those debts were already included in DBRS Morningstar's adjusted debt ratios.

Sovereign Support Remains Key to the Azores’ Ratings

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

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors

The Passed-through Social credit considerations have a relevant effect on the ratings, as the social factors affecting the Republic of Portugal’s ratings are passed-through to the Azores.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

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 regional economy’s recovery and the Azores’ financial performance and debt metrics. The financial situation of SATA and the potential impact for the region’s credit profile. The relationship between the central government and the Autonomous Region of the Azores.

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.dbrsmorningstar.com/research/401837/portugal-republic-of-scorecard-indicators-and-building-block-assessments.

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 the Rating European Sub-Sovereign Governments (August 12, 2022) https://www.dbrsmorningstar.com/research/401273/rating-european-sub-sovereign-governments. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

The sources of information used for this rating include the 2016-2021 financial statements and monthly budgetary execution from the Autonomous Region of the Azores, SATA’s 2020 and 2021 accounts, Instituto Nacional de Estatística (INE) and Serviço Regional de Estatística dos Açores (SERA). 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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/402308.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Mehdi Fadli, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head Global Sovereign Ratings
Initial Rating Date: June 12, 2019
Last Rating Date: March 04, 2022

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