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 (Azores) at BBB (low) and its Short-Term Issuer Rating at R-2 (low). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS
The Azores’ ratings are underpinned by (1) the regional government's willingness to consolidate its public finances in coming years, as demonstrated in its initial budget for 2023, in order to progressively bring back its operating performance to the sound level reached over the five years prior to the COVID-19 pandemic; (2) a high debt ratio which increased noticeably during 2020-2022 but is expected to start improving from 2023 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 (“A”, Stable) as well as the support stemming from the national government.

The Stable Trend reflects DBRS Morningstar's view that risks to the ratings are balanced. The strong performance of the hospitality sector since 2022 has translated into higher tax revenues which should help the region achieve its fiscal consolidation path in the coming years. Nevertheless, the region’s financing deficit remained high in 2022 and the fiscal rebalancing in 2023 is likely to be weaker than expected. The positive momentum in the tourism sector is also supporting the turnover of the region's airline company, SATA Group. Combined with cost savings, SATA has started to improve its financial performance in 2022 and exceeded the targets set in its restructuring plan, but still recorded losses. In the first half of 2023, the number of passengers carried by the company continued to increase rapidly which should support its turnover and help mitigating the region's potential risks related to the airline.

CREDIT 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.

The Azores' ratings could be downgraded if (1) SATA's, or other regional companies', financial and liquidity profiles deteriorate, 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.

CREDIT RATING RATIONALE
The Region’s Financial Performance is on the Path of Improvement Following the Strong Fiscal Impact of the COVID-19 Pandemic

The Azores’ budgetary performance slightly improved in 2022 but has remained well below the level seen prior to the COVID-19 pandemic. The operating results-to-operating revenues ratio stood at - 3.5% last year, from - 5.6% in 2021 and -5.7% in 2020, versus a surplus of 8.5% on average during 2015-2019. Similarly, the financing deficit accounted for 15.1% of operating revenues in 2022, from 17.5% in 2021 (excluding SATA's capital reimbursement) and 29.8% in 2020, compared with a deficit of 5.5% between 2015 and 2019. The very large budgetary shortfalls in the last three years were mainly due to COVID-related higher expenditures, particularly in healthcare, education and support to the regional economy. DBRS Morningstar views the region's 2023 initial budget as a first step towards the region re-balancing its accounts, through achieving operating and financing surpluses.

Due to the large deficits of the last three years and the financial difficulties of SATA, 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, has reached 331% of the region’s operating revenues at the end of 2022, versus 241% at the end of 2019. 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 positively the changes implemented by the region 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 Strong Performance of the Tourism Sector Since 2022 Supports the Growth of the Regional Economy and Should Ease the Financial Pressure on SATA

On the economic front, the region has benefited from a strong recovery of the hospitality sector since 2022. Overnight stays in 2022 exceeded their 2019 level by 8% and showed a lower level of seasonality throughout the year. This favorable trend continued in 2023 as overnight stays between January and May 2023 were 14% above their 2019 level. This contributed to the good performance of the labor market with an unemployment rate standing at 6.2% in Q1 2023, below the national unemployment rate of 7.2%, versus 10% on average during 2015-2019. Going forward, the situation of the tourism sector will remain exposed to uncertainties related to inflationary pressures. DBRS Morningstar will also monitor the potential uplift for the economic trajectory of the 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 positive momentum of the tourism sector is also supporting the turnover of SATA, contributing to mitigate the region's potential risks related to the airline, following the approval by the European Commission (EC) in June 2022 of EUR 453 million in restructuring aid to SATA to support the company’s restructuring plan. The support took the form of a EUR 318 million equity injection by the region notably through the conversion into equity of a EUR 82.5 million direct loan from the region to SATA as well as the take-over in 2022 by the region of EUR 174 million of SATA’s debt which was guaranteed by the region. It also includes a guarantee of the region until 2028 on an additional EUR135 million of SATA’s debt funding. The restructuring plan includes operational-efficiency measures and the divestment by SATA of its controlling shareholding (51%) in its subsidiary and international routes’ arm, Azores Airlines, which was historically accounting for the largest share of the airline group’s losses. The international public tender for the divestment of Azores Airlines was launched in March 2023. DBRS Morningstar considers that the EC approval of the restructuring aid and the implementation of the restructuring plan has reduced in the short-to-medium term 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 end-June 2023, the region's guarantee exposure to SATA amounts to EUR 200 million and is currently only related to long-term debt maturing in 2028. 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 in 2021, including interest amounts.

Sovereign Support Remains Key to the Azores’ Ratings

While the Azores does not benefit at the moment from any debt 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, and that the State Budget Law for 2023 gives the possibility to the central government of granting guarantees to the two Portuguese autonomous regions.

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.

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

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 (July 4, 2023) https://www.dbrsmorningstar.com/research/416784/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 situation and the Azores’ financial performance, liquidity and debt metrics. The financial situation of SATA, the implementation of its restructuring plan 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/417483/portugal-republic-of-scorecard-indicators-and-building-block-assessments.

Notes:
All figures are in Euros unless otherwise noted.

The principal methodology is Rating European Sub-Sovereign Governments (August 12, 2022) https://www.dbrsmorningstar.com/research/401273/rating-european-sub-sovereign-governments. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this rating include the Autonomous Region of the Azores for the 2017-2022 financial statements, 2023 monthly budgetary execution, debt and liquidity situation, 2023 budget, 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 credit 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 credit 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://registers.esma.europa.eu/cerep-publication/. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/417840.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Mehdi Fadli, Senior Vice President, Sovereign Credit Ratings
Rating Committee Chair: Nichola James, Managing Director, Sovereign Credit Ratings
Initial Rating Date: June 12, 2019
Last Rating Date: February 3, 2023

DBRS Ratings GmbH, Sucursal en España
Paseo de la Castellana 81
Plantas 26 & 27 28046 Madrid, Spain
Tel. +34 (91) 903 6500

DBRS Ratings GmbH
Neue Mainzer Straße 75
60311 Frankfurt am Main Deutschland
Tel. +49 (69) 8088 3500
Geschäftsführer: Detlef Scholz
Amtsgericht Frankfurt am Main, HRB 110259

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.