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

DBRS Ratings GmbH (Morningstar DBRS) 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’ credit ratings are underpinned by (1) the regional government's willingness to continue to consolidate its public finances, as demonstrated in its capacity to start reducing its large deficit in 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 started decreasing in 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 Morningstar DBRS' view that risks to the credit 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 goals in the coming years. Nevertheless, the region's financing deficit remained high in 2022 and 2023, despite a first step towards rebalancing achieved last year. 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, but still recorded losses. Up to the third quarter of 2023, SATA's main subsidiaries improved their financial performance in comparison with 2022, and we understand the targets set in its restructuring plan have been met.

CREDIT RATING DRIVERS
The Azores’ credit 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 credit rating is upgraded.

The Azores' credit 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 credit rating is downgraded.

CREDIT RATING RATIONALE
The Region’s Financial Performance in 2023 Is Expected to Continuate the Path of Improvement But Debt Level Remains Very High Following the Strong Fiscal Impact of the COVID-19 Pandemic

The Azores’ budgetary performance has continued to improve in 2023, and the regional administration expects a lower financing deficit than in 2022. In 2023, the region benefited from fast-growing fiscal revenues, supported by the strong increase of direct taxes, especially corporate income tax, which outpaced lower than anticipated indirect taxes. Indirect taxes were negatively impacted by the National Statistical Institute’s downward adjustment of the population registered in Azores which impacted the VAT calculation distribution formula, and by lower than anticipated petrol tax revenues.

Despite a slight improvement in the last two years, operating performance has remained well below the level seen prior to the COVID-19 pandemic. The operating results-to-operating revenues ratio stood at an estimated - 3.5% in 2022, 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 represented 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. Morningstar DBRS expects that these large deficits will remain concentrated in 2020-2022 and views the 2023 expected budgetary performance improvement as a first step taken by the region in re-balancing its accounts.

Azores’ adjusted debt stock as calculated by Morningstar DBRS, which includes direct debt and indirect and guaranteed debt of several regional companies including SATA, is estimated to have decreased to around 320% of the region's operating revenues in 2023 versus 331% at year-end 2022. From an international perspective, this debt level remains very high. Due to the large deficits of the last four years and the financial difficulties of SATA, the Azores’ adjusted debt stock has increased significantly as it was standing at 241% at the end of 2019. The medium-term debt trajectory of the region will, therefore, remain one of the key focuses of Morningstar DBRS' analysis.

Morningstar DBRS 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 Regional Economy’s Growth and Should Ease the Financial Pressure on SATA

On the economic front, the region has benefited from the strong performance of the hospitality sector since 2022. Overnight stays grew by 11% in 2023 compared with 2022, exceeding their 2019 level by 19% and showed a lower level of seasonality throughout the year. This contributed to the good performance of the regional economy and the labor market. Real GDP growth amounted to 6.8% in 2022 following 7.4% in 2021, versus 6.8% in 2022 for the national average following 5.7% in 2021. For the first time since Q3 2017, the regional unemployment rate fell below the national unemployment rate from Q4 2022 and stood at 6% in Q3 2023, versus 6.1% nationally and versus 10% on average during 2015-2019. Morningstar DBRS will monitor the potential economic uplift from 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 725 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. The European Commission (EC) in June 2022 approved 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, although it is currently paused until a new government could take ownership of the sale. Morningstar DBRS 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-2023, the region's guaranteed exposure to SATA amounts to EUR 200 million and is currently related to long-term debt maturing in 2028. Moreover, Morningstar DBRS notes that the EC has closed its investigation related to past public support measures provided to SATA, given that those capital injections were reimbursed to the region in 2021, including interest amounts.

Sovereign Support Remains Key to the Azores’ Credit Ratings And Is Expected To Continue Besides that Snap Elections Have Been Called

While the Azores does not benefit at the moment from any debt guarantee from the central government, Morningstar DBRS 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 during the European sovereign debt crisis, and that the State Budget Law for 2024 gives the possibility to the central government of granting guarantees to the two Portuguese autonomous regions.

Following the rejection of the 2024 budget by the regional assembly, early elections were called and will take place on February 4, 2024. Until a new government is formed, the region's finances will be run using the 2023 budget. Morningstar DBRS continues to expect that fiscal consolidation and debt control will remain a priority for the next government. Additionally snap elections for the Republic of Portugal have also been called and will take place in March 2024. Morningstar DBRS does not expect those elections to negatively impact the institutional arrangements between the central government and the region.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

Social (S) Factors

The Passed-through Social credit considerations have a relevant effect on the credit ratings, as the social factors affecting the Republic of Portugal’s credit 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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024) at https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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 main developments in political landscape, the central government support, Azores’s fiscal performance in 2023, financial forecasts and the situation of the regional economy.

For more information on the Key Indicators used for the Republic of Portugal, please see the Sovereign Scorecard Indicators and Building Block Assessments: https://dbrs.morningstar.com/research/426949/portugal-republic-of-scorecard-indicators-and-building-block-assessments.

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

Notes:
All figures are in Euros unless otherwise noted.

The principal methodology is Rating European Sub-Sovereign Governments (August 11, 2023)
https://dbrs.morningstar.com/research/419048/rating-european-sub-sovereign-governments. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings,
https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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 credit rating include Autonomous Region of the Azores for the 2017-2022 financial statements, 2023 monthly budgetary execution, debt and liquidity situation, 2024 National budget, 2024 Draft regional budget, Instituto Nacional de Estatística (INE) and Serviço Regional de Estatística dos Açores (SERA). Morningstar DBRS considers the information available to it for the purposes of providing this credit rating to be of satisfactory quality.

Morningstar DBRS 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. Morningstar DBRS’s outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS 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 Morningstar DBRS 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/427178.

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

Lead Analyst: Jorge Espinosa, Assistant Vice President, Credit Ratings, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Credit Ratings, Global Sovereign Ratings
Initial Rating Date: July 12, 2019
Last Rating Date: July 28, 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 dbrs.morningstar.com.