Morningstar DBRS Upgrades the Autonomous Region of the Azores to BBB, Changes Trend to Stable

DBRS Ratings GmbH (Morningstar DBRS) upgraded the Autonomous Region of the Azores' (Azores or the Region) Long-Term Issuer Rating to "BBB" from BBB (low) and upgraded the Short-Term Issuer Rating to R-2 (middle) from R-2 (low). The trends on all ratings changed to Stable from Positive.

KEY CREDIT RATING CONSIDERATIONS
The upgrades of Azores' credit ratings are underpinned by the upgrade of the Republic of Portugal's Long-Term Foreign Currency and Long-Term Local Currency Issuer Rating to A (high) from "A" on 17 January 2025. Morningstar DBRS considers that the improvement in Azores' fiscal position in 2023, benefitting from higher tax revenues amid strong economic growth, might not continue in 2024. On the other hand, there is clear evidence of central government support through direct and indirect debt arrangements and regional financing could increase from this year. Moreover, the region continues to reduce its public sector debt and SATA has considerably improved its operating performance since 2021, easing the completion of the Region's divestment from SATA's international business division.

Azores' credit ratings remain underpinned by (1) the regional government's willingness to continue to consolidate its public finances, 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 that started decreasing in 2023 after a noticeable increase during 2020-22; (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 (high), Stable) as well as the support stemming from the national government.

CREDIT RATING DRIVERS
Morningstar DBRS could upgrade the credit ratings if (1) the Portuguese sovereign credit ratings were upgraded or (2) if the region were to materially reduce its indebtedness and risk exposure to loss-making regional companies.

Morningstar DBRS could downgrade the credit ratings if (1) SATA's, or other regional companies', financial and liquidity profiles were to deteriorate, prompting guarantee calls or a marked weakening of the region's already high debt metrics; (2) the region were to fail 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 ratings were downgraded.

CREDIT RATING RATIONALE

Budgetary Performance Remains Weak And the 2025 Budget Is Oriented Towards Investment Rather Than Fiscal Consolidation

The Azores' budgetary performance improved in 2023. The regional administration reduced its financing deficit to 8.5% of operating revenues from 15.1% in 2022. Nevertheless, this deficit remains relatively high, and the budgetary data from January to November 2024 shows a deterioration of the budgetary performance, increasing the financing deficit to 14.9% of operating revenues. During the last two years, the region benefited from fast-growing fiscal revenues that outperformed the Region's expectations, however, increased expenditure during 2024 has affected negatively the budgetary performance. Operating performance deteriorated and has remained well below the level seen prior to the COVID-19 pandemic. From January to November 2024, the operating results-to-operating revenues ratio decreased to -13.2% in 2023 from - 5.1% in 2022, versus a surplus of 8.5% on average during 2015-2019.

However, operating revenues strongly recovered which should allow the region to improve rapidly its budgetary performance with a stronger control over operating expenditure. The increase of personnel expenditure was significant as the salaries were adjusted for all the purchasing power losses due to the elevated inflation in recent years, in part reflecting decisions taken at the national government level that the region needs to adopt. In 2025, the negotiation of the regional financing law could acknowledge part of it, resulting in higher transfers to the regional government. Morningstar DBRS views the fiscal performance still far from levels seen before 2019 and low fiscal space exists should another shock emerge. A structural weakening of the region's financial performance would potentially have a negative impact on its credit ratings. The regional government has approved a 2025 budget with the aim of improving public finances and controlling new debt, which is just permitted for refinancing purposes. Also, the consolidation of their public sector debt into the region's balance sheet also continues to be a key objective, including EUR 150 million transfer from the central government to reduce the public sector commercial debt.

Azores Public Sector Debt and Commercial Debt Continue to Decrease and Divestment of SATA Is Still Scheduled

Azores' adjusted debt stock as calculated by Morningstar DBRS, which includes direct debt and indirect and guaranteed debt of several regional companies including SATA, and also public-private partnerships (PPPs), is estimated to have decreased to around 355% of the region's operating revenues in 2024 from 383% at year-end 2023, which is still very high by international standards. Due to the large deficits of the last four years and the operational difficulties posed by the lockdowns that affected the financial situation of SATA, Azores' adjusted debt stock to operating revenues has increased significantly from 298% at end-2019. The adjusted debt stock is expected to keep decreasing during the next years, although the direct debt could increase since the region is reducing the debt stock of the regional companies and the commercial debt. The medium-term debt trajectory of the region will, therefore, remain one of the key focuses of Morningstar DBRS' analysis.

Given the Region's progress with re-centralizing debt, Morningstar DBRS sees a reduced risk from contingent liabilities affecting the Region's debt in the medium term and expects the region to progressively decrease its debt levels supported by improved fiscal results and economic growth. The Azores converted EUR 75 million commercial debt into financial debt in 2024 in the form of loans at fixed interest rates and also refinanced EUR 37.4 million of debt falling due in 2025 and 2026 into a loan due in 2029. For 2025, the funding needs are also lower than in previous years, at EUR 96 million versus EUR 110 million in 2024, however, the region will again convert commercial debt into financial debt for an amount of EUR 150 million. This decrease of funding needs reflects both the expected reduction of the financing deficit and lower debt repayments this year. If deemed appropriate, the region could resort again to central government loans in 2025. Azores has always maintained a close relationship with the central government in market consultations for financing and, for the first time since 2012, the Region has opted to take a direct loan from the State to cover the 2024 financing needs. Morningstar DBRS takes the view that this support was potentially available before and is only used by the Region to improve its funding conditions, while its access to funding in 2024 remained similar to that of 2023.

The international public tender for the divestment of Azores Airlines was launched in March 2023 and suspended due to regional elections. In the meantime the value company was re-evaluated at a higher level than previously estimated, based on improved economic and financial conditions plus an improved operating performance of SATA, which changed the tender conditions. We consider that the divestment could take place before the end of 2025 as agreed with the European Commission, unless the period is extended. Also, we view that this restructuring plan and the restructuring aid provided to SATA have reduced the short-to-medium term solvency and liquidity risks of the company, reducing the region's potential risks related to the airline. Nevertheless, we will monitor the implementation of the restructuring plan going forward and assess any potential negative financial impact on the region's credit profile stemming from SATA.

Strong Tourism Performance Drives Economic and Employment Growth, EU Funds Will Remain Supportive

On the economic front, the region has benefited from a strong performance of the hospitality sector that continues to grow. In fact, the number of tourists up to November 2024 was already higher than the tourists received in all of 2023. Up to November 2024, overnight stays grew by 11% compared to the same period in 2023, exceeding their 2019 level by 33% and showing a lower level of seasonality throughout the year. Moreover. tourism growth has been positively influenced by an international tourism uptick during the last two years, with international tourists currently accounting for 70% of the total against 60% in 2022. This strong performance of the tourism sector led to the good performance of the regional economy. Latest estimates point to real GDP growth of 3.4% in 2023 compared with 2.5% for the national average.

The recent stronger economic performance of the last three years also contributed to an improvement in the labor market, with the highest number of employed population of all times, at 120,000 thousands out of 126,000 active population. The regional unemployment rate, at 4.9% versus the 6.1% nationally in Q3 2024, decreased significantly compared to the average of 10% in 2015-2019. The regional unemployment is usually above the national average but occasionally falls below like in Q3 2024 or Q4 2022. Additionally, EU funds have been important in supporting the regional economy, employment growth and infrastructure development in the Azores, and Morningstar DBRS notes that financial support will continue during the new EU budget. These funds represent around one third of Azores' 2023 estimated GDP. Recovery and Resilience Facility (RRF) funds will be mainly concentrated on projects related to digital transition and climate transition. The capacity of the region to execute those projects will therefore be key to benefit from funds and accelerate economic transformation and recovery.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a relevant effect on the credit analysis.

Social (S) Factors

The following Social factors had a relevant effect on the credit analysis: The Passed-through Social credit considerations have a relevant effect on the credit ratings, as the social factors affecting Portugal's credit ratings are partially passed through to Azores. Portugal's relatively low level of human capital, as measured by GDP per capita, is factored into the sovereign credit rating, which has been used as an important input for Azores' credit ratings. Nonetheless, GDP per capita is only modestly lower than the national level, standing at approximately 90% of Portugal's average in 2022. Respect for human rights is high, and there is widespread access to quality healthcare and other basic services.

Credit rating actions on Republic of Portugal are likely to have an impact on this credit rating. ESG factors that have a significant or relevant effect on the credit analysis of Autonomous Region of the Azores are discussed separately at https://dbrs.morningstar.com/issuers/17486.

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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

RATING COMMITTEE SUMMARY
Morningstar DBRS' European Sub-Sovereign Scorecard generates a result in the BBB (low) - BBB (high) range. The main points discussed during the Rating Committee included the fiscal and financial impacts of the upgrade of Republic of Portugal's credit rating, the fiscal and debt evolution in 2024, the economic situation in the region and its outlook, and its financial forecasts.

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/445934.

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 the Rating European Sub-Sovereign Governments (09 August 2024) https://dbrs.morningstar.com/research/437618. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

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

The sources of information used for these credit ratings include Autonomous Region of the Azores for the 2017-2023 financial statements, 2024 monthly budgetary execution, debt and liquidity situation, 2024 National budget, 2025 National budget, 2025 regional budget, Instituto Nacional de Estatística (INE) and Serviço Regional de Estatística dos Açores (SREA) national statistical agency, central bank, Ministry of Finance, IMF, World Bank. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings 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' 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://dbrs.morningstar.com/research/446372.

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

Lead Analyst: Jorge Espinosa, Assistant Vice President, Global sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: 12 July 2019
Last Rating Date: 26 July 2024

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