Fitch Ratings has upgraded the rating on the city of Houston, TX's approximately $906.3 million outstanding airport system subordinate lien revenue bonds.

The Rating Outlook is Stable.

The Houston Airport System (HAS) also has approximately $1.15 billion in parity subordinate lien revenue bonds, which are not rated by Fitch.

RATING RATIONALE

The upgrade reflects the system's sustained robust financial performance and future leverage expectations, supported by the strong regional monopoly characteristics of this dual airport system. HAS's cost recovery mechanisms have historically resulted in a relatively stable leverage profile below 8x, with long term debt consolidated on the subordinate lien. While Fitch expects leverage to rise moderately with anticipated future borrowings for the CIP, rating case metrics remain in-line with the rating level.

KEY RATING DRIVERS

The rating reflects HAS's large dual-hub airport system in Houston's strong metropolitan service area, which forms strategically important components of United Airlines' and Southwest Airlines' networks. The rating level also reflects anticipated borrowings associated with HAS's $2.3 billion capital program through 2027, the timing and structure of which are still to be determined. Despite the increase in the airports capital program and borrowing, leverage remains below 8x through 2027.

STRONG SERVICE AREA - Revenue Risk (Volume): High Stronger

Fitch has revised its assessment of Revenue Risk (Volume) to 'High Stronger' from 'Stronger' following the publication of its new Transportation Infrastructure Rating Criteria, which assesses volume risk on a five-point scale.

Houston's broad economic base supports strong demand for air service at both George Bush Intercontinental (IAH) and William P. Hobby (Hobby) airports, evidenced by a large O&D enplanement base of greater than 17 million enplanements. The airport system also benefits from relatively low traffic volatility and very limited competition. Long-standing relationships with key airlines and the desirability of HAS's service area substantially mitigates the airport system's sizable exposures to carrier concentration and connecting traffic at 77% (50.1% United, 26.4% Southwest) and 39% of total enplanements, respectively.

ADEQUATE COST RECOVERY MECHANISMS - Revenue Risk (Price): Midrange

The airport system has a hybrid use and lease agreement with signatory airlines, which provides adequate charge-setting authority to the airport system with approximately 53% of operating costs covered by airline revenues in 2021. The compensatory nature of the system's terminal cost center somewhat limits HAS's ability to prevent revenue declines during periods of flat or declining traffic performance. However, financial metrics have not materially deteriorated during previous economic downturns, and terminal lease agreements are partially transitioning to rate setting with stronger cost recovery terms. HAS's blended cost-per-enplanement of $13.03 is competitive in comparison to other large-hub airports.

SIZABLE, DEBT-FUNDED CAPITAL PROGRAM - Infrastructure Development/Renewal: Midrange

HAS's $2.3 billion, five-year capital improvement program (CIP) through 2027 is sizable and approximately $937 million larger than the prior year's plan. While the 2022-2026 CIP primarily focused on the IAH International Terminal Redevelopment Project (ITRP), the Domestic Redevelopment Program dominates the new proposed five-year CIP. Other projects focus on airfield and general maintenance and improvement needs.

The airport system has moderate access to excess cash flow or external funding, evidenced by the approximately 40% of the plan being funded with internal liquidity and federal funds and the remainder expected to be supported with future borrowings. Annual issuances between $160 million-$340 million are anticipated, with the exact timing and structure of future borrowings still being determined as program planning is refined.

SUBORDINATED DEBT - Debt Structure: Midrange

HAS maintains a multi-lien structure for its debt, although no senior lien bonds are outstanding. The senior lien remains open, however, and HAS maintains authorization for up to $350 million of senior lien commercial paper (CP), with $20 million drawn as of fiscal year end 2021. HAS plans to utilize CP to fund projects in the short term, coupled with long term bonds on the subordinate lien to take-out short-term borrowings. Structural strengths include the debt's fixed rate, fully amortizing nature, a declining debt service profile, and an adequate 1.1x DSCR rate covenant and additional bonds test. The majority of the subordinate lien's debt service reserve requirement is fulfilled with surety policies, though a $33 million cash funded senior reserve was transferred to the subordinate lien.

Financial Profile

HAS's total DSCR (including offsets to debt service) in fiscal 2021 was approximately 10.8x due to the use of PFC's and CARES Act proceeds for debt service. Leverage levels were roughly 7.4x in fiscal 2021, due to the drop in operating revenues associated with the pandemic, and reach 7.5x by 2027 in Fitch's rating case after decreasing in the near term, reflecting the full $1.3 billion of borrowing for the CIP in 2023 to 2027.

HAS's liquidity position was healthy at 690 days cash on hand in fiscal 2021 but could decline as cash is expended to support capital needs. Management seeks to maintain a minimum of six months cash on hand as HAS proceeds with its capital program. The overall financial profile is strong, with leverage and coverage levels in line with the rating.

PEER GROUP

Large-hub peers for Houston Airport System include Chicago O'Hare (O'Hare; A+/Stable), and Metropolitan Washington Airports Authority (MWAA; AA-/Stable), with MWAA serving as another two-airport system. On a rating case basis, HAS's total leverage levels are similar to MWAA, while O'Hare's leverage levels are higher. MWAA and O'Hare have comparatively less price risk than HAS, which enables MWAA to achieve a higher rating with similar leverage levels while O'Hare is able to achieve the same rating with higher leverage.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Material traffic declines and/or additional borrowings resulting in leverage increasing to and remaining above 10x on a sustained basis.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Traffic and revenue performance resulting in leverage at or below 7x on a sustained basis following completion of the 2023-2027 CIP borrowing.

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

CREDIT UPDATE

Total system enplanements for fiscal 2022 (year end 6/30) were approximately 88% of fiscal 2019 levels, with the last three months averaging approximately 91% of 2019 enplanements for the same time period. IAH recovery has slightly outpaced that of Hobby, with total fiscal 2022 enplanements at just over 88% of 2019, compared to 86% for Hobby. Management expects total enplanements to reach fiscal 2019 numbers by fiscal 2024.

In fiscal 2021, revenues were down 33% over fiscal 2020, as the airport system continued to be impacted by the pandemic. Debt service was paid entirely from PFCs and federal relief funds in fiscal 2021. Total operating expenses decreased by over $56 million, or 10%, primarily due to a decrease in pension and OPEB-HB expenses. As a result, net revenues declined, and net leverage as measured by net debt to CFADS increased to above 7x in fiscal 2021.

Positively, revenues outperformed Fitch's coronavirus rating case projections by approximately 3% in fiscal 2021, and 2022 net revenues are tracking pre-pandemic levels. Although CPE increased in fiscal 2020 and 2021 to above $14 and $9 for IAH and Hobby, respectively, CPE remains competitive, and Fitch expects it to return to pre-pandemic levels.

The airport system's current five-year CIP for 2023 - 2027 totals $2.3 billion, an increase of roughly $1 million as compared to the prior year's reduced plan. With the prior CIP focusing on the reconstruction of the international terminal at IAH, the current plan will shift its focus to IAH's domestic redevelopment program. The plan is still being finalized and is expected to include considerable debt/CP funding at roughly $1.3 billion or 57%, with the remainder comprised of internal airport funds and grants.

FINANCIAL ANALYSIS

Fitch Cases

With recovery largely tracking the expected Fitch US Airport Traffic projections, cases were developed reflecting Fitch's enplanement recovery forecast. Additionally, Fitch's rating and downside cases include the full $1.3 billion in anticipated borrowing through fiscal 2027 and unrestricted cash is projected to remain at fiscal 2021 levels in all cases.

Under Fitch's rating case, traffic recovers to 95% of pre-pandemic levels in fiscal 2023 and fully recovers to pre-pandemic levels by fiscal 2024, with annual growth below 2% thereafter. Non-airline revenues mostly fluctuate with passenger traffic, while airline payments are driven by cost-recovery terms under the airline use agreements and projected to grow at 2% annually. Operation and maintenance expenses grow at 4% annually after fiscal 2023.

The airport systems rating case results in leverage of 7.5x in 2027, which is higher than historical levels but still consistent with the indicative 'A+' category range for an airport with high stronger volume risk and midrange price risk. Coverage with PFCs and grants as offsets averages 1.9x (1.5x when PFCs are treated as revenues) from 2023 to 2027, and blended CPE averages below $10.50 through the projection period, which is back to pre-pandemic levels.

Fitch also ran a downside case where traffic is assumed to have a one-year delay in recovery, such that fiscal 2023 enplanements remain at fiscal 2022 levels, fiscal 2024 enplanements recover to 95% of pre-pandemic levels, and full recovery by fiscal 2025. Airline revenues grow at 1.5% in the downside case, with non-airline revenues mostly fluctuating with traffic levels. Given the cost-recovery terms of the airline agreements and the large percentage of total gross revenues coming from airline revenues, DSCR and leverage are only slightly worse than the rating case, with leverage remining below 8x through 2027. CPE averages about $0.30 higher in the downside case and remains competitive for similarly sized airports.

SECURITY

The bonds are secured by a subordinate lien on the net revenues generated from the operations of the airport system that includes the two primary commercial aviation facilities, IAH and Hobby airports.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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