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

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Long-Term Issuer Rating of the Autonomous Region of the Azores (the Azores) at BBB (low) and its Short-Term Issuer Rating at R-2 (low). At the same time, DBRS Morningstar has revised the trend on all ratings to Negative from Stable.

KEY RATING CONSIDERATIONS
DBRS Morningstar's trend change to Negative from Stable primarily reflects the likely Azores' balance sheet implications from SATA Group's (SATA) financial difficulties. The regional airline company, already in a weak financial position at the beginning of 2020, has seen its difficulties compounded by travel restrictions and the collapse of tourism due to the Coronavirus Disease (COVID-19). The recent financial support provided to SATA by the regional government in the form of a guarantee, and approved by the European Commission (EC) in August 2020, gives the airline six months to present a restructuring plan. The collaboration of the Republic of Portugal (BBB (high), Stable) in obtaining the EC's approval for the rescue loan, indicates, in DBRS Morningstar's view, the national government's oversight and support towards the region. In order to assess the Azores' medium-term credit risk, DBRS Morningstar seeks to gain greater understanding on the recovery of the tourism industry in the region and on SATA's medium-to-long-term viability.

The Azores’ ratings remain underpinned by (1) sound operating results and an overall stable financial performance over the last five years; (2) a high and historically relatively stable debt ratio; now expected to increase noticeably in 2020 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 and its support.

RATING DRIVERS
An upgrade is unlikely in the near term. However, the Azores’ ratings could be upgraded if the region materially reduces its indebtedness and risk exposure to loss-making regional companies. The ratings trend could return to Stable if (1) SATA's medium-to-long term solvency is reinforced, reducing the region's contingent liabilities related to the airline; (2) the region’s economy recovers faster than currently anticipated; or (3) there are strong indications of a further strengthening of the relationship between the region and the central government.

The Azores' ratings could be downgraded if (1) SATA's, or other regional companies' financial and liquidity profile deteriorates further, prompting guarantee calls or a marked weakening of the region’s debt metrics; (2) the region's underlying operating performance deteriorates and the region incurs large deficits that prompt a substantial 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

SATA’s Financial Difficulties Weaken the Region’s Credit Profile

The region continues to face structural challenges. DBRS Morningstar considers that regional companies in the Azores, most 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, remains a key concern for DBRS Morningstar. The COVID-19 outbreak has exacerbated the strains on the regional company and has prompted the regional government to provide SATA with EUR 133 million in liquidity support. This financial support, in the form of a guarantee granted by the regional government, has been approved by the EC under EU State aid rules in August 2020. It is meant to address SATA's urgent and immediate liquidity needs until the end of January 2021. By that date, the airline, together with the regional and national governments, is expected to present a restructuring plan to the EC, aimed at ensuring SATA's viability.

Simultaneously, the EC has also opened an investigation regarding prior capital injections realised by the region into SATA but not notified to the Commission. SATA provides an essential public service, offering air connections between the nine islands of the Archipelago but also connections under public service obligations between the region and Portugal mainland. The outcome of the investigation will be monitored to assess for any impact on SATA's viability or the region's financials, but also on the continuity of future air routes towards the region and potential spill-over effects for the regional economy.

DBRS Morningstar considers that the national government's involvement to address this structural challenge –particularly in the context of COVID-19– will be critical to avoid a deterioration in the region's credit profile. DBRS Morningstar currently considers that additional information should become available in the next six months regarding the viability of SATA and the potential participation of the national government in any future plan for the company.

The Azores’ Economy Suffers From the Collapse of the Tourism Sector

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%, therefore entering into 2020 on a solid footing. The economic growth was supported by steady expansion of the tourism sector within the region’s territory, which is now the sector the most severely affected by the COVID-19 pandemic. While DBRS Morningstar expects considerable economic disruption in 2020 and most likely 2021, the full impact of the coronavirus on regional output will depend on the depth and duration of the shock, two parameters which to-date continue to remain uncertain.

Air passenger inflows into the region have declined substantially, with a drop of 64% between January and August 2020 compared with the same period in 2019. The impact was most noticeable in April and May, with a decline of 99% compared to 2019. This drop had direct consequences for restaurants and hotels in the region, with revenues from tourism estimated to have declined by close to 80% at the end of July 2020 compared with the first seven months of 2019. The impact of the pandemic on the regional labour market is currently difficult to estimate, as corporates have benefited from the national government's subsidised working scheme, in line with the rest of Portugal, as well as regional support, which has so far limited job losses.

Going forward, the region's tourism sector will remain constrained by the evolution of the healthcare situation, particularly in Europe and North America which represent the main source of tourists in the region. 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 EU under its next generation EU programme (NGEU) and possibly its new multi-annual financial framework (2021-27 period).

The Region’s Financial Performance, Although Strengthening in Recent Years, Will be Affected by the COVID-19 Pandemic

The Azores’ financial performance, while it has been relatively stable in the last five years, with solid operating results and small, albeit recurring, financing deficits, is expected to deteriorate in 2020. The regional government estimates the COVID-19 related deficit to represent an additional EUR 285 million for its annual budget, or about 30% of its 2019 operating revenues. This very large budgetary shortfall, corresponding to a blend of lower tax receipts and higher expenditure, particularly in healthcare and education (both responsibilities of the region), will be covered by an increase in the region's debt level.

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, represented 241% of the region’s operating revenues at the end of 2019. While DBRS Morningstar assesses this ratio as already high by international standards, it is now expected to increase substantially in 2020, with the additional direct debt and guarantees granted by the region. This represent a negative credit feature in DBRS Morningstar's analysis of the region's creditworthiness. However, the region’s debt ratio continues to compare very favourably on a national basis, as it remains substantially lower than that of Madeira (472% in 2019).

DBRS Morningstar also views positively the changes implemented in the last 24-months to re-centralise part of the regional companies’ debt onto the region’s own balance sheet. These operations were concomitant with the dissolution of two regional companies managing urban and housing rehabilitation and healthcare, respectively. 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.

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 does consider that any assistance previously provided to Madeira by the Portuguese government would be available 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.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

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 COVID-19 outbreak and its impact on the regional economy, as well as the Azores’ financial performance and debt metrics. The rescue 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/366854.

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. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Rating European Sub-Sovereign Governments (September 4, 2020) https://www.dbrsmorningstar.com/research/366368/rating-european-sub-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include the 2015-19 financial statements and monthly budgetary execution from the Autonomous Region of the Azores, quarterly debt metrics from the Bank of Portugal, economic indicators (unemployment, GDP metrics) from the Instituto Nacional de Estatística (INE). 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.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are 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:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/367252.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Nicolas Fintzel, Vice President, Global Sovereign Ratings
Rating Committee Chair: Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 12, 2019
Last Rating Date: March 27, 2020

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