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

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 remains negative.

KEY RATING CONSIDERATIONS
The Azores’ ratings are underpinned by (1) sound operating results and an overall stable financial performance over the last five years prior to the crisis; (2) a high and historically relatively stable debt ratio but that increased 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.

The Negative trend continues to primarily reflect the potential implications of SATA Group's (SATA) financial difficulties for the Azores' balance sheet. 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 EUR 133 million in 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, provided the airline with an initial six month window to present a restructuring plan. DBRS Morningstar understands that this timeline has been extended and that a potential increase in the amount of the liquidity support could be envisaged given the continued adverse impact of COVID-19. The collaboration of the Republic of Portugal (BBB (high), Stable) in the process with the EC indicates, in DBRS Morningstar's view, the national government's oversight and support for 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.

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 already high debt metrics; (2) the region fails to stabilise 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.

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 in the form of an explicit guarantee.

On top of the restructuring plan, the process with the EC also includes an investigation regarding prior capital injections summing EUR 73 million from the region to SATA between 2017 and 2019. 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's 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. Following the extension of the initial six months' timeline, DBRS Morningstar considers that additional information should become available in coming weeks and 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. The economic disruption was significant in 2020 and the recovery for 2021 is still uncertain.

COVID-19 has triggered a severe blow to the hospitality sector, which suffered a 69% decline in overnights stays in 2020 compared to 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 sources 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 cohesion policy program but also the next generation EU programme (NGEU).

The Region’s Financial Performance, Although Strengthening in Recent Years, Is Strongly Hit 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, deteriorated markedly in 2020. Based on the region’s estimates, the operating results-to-operating revenues ratio stood at -5.5% in 2020, versus a surplus of 8.5% on average in the last five years. Similarly, the financing deficit represented 29% of operating revenues last year compared with a deficit of 5.5% between 2015 and 2019. This very large budgetary shortfall is due to a blend of lower tax receipts and higher expenditure, particularly in healthcare and education (both responsibilities of the region). DBRS Morningstar will focus its analysis on whether these large deficits remain concentrated in one or two years and do not translate into a structural weakening of the region's financial performance.

As a consequence, 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, is expected to have reached between 280% and 300% of the region’s operating revenues at the end of 2020, versus 241% at the end of 2019. From an international perspective, this debt level is 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 also positively the changes implemented in the last two 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 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 can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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 on the Azores’ financial performance and debt metrics. The financial situation 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/374340/portugal-republic-of-scorecard-indicators-and-building-block-assessments.

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:
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.

All figures are in Euros (EUR) unless otherwise noted.

The principal methodology is the Rating European Sub-Sovereign Governments (September 4, 2020) https://www.dbrsmorningstar.com/research/366368/rating-european-sub-sovereign-governments. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include the 2015-20 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) and from 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 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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/374886/.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Mehdi Fadli, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: June 15, 2018
Last Rating Date: September 25, 2020

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