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 five years prior to the COVID-19 pandemic and the regional government's willingness to consolidate its public finances in the coming years; (2) a high and, historically, a relatively stable debt ratio which increased noticeably from 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 as well as the support stemming from the national government.

The Negative trend continues to reflect the potential short- and medium-term budgetary and liquidity implications of SATA Group's (SATA) financial situation for the Azores. The region has granted liquidity support to SATA approved by the European Commission (EC) in the context of a restructuring plan for SATA still being discussed. This liquidity support takes the form of guarantees currently amounting to EUR 192.5 million and a loan of EUR 82.5 million from the region to SATA. The region's direct financial exposure to SATA, including guarantees and the loan has therefore continued to increase and now amounts to EUR 340 million (including EUR 65.0 million of guarantees pre-COVID) or 35% of the Azores' estimated 2021 operating revenues.

While initially expected by year-end 2021 or beginning 2022, DBRS Morningstar understands that the EC should provide its final decision on the investigation relating to new potential public support measures as part of SATA's restructuring plan in the near future. Once the EC’s final decision is known, DBRS Morningstar expects to gain clarity on the potential short-term implications for the region’s finances and liquidity. In addition, the EC’s decision, as well as the company’s restructuring plan, should provide some clarity on the medium-term budgetary impacts, depending on the financial and funding plan of the company and its expected future operational performance. Nevertheless, on a more positive note, DBRS Morningstar understands that SATA's financial performance was on track for a strong improvement in 2021 on the back of the rapid recovery of the tourism sector in the Azores from Q4 2021 and the implementation of cost saving measures.

The close collaboration of the Republic of Portugal (BBB (high), Positive) in the process with the EC indicates, in DBRS Morningstar's view, the Portuguese central government's oversight and support for the region. In case of need, DBRS Morningstar expects the region to benefit from central government financial 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 and liquidity is reinforced, reducing the region's potential risks 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 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 rating is downgraded.

RATING RATIONALE

SATA’s Restructuring Process Remains the Main Risk for the Region’s Credit Profile

The region continues to face structural challenges. DBRS Morningstar considers that regional companies in the Azores, some 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 its financial results have prompted the regional government to provide SATA with liquidity support in the form of explicit guarantees and a loan.

On top of the restructuring plan, the process with the EC also includes an investigation regarding other support measures notably prior capital injections summing EUR 72.6 million from the region to SATA between 2017 and 2019 which were reimbursed by SATA in 2021 but also a planned restructuring aid through potential new capital injections. In 2021, SATA has reimbursed the region EUR 73.4 million related to the 2017-2019 capital increases, including interests, which were part of the EC investigation. 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 and liquidity, but also on the continuity of future air routes to and from 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 will be critical to avoid a deterioration in the region's credit profile. Additional information should become available in the first half of 2022 regarding the implementation of the restructuring plan of SATA, its financial and funding implications for the region and the potential participation of the national government in any future plan for the company.

After A Sharp Contraction in 2020, the Recovery Seems Under Way, Supported by a Positive Momentum for the Hospitality Sector from the Spring of 2021

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%, supported by steady expansion of the tourism sector within its territory. However, the economic disruption was considerable in 2020, with an economic contraction estimated at 9.2%, versus 8.4% nationally. COVID-19 has triggered a severe blow to the hospitality sector, which suffered a 71% decline in overnights stays in 2020 compared to 2019. The hospitality recovery nevertheless started in the spring of 2021 and accelerated in Q4 2021, with overnights stays accounting for 94% of their Q4 2019 level during that last quarter. Going forward, the recovery of the tourism sector, which may be supported by the opening of new airline routes to the Azores in 2022, will be key for the regional economy. 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 European Union (EU, AAA, Stable). On top of traditional EU operation programs, the region could receive up to EUR 580 million in grants related to the Recovery and Resilience Facility (RRF).

The unemployment rate stood at 6.9% at Q3 2021 (7.3% nationally) versus 7.6% at year-end 2019 (6.9% nationally). However, the actual impact of the pandemic on the regional labour market is still 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.

The Region’s Financial Performance, Although Strengthening in Recent Years, Was Strongly Hit in 2020 and 2021, but Should Improve from 2022

The Azores’ financial performance, while it has been relatively stable in the previous five years, with solid operating results and small, albeit recurring, financing deficits, it deteriorated markedly in 2020 and 2021. The operating results-to-operating revenues ratio stood at -5.7% in 2020 and -5.2% in 2021, versus a surplus of 8.5% on average in the five years prior to the pandemic. Similarly, the financing deficit represented 30% of operating revenues in 2020 and remained close to 10% in 2021 (17% excluding SATA's capital reimbursement) compared with a deficit of 5.5% between 2015 and 2019. Those very large budgetary shortfalls were mainly due to COVID-related higher expenditures, particularly in healthcare and education (both responsibilities of the region). DBRS Morningstar expects these large deficits to remain concentrated in 2020 and 2021 and understands that the region is targeting re-balancing its accounts by 2024. A structural weakening of the region's financial performance would potentially have a negative impact on its ratings.

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, has reached 301.8% of the region’s operating revenues at the end of 2021, versus 241% at the end of 2019, mainly due to higher regional financing needs due to the COVID-19 pandemic, but also due to the large increase of SATA's debt. From an international perspective, this debt level is very 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 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. The region has also decided to take over hospitals' debts which are part of its direct debt from 2020. This did not have any impact on DBRS Morningstar's debt metrics as those debts were already included in DBRS Morningstar's adjusted debt ratios.

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 takes the view that any assistance previously 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, 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 (low) – BB range. The main points discussed during the Rating Committee include the regional economy’s recovery and 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/392920/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:
All figures are in euro (EUR) unless otherwise noted.

The principal methodology is the Rating European Sub-Sovereign Governments (September 1, 2021) https://www.dbrsmorningstar.com/research/383672/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 2016-2021 financial statements and monthly budgetary execution from the Autonomous Region of the Azores, SATA’s 2020 accounts, Instituto Nacional de Estatística (INE) and 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/393287.

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 Global Sovereign Ratings
Initial Rating Date: July 12, 2019
Last Rating Date: September 03, 2021

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