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

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 is Stable.

KEY RATING CONSIDERATIONS
The Azores’ ratings are underpinned by (1) the regional government's willingness to consolidate its public finances in coming years, as demonstrated in its initial budget for 2023, 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 which increased noticeably during 2020-2022 but is expected to start improving from 2023 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 (A (low), Stable) as well as the support stemming from the national government.

The Stable Trend reflects DBRS Morningstar's view that risks to the ratings are balanced. The strong recovery of the hospitality sector since 2022 has translated into higher tax revenues which should help the region achieve its fiscal consolidation path in the coming years. The positive momentum in the tourism sector should also support the turnover of the region's airline company, SATA Group. Combined with cost savings, DBRS Morningstar understands that this has helped SATA to improve its operational performance in 2022, which should allow the company to be in line or even exceed the targets set in its restructuring plan, mitigating the region's potential risks related to the airline.

RATING DRIVERS
The Azores’ ratings could be upgraded if any or a combination of the following occur: (1) the region materially reduces its indebtedness and risk exposure to loss-making regional companies; (2) Azores’ economic outlook outperforms current expectations; (3) there are indications of a further strengthening of the relationship between the region and the central government; or (4) the Portuguese sovereign rating is upgraded.

The Azores' ratings could be downgraded if (1) SATA's, or other regional companies' financial and liquidity profile deteriorates, 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
The Region’s Financial Performance is on the Path of Improvement Following the Strong Fiscal Impact of the COVID-19 Pandemic

The Azores’ budgetary performance has slightly improved in 2022 but has remained well below the level seen prior to the COVID-19 pandemic. The operating results-to-operating revenues ratio stood at an estimated - 3.3% last year, from - 5.6% in 2021 and -5.7% in 2020, versus a surplus of 8.5% on average during 2015-2019. Similarly, the financing deficit accounted for an estimated 15% of operating revenues in 2022, from 17% in 2021 (excluding SATA's capital reimbursement) and 29.8% in 2020, compared with a deficit of 5.5% between 2015 and 2019. The very large budgetary shortfalls in the last three years were mainly due to COVID-related higher expenditures, particularly in healthcare, education and support to the regional economy. DBRS Morningstar views the region's 2023 initial budget as a first step of the region in re-balancing its accounts, through operating and financing surpluses.

Due to the large deficits of the last three years and the financial difficulties of SATA, 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 an estimated 330% of the region’s operating revenues at the end of 2022, versus 241% at the end of 2019. 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 positively the changes implemented by the region 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 several regional companies. 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 Strong Recovery of the Tourism Sector Supports the Growth of Regional Economy and Should Ease the Financial Pressure on SATA

On the economic front, last year has seen a strong recovery of the hospitality sector. Overnight stays between January and November in 2022 exceeded their 2019 level by almost 5% and showed a lower level of seasonality throughout the year. This contributed to the good performance of the labor market with an unemployment rate standing at 6% in Q3 2022, close to the national unemployment rate of 5.8%, versus 10% on average during 2015-2019. Going forward, the situation of the tourism sector will remain exposed to uncertainties related to inflationary pressures. DBRS Morningstar will also monitor the potential uplift for the economy trajectory of the 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 positive momentum of the tourism sector is also expected to support the turnover of SATA, contributing to mitigate the region's potential risks related to the airline, following the approval by the European Commission (EC) in June 2022 of a EUR 453 million restructuring aid to SATA to support the company’s restructuring plan. The support took the form of a EUR 318 million equity injection by the region notably through the conversion into equity of a EUR 82.5 million direct loan from the region to SATA as well as the take-over in 2022 by the region of EUR 174 million of SATA’s debt which was guaranteed by the region. It also includes a guarantee of the region until 2028 on additional EUR135 million of SATA’s debt funding. The restructuring plan includes operational-efficiency measures and the divestment by SATA of its controlling shareholding (51%) of its subsidiary and international routes’ arm, Azores Airlines, which was historically accounting for the largest share of the airline group’s losses. DBRS Morningstar consider that the EC approval of the restructuring aid and the implementation of the restructuring plan has reduced in the short-to-medium terms the region's potential financial risks related to the airline, especially because the company had a large exposure to short-term debt which was largely guaranteed by the Region. As of year-end 2022, the region's guarantee exposure to SATA amounts to EUR 200 million and is currently only related to long-term debt maturing in 2028. Moreover, DBRS Morningstar notes that the EC has closed its investigation related to past public support measures provided to SATA, given that those capital injections have been reimbursed to the region in 2021, including interests.

Sovereign Support Remains Key to the Azores’ Ratings

While the Azores does not benefit at the moment from any debt guarantee from the central government, DBRS Morningstar takes the view that any assistance previously and currently 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, and that the State Budget Law for 2023 gives the possibility to the central government of granting guarantees to the two Portuguese autonomous regions .

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Social (S) Factors

The Passed-through Social credit considerations have a relevant effect on the ratings, as the social factors affecting the Republic of Portugal’s ratings are passed-through to the Azores.

There were no Environmental or Governance factors that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022).

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 regional economy’s recovery and the Azores’ financial performance, liquidity and debt metrics. The financial situation of SATA, the implementation of its restructuring plan 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/408861/portugal-republic-of-scorecard-indicators-and-building-block-assessments

Notes:
All figures are in euros (EUR) unless otherwise noted.

The principal methodology is the Rating European Sub-Sovereign Governments (August 12, 2022) https://www.dbrsmorningstar.com/research/401273/rating-european-sub-sovereign-governments. In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022) in its consideration of ESG factors.

The sources of information used for this rating include the Autonomous Region of the Azores for the 2016-2021 financial statements, 2022 monthly budgetary execution, debt and liquidity situation, 2023 budget, 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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://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/409291.

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

Lead Analyst: Mehdi Fadli, Senior Vice President, Senior Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head Global Sovereign Ratings
Initial Rating Date: June 12, 2019
Last Rating Date: September 02, 2022

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