The industry that makes it possible to move people and things--U.S. transportation infrastructure providers--could be stuck in the slow lane for a while. Standard & Poor's Ratings Services believes that the largest sectors--ports, airports, and toll roads--will likely deliver weak operating and financial results into 2010. Moreover, in our view, the timing and strength of a recovery may vary widely for these sectors and their issuers. In sum, we think it could take years for business to return to 2008 levels.

Generally, we have observed that transportation demand improves with the economy, with some lag. Typically, we see port activity bounce back first as sales of consumer goods stimulate shipping, followed by airports and toll roads as people travel more with improvement in employment and incomes. Already, we have seen that the rate of erosion in all three areas has slowed. And Standard & Poor's Chief Economist David Wyss believes the recession may have ended in September.

Still, Mr. Wyss feels that the economic recovery will be slow and uneven (see “U.S. Economic Forecast: “Is It Safe Yet?” published Oct. 12, 2009, on RatingsDirect), with GDP rising a tepid 1.8% in 2010. Thus, for many of Standard & Poor's rated issues, we expect port container volumes, airline passenger traffic, and vehicle miles traveled on the toll roads we rate to continue to decline, along with revenues because it's hard to raise rates in a weak economy. While the credit markets have improved dramatically from a year ago, the credit crisis has made it more challenging for many issuers to restructure debt with the erosion in counterparty and bond-insurer credit quality and the unwinding of swaps that have been largely out of the money.

That said, about 220 transportation obligors that we follow are monopoly providers of infrastructure with ratings in the 'A' category and stable outlooks, thanks to what we consider their strong business and solid financial profiles. Many have managed through the recession, reducing costs, deferring capital expenditures, and relying on contractual revenue streams such as minimum annual guarantees (MAGs). They've also cut services, reduced staffing, and restructured long-term debt.

Were the U.S. and global economic slowdown to become more severe or extend beyond 2010, we would expect the credit fundamentals of many issuers to deteriorate, which would then lead us to downgrade the more-exposed issuers. Among these, we think, could be issuers that depend on rising revenue or more robust demand to service high fixed cost or growing debt. Still, others might face rising competition, or be unable or unwilling to increase rates to maintain financial metrics--including debt service coverage and liquidity ratios--that are commensurate with their current rating.

The Ratings Distribution

For many decades, we have seen the U.S. transportation infrastructure sectors enjoy strong demand but also suffer from funding shortfalls and large, uneven capital requirements as they added capacity in large chunks in anticipation of existing traffic levels. In evaluating the industry's revenue bonds, we consider both the broader trends affecting the sector, including the health of local, regional, and national economies, as well as sector-specific credit characteristics, such as financial performance, competition, management, capital plans, debt structure, and legal protections and their ability to deal with regulatory issues.

In addition to strong business positions, most infrastructure providers have cost-recovery business models that allow for rate adjustments. Yet ports and airports tread a fine line between charging tenants and customers as much as necessary to cover debt and operating costs, and charging so much that it reduces demand or their competitive position. Toll road operators also face various limits in increasing tolls, so they mainly aim to keep costs down.

Of our 261 total public transportation sector ratings--many issuers have more than one rating--the largest share is held by airport operators followed by toll road operators (see chart 1) with the majority of ratings falling within the 'A' category (see chart 2). Since September 2008, upgrades have outpaced downgrades by almost 2 to 1 (see table 1), reflecting managements' actions to enhance revenues, control costs, and take affirmative steps in the face of weakened demand indicators, as well as unique issuer-specific factors. Additionally, most of the upgrades were associated with federal grant-secured ratings that are less exposed to volume declines and benefit from strong levels of federal support and debt service coverage (DSC) levels. However, as the table indicates, the outlook trend has been negative, with negative outlooks outnumbering positive outlooks by 2 to 1, including issuers whose outlooks were revised from positive to stable. The primary driving factors behind these negative outlooks have been the erosion in traffic, containers, and other volume indicators that, if not mitigated by actions to increase rates or reduce costs, are likely to hurt financial metrics in the next 12-24 months.

Chart 1

Chart 2

Table 1

Over the past 12-15 months, we've often seen what we consider significant deterioration in demand trends for all three major transportation sectors.

Ports

Cargo demand, like much of the U.S. economy, entered what we view as a precipitous decline that volatile fuel prices have exacerbated, and we think that will continue into 2010.

At the moment, a significant drop in 20-foot-equivalent-unit (TEU) containers indicates that nearly all U.S. ports are suffering from lower traffic. West Coast ports experienced the largest growth in container traffic during the past decade, both in percentage terms and on a total volume basis, but are now experiencing the largest declines. According to current operational data published by the ports, several major West Coast ports have suffered double-digit drops in calendar 2009 year-to-date container traffic. These include Los Angeles (16.3%), Long Beach (25.1%), Oakland (12.9%), Seattle (16.4%), and Tacoma (15.3%). Ports on the East Coast have also suffered, with container cargo volumes at the Port Authority of New York and New Jersey down 14.4% and general cargo (measured in metric tons) down more than 20%.

To help gauge the health of maritime demand, we monitor the balance between import and export traffic through U.S. ports. A weak dollar has made U.S. goods comparatively cheap in overseas markets, helping increase exports while making imports more expensive. Recently, however, volatile exchange rates and weak global growth have led to uncertainty in the outlook for exports. For this year, Standard & Poor's expects U.S. imports and exports to fall 14.6% and 10.4%, respectively, before returning to positive territory in 2010.

Each port, however, has a unique business and financial risk profile based on size, facilities, location, customer base, and inland transportation links. Ports operating as public authorities or enterprise funds separate and apart from the state or local governments' general funds typically have what we consider stable revenues and moderate debt. They also have, in our view, a variety of manageable operating expense profiles, depending on whether they are an operating port (providing labor and facilities) or landlord port (leasing terminals for development to tenants who contract for labor). Many smaller ports specialize in niche cargo types or trade routes, and some have growing cruise-ship operations, all of which makes it difficult to generalize about the sector. In addition, several ports, such as the Port Authority of New York and New Jersey, have other businesses, including airports, real estate, and toll bridges.

Key issues that we believe will likely effect port creditworthiness include:

• The U.S. recession and global slowdown, which pressure cargo transport and port revenues.
• Weakness in the global container shipping industry as shippers struggle with excess capacity, lower prices, and the availability of credit.
• Difficulty in raising wharfage and dockage charges and other port fees.
• Increased competition between large port operators and small or growing ports, as well as between the West, East, and Gulf Coasts for discretionary cargo as a result of changing trade routes, terminal expansions, and the expansion of the Panama Canal (which may shift some Asian cargo from West Coast ports to Gulf and East Coast ports).
• Long-term capital investment and debt needs -- which the 2009 U.S. economic stimulus package somewhat alleviates -- including money for dredging, waterfront facilities, and surface transportation that connects seaports to inland customers and distribution centers.
• Volatile costs, particularly fuel, for maritime, barge, rail, and trucking, which could alter the economics and logistical decisions of global shipping players.

Despite these challenges, we believe port management teams will continue to take steps to mitigate risks to financial performance. Many ports have long-term agreements with customers (such as terminal operators and shippers) that include MAGs, which cushion some of the impact of the cyclicality of traffic flows. Ports also generally limit infrastructure projects to those necessary to accommodate existing traffic or near-term increases, providing relatively stable returns on investments. And although ports often borrow to finance large projects, existing debt covenants and prudent financial management limit risks. Therefore, we view U.S. port credit quality as generally stable. Since 2004, our rating actions have been generally positive, with 13 upgrades and only two downgrades.

Airports

U.S. airport traffic has historically lagged economic recoveries. Passenger traffic is still falling in many instances as airlines continue to cut capacity, although the rate of decline is slowing, particularly as many operators catch up to the declines that started last year. As of last July, according to the Bureau of Transportation Statistics, U.S. domestic and international air traffic was down 3.7% from a year earlier -- the 16th consecutive month of decline -- with nearly all airports experiencing declines, some as much as 20%-25%. At some airports, both business and leisure travel have dropped. We've witnessed a fall-off in capacity through scheduled seats and departures measures at large, medium, and small hubs and expect this trend to continue into 2010.

Although airlines can adjust capacity to reflect lower demand, historically, fewer passengers and reduced airline volumes typically have had what we consider a significant adverse impact on airports' financial performance. The airport sector generates about two-thirds of its total revenues from nonairline sources. Cargo carriers have also experienced larger volume declines since fall 2008 than in the period after Sept. 11, 2001, weakening landing fee revenue at U.S. airports. In addition, in our view, the still-unfolding H1N1 flu epidemic could further hurt airports such as Miami, Houston, and Dallas, which have experienced a drop in international travel.

Among the several rating issues we see as affecting the sector are the volatile airline industry, increased capital needs to meet future traffic projections, and pressure for creditworthy airports to assume more risk by expanding commercial development for airport-related businesses.

We have seen airport operators respond to these challenges by scaling back or deferring capital programs; reducing or containing increases in operating budgets; increasing liquidity by reducing capital and operating expenses (with layoffs, wage and hiring freezes, and reduced services); raising airline rates and charges; enhancing nonaeronautical revenues from retail and concession development; and refinancing debt (despite typically having to pay a premium in this market).

Many airport operators often try to avoid raising airline fees in times of financial stress and look to nonairline sources such as parking--sometimes at the expense of not increasing airline charges, with the net result of lowering DSC. While this may provide temporary relief--particularly for airports with higher cost structures--sustained lower DSC is likely to have negative rating implications. Airport management and governing boards are also generally reluctant to increase parking and rental car rates significantly, particularly during an economic downturn.

We understand that most long-term capital expansions are on hold for now. However, the need continues for routine capital expenditures and safety and security projects, many of which are debt-financed. In addition, we believe that spending to improve efficiencies may be necessary; these include investments in technology to enable smarter use of airline gates, air field improvements to enhance capacity and efficiency, and better baggage screening to meet security requirements and reduce labor costs.

Toll Roads

Current economic conditions indicate a long and winding recovery for some toll road operators. Toll roads represent a small fraction of the overall U.S. roadway network (less than 5%) but often provide key links within metropolitan and important long-haul interstate routes for commercial traffic.

By one broad measure--the U.S. Bureau of Transportation Statistics' vehicle miles traveled (VMT)--as of June 2009, traffic had declined in 17 of the previous 19 months along federal highways due to high gas prices and the economic slowdown. Many operators are expecting traffic declines and revenue weakness to continue through year-end. However, several toll operators have raised tolls in advance of the decline in traffic or in reaction to it, boosting their revenues. Our stable outlook on the sector takes account of the weakened economy, rising fuel prices, and public sector owners' rising capital requirements. However, we also see management as well prepared for what's to come. We believe that toll technology, which allows for the automated adjustment of tolls depending on traffic and/or times of day, could enhance flexibility in raising revenue (see "Global Toll Facilities Ratings And Outlooks: Current List," published Oct. 22, 2009, on RatingsDirect).

In our view, key credit trends for toll road operators include:

• For higher-priced, congestion-relieving toll facilities, competition from free roadways and other transportation modes as traffic levels remains low;
• Longer-term capital needs to meet forecast traffic growth and maintain existing infrastructure, including new technology fore electronic toll collection;
• Affording new technology for electronic toll collection;
• Pressure for creditworthy toll facilities to assume a broader role in expanding and maintaining networks outside of their system, resulting in higher levels of debt and operating expenses that may not be offset with higher toll revenues; and
• Potential for reduced toll-rate flexibility in the future as many operators move toward regular inflation-adjusted toll increases, raising the likelihood that rate increases could lead to lower traffic and reduced revenues.

One option toll roads have over other transport sectors, however, is in the area of technology. Some have the ability to offer electronic toll discounts, for example at different times of the day, as a way to make up for revenue declines.

Credit Fundamentals Could Weaken If Economies Remain Soft

Overall, we believe many transportation-related issuers will likely continue to face challenges because of reduced demand for infrastructure, which would result in weaker revenue from tolls, airline landing fees, and maritime wharfage charges. Providers' credit quality, however, has held up largely because of their ability to implement rate increases, greater reliance on contractually-obligated revenue streams such as MAGs, and focus on reducing costs and deferring capital. If the U.S. and global economies remain weak into 2010, then we expect some deterioration in credit fundamentals that could result in downgrades of issuers we view as more exposed. These are entities that depend on revenue/demand growth to service a high fixed-cost or increasing debt structure, have an exposure to counterparties and a concentration in tenants/users, face increased competition, and are unable or unwilling to increase rates to maintain financial performance consistent with their current rating.

Sidebar: Grant Anticipation Revenue Vehicles

Grant anticipation revenue vehicles (GARVEEs) have, we believe, proven to be a critical financing tool for state and regional transport agencies, which issue the bonds and pledge future federal highway funding as the sole security for repayment. This financing mechanism allows states to maximize transportation grant revenues beyond traditional pay-as-you-go funding from state general funds, thus accelerating construction of priority projects, and more efficiently spread costs over the asset's life.

An important assumption underlying Standard & Poor's transportation grant ratings is that the supportive legislative framework and Congressional appropriations that fund transportation grant programs will continue in some form into the future, well beyond the current multiyear budget authorization. We base this assumption on historical precedent, our view of the political and economic importance of national highway and mass transit systems, the broad bipartisan political support for transportation spending programs at all levels of government, and a Congressional record of continuing appropriations and extensions to budget authorizations when they expire. The six-year authorization of the federal highway and transit programs expired on Sept. 30, 2009, and Congress has yet to agree on the form and duration of a successor program. However, Congress has approved a continuing resolution that will maintain funding for all federal discretionary programs at their current levels for 30 days, including the federal highway and transit programs.

It is this record, the strong programmatic features of many of the state GARVEE programs, and high debt service coverage (DSC) levels that have led us to raise several ratings on state department of transportation issuers, despite the uncertainty about a successor to the current highway authorization funding law. Those upgrades associated with GARVEE-secured credits reflect our expectation that the long-standing federal aid highway program will likely continue to receive significant funding and that those state programs we evaluated (California, Missouri, North Carolina, and Montana) will receive their relative historical share of annual Title 23 distributions from the federal highway trust fund (HTF). These credits demonstrate very strong levels of DSC, strong state support as well as programmatic and structural features that contribute to 'AA' category ratings.

In our view, risks associated with delays in authorizations of the federal highway and transit programs, changes in law, declining HTF balances, or Congressional or administrative modifications to grant programs will not end the long-standing practice of federal aid for transportation on which we base our GARVEE ratings. However, we anticipate that changes in program rules, constrained funding sources, and federal budget pressures may result in reduced authorization and appropriation levels and diminish DSC levels, which are currently viewed as very strong for most rated entities.

Writer: Craig Schneider

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