Morningstar DBRS Changes Trends on the Autonomous Region of the Azores to Positive, Confirms Ratings at BBB (low)

DBRS Ratings GmbH (Morningstar DBRS) changed the trend on the Autonomous Region of the Azores' (Azores or the Region) Long-Term Issuer Rating to Positive from Stable and confirmed the rating at BBB (low). At the same time, Morningstar DBRS changed the trend on Azores' Short-Term Issuer Rating to Positive from Stable and confirmed the rating at R-2 (low).

KEY CREDIT RATING CONSIDERATIONS
The Positive trends are underpinned by Morningstar DBRS' trend change on the Long-Term Foreign Currency and Long-Term Local Currency Issuer Ratings (both rated "A") of the Republic of Portugal (Portugal) to Positive from Stable on 19 July 2024.

Morningstar DBRS' considers that Azores' fiscal position improved in 2023 related to an increase in tax revenues stemming from strong economic momentum in recent years. This fiscal improvement should allow the Region to continue making progress towards budget balance and stabilizing its debt burden. Moreover, SATA has considerably improved its operating performance since 2021, easing the completion of the Region's divestment from SATA's international business division.

Azores' credit ratings remains underpinned by (1) the regional government's willingness to continue to consolidate its public finances, as demonstrated in its capacity to start reducing its large deficit in 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 2020-22 but started decreasing in 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", Positive) as well as the support stemming from the national government.

CREDIT RATING DRIVERS
Morningstar DBRS could upgrade the credit ratings if (1) the Portuguese sovereign credit rating is upgraded or (2) if the region were to materially reduces its indebtedness and risk exposure to loss-making regional companies.
Morningstar DBRS could change the trends on the credit ratings back to Stable if the positive trend on Portugal's sovereign credit rating is reverted to Stable. The trend could also be reverted back to Stable if Azores' indebtedness were to increase again.

Morningstar DBRS could downgrade the credit ratings if (1) SATA's, or other regional companies', financial and liquidity profiles were to deteriorate, prompting guarantee calls or a marked weakening of the region's already high debt metrics; (2) the region were to fail 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 credit rating is downgraded.

CREDIT RATING RATIONALE

Azores' Budgetary Performance Improved But Remains Insufficient To Balance Accounts

The Azores' budgetary performance has continued to improve in 2023. The regional administration reduced its financing deficit to 8.5% of operating revenues from 15.1% in 2022. Nevertheless, this deficit remains relatively high. In 2023, the region benefited from fast-growing fiscal revenues that outperformed the Region's expectations, supported by the strong increase of direct taxes, especially corporate income tax. Indirect taxes were stable at EUR 505 million despite the positive impact of inflation on nominal private consumption; this was because the Portuguese National Statistical Institute downwardly adjusted the population registered in Azores which impacted the VAT calculation distribution formula leading these revenues decreasing by 2%. VAT is the largest tax element representing around 35% of operating revenues.

Operating performance slightly deteriorated and has remained well below the level seen prior to the COVID-19 pandemic. The operating results-to-operating revenues ratio decreased to -5.1% in 2023 from - 3.5% in 2022, versus a surplus of 8.5% on average during 2015-2019. However, operating revenues strongly recovered which should allow the region to improve rapidly its budgetary performance with a stronger control over operating expenditure. The operating performance deterioration is affected by the increase of public salaries of within the education sector and the increase of interest costs, that together led toa 7% increase in operating expenditures in 2023. Morningstar DBRS views the fiscal improvement in 2023 as a first step towards re-balancing regional accounts, but performance is still far from levels seen before 2019 and low fiscal space exists should another shock emerge. A structural weakening of the region's financial performance would potentially have a negative impact on its credit ratings.

Azorean Debt Ratios Are Improving After Debt Re-centralization, And Region Will Take Debt From Central Government

Azores' adjusted debt stock as calculated by Morningstar DBRS, which includes direct debt and indirect and guaranteed debt of several regional companies including SATA, and also public-private partnerships (PPPs), is estimated to have decreased to around 383% of the region's operating revenues in 2023 from 397% at end 2022, which is still very high by international standards. Due to the large deficits of the last four years and the operational difficulties posed by the lockdowns that affected the financial situation of SATA, Azores' adjusted debt stock has increased significantly from 298% at end-2019. The medium-term debt trajectory of the region will, therefore, remain one of the key focuses of our analysis.

Given the Region`s progress with re-centralizing debt, Morningstar DBRS sees a reduced risk from contingent liabilities affecting the Region's debt in the medium term and expects the region to progressively decrease its debt levels, supported by improved fiscal results and economic growth. The Azores' financing needs for 2024 decreased to EUR 110 million versus EUR 262 million in 2023. This decrease reflects both the expected reduction of the financing deficit and lower debt repayments this year, although the Region will also translate EUR 75 million commercial debt into financial debt in 2024. Azores has always maintained a close relationship with the central government in market consultations for financing and, for the first time since 2012, the Region has opted to take a direct loan from the State to cover the 2024 financing needs. Morningstar DBRS takes the view that this support was potentially available before and is only used by the Region to improve its funding conditions, while its access to funding remains similar to last year.

The international public tender for the divestment of Azores Airlines was launched in March 2023 and postponed due to regional elections, until the next government takes the ownership on this process. However, a re-evaluation of the company considers the entity to be of higher worth than previously estimated, based on improved economic and financial conditions plus an improved operating performance of SATA, which might change the tender conditions. We consider that the tender would take place before 2025 as agreed by the European Commission, unless the period is extended, and that this restructuring plan and the restructuring aid provided to SATA have reduced the short-to-medium term solvency and liquidity risks, reducing the region's potential risks related to the airline. Nevertheless, we will monitor the implementation of the restructuring plan going forward and assess any potential negative financial impact on the region's credit profile stemming from SATA.

Strong Tourism Performance Drives Economic Growth And All-Time Highs On Labour Market And EU Funds Will Continue To Support

On the economic front, the region has benefited from a strong performance of the hospitality sector since 2022. Up to May 2024, overnight stays grew by 11% compared to the same period in 2023; and the annual overnight stays in 2023 had already increased 11% compared with 2022, exceeding their 2019 level by 19% and showing a lower level of seasonality throughout the year. Tourism growth during 2023 was positively influenced by an international tourism uptick, with international tourists currently accounting for 66% of the total against 60% in 2022. This strong performance of the tourism sector led to the good performance of the regional economy. Latest estimates point to real GDP growth of 2.5% in 2023 compared with 2.1% for the national average.

The recent stronger economic performance of the last three years also contributed to an improvement in the labor market with the highest number of employed population of all times at 119 thousands out of 128 thousands active population. The regional unemployment rate is usually above the national average but occasionally falls below for instance in Q4 2022. At the end of Q12024, the unemployment rate stood at 7.0% compared with 6.8% nationally, but improved from 10% on average in 2015-2019. Additionally, EU funds have been important in supporting the regional economy, employment growth and infrastructure development in the Azores, and Morningstar DBRS notes that financial support will continue during the new EU budget. These funds represent around one third of Azores' 2023 estimated GDP. RRF will be mainly concentrated on projects related to digital transition and climate transition. The capacity of the region to execute those projects will therefore be key to benefit from funds and accelerate economic transformation and recovery.

Coalition Government Remains Committed To Control Debt And Budget Approved Without Absolute Majority

Azores has a new government since March 2024 and the 2024 budget was approved in May 2024. Following the rejection of the 2024 budget by the regional assembly, elections took place on February 4, 2024. The coalition of Social Democratic Party (PSD), the Social Democrats, the CDS - People's Party (CDS-PP) and People's Monarchist Party (PPM), won the elections with 26 seats, which is three seats below an absolute majority. However the coalition managed to gain support to approve its 2024 budget, which includes a net zero debt increase premise by which, we continue to foresee that fiscal consolidation and debt control remains a priority of the current government.

Similarly we continue to view the new government's budgetary objectives as aligned with the central government. The State Budget Law for 2024 gives the possibility to the central government of granting guarantees to the two Portuguese autonomous regions. Azores has decided to take debt from the central government to cover its 2024 financing needs to improve its funding conditions, after more than 10 years remaining independent from any debt or guarantee from the State. Additionally the central government has communicated its intention to support the region for the extraordinary costs from a fire that took place in 2024 at a hospital facility within the islands up to an 85% of the cost. Morningstar DBRS considers that the relationship between the region and the central government remains on par with Madeira.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
ESG Considerations had a relevant effect on the credit analysis.

Social (S) Factors

The following Social factor had a relevant effect on the credit analysis: The Passed-through Social credit considerations have a relevant effect on the credit ratings, as the social factors affecting the Republic of Portugal's credit ratings are partially 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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) https://dbrs.morningstar.com/research/427030.

RATING COMMITTEE SUMMARY
Morningstar DBRS' European Sub-Sovereign Scorecard generates a result in the BBB (high) - BBB (low) range. The main points discussed during the Rating Committee include the main developments in political landscape, the central government support, Azores's fiscal performance in 2023 and 2024, financial forecasts and the situation of the regional economy.

For more information on the Key Indicators used for the Republic of Portugal, please see the Sovereign Scorecard Indicators and Building Block Assessments: https://dbrs.morningstar.com/research/436410/.

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 unless otherwise noted.

The principal methodology is the Rating European Sub-Sovereign Governments (28 June 2024) https://dbrs.morningstar.com/research/435130. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The sources of information used for these credit ratings include Autonomous Region of the Azores for the 2017-2023 financial statements, 2024 monthly budgetary execution, debt and liquidity situation, 2024 National budget, 2024 regional budget, Instituto Nacional de Estatística (INE) and Serviço Regional de Estatística dos Açores (SERA) national statistical agency, central bank, Ministry of Finance, IMF, World Bank, Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

Morningstar DBRS 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. Morningstar DBRS' outlooks and ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://dbrs.morningstar.com/research/436851.

These credit ratings are endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Jorge Espinosa, Assistant Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: July 12, 2019
Last Rating Date: January 26, 2024

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