Fitch Downgrades Tucson USD No. 1, AZ's IDR and GOs to 'A'; Outlook Stable
-$70.32 million Arizona refunding bonds, series 2016.
The bonds are scheduled for a negotiated sale on or around the week of August 1. Proceeds will be used to refund outstanding debt for savings.
In addition, Fitch downgrades the following ratings:
--Issuer Default Rating (IDR) to 'A' from 'AA-';
--$126.7 million unlimited tax obligation bonds to 'A' from 'AA-'.
The Rating Outlook is Stable.
SECURITY
The GO bonds are payable from an unlimited ad valorem tax against all taxable property in the district.
KEY RATING DRIVERS
Limited Financial Flexibility: The downgrade of the district's IDR to 'A' from 'AA-' reflects application of Fitch's revised criteria for U. S. state and local government credits, which were released on April 18. Under the new criteria, Fitch considers the district's financial resilience in the context of a moderate revenue stress test. The stress analysis underscores the district's limited financial flexibility, consistent with persistent operating deficits, attributed largely to a declining enrollment base. The rating also reflects the district's capacity to rebalance its operations through cost cutting and facility closures, and low long-term liability profile.
Economic Resource Base
The district encompasses almost 230 square miles and provides public education to a sizable portion of the Tucson metropolitan statistical area (MSA).
Revenue Framework: 'bbb' factor assessment
The assessment is based on a stagnant revenue profile reflecting both the downward pressure created from the district's declining enrollment base and improved state funding associated with implementation of proposition 123 which compensates Arizona school districts for previously withheld inflation adjustments. Arizona schools are funded to a state-determined base level, above which the district does not have the independent legal ability to raise revenues for operations.
Expenditure Framework: 'aa' factor assessment
Spending pressure could arise to the extent that enrollment drops below that used to establish the district's annual budget. Expenditure flexibility resides in the district's ability to adjust staffing and salaries and to close facilities. Fitch expects carrying costs to remain moderate based on the district's rapid amortization, debt plans, and moderate, actuarially-based pension contributions.
Long-Term Liability Burden: 'aaa' factor assessment
The district's long-term liability burden is 8.3% of personal income. Modest regional debt needs and the district's moderate net pension liability are not expected to out-pace population and income trends, suggesting ongoing consistency with the 'aaa' long-term liability burden assessment.
Operating Performance: 'bbb' factor assessment
The district's financial cushion is susceptible to further diminishment in an unexpected revenue stress scenario. However, Fitch expects the district to use its expenditure flexibility to maintain a financial cushion at the current approximate level, commensurate with a 'bbb' operating performance assessment.
RATING SENSITIVITIES
Financial Performance: The 'A' IDR could come under downward pressure if the district fails to restore structural balance and maintain adequate reserves commensurate with the 'bbb' operating performance assessment.
CREDIT PROFILE
The Tucson MSA has roughly one million residents and has experienced strong population increases over the past decade. Tucson USD No. 1 enrollment has declined by 20% over the same period, attributed by the district to charter school competition. The local economy is driven by agriculture, manufacturing, aerospace, higher education, healthcare, government, technology, and tourism. The region suffered severe tax base losses associated with the recessionary housing collapse, but economic recovery is well underway as indicated by improving regional employment and residential market trends. IHS projects moderate economic growth in the Tucson MSA over the medium term driven by business and health services, construction and mining. Regional development suggests ongoing tax base expansion.
Revenue Framework
Operating revenues are provided primarily from state support and local property tax revenues, as well as from Pima county contributions, to fund operations to a level consistent with the state's per pupil equalization formula. The state establishes school district revenue budgets to fund both maintenance and operations (M&O) and capital, incorporating the annual state-wide constant base level per pupil funding, district-specific average daily membership (ADM) projections, and distinct characteristics of the district. Additional local funding is available to the district through voter-approved overrides. The district does not have, nor does it plan to seek, capital or M&O overrides.
The district's revenues have dropped over the past decade due primarily to ongoing enrollment declines associated with charter school growth, the effects of Senate Bill 1070, Arizona's anti-immigrant law passed in 2010, and online instructional program offerings. The district's ADM declined by 11,564 (20.3%) from 56,958 in fiscal 2006 to 45,394 in fiscal 2016. Officials project ongoing but smaller near-term enrollment losses as the district implements operating and facility improvements to recapture student growth. Fitch's assessment of revenue growth incorporates this projection. Relatively flat fiscal 2017 revenues reflect modest enrollment losses, offset by increased state funding associated with implementation of Proposition 123, approved by Arizona voters in May 2016. The measure provides reimbursement over 10 years for the state's failure to inflation-adjust state support since fiscal 2010 and ongoing inflation adjustments to the base level of support. Fiscal 2018 revenue could decline further depending on enrollment, as well as implementation of the state's "current year funding program" which would use a current year enrollment estimate, rather than the prior year's enrollment, as the basis for a district's revenue budget. Commensurate with the rollout of current year funding, the state would allow an increase in allowed carry - forward of reserves to provide an additional financial cushion.
Expenditure Framework
Tucson USD spends about half of its operating budget on instruction, followed by plant operations, administration and support functions.
Tucson USD is susceptible to spending pressures to the extent that expenditure adjustments do not keep pace with changes in ADM.
The district has discretion over employment levels, including student-to-teacher ratios. Instructional, administrative, and support staffing arrangements are guided by district policy and a series of meet and confer agreements and memoranda of understanding between the district and its employee groups. These are adjusted annually and the district retains ultimate decision-making authority with respect to all staffing, salary and workforce rules. The district has reduced total staff in proportion to enrollment losses over the past decade. The district has also closed 20 (about 15%) of its schools over the past 11 years. Many of the facilities were repurposed and nine were approved by voters for sale in November 2014. Of the nine approved for sale, only three have been put up for sale, two have sold to date and one is in escrow to be sold. Although sizable facility capacity remains in relation to ADM, the district does not have immediate plans to close additional schools.
Carrying costs are a moderate 13.3% of spending. These are likely to remain moderate considering rapid debt amortization, the district's debt plans, pension contribution levels, and the potential for a decline in overall spending.
Long-Term Liability Burden
The district's long-term liabilities are 8.3% of personal income. Immediate capital needs are modest and will be addressed through capital project funds and the Arizona School Facilities Board. District and community planning has identified the potential for up to $300 million in capital improvements over the medium term. However, rapid amortization of district and overlapping debt, and regional growth are likely to offset the district's new issuance and moderate net pension liability to maintain the district's long-term liability burden at the 'aaa' assessment level.
Operating Performance
A 'bbb' operating performance assessment indicates the district's limited financial resilience in a revenue stress scenario, taking into account its expenditure flexibility. The district completed fiscal 2015 with unrestricted reserves of $28 million (9.5%) of spending and estimates a modest addition to reserves in fiscal 2016, approximately equal to its informal total general fund target of about $32 million. Fitch expects that the district will exercise its spending flexibility to maintain its financial cushion consistent with the 'bbb' assessment.
The district's budget includes a modest amount of cost deferrals. The district has addressed a number of operating and facility improvements identified in a recent facility assessment. Additional projects and improvements are underway and planned for implementation over the medium term.
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