OREANDA-NEWS. Fitch Ratings affirms the following Sacramento City Unified School District, California (the district) bonds:

--$234.9 million general obligation bonds (GOs) at 'A+';
--$43.1 million Sacramento City Unified School District Joint Powers Financing Authority lease revenue refunding bonds (LRBs), 2014 series A at 'A'.

The Rating Outlook is revised to Stable from Negative.

SECURITY

The GOs are payable from an unlimited ad valorem property tax.

The LRBs are payable from annual lease payments for the use and occupancy of essential district school buildings.

KEY RATING DRIVERS

IMPROVED FINANCIAL PERFORMANCE: The Outlook revision reflects a return to structural budget balance and greatly improved reserve position, although the district has shown a willingness to budget reserves down to a very low level during periods of state funding cuts. The district is currently benefitting from rapid state funding gains.

CHALLENGING BUDGET ENVIRONMENT: The district must manage a volatile state funding environment and has no meaningful revenue raising flexibility because of state law, forcing budget adjustments to be made primarily through expenditure reductions.

ECONOMIC RECOVERY GATHERS STEAM: Sacramento's government-dominated economy is growing at a healthy pace. The district's large, diverse tax base has fully recovered after a period of relatively manageable assessed value (AV) declines during the national housing downturn.

SIGNIFICANT LONG-TERM LIABILITIES: The district's long-term liability profile is weak, with a moderate debt burden offset by a poorly funded teachers' pension plan and a large unfunded liability for other post-employment benefits (OPEB).

LEASE APPROPRIATION RISK; ESSENTIALITY: The LRBs ratings are notched below the GO rating to reflect annual appropriation risk of lease payments balanced by the essential nature of the leased assets and a covenant to budget and appropriate lease payments.

RATING SENSITIVITIES
MAINTENANCE OF STRUCTURAL BALANCE: The rating could come under downward pressure if the school district fails to maintain adequate reserves. The rating is unlikely to move higher with near-term increases in fund balance due to our expectation that reserves would be drawn to low levels in recessions.

CREDIT PROFILE

The district includes just over half of California's state capital and some adjacent suburban areas. The district is the state's 13th largest school system with about 42,000 students.

WEAK FINANCIAL PERFORMANCE

The district has significantly improved its financial position over the past two years. It rapidly rebuilt reserves with a large unexpected general fund surplus in fiscal 2014 and a small surplus in 2015 (unaudited actual data), as surging state funding raised revenues. The district added $27.5 million to fund balance over the period, increasing unrestricted fund balance to $39.9 million, or a healthy 9.3% of spending. The district's fiscal 2016 budget shows a small deficit, but Fitch expects some addition to fund balance, given quite conservative revenue and expenditure assumptions. The district's multiyear projections show significant draws on fund balance in 2017 and 2018, but management plans to take action as necessary to maintain structural balance with use of reserves limited to one-time items and spending down restricted funds.

WEAK POLICY FRAMEWORK

Financial oversight has improved in recent years with increased focus on maintaining structural balance, but the district lacks a formal fund balance policy or sustained track record that would support expectations that the improvements in financial performance will be durable. It has previously shown a willingness to budget spending reserves down to the state's minimum 2% reserve for economic uncertainty, which Fitch believes is inadequate to buffer against the uncertainty and volatility of school funding in California.

The district replaced top management in recent years, and the new superintendent and chief business officer have paid strong attention to aligning ongoing expenditures with ongoing revenues. The district also benefits from strong financial planning and reporting requirements under state law with conservative and frequent budget and financial planning processes overseen by the County Office of Education.

DIFFICULT REVENUE ENVIRONMENT

The district is highly dependent on the state of California for funding and has no meaningful local revenue raising flexibility. The lack of local revenue flexibility forces the district to manage state funding volatility with periods of reserve spending and spending adjustments. The district has shown a willingness to trim expenditures sharply, but only after reducing reserves to minimal levels. The district is currently in a period of strong state funding growth, but the funding environment remains volatile.

STATE CAPITAL GROWTH ACCELERATES

The district sits at the heart of a significant, government-dominated economy that is currently experiencing healthy growth. While the Sacramento region remains dominated by government - which provides more than a quarter of all jobs in the Sacramento metropolitan area - the economy has diversified over the years. The economy also includes significant healthcare, educational, professional services, technology, and construction industry employers.

The city's unemployment rate trends higher than the national average, and has fallen sharply with the economic recovery. The non-seasonally adjusted unemployment rate of 6.0% in October 2015 was above the nation's 4.8% rate, but down by more than six percentage points over the four years on surging payroll growth. District socioeconomic indicators are somewhat below average with an elevated poverty rate (16.4%) and median household income at 94% of the national level.

The school district's $29.1 billion tax base is largely residential and quite diverse with the top 10 taxpayers representing just 3.9% of AV. Sacramento's older, more established housing stock has protected it from the extraordinary declines seen in communities with large amounts of new development during the housing boom. AV declined a manageable 9.4% from its peak in fiscal 2009 to its trough in fiscal 2013. AV surpassed its pre-recession peak in fiscal 2015 and is projected to rise 4.7% fiscal 2016. The city is experiencing significant downtown development that should bolster tax base growth in the upcoming years, including construction of a new basketball arena and development of its old rail yards.

MODERATE BUT RISING DEBT BURDEN

The district's debt burden is moderate, with direct and overlapping debt equal to 4.1% of AV, or $3,455 per capita. The district's debt burden is likely to rise somewhat over the next several years due to continued borrowing to support the district's capital plan. Sacramento voters approved a $414 million GO bond authorization in November 2012, of which $254 million remains to be issued over the next several years. The district is likely to issue the bonds gradually in a way that does not increase debt ratios sharply. Amortization is solid with 47.3% of debt paid down over 10 years.

SIGNIFICANT RETIREE LIABILITIES

Post-employment liabilities are a significant and growing burden on the district. The district participates in the California Public Employees' Retirement System (CalPERS) and the California State Teachers' Retirement System (CalSTRS) pension systems. Contribution rates for CalPERS are rising based on updated actuarial and rate of return assumptions, while CasSTRS rates are rising rapidly in an effort to address a history of underfunding due to statutory contribution rates that were held below actuarially required rates for many years. The district's unfunded accrued actuarial OPEB liability is high at $615.2 million, or 2.2% of AV.

Carrying costs for debt service, pension and OPEB remain moderate at 16.3% of governmental funds spending in fiscal 2015. Rising healthcare costs and CalSTRS's weak funding ratio are likely to push carrying costs higher over the next several years, though district officials are actively working with labor unions to reduce the growth of medical and OPEB costs.