TEXT-Fitch revises Modesto City SD, Calif. outlook to stable

Tue Jan 29, 2013 3:02pm EST

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Jan 29 - Fitch Ratings affirms Modesto City School District, California's
(the district) general obligation bonds (GOs) as follows:

--$24.6 million GOs (Election of 2001) series A at 'AA-'.

The Rating Outlook is revised to Stable from Negative.

SECURITY

The bonds are secured by an unlimited property tax on all taxable property
within the district.

SENSITIVITY/RATING DRIVERS

SOUND FINANCIAL OPERATIONS: The Outlook revision to Stable from Negative
reflects material and persistent financial outperformance compared to district
projections, an improved revenue outlook, and the expectation that the district
will retain a sound financial cushion over the foreseeable future.

WEAK ECONOMY, MODEST IMPROVEMENTS: The local economy continues to show signs of
weakness, including four consecutive years of significant tax base contraction,
high unemployment, and low income levels. However, unemployment has fallen
somewhat over the past year and recent home price data shows tentative signs of
recovery.

ADEQUATE DEBT PROFILE: The district's identified capital needs are minimal and
its other post-employment benefits (OPEB) liability is manageable. However,
CalSTRS pension costs likely will rise significantly moving forward and
substantial use of capital appreciation bonds (CABs) slows amortization
somewhat.

GOOD MANAGEMENT PRACTICES: The district benefits from a conservative management
team that has consistently and materially outperformed its budget and cut
expenditures early in the downturn. Like all California schools, the district is
required to publish a large amount of forward-looking financial data multiple
times per year.

CREDIT PROFILE

Modesto City School District is located in economically stressed Stanislaus
County in the northern San Joaquin Valley. The district shares a governing
board, administration, and a majority of its financial operations with Modesto
City High School District, a legally separate district. Please see the rating
action commentary titled 'Fitch Affirms Modesto City High School District,
California's GOs at 'AA-'; Outlook Revised to Stable' dated Jan. 29, 2013 for
more information. As is typical for agriculturally-concentrated economies,
economic factors are weak.

Modesto's October 2012 unemployment rate was high at 12%, though down moderately
from the prior year rate of 13.4%. This improvement was due to a 1.7% employment
base expansion over the same period. The district's tax base is highly
concentrated in its top taxpayer, E&J Gallo Winery, which makes up 6.8% of
assessed value (AV). Top 10 taxpayer concentration is moderate at 13.3% of AV.

DISTRESSED HOUSING MARKET WEIGHS ON TAX BASE

The county's housing market is the third worst-performing in the country, as
measured by home price losses from peak to current values. This distressed
performance has severely impacted the district's AV, which has fallen a
substantial cumulative 30.4% from fiscal years 2009-2013. In fiscal years 2012
and 2013 the losses were 15.8% and 2.1%, respectively. Year-over-year Zillow
average home value data is positive, showing a 12.4% gain to $138,400 in
December 2012. If these gains hold, AV could trend positive beginning in fiscal
2014.

Fitch's concerns about AV losses are mitigated by the state's Proposition 98
funding formula. This formula mandates a minimum per pupil level of district
funding. To the extent that local tax base contraction results in lost local
property tax revenues, the state is obligated to replace those revenues up to
the minimum funding level. However, state revenues have been subject to
significant deferrals in recent years that the state has recently begun to pay
back.

SOUND FINANCIAL PERFORMANCE TO DATE

The district implemented expenditure reductions sufficiently early in the
economic and funding downturn that it has been able to stabilize and grow its
financial cushion in three of the past four years. Audited results for fiscal
2012 point to a sizeable $9 million operating surplus (after transfers) that
raise the total and unrestricted general fund balance to high levels of $72.2
million (30.7% of expenditures and transfers out) and $71.7 million (30.3%),
respectively.

Fiscal 2013 general fund operations are projected to result in a $13.1 million
operating deficit. However, management historically has well-outperformed its
budgetary and 1st interim financial projections. In fiscal 2012 the district
out-performed its 1st interim projections by nearly $30 million. Management
expects the actual fiscal 2013 operating deficit to range between $1 million and
$2 million, which would leave the district's financial cushion at still-high
levels. A majority of the district's financial out-performance was due to
spending well below projected amounts, particularly with regard to categorical
programs.

DISTRICT LIKELY TO OUTPERFORM CONSERVATIVE FINANCIAL PROJECTIONS

The district is projecting substantial operating deficits from fiscal years
2013-2015 ranging from $11.3 million to $24.2 million, which are an improvement
from prior years' projections. The assumptions include no revenue growth and the
sunsetting of significant labor concessions in fiscal years 2014 and 2015. As in
prior years, Fitch believes that these projections reflect a large degree of
conservatism, and Fitch expects management will substantially narrow or close
its out-year deficits in order to retain the district's solid financial cushion.
If the district drew down its general fund balance on a consistent basis or more
than moderately, however, Fitch likely would take negative rating action.

STATE REVENUE PRESSURES TENTATIVELY EASING SOMEWHAT

The district has faced several years of challenged state funding levels as
California has dealt with its own financial issues. However, two recent
developments could provide a boost to the district's revenue position. First, in
November 2012 California voters passed Proposition 30, which prevented
significant automatic K-12 funding cuts from occurring in fiscal 2013. Fitch
previously cited this issue as a material risk. Second, the governor's budget
proposes a 5% increase of fiscal 2014 Proposition 98 funding, by far the
district's largest funding source. Actual funding, however, will not be
determined until the state budget is adopted around June.

The district has a moderate amount of remaining legal expenditure flexibility
that could be utilized should the district's funding outlook deteriorate from
current expectations. Options include a limited degree of class size
flexibility, cuts to athletic programs and various auxiliary positions, and
categorical programs that could be eliminated. As with most districts that have
implemented significant cuts in recent years, political considerations could
make it difficult to implement some or all of these legal options. A history of
mixed labor relations could also hamper expenditure flexibility, although recent
negotiations reportedly have been quite amicable. Nonetheless, Fitch views
favorably the existence and identification by management of potential and
significant expenditure reductions.

SOUND MANAGEMENT PRACTISES, TYPICAL AB1200 REPORTING PROCEDURES

The district has adhered to sound management practices, including the use of
very conservative budgeting, ongoing maintenance of a solid fund balance, and
years of expenditure reductions to mitigate the weak funding environment.

The district also is subject to AB1200 financial reporting procedures, as are
all California districts. These procedures require the district to perform
multi-year financial forecasting multiple times per year and to comment on over
30 potential financial red flags. The district's budgets and two interim reports
must be reviewed and certified internally and also by the county office of
education. Qualified or Negative certifications may lead to various levels of
external financial intervention. Fitch views these statewide school procedures
as strong.

ADEQUATE DEBT PROFILE WEIGHED BY CALSTRS CONCERNS, CABS' IMPACT ON AMORTIZATION

The district's debt profile is adequate overall. Fitch cannot calculate the
district's net debt levels precisely due to a lack of overlapping debt data.
However, the district's tax base is a subset of the Modesto High School
District's, whose net debt levels are moderate at $1,672 per capita (2.9% of
AV). Identified capital needs are minimal. The district has no plans to issue
further debt and its OPEB liability is manageable.

However, these strengths are moderately offset by two factors. First, the
district participates in the poorly funded CalSTRS pension system, as do all
schools in the state. Although the district is paying 100% of its required rate,
in fiscal 2011 system contributions were equal to just 46.7% of the actuarially
required rate.

Second, all of the district's GO debt consists of non-callable CABs, which slows
principal amortization somewhat. This credit weakness is somewhat mitigated by
the CABs' serial maturation each year through final maturity in fiscal 2027.
Also, principal amortization is only modestly below average, at 42% in 10 years
(as calculated using final accreted values).

CalSTRS contribution rates are set by statute and they have not been increased
to reflect the weak investment return environment over the past several years.
As a result, the system's Fitch-adjusted funded ratio has fallen to a low 65.7%
and future contribution rates likely will need to rise substantially from
current levels. It is unclear which stakeholders would face increased
contribution rates, and how such increases would be implemented, but Fitch
believes districts would be likely to bear at least part of the burden.

Additional information is available at 'www.fitchratings.com'. The ratings above
were solicited by, or on behalf of, the issuer, and therefore, Fitch has been
compensated for the provision of the ratings.

In addition to the sources of information identified in Fitch's Tax-Supported
Rating Criteria, this action was additionally informed by information from
Creditscope and Zillow.

Applicable Criteria and Related Research:
--'Tax-Supported Rating Criteria' (Aug. 14, 2012);
--'U.S. Local Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:
Tax-Supported Rating Criteria
U.S. Local Government Tax-Supported Rating Criteria
FILED UNDER:
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