[January 29, 2013]

Fitch Affirms Modesto City High School District, CA's GOs at 'AA-'; Outlook Revised to Stable

Fitch Ratings has affirmed Modesto City High School District, California's (the district) general obligation bonds (GOs) as follows and has revised the Rating Outlook to Stable from Negative:

--$93.1 million GOs (Election of 2001) series A at 'AA-'.

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 five 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 debt burden is moderate, identified capital needs are minimal, and the 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 High 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 School District, a legally separate district whose tax base is about a third of the high school district's. Please see the press release titled 'Fitch Affirms Modesto City 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 has significant exposure to food processors but there is little tax base concentration among the top 10 payers, which make up just 7.1% of assessed valuation (AV).

DISTRESSED HOUSING MARKET WEIGHS ON (News - Alert) 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 28.1% from fiscal years 2008-2013. In fiscal years 2012 and 2013 the losses were 8.6% and 4.7%, 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 esult 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 PRACTICES, 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.

DEBT PROFILE WEIGHED BY CALSTRS CONCERNS & CABS' IMPACT ON AMORTIZATION

The district's debt profile is adequate overall. Net debt levels are moderate at $1,672 per capita (2.9% of AV), principal amortization is moderate, and 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 45% in 10 years (as calculated using final accreted values).

The district's current GO authorization tax rate is currently $38.16 per $100,000 AV, which exceeds the district's estimated maximum tax rate of $30 at the time the bonds were authorized by voters in 2001. This weakness is mitigated by the low nominal tax bill associated with GO debt service, apparent lack of political or taxpayer backlash as a result of the tax rate, and no intent from the district to seek an additional GO authorization.

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

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=686015

U.S. Local Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=685314

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