Fitch Downgrades Philadelphia School District's Underlying Rating to 'BB-'; Outlook Remains Negative

NEW YORK--()--Fitch Ratings downgrades to 'BB-' from 'BB' the underlying rating on the following bonds:

--$1.9 billion Philadelphia School District (the district) general obligation (GO) bonds;

--$1.1 billion State Public School Building Authority (Commonwealth of Pennsylvania) (The School District of Philadelphia Project) school lease revenue bonds.

The Rating Outlooks for the underlying district and authority ratings remain Negative.

All of the bonds have an 'A+' enhanced rating based on the Pennsylvania School Credit Enhancement Direct-Pay Intercept Program (the program). The Rating Outlook for the program is Stable, reflecting the Stable Outlook on the Commonwealth of Pennsylvania's GO bonds.

SECURITY

All of the bonds are secured by protections under the Pennsylvania School Credit Enhancement Law as well as the district's full faith and credit and taxing power.

KEY RATING DRIVERS

WEAKENING UNDERLYING CREDIT PROFILE: The downgrade of the underlying rating largely reflects the continued deterioration of the district's already tenuous financial position.

UNCERTAIN RECOVERY PROSPECTS: The district's plans to achieve structural balance rely heavily on its continued ability to achieve dramatic expenditures savings, particularly gaining significant negotiated concessions from the teacher's union. Fitch believes the level of cooperation needed to fully realize these plans will likely not be forthcoming, resulting in continued negative operations and increased accumulated deficits.

RAPID CHARTER SCHOOL GROWTH: The number of students enrolled in charter schools has almost doubled in the past four years. Further growth is expected, increasing the challenges of the district's financial environment.

LIMITED ABILITY TO RAISE REVENUE: As is typical for school districts, the majority of funding is from state sources. Raising locally generated revenue requires city council approval. The state's increasingly challenged financial position limits the likelihood of increased state aid.

ELEVATED DEBT LEVELS: The district's overall debt burden is high relative to the tax base, although annual debt service expenditures consume a moderate share of the district's operating budget. Payments for other long-term liabilities are modest but growing.

STABLE SERVICE AREA: Demographic and economic indicators are weak, although the city's economy is anchored by the presence of several large healthcare and higher education institutions. However, the district is challenged by the migration of students to charter schools.

SOUND INTERCEPT PROGRAM: The enhanced, programmatic 'A+' rating is based on the Pennsylvania School Credit Enhancement Direct-Pay Intercept Program (Intercept Program) under state law. The program requires the withholding of state appropriations and their direct payment to bondholders or their paying agents.

SOLID COVERAGE: For fiscal 2014, budgeted commonwealth subsidies to the district cover annual debt service obligations, including short-term debt, by 2.38 times (x). This exceeds the 1.25x required for eligibility under Fitch's criteria for the use of this intercept program's rating.

RATING SENSITIVITIES

FURTHER FINANCIAL DETERIORATION: Additional reductions in financial flexibility over the medium term due to an inability to make at least modest progress in stemming operating deficits would lead to a further downgrade.

CREDIT PROFILE

LARGE URBAN DISTRICT WITH WEAK SOCIOECONOMICS

The Philadelphia School District is the nation's eighth largest school district and the largest in the commonwealth, with fiscal year 2014 enrollment of 203,000 students, including charter school students. District enrollment has shown growth in recent years primarily because charter school enrollment continues to escalate at a healthy rate. The current population of 66,000 is almost double the fiscal 2010 level. Non-charter school enrollment has declined fairly rapidly.

As both a city and county and with an estimated population of almost 1.5 million residents, Philadelphia benefits from its role as a regional economic center with a stable employment base weighted in higher education and health care sectors. Led by the University of Pennsylvania, Jefferson Health System and Temple University, the city is home to several large colleges and universities and is anchored by multiple hospitals and health systems.

Though well down from past levels, the city's May 2014 unemployment rate of 7.7% remains high as does the poverty rate at over 26% of the population. Income levels on both a per capita and median household level are well below the state and national averages.

DEFICIT FINANCING OFFSETS LARGE FISCAL 2013 OPERATING DEFICIT

Fiscal 2013 results show an operating deficit of almost $250 million across the district's three operating funds. The deficit was driven largely by increases in debt service payments following fiscal 2012 restructurings and payments to charter schools. Increased charter school enrollment has caused financial pressure for the district, and Fitch expects this trend to continue.

Results would have been even weaker without a favorable outcome in the district's negotiations with its blue collar unions. The district bridged the $250 million operating gap with the issuance of deficit bonds. The $300 million in proceeds yielded a surplus of $59 million but were not sufficient to eliminate the accumulated unrestricted fund deficit, which stood at -$63 million or -2% of expenditures at fiscal year-end.

FISCAL 2014 CONTINUES NEGATIVE OPERATIONS

Preliminary fiscal 2014 results show a further operating deficit, with an estimated $67 million decline in fund balance, worse than the budgeted $39 million deficit. The district closed 24 schools and laid off 3,800 employees before hiring back almost 1,900 when some funding was restored. The deficit was exacerbated by further increases in payments to charter schools and revenues from building sales coming in under budget. Fitch expects the accumulated unrestricted general fund deficit to double to about 4% of spending.

PLAN DEPENDS ON LABOR SAVINGS AND OUTSIDE AID

The district's fiscal 2015 budget was balanced through a number of measures. The district laid off over 300 employees this summer. A one percent sales tax previously directed to the city was extended, with the first $120 million going to the district, and a $2 per pack cigarette tax within the city was recently enacted, estimated to generate $49 million in fiscal 2015. The city is planning to borrow an additional $30 million for the district. District officials note that these efforts bring them to a bare minimum service level, and are seeking significant additional funding to provide more optimal educational opportunities. For the second consecutive year the state advanced the district some of its annual funding, helping the district to bridge its cash flow gap and reduce its short-term borrowing needs.

The district reached an agreement in 2012 with the Service Employees International Union (SEIU) that provides $100 million in savings over the four year life of the contract, largely from an approximately 10% reduction in wages. Earlier this year the district also reached agreement with its administrators for a new contract that includes 12 - 16% pay cuts, a shorter work year, and increased health care contributions, netting $20 million a year in savings.

The district's contract with the Philadelphia Federation of Teachers (PFT) expired in August 2013. The district was requesting large wage cuts similar to those agreed to by SEIU, but has since shifted to seeking benefit and work rule changes. PFT is not legally permitted to strike.

ELEVATED DEBT LEVELS

Overall debt ratios are above average at over $4,800 per capita and a very high 17.3% of market value. The market value ratio is overstated due to antiquated property assessment practices, which the city recently updated. Based on the city's revised market value, debt would still be a high 6.5% of market value. Amortization is slightly below average at approximately 43% in 10 years.

The district will be faced with a more than doubling of pension costs from fiscal 2012 to fiscal 2017. The district is hoping for relief from the state as the state pursues pension reform. The district participates in a state-sponsored plan with approximately 67% of employer contributions made by the state. The plan is currently approximately 63% funded using a Fitch-adjusted 7% return level, and the funding level has been deteriorating as the state has consistently underfunded its annual required contribution (ARC). The increased costs are partially caused by the plan shifting towards full funding of the ARC by 2017, which Fitch views favorably. Other post-employment benefits are minimal. Carrying costs are a moderate 15% of governmental spending, though this is expected to grow with increased pension costs.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from Creditscope, University Financial Associates, S&P/Case-Shiller Home Price Index, IHS Global Insight, Zillow.com, National Association of Realtors, and Bond Counsel.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'U.S. Local Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

--'U.S. State 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

U.S. State Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=886475

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Contacts

Fitch Ratings
Primary Analyst
Eric Friedman
Director
+1-212-908-9181
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Bernhard Fischer
Director
+1-212-908-9167
or
Committee Chairperson
Amy Laskey
Managing Director
+1-212-908-0568
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Eric Friedman
Director
+1-212-908-9181
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Bernhard Fischer
Director
+1-212-908-9167
or
Committee Chairperson
Amy Laskey
Managing Director
+1-212-908-0568
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com