Correction: Fitch Rates Philadelphia School District's Bonds 'A+'; Underlying Rating 'BB-'

NEW YORK--()--(This is a correction of a release originally published on Oct. 7, 2016. It corrects the amount of the Series F 2016 GO refunding bonds.)

Fitch Ratings has assigned an 'A+' rating to the following bonds issued for the school district of Philadelphia (the district) based on the Pennsylvania School Credit Enhancement Direct-Pay Intercept Program:

--$573.315 million State Public School Building Authority (Commonwealth of Pennsylvania) (SPSBA) school lease revenue refunding bonds (the school district of Philadelphia project) series 2016A.

Additionally, Fitch Ratings has assigned an 'A+' rating to the following bonds issued by the district based on the Pennsylvania School Credit Enhancement Intercept Program:

--$90.555 million school district of Philadelphia general obligation (GO) bonds series D of 2016;

--$146 million school district of Philadelphia GO bonds series E of 2016 (qualified school construction bonds - federally taxable - direct subsidy);

--$580.165 million school district of Philadelphia GO refunding bonds series F of 2016.

The bonds are scheduled to be sold via negotiated sale the week of October 19. Proceeds will be used to refund certain outstanding bonds and pay for various capital projects.

Concurrently, Fitch has assigned an underlying rating of 'BB-' to the series 2016 bonds and has affirmed this rating on approximately $3.1 billion of the district and authority's outstanding bonds, and has affirmed the district's 'BB-' Issuer Default Rating (IDR).

The Rating Outlooks for the commonwealth's programs are Stable, reflecting the Stable Outlook on the commonwealth's IDR. The Rating Outlooks for the underlying district and authority's ratings have been revised to Stable.

SECURITY

The bonds issued by the authority are special limited obligations of the authority. For these bonds, payments from the State Treasurer are made directly to the Trustee on the last Thursday of April and October of each year, in advance of lease rental payments due on May 15 and November 15, and debt service payments on June 1 and December 1. The district has covenanted that it will include in its budget appropriations for payments to the authority. For these payments, the district irrevocably has pledged its full faith, credit and taxing power. All of the authority and GO 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.

The underlying rating on the bonds is based on the district's full faith and credit GO pledge. Various statutory mechanisms direct property tax revenues first to the GO bonds fiscal agent on a daily basis. But Fitch does not assess the revenues as special revenues under chapter nine of the federal bankruptcy code and they are therefore not exempt from the automatic stay in a bankruptcy filing and do not warrant a rating above that of the district's IDR.

KEY RATING DRIVERS

The 'BB-'IDR reflects the school district of Philadelphia (SDP)'s constrained budgetary environment with limited independent ability to materially alter its fiscal profile. The current rating level implies an elevated vulnerability to default risk, particularly in the event of adverse changes in conditions. Fitch believes that a consistent history of support from other levels of government provides a modicum of comfort that the district will continue to meet its financial obligations. While the Rating Outlook has been revised to Stable from Negative, rating transition risk is elevated at below-investment grade levels.

Over the past several years, the district has taken multiple steps to reduce recurring spending and has worked with external stakeholders to boost revenues. But further expense reductions are likely to directly affect core service delivery; in fact, the district has taken steps to use new revenues to restore some prior year cuts to address such concerns. SDP's management, including a new chief financial officer, are taking important steps to address these limitations but their options are limited absent external cooperation, particularly from the commonwealth and city.

Economic Resource Base

Philadelphia serves as a regional economic center in the northeast, with a stable employment base weighted toward the higher education and healthcare sectors. Jobs expansion since the recession has been steady and strong, but low wealth levels and weak population growth persist and limit growth prospects. The population is estimated at 1.5 million.

Revenue Framework: 'bbb' factor assessment

Fitch expects the school district of Philadelphia's (SDP) revenues will grow annually near the rate of inflation with key components including the property tax and subsidies from the commonwealth. SDP's lack of any material independent legal revenue-raising capability limits the revenue framework assessment.

Expenditure Framework: 'bbb' factor assessment

Expenditure pressures are significant but the district retains some flexibility to manage their growth with moderate carrying costs. Pension expense and charter school payments in particular drive Fitch's expectations. Commonwealth reimbursements offset a significant share of pension spending. Fitch views charter school spending as SDP's most critical expenditure challenge, and will closely monitor efforts to moderate the current growth trajectory. The labor environment also poses limitations on expenditure flexibility.

Long-Term Liability Burden: 'aa' factor assessment

Debt and unfunded pension liabilities present only a moderate burden on the district's economic resource base. OPEB liabilities are minimal, with the district providing no healthcare benefits for retirees or dependents.

Operating Performance: 'bb' factor assessment

The district has built up modest budgetary, cash-basis reserves in recent years with expense management and successful negotiation of revenue support from the city and commonwealth. But those reserves will likely be drawn down within several years. SDP retains very limited financial flexibility and would be stressed in the event of an economic downturn, absent assistance from the city or commonwealth. Both entities have previously stepped in to support the district. Fitch anticipates similar support going forward, but the timing and extent is uncertain as Philadelphia and Pennsylvania face their own fiscal constraints.

RATING SENSITIVITIES

Sustainable Revenue Improvement: SDP has successfully negotiated several revenue increases in recent years with the city and commonwealth including a permanent cigarette tax, the first $120 million of the city's 1% sales tax, and increases in the property tax rate. Establishment of a long-term revenue solution that more fully addresses the district's anticipated expenditure demands could improve Fitch's assessment of the district's revenue framework and operating performance.

Shift in Charter School Expenditures: Payments to charter schools have been, and will likely continue to be, the most significant driver of the district's expenditures. A material change in the mandatory per pupil payments SDP makes to charter schools, either through changes in enrollment patterns or in the structure of the payments themselves, could alter Fitch's view of the district's expenditure growth or financial resilience.

CREDIT PROFILE

The School District of Philadelphia is the nation's eighth largest school district and the largest in the commonwealth, with fiscal year 2016 enrollment of 202,686 students, including charter school students. Total enrollment has been relatively stable in recent years but district school and charter school enrollment continue to diverge. Charter school enrollment has grown approximately 8% on average annually since fiscal 2012, while district public school enrollment declined an average 3% each year. Recent data indicates a possible shift in enrollment with district enrollment losses narrowing and stabilizing in fiscal 2016, while charter school enrollment tapered off and actually declined last year. The district reports recent policy changes may be driving down cyber charter enrollment, but enrollment at standard charter schools also dipped slightly last year. Fitch will continue to monitor enrollment data to assess whether there is a sustainable and material shift in enrollment patterns.

Revenue Framework

Commonwealth subsidies comprise the majority of SDP's revenues, with various locally provided revenues also making up a significant share. Pennsylvania's funding comes in the form of direct aid for education and reimbursement for a substantial share of annual pension costs. Local revenues consist mainly of a property tax and certain other taxes collected by the city of Philadelphia, and an annual allocation of $120 million of the sales tax levied within the city.

Fitch anticipates commonwealth subsidies to the district will grow modestly, near the rate of inflation. Unlike many other states, the vast majority of local school aid is not distributed on a per pupil basis and is not directly tied to enrollment. Pennsylvania has only decreased annual funding to SDP once in the past three decades. There were multiple decreases in basic education funding (BEF, the largest component) including just after the last recession, but the commonwealth continued to fund a share of pension expense and overall state funding generally increased. Pennsylvania faces its own fiscal challenges to restore structural balance, tempering the trajectory of future increases in district subsidies.

Local revenues should grow at a similar pace, particularly following recent increases agreed to by the city and commonwealth. Property taxes are the main component (roughly two-thirds) and Fitch views prospects for the city's tax base positively. Some local sources are more volatile, and others flat such as the $120 million annual share of the city sales tax.

SDP retains essentially no independent legal ability to raise revenues, relying on external stakeholders (primarily the commonwealth and city) to authorize and collect funds that are transferred to the district.

Fitch notes that SDP has been able to negotiate increases in revenues with both the commonwealth and city, particularly in the last several years. Most recently the commonwealth permanently extended a cigarette tax collected for the school district by the state department of revenue that would have expired at the end of fiscal 2019 and added a floor for district receipts to offset the volatility of the narrow base. These changes will provide substantial fiscal support for SDP, but will address only one-fourth of the projected five-year financial plan cumulative budget gap.

Expenditure Framework

The district's largest expense is for personnel, particularly teachers. Charter school payments are the second largest item. Through aggressive expenditure reduction, SDP brought down central administrative costs which now represent approximately 3% of spending - the remainder goes towards direct supports for individual schools, including capital financings.

The district's five-year plan projects expenditure growth at nearly twice the rate of revenue growth. Fitch anticipates actual performance to be more balanced in light of recent revenue enhancements (such as the permanent extension and establishment of a revenue floor for the cigarette tax ) not currently reflected in the plan. But Fitch anticipates expenditure growth will exceed expected revenue growth by a wide margin, absent significant policy changes. Pension expenses and charter schools have been the primary historical drivers. Growth in pensions will continue but should moderate as the district's Public School Employees Retirement System (PSERS) contributions have reached full actuarially recommended levels this fiscal year after several years of steep ramp-up. SDP currently projects charter school growth to maintain a rapid pace. Under current law, the district makes a per-pupil payment to charter schools for each resident student enrolled in a charter. Fitch views the growth in charter school enrollment as the district's most pressing expenditure challenge.

Despite the rapid escalation in pension costs, SDP's carrying costs remain moderate. Fitch anticipates the growth in pension expense to continue, but at a slower pace in coming years based on the district's five-year financial plan projections, which are in turn based on guidance from PSERS. The carrying cost metric somewhat overstates the district's burden as the commonwealth reimburses SDP for at least 50% of annual pension expense. The reimbursement is based on a statutory formula tied to each school district's property values and personal income.

A difficult labor environment, with the teachers union operating without a contract for three years, is a negative factor. The district's controlling board, the School Reform Commission (SRC), had attempted to impose contractual terms but state courts ruled against the SRC. Most other unionized employees are under contract. The most recent settlement with the largest non-teacher unit provides a measure of predictability, but also requires steady wage increases after several years of relatively austere terms under prior contracts. As an additional limitation on expenditure flexibility, per-pupil charter school payments are generally outside of the district's direct control and are likely to continue their steady escalation in the current statutory framework.

A very modest decline in charter school enrollment last year (and hence per pupil payments from the district), and apparent stabilization in traditional public school enrollment, could signal some relief in this expense item. But it is too early to determine if the enrollment stabilization will become a trend. Fitch notes positively that SDP is engaging with charter school leaders in an effort to craft a sustainable statutory and regulatory framework that could provide more fiscal stability for the district. Fitch will monitor the district's progress and determine whether any such changes materially improve the agency's assessment of SDP's expenditure framework and operating performance.

Long-Term Liability Burden

SDP's long-term liability burden is moderate at 15.8% of personal income as of fiscal 2015 (year ended June 30), weighted towards direct and overlapping debt (issued by the contiguous city). Most debt is for capital needs, but the district has occasionally pursued explicit deficit financing to manage budgetary stress. The current five-year plan envisions no deficit bonds and moderate capital issuance in line with historical trends. Regarding overlapping debt, Fitch anticipates the new mayoral administration will moderately increase the city's outstanding debt to support specific initiatives - newly approved revenues will support debt service. Substantial issuance without expected accompanying economic growth could pressure the assessment of SDP's long-term liability burden.

The unfunded pension liability is roughly one-third of the total burden. The district's pension funding is determined by commonwealth statutes that dictated a ramp-up to full actuarial recommendations over several years - fiscal 2017 is the first year the statutes provide for a full actuarially recommended contribution to PSERS. The pension liability could moderate over the long term if actuarial assumptions are met and the statutory requirements for full actuarially determined funding remain in place.

Changes to PSERS and the commonwealth's retirement system for its own employees have been discussed for several years by Pennsylvania's legislative and administration leadership - the terms are wholly outside of the district's control as this is a statewide plan. Given the current scope of proposed changes, Fitch does not anticipate any such structural reforms would reduce the liability to a level that would improve Fitch's assessment of the district's long-term liability burden.

The district will eliminate all variable rate debt exposure with the refunding components of the proposed transaction, which Fitch views positively as it eliminates an element of risk. SDP does remain counterparty to two swaps related to series 2003 State Public School Building Authority lease revenue bond transactions - the district's exposure is limited as it retains sole authority to terminate the swaps and faces no collateral posting requirements.

Operating Performance

With limited inherent budget flexibility, the district retains minimal gap-closing capacity. SDP has only a modest budgetary fund balance and essentially no balance on an audited GAAP basis, and would face significant difficulty operating during a downturn without assistance from external stakeholders. Fitch notes the commonwealth, city, and federal government (through the federal stimulus act) have historically stepped in to provide the district with sufficient resources to maintain operations. Similar responses are likely in the event of another downturn, particularly from the commonwealth and city. Both entities face their own fiscal challenges and Fitch anticipates their capacity to provide assistance would be adequate but limited in scope.

SDP's budgetary management practices are sound but limited by fiscal constraints. The district generally meets demands for required funding such as statutory pension requirements. Even during the fiscal 2016 commonwealth budget impasse when SDP was without most state funding for nine months, the district only delayed one month of charter school payments. To achieve balance in recent years and establish a modest budgetary reserve, the district relied on a mix of significant structural expense reductions, successful negotiation of recurring revenue increases from the commonwealth and city, and certain short-term budgetary effects. The short-term effects included difficulty in hiring for a significant number of teacher vacancies- the district acknowledges such events are not sustainable and has already filled most vacancies going into the current school year.

The district's comparatively narrow liquidity profile is bolstered by consistent marketplace access for cash flow borrowing given the timing difference of revenues and expenses in a fiscal year - SDP has issued public or privately placed tax and revenue anticipation notes for many years, supported by state aid payments that provide multiples of coverage. The district relies heavily on the credit enhancement offered by Pennsylvania's intercept provisions for school aid when accessing credit markets. The fiscal 2016 commonwealth budget impasse led some marketplace participants to question the value of the provisions - recent legislation addressed those concerns and provides for commonwealth general fund money to make intercept-eligible debt service payments in the event of another budget impasse.

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

In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.

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+1-212-908-0241
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
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Director
+1-212-908-0593
or
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or
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Contacts

Fitch Ratings
Primary Analyst
Eric Kim
Director
+1-212-908-0241
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Shannon McCue
Director
+1-212-908-0593
or
Committee Chairperson
Amy Laskey
Managing Director
+1-212-908-0568
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com