Fitch Upgrades Surprise (AZ)'s Revs to 'AA+' on Criteria Change; Outlook Stable

AUSTIN, Texas--()--Fitch Ratings has upgraded the following Surprise, AZ obligations to 'AA+' from 'AA-':

--$34 million outstanding pledged revenue and revenue refunding obligations, series 2015.

Fitch also upgrades the city of Surprise, AZ Long-Term Issuer Default Rating (IDR) to 'AA+' from 'AA-'.

The Rating Outlook is Stable.

SECURITY

The excise tax revenue obligations are payable from installment payments made by the city to the trustee, secured by a pledge of the city's excise taxes and state shared revenues. Installment payments are not subject to annual appropriation.

KEY RATING DRIVERS

The upgrade of the Long-Term Issuer Default Rating (IDR) rating to 'AA+' reflects the application of Fitch Ratings' revised criteria for U.S. state and local governments released on April 18, 2016. In particular, the criteria highlight the impact of the local economy on the city's revenue growth prospects and its low long-term liability burden. The 'AA+' excise tax and state-shared revenue obligation (ETRO) rating reflects a solid coverage cushion and expectations for strong pledged revenue growth. The ETRO rating is limited by the city's IDR.

Economic Resource Base

Surprise is located in Maricopa County (rated 'AAA'/Outlook Stable), 20 miles northwest of Phoenix. The city's 2015 population of 128,422 has realized a rapid 10% compound annual growth rate (CAGR) over the past 15 years and its median household income exceeds that of the U.S. by 16%. The Surprise stadium is the Spring Training home to Major League Baseball's Texas Rangers and Kansas City Royals.

Revenue Framework: 'aaa' factor assessment

The city 's revenue growth has outpaced that of U.S. GDP over the past 10 years ending in fiscal 2014. Growth prospects remain strong. The city has the independent legal ability to adjust its transaction privilege tax (TPT) rate, providing ample revenue-raising capacity.

Expenditure Framework: 'aa' factor assessment

Surprise's natural pace of spending growth is likely to remain in line with the city's revenue growth. Expenditure flexibility is provided through the city's management of its labor costs. Expectations for moderate carrying costs over the medium term incorporate the city's currently low 9.3% carrying costs, its proposed debt issuances, and a likely increase in pension contributions pursuant to plans under development to fully fund pension liabilities.

Long-Term Liability Burden: 'aaa' factor assessment

The city's long-term liability burden is a low 5% of estimated personal income. Fitch expects the long-term liability burden to remain consistent with a 'aaa' assessment because population and income growth are likely to be aligned with additional debt needs and the city's pension funding should limit growth in net pension liabilities.

Operating Performance: 'aaa' factor assessment

Fitch expects Surprise to demonstrate a high level of financial resilience during a moderate economic downturn based on its revenue raising capacity and expenditure flexibility, supplemented by its current level of healthy reserves.

RATING SENSITIVITIES

Strong Financial Flexibility: The 'AA+' IDR is sensitive to the city's ongoing financial flexibility and its ability to affordably manage growth as reflected in structurally balanced operations and a sound financial cushion.

Solid Coverage Cushion: The ETRO rating is sensitive to maintenance of a solid pledged revenue coverage cushion.

CREDIT PROFILE

The local economy in Surprise has transitioned from an agricultural base to a residential community with retail, construction and service sectors. These have contributed to growth of the city's employment and sales tax base over the past five years. Major employers are represented by education, retail sales, government, grocery sales, and warehouse/distribution.

Surprise is home to an auto mall comprised of six dealerships. The most recent of these, a Honda dealership, opened in 2016. Hyundai and Subaru dealerships are slated to open in 2017. Fiscal 2016 commercial development has included $123 million of capital investment and the permitting of one million square feet of commercial/industrial space. The city reports continuing residential and commercial growth and a notable research and development center underway. Fitch expects the recent completion of transportation improvements to spur additional growth in the city's local economy.

Revenue Framework

The city's local sales tax or transaction privilege tax (TPT) collections contributed 38% of fiscal 2015 general fund revenues, followed by state shared revenues (31%). Ad valorem property tax revenues contributed 7% to revenues.

Surprise's general fund revenue CAGR of 5.4% for the 10 years ending in fiscal 2014 exceeded economic performance of the U.S. as measured by GDP. Prospects for growth remain strong based on development underway and the city's participation in regional economic growth.

Additional support for its strong revenue framework is derived from the city's independent legal ability to adjust its TPT rate without respect to limit, providing ample revenue-raising capacity. The city's rate is currently 2.2% for most categories, within the state-wide range of .25% to 5.3% and average of 2.1% in 2016.

Expenditure Framework

Public safety accounts for 47% of the city's general fund operating expenditures, a spending level typical of U.S. municipalities.

Fitch expects the city's public safety and other operating expenditures to grow in line with its revenues.

Surprise participates in a meet-and-confer process with police and fire-fighter employees. However, the meet and confer process defers ultimate decision-making authority for work rules and pay to the city. Other workers are not subject to bargaining. The city's carrying costs at 9.3% of fiscal 2015 governmental expenditures do not pressure its operating budget. Fitch expects the city to maintain moderate carrying costs over the medium term based on its debt issuance plans and assuming moderate ongoing growth of its operating budget. The city's 10-year principal amortization rate is rapid at 80% providing an additional measure of flexibility.

Long-Term Liability Burden

The city of Surprise has a low long-term liability burden approximating 5% of estimated personal income. The city's $252 million long-term liability burden consists primarily of debt ($180 million), $146 million of which is overlapping. The city has placed a $63 million general obligation bond question on the November ballot to fund a variety of projects which would be funded with issuances in 2017 and 2020 if the ballot item is successful. Fitch expects the city's long-term liability burden to remain low based on moderate area debt needs (including the city's current GO plans), an expanding economic base and the city's plans to fully fund its net pension liabilities.

The city participates in four multiple employer pension plans, of which two are cost-sharing and two agent plans. The cost sharing plans are the Arizona State Retirement System (ASRS) and the Elected Officials Retirement Plan (EORP). The agent plans are the Public Safety Personnel System (PSPRS) for police and for fire. Under GASB 67 and 68, the city reports a fiscal 2015 ASRS net pension liability (NPL) of $34.2 million (governmental portion), with fiduciary assets covering 69% of total pension liabilities at the plan's 8% investment return assumption (approximately 63% based on a lower 7% investment rate assumption). The NPL for the city's EORP plan is $1.6 million, with fiduciary assets covering 32% of the total pension liabilities of the plan at the plan's 7.85% investment rate assumption (approximately 29% based on a lower 7% investment rate assumption). The NPL for the city's PSPRS police and fire plans are $11 million and $6 million respectively, with fiduciary assets covering 69% of total police plan and 81% of fire plan pension liabilities at the plan's 7.85% investment return assumption (approximately 63% and 75% based on a lower 7% investment rate assumption). The city has reported that they are in the process of developing a plan to fully fund pension liabilities. Additionally, proposed legislation provides modest PSPRS reforms applicable to new hires and eliminates the automatic cost of living adjustments currently in place which Fitch anticipates could, if implemented, improve long-term plan sustainability.

Operating Performance

Fitch expects Surprise to maintain a high level of financial flexibility through economic downturns based on its ample revenue raising capacity and solid financial flexibility, supplemented by its ample reserves.

The city's operating deficits and reserve diminishment during fiscal 2010 through 2012 resulted from a sizable $22 million decline in economically sensitive revenues (fiscal 2008 through 2011), pay-go spending, and accounting adjustments to recognize distinctions between general operating, capital and development fee funds. The city's subsequent strong operating performance and reserve replenishment reflects the benefit of revenue growth and willingness to cut costs. Fitch expects the city to maintain reserves above of its two-month of spending policy floor, well above an amount needed for an 'aaa' assessment of financial resilience.

Fitch expects Surprise to maintain sound financial operating and reporting. The rapid deterioration in financial performance noted above seems unlikely to recur based on the city's enhancements to internal controls adopted in fiscal 2012 and 2013. Surprise consistently makes pension contributions at the actuarially determined levels.

Revenue Stream Analytical Conclusion

Pledged revenues include transaction privilege (sales) taxes, state-shared revenues (consisting of state-shared sales taxes and state revenue sharing), charges for services, permits and fees, and fines and forfeitures. Pledged revenues reflect a solid 4.9% CAGR from fiscal 2004 through 2014 and subsequent gains of 4% and 6.7% respectively in fiscal 2015 and 2016. Growth prospects remain strong.

To evaluate the sensitivity of the dedicated revenue stream to cyclical decline, Fitch considers both revenue sensitivity results (using a 1% decline in national GDP scenario) and the largest decline in revenues over the period covered by the revenue sensitivity analysis. Based on the city's 10-year pledged revenue history, Fitch's analytical sensitivity tool (FAST) generates a 4.4% scenario decline in pledged revenues. The largest actual cumulative decline in historical revenues is 27%, from fiscal 2008-2011, reflecting sensitivity of TPT and state shared revenues to the economic downturn.

Assuming issuance up to the 3.0x ABT, well below actual current coverage, senior debt service would still be covered with a 67% drop in revenues, 15x the scenario results and 2.5x the largest actual revenue decline in the review period. However, Fitch does not expect the city to issue to the ABT based on its use of excise tax and shared sales tax revenues for operations. The city plans to issue GO bonds, for additional debt needs, subject to voter approval. Fiscal 2015 pledged revenues of $91.8 million are up for the fourth consecutive year and cover MADs (2019) a high 21.7x. At this level, debt service would be covered with a 95% drop in revenues, 22x the scenario results and 3.5x the largest decline in the review period. This level of resilience is consistent with an 'AAA' rating (noting additionally that the fiscal years 2008 -2011 performance reflected a housing bust that disproportionately affected the Arizona economy to an extent that Fitch believes is less likely to be repeated in the future).

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.

Applicable Criteria

U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)

https://www.fitchratings.com/site/re/879478

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Contacts

Fitch Ratings
Primary Analyst
Rebecca Meyer
Director
+1-512-215-3733
Fitch Ratings, Inc.
111 Congress Avenue
Austin, TX 78701
or
Secondary Analyst
Teri Wenck
Director
+1-512-215-3742
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
Rebecca Meyer
Director
+1-512-215-3733
Fitch Ratings, Inc.
111 Congress Avenue
Austin, TX 78701
or
Secondary Analyst
Teri Wenck
Director
+1-512-215-3742
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