Fitch Rates Minneapolis Special SD GOs & COPs 'AA+'/'AA-'; Downgrades Outstanding on Criteria Change

NEW YORK--()--Fitch Ratings has assigned a programmatic rating of 'AA+' and underlying rating of 'AA-' to the following Minneapolis Special School District No. 1, MN general obligation (GO) bonds and certificates of participation (COPs) :

--$45.4 million GO school building bonds, series 2016A;
--$56 million GO long-term facilities maintenance bonds, series 2016B;
--$23.7 million full-term COPs, series 2016C.

The 'AA+' programmatic rating is based on the district's participation in the Minnesota School District Credit Enhancement Program.

Fitch also has downgraded the following underlying ratings due to a change in rating criteria:

--The district's Issuer Default Rating (IDR) to 'AA-' from 'AA';
--Approximately $300 million of outstanding district GO bonds to 'AA-' from 'AA';
--Approximately $244 million of outstanding full-term COPs to 'AA-' from 'AA';
--Approximately $35 million of outstanding series 2010A and 2010B annual appropriation COPs to 'A+' from 'AA-'.

The Rating Outlook is Stable.

SECURITY
The GO bonds are backed by a pledge of the full faith and credit and unlimited taxing power of the district. The full-term COPs are payable from district lease payments that come from a separate unlimited property tax levy and are not subject to appropriation. Both the GO bonds and full-term COPs are backed by the state credit enhancement program.

The series 2010A and 2010B COPs are special limited obligations of the district payable solely from rental payments made by the district under the terms of the lease purchase agreement between the trustee and the district, subject to annual appropriation.

KEY RATING DRIVERS

Fitch's downgrade of the Minneapolis Special School District No. 1's IDR and GO ratings to 'AA-' from 'AA', and annual appropriation-backed bonds to 'A+' from 'AA-', reflects the application of its revised rating criteria for U.S. tax-supported issuers published on April 18, 2016. The revised criteria place greater emphasis on the independent ability to raise revenues without recourse to voters than did Fitch's prior criteria.

In addition, the revised criteria consider an issuer's relative ability to maintain fiscal resilience in a mild downturn in light of historical revenue volatility and inherent budget flexibility. In Fitch's opinion, the district's standalone revenue-raising flexibility is heavily constrained by state statute. Its reserve cushion is adequate, but not especially strong, relative to the year-over-year swings in state revenues that it has experienced during past economic downturns. The rating continues to incorporate the district's low long-term liability burden and solid expenditure flexibility.

Economic Resource Base
The district is coterminous with the city of Minneapolis (GO rating of 'AAA'/Outlook Stable), the broad and diverse economic base of which benefits from the large presence of relatively stable health care, higher education and government employers. Banking, finance and retail also play a major role in the economy. Minneapolis's population and workforce have grown steadily since the recession with population up an estimated 7% since the 2010 U.S. Census. Unemployment has trended below the U.S. average. The district serves approximately 37,000 students. Enrollments have risen by 12% over the past six years, but officials project flat-to-declining enrollments through 2026 due to competition from charter schools.

Revenue Framework: 'bbb' factor assessment
Fitch anticipates that general fund revenues will grow in line with inflation as healthy natural growth in state transfers is somewhat offset by enrollment declines that curtail the pace of future aid growth. The district's independent legal ability to raise revenues is very limited, as it has no direct control over the level of state assistance, and its margin for property tax levy increases is set annually by Minnesota's Department of Education.

Expenditure Framework: 'aa' factor assessment
Expenditure growth is likely to outpace the natural pace of revenue expansion absent continued policy action, given the need to provide a competitive student curriculum & activities and teacher salary increases to retain staff and pupils versus private and charter school alternatives. Fitch views the district's spending flexibility as solid given moderate fixed carrying costs for pensions, debt service and retiree healthcare at 15% of total spending.

Long-Term Liability Burden: 'aaa' factor assessment
The district has a low long-term liability burden made up of unfunded employee pension liabilities and direct and overlapping debt, all measured against the aggregate personal income of Minneapolis residents. Unfunded pension obligations account for roughly 45% of the district's liabilities. District officials expect growth in the direct debt burden to be moderate. Minneapolis's growing population and rising income levels are likely to largely counter-balance growth in these liabilities.

Operating Performance: 'a' factor assessment
The district retains strong gap-closing capacity based on its ability to reduce or postpone capital spending and consolidate departments and functions to close the budget gaps caused by a mild U.S. downturn. Fitch expects the district's financial operations could be more challenged in a downturn than would be the case for more highly-rated entities, but that it would restore flexibility quickly. Management has made consistent efforts to support financial flexibility, with limited non-recurring support of operations and no cash flow borrowing.

RATING SENSITIVITIES
FISCAL RESERVE LEVELS: A sustained strengthening of the district's fiscal reserve cushion back to historic (i.e. pre-2012) levels as a cushion against future downturns could positively impact the ratings. By contrast, declines in available reserves to levels below district management's adopted fund balance policies (i.e. 8% of expenditures), regardless of whether district revenues are declining or expanding, would tend to place downward pressure on the ratings.

INCREASED LONG-TERM LIABILITIES: If Fitch expected the long-term liability burden to materially increase above current levels in relation to Minneapolis's population and resident income levels, then this could also place downward pressure on the ratings.

PACE OF STATE REVENUE GROWTH: If state aid revenues grow at a more robust pace than is currently anticipated (i.e. faster than the rate of inflation), then this could generate upward pressure on the ratings particularly if stronger revenue growth occurred across economic cycles. Conversely, sustained reductions in aid that impacted operations and reserves would lead to negative rating pressure.

CREDIT PROFILE

The district provides K-12 public education for children of Minneapolis residents. Minneapolis is the largest city in the state of Minnesota (GO rated 'AAA'/Outlook Stable) with an estimated 2015 population of 411,000. The city and state are notable for their economic vibrancy. Population and labor force growth have been strong since the 2008-2009 recession, and unemployment has trended below 4% in recent years and below the US average historically. Resident wealth levels are above-average.

The city's tax base has experienced a strong rebound since 2011, with taxable assessed value (AV) rising by over 10% in 2015 alone. The commercial portion of the tax base, which is primarily located in Minneapolis's central business district, is supported by a diverse group of businesses and is home to numerous corporate headquarters, including those of Target Corporation and US Bank.

Revenue Framework
The district is highly dependent upon funding from the state of Minnesota. State aid transfers across all categories have averaged approximately 70% of general fund revenues in the past five fiscal years. Local property taxes account for about 20% of revenues, and service charges, fees and federal grant revenues account for the remainder. The district's independent ability to raise revenues is heavily restricted under state statute, which is the case for most public school districts in the United States.

Fitch anticipates that revenues will likely expand at a pace approximating the U.S. rate of inflation, which would be somewhat stronger than their historical growth rate. The district's 10-year compound annual growth rate (CAGR) for general fund revenues was 1.2% for the period from fiscal 2005 to 2015. The U.S. Consumer Price Index (CPI) CAGR for the same period was 2%. A sharp decline in enrollments between the early 2000s and 2011 was largely responsible for the district's volatile general fund revenue pattern during this period - revenues actually declined for several years before rebounding post-fiscal 2011. This was a natural result of how state aid revenues are determined under public-funding formulas, which assign a high degree of importance to enrollment levels when determining state aid allotments.

Enrollments fell from 49,190 in fiscal 2001 to 33,147 in fiscal 2011 - a 33% cumulative decline. Since 2011, enrollment has recovered some lost ground, rising to 37,299 in the current fiscal/school year (i.e. 2017), a nearly 13% increase. Rebounding enrollments have positively impacted state aid and overall general fund revenue patterns since 2012. It is unclear whether this renewed growth will be sustained, however. District officials conservatively project a gradual decline in enrollments to about 34,000 by 2026 based on a continued, intense challenge from charter, private and parochial schools, which compete directly with the district to educate Minneapolis's K-12 population.

Because the student body contains a high proportion of English learners, low income students, and students requiring special education, the effect of modest enrollment declines on state aid revenues may be muted if the declines occur gradually. The state's public school funding formula provides additional support to districts with a higher number of students requiring supplemental instruction.

As with public school districts in most other U.S. states, Minnesota's K-12 school districts' legal, independent revenue-raising ability is heavily restricted by state statute. As a result, the school board's standalone ability to raise new recurring revenues to fund operations is highly circumscribed. The board and management team have no control over the nearly 70% of general fund revenues originating from the state of Minnesota.

Under state statute, the Minnesota Department of Education must certify and approve the district's annual property tax levy. Using the funding formula, the Department calculates the district's levying margin each year. The school board can ask the Department to certify a property tax levy increase up to the maximum permitted margin, or some lesser amount. The annual margin calculated by the Department is based partly on enrollments, and partly on the district's prior-year rate of expenditure growth, along with other factors. The board has not always requested the maximum annual levy increase; its margin within the formula's limitations is typically not very broad, however.

The district has traditionally supplemented its limited levying capacity under the state formula with new levies approved through voter referendums. In November 2016, district voters approved by 84% a referendum that renewed $65 million of annual property taxing capacity for another nine years. The referendum levy includes a 1.04% annual growth factor. The referendum levy equals 11% of fiscal 2016 (unaudited) general fund revenues. The recent referendum was the second extension of the levy.

Expenditure Framework
Teacher and support staff salaries account for the majority of the district's expenditures, given the nature of the services provided by the district. Instruction-related expenses account for about three-quarters of spending.

Fitch expects the district's general fund spending will grow at a somewhat faster pace than its natural rate of revenue growth in the absence of continuous policy action to control costs. Fitch bases its view on the last five years of audited financial statements, along with draft results for fiscal 2016 and the district's annual budget books for fiscals 2015 through 2017. Expenditure growth has outstripped the pace of revenue expansion for the last several years, likely due in part to rising enrollments that have included a high proportion of students requiring special education instruction. Spending and revenues have both been above budget in recent years. Fitch expects new budgeting policies that are being adopted by management and the hiring of an internal auditor could slow these trends over time, but believes continued cost pressures remain a vulnerability that will require management vigilance.

Fitch believes that Minneapolis Public Schools has solid flexibility to reduce its main expenditure items. Management has the ability to lay off teachers and support staff, institute hiring freezes, increase class sizes, and redesign academic, athletic and extra-curricular programs to control costs. The district also has the ability to slow down its rate of pay-go capital spending during leaner economic times and reconfigure its facilities footprint in response to enrollment changes. Carrying costs for debt, pensions and other post-employment benefits (OPEB) are moderate, equaling approximately 15% of total governmental expenditures in fiscal 2015 and fiscal 2016 (unaudited).

District management engages in collective bargaining agreements with 13 employee bargaining units. Contracts with the unions typically run for two years to provide management with greater flexibility to bargain for revised contract terms and potential labor concessions such as increased employee healthcare contributions.

Long-Term Liability Burden
The district's long-term liability burden, which consists of both direct and overlapping debt as well as unfunded employee pension liabilities, is relatively low at approximately 9% of the aggregate personal income of Minneapolis residents. The district's proportional share of the unfunded pension liabilities of the Minnesota state plans in which it participates (along with one small Minneapolis legacy plan) accounts for 44% of the liability, direct debt accounts for 35% including the current issue, and the district's share of the debt of overlapping entities accounts for a modest 21% of its liabilities. Approximately 68% of direct debt amortizes within 10 years.

The district participates in two cost-sharing multi-employer defined benefit pension plans administered by the state: the General Employees Retirement Fund (GERF) and the Minnesota Teachers' Retirement Association (TRA). Annual payments to the plans are set by state statute, rather than by actuarial recommendations, and have been lower than actuarially sustainable levels. The TRA had an assets-to-liabilities ratio of 82% as of June 30, 2014, using the plan's official 8.25% rate of return on investments assumption. Using Fitch's more conservative 7% discount rate assumption, the plan's ratio of assets to liabilities was 72%. The GERF's assets-to-liabilities ratio was 81% as of June 30, 2015. Using the Fitch-adjusted 7% rate of return assumption, the ratio was 74%. The district's pension contributions are increasing at a manageable rate.

The district's unfunded actuarial accrued OPEB liability is modest at $56 million, or 0.3% of resident personal income. The district has set aside funds to cover this liability by establishing an OPEB trust.

Operating Performance
Fitch regards the district's gap-closing capacity as strong. Despite a virtual absence of independent revenue-raising power, management retains a solid ability to cut costs using a variety of devices. These include hiring freezes for vacant positions, reduced staff travel, program redesign, deferred capital spending and, in more stressed situations, staff layoffs and labor concessions to close larger budget gaps. While many of these measures would likely be viewed as less-than-palatable by management given the need to compete with alternative education providers such as charter schools, Fitch notes the district's solid record of keeping spending in line with revenues during the pre-2012 period.

Only a small portion of the budget goes to administration, with the bulk of spending on instruction. Many programs targeted at specific student groups could be merged or consolidated, at least temporarily, to control spending. The district also retains a healthy reserve cushion. Fitch believes financial operations could be more challenged in a downturn than would be the case for more highly-rated entities, but expects the district would recover financial flexibility quickly.

Management has made consistent efforts to maintain financial flexibility during the present economic recovery, with reserves sustained in line with policy targets. The district has also avoided material deferral of required spending on capital maintenance and programs. It has occasionally resorted to non-recurring actions to support operations, including inter-fund transfers. Liquidity remains healthy.

Four operating deficits between fiscal 2012 and fiscal 2015 were due to a combination of factors that included late state aid payments, planned pay-go capital spending, and above-budget special education costs. Despite state aid gradually increasing on a per-pupil basis, state-level actions exerted negative pressure in fiscals 2011 through 2013. To close its own budget gaps, the state shifted its funding formula such that aid was deferred. These state aid shifts were reversed in fiscal 2014, increasing this source of revenue, but this growth was largely offset by declines in property taxes and federal aid.

Fiscal 2015 concluded with a $7.3 million general fund deficit (1.3%) caused by above-budget special education and student transport costs, and a decision to lower class sizes. Revenues and expenditures were above-budget in fiscal 2015, but spending grew more quickly than revenues. Fiscal 2016 ended with a narrow $771,000 surplus made possible by a $16 million inter-fund transfer. Absent the transfer, fiscal 2016 would have concluded with an operating deficit. Fiscal 2016 spending was $49 million (9%) above-budget as a result of increased regular instruction, special education and support costs. Available reserves equaled 13% of general fund spending at fiscal 2016-year end, slightly below the prior-year's 14% of spending. The fiscal 2017 budget grows by 5% over fiscal 2016 and is balanced without the use of reserves. District officials report revenues and expenditures tracking close to budget.

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
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Michael D'Arcy
Director
+1-212-908-0662
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Arlene Bohner
Senior Director
+1-212-908-0554
or
Committee Chairperson
Laura Porter
Managing Director
+1-212-908-0575
or
Media Relations
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elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Michael D'Arcy
Director
+1-212-908-0662
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Arlene Bohner
Senior Director
+1-212-908-0554
or
Committee Chairperson
Laura Porter
Managing Director
+1-212-908-0575
or
Media Relations
Elizabeth Fogerty, New York, +1 212-908-0526
elizabeth.fogerty@fitchratings.com