OREANDA-NEWS. Fitch Ratings has affirmed the following Natomas Unified School District, California (the district) general obligation (GO) bonds ratings:

--\$11.9 million GO refunding bonds, series 1999, and GO bonds (election of 2002), series 2004B at 'BBB+'.

The Rating Outlook is Positive.

SECURITY

The bonds are secured by the district's full faith, credit, and unlimited ad valorem property tax pledge.

KEY RATING DRIVERS

CONTINUED GENERAL FUND STRUCTURAL IMBALANCE: The district's finances are benefitting from the state's local control funding formula (LCFF) and its own improved general fund liquidity position. However, the district is also projecting a more prolonged than expected general fund structural imbalance which it expects to resolve in fiscal 2016.

LOWER BUT SOLID GENERAL FUND BALANCES: Due to net operating deficits after transfers in fiscal years 2013, 2014, and 2015 (projected), the district has lower but still solid general fund balances.

IMPROVED EXECUTIVE MANAGEMENT STABILITY: Executive management turnover has diminished considerably, most recently evidenced by the extension of the current superintendent's contract.

MIXED SOCIO-ECONOMIC CONTEXT: Although the district's wealth characteristics are above average, regional unemployment remains somewhat elevated, and there are indications of significant socioeconomic constraints for many of the district's families.

REBOUNDING TAX BASE: The district's assessed valuation (AV) has started recovering from the housing-led recession. Potentially significant new development is poised to commence once the de facto construction moratorium is lifted, which is expected by June.

HIGH DEBT BURDEN; RISING CARRYING COSTS: The district's debt burden remains very high with moderate amortization. Carrying costs for debt service, pension, and other post-employment benefits (OPEB) are affordable, although Fitch expects pension costs to increase due to the poorly funded state pension system for teachers.

RATING SENSITIVITIES

An upgrade to the 'A' rating category will depend on the district's ability to control its expenditures to better match revenues, maintain solid general fund balances and reserves, and protect its improved general fund liquidity position.

CREDIT PROFILE

Located in the northwestern portion of Sacramento County, approximately four miles north of downtown Sacramento, the district is home to approximately 73,000 residents. It is responsible for 13 schools plus six charter schools. Approximately one-quarter of its student body attends charter schools.

LOWER BUT SOLID GENERAL FUND BALANCES WITH CONTINUED STRUCTURAL IMBALANCE

The district ended fiscal 2014 with a lower, but still solid, unrestricted general fund balance of \$13.7 million or 18% of spending, down from a peak \$19.5 million or 29.7% of spending two years prior. The district outperformed its budgeted net operating deficit (after transfers) of \$5.5 million due to under-expenditures on contract services and operations. The district's actual, much smaller, net operating deficit of \$1.6 million was largely caused by restoration of classified employees' 10 furlough days.

Despite a projected 10.3% funding increase in fiscal 2015, largely due to the state's implementation of LCFF and student enrollment increases, first interim report projections indicate that there will be a further \$5.7 million general fund drawdown. This would lower the unrestricted general fund balance to \$9.2 million, a still good 10.5% of spending. Most of this structural imbalance is being generated by the 6% salary increase, a 1.5% off-schedule salary increase, and other remuneration enhancements negotiated for both certificated and classified employees in fiscal 2015. Apart from a further 1.5% off-schedule increase for both certificated and classified employees in fiscal 2016, there will be no other salary increases in fiscal years 2016 (for both certificated and classified) or 2017 (for classified only) since only non-remuneration labor contract reopeners are permitted.

The general fund balance will remain above the board's 9% minimum reserve policy, additional LCFF funding is expected to cover the increased remuneration costs, and no more general fund balance drawdowns are currently anticipated. Although the first interim report projections indicate a \$1.6 million drawdown in fiscal 2016, the district now projects that this will be avoided by the rolling forward of \$1 million in fiscal 2015 under-expenditures, plus \$2 million in additional LCFF funding per the Governor's proposed fiscal 2016 budget. Fitch notes the district's position that settling labor contracts through fiscal 2016 for certificated employees and fiscal 2017 for classified employees will allow the district to move past contentious labor contracts (the classified labor negotiations required state mediation) and focus instead on the district's educational goals. However, this is being achieved at the cost of prolonging the general fund structural imbalance.

General fund balance expectations are lower than in prior forecasts and unbalanced general fund operations now extend into fiscal 2015. Current indications show a small operating surplus after transfers in fiscal 2016, adding to an adequate but much reduced unrestricted general fund balance, as labor agreements have absorbed a significant portion of revenue gains. However, due to furlough and service restorations, the district now benefits from greater expenditure flexibility.

The district ended fiscal 2013 with strong general fund cash and investments and low liabilities, does not anticipate any cash flow weakness in fiscal years 2015-2017, and maintains good access to borrowable resources. Currently, borrowable resources outside the general fund total \$18.6 million (equivalent to 24% of fiscal 2014 general fund spending). The district also remains committed to its policy of maintaining a minimum 9% general fund reserve through fiscal 2017, which is well in excess of the state's 3% minimum reserve requirement.

IMPROVED EXECUTIVE MANAGEMENT STABILITY

After considerable turnover, the current superintendent (the fifth in three years) has been in place since in June 2012 and his contract has just been extended by four years. Executive management level turnover has decreased.


MIXED SOCIO-ECONOMIC CONTEXT

The regional economy was hard hit by the economic downturn. As a result, the county unemployment rate remained somewhat elevated at 6.8% in October 2014, although improved from a year earlier (8.5%). The region is likely to benefit from the ongoing growth in the majority of employment sectors.

Census data indicate that the district's wealth characteristics are above-average. However, approximately half of the district's student body is eligible for free or subsidized meals. The district's 62% unduplicated count of English learners, economically disadvantaged students, and foster care youths also suggests significant socioeconomic constraints for many of the district's families.

REBOUNDING TAX BASE

In the prior decade, the district experienced a period of rapid AV growth resulting from large scale housing development. However, during fiscal years 2010-2013 AV declined by a cumulative 23.9%. This was due to both the housing-led recession and a de facto moratorium on new construction pending levee improvements around the Natomas flood plain to meet certain flood requirements. Subsequently, despite the continued construction moratorium, there has been a partial AV rebound propelled by improving residential property prices. AV grew by 4.3% in fiscal 2014 and an even stronger 7.2% in fiscal 2015.

The most vulnerable levees around the Natomas flood plain have now been upgraded and the federal government has authorized completion of the remaining levee upgrades. Consequently, FEMA is currently completing an expedited flood risk remapping process which is expected to result in the de facto construction moratorium being lifted by June.

This could open up considerable expansion of the district's residential and commercial property base. For example, 5,000 residential housing permits were pulled before the moratorium that could proceed as soon as any code changes made in the interim have been addressed. In addition, there are millions of square feet of commercial property development ready to go forward. The city of Natomas is predicting 4,000 additional residential units based on permits currently being pulled for newly proposed developments. The speed with which these properties are constructed will depend on developers' assessment of consumer demand.

HIGH DEBT BURDEN; RISING CARRYING COSTS

Overall debt equals a high \$7,913 per capita and 7.7% of AV. Debt amortization is moderate at 57.7% in 10 years, taking into account the district's limited exposure to capital appreciation bonds. The district is considering extensive future debt issuance plans given its improved AV and debt capacity, the student enrollment increase expected to result from new residential construction, and voter approval of a \$129 million school facilities bond authorization in November 2014 (strongly supported by 72% of voters). Fitch expects that new debt issuances will keep overall debt levels high for the foreseeable future.

The district's fiscal 2014 debt repayments, pension costs, and OPEB pay-as-you-go contributions cumulatively totaled an affordable 16.4% of total governmental spending. However, such carrying costs are likely to rise. In addition to repayment of additional bonded indebtedness, pension costs are also expected to rise given the poorly funded state-sponsored pension system for teachers. The district is facing considerable contribution rate increases to address the current low funding levels caused by statutory contribution rates that have been substantially below the level required to amortize existing obligations.