OREANDA-NEWS. February 11, 2016.  Fitch Ratings has affirmed the underlying 'BB-' rating on the following bonds issued for the school district of Philadelphia (SDP, or the district):

--\\$1.1 billion Pennsylvania State Public School Building Authority school lease revenue and revenue refunding bonds issued on behalf of SDP;
--\\$1.6 billion school district of Philadelphia general obligation (GO) and GO refunding bonds;

The Rating Outlooks for the underlying district and authority ratings remain Negative. The enhanced rating of 'A+' with a Stable Outlook on the bonds reflects protections under the Pennsylvania School Credit Enhancement Law. (For more information on the Pennsylvania School Credit Enhancement Law, see 'Fitch: Pennsylvania Interim Budget Supports Value of School Credit Enhancement Programs', dated Jan. 11, 2016.)


The bonds are payable from the district's full faith, credit and taxing power. The rating on the bonds is enhanced by the Pennsylvania School Credit Enhancement Law.


UNCERTAIN RECOVERY PROSPECTS: The district has made progress towards structural budgetary balance with several years of dramatic expenditure cuts and implementation of substantial recurring revenue increases. Major obstacles remain, including rising cost pressures and the incomplete commonwealth budget.

RAPID CHARTER SCHOOL GROWTH: The number of students enrolled in charter schools more than doubled in the past six years. Further growth is expected, increasing financial challenges as charter schools divert resources from the district.

LIMITED ABILITY TO RAISE REVENUE: As is typical for school districts, the largest source of funding is from the state. Raising locally generated revenue requires city council approval.

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 moderate but growing.

STABLE, BUT CHALLENGED, 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.


FURTHER FINANCIAL DETERIORATION: Additional reductions in the Philadelphia school district's financial flexibility over the medium term due to an inability to continue making progress toward long-term structural balance would lead to a further downgrade.



The district's fiscal 2015 budget was balanced through a number of largely recurring measures, including \\$120 million from a one percent city sales tax and \\$49 million from a new locally-levied cigarette tax. SDP ended the year on June 30 with a modest budgetary operating surplus of \\$6.9 million across its three primary funds. For fiscal 2016, the district anticipates another modest operating surplus, benefiting from \\$70 million in new recurring revenues via city tax increases and continued fiscal austerity. This follows several years of operating deficits and \\$300 million in deficit borrowing in fiscal 2013.


New labor contracts have been a key source of recurring savings for SDP. 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. In 2014 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. Both contracts expire on Aug. 31, 2016 and the district is engaged in negotiations to extend them. Fitch anticipates SDP will work with the unions to reach fiscally sustainable terms.

The district's contract with the Philadelphia Federation of Teachers (PFT) expired in August 2013. For some time, the district was requesting large wage cuts similar to those agreed to by SEIU, but the two sides could not reach an agreement. PFT is not legally permitted to strike. In October, 2014, the School Reform Commission (SRC), the commonwealth-appointed board overseeing the district, cancelled the union's existing, expired contract and attempted to impose changes in health care benefits, require employee contributions to health care benefits, and eliminate an existing health and welfare fund. This would have saved the district approximately \\$50 million a year.

In January 2015, the Commonwealth Court ruled the SRC's actions illegal. The Supreme Court of Pennsylvania accepted SRC's appeal in August and is currently reviewing legal briefs on the case. Fitch is not aware of a scheduled trial date. In the interim, teachers continue to work under terms of the expired contract and all salary increments under the prior contract have been frozen since August 2013.


While positive, recent fiscal improvement does not fully address SDP's lingering challenges. The district's fiscal 2015 - 2019 five-year financial plan projects a steadily increasing structural budgetary gap across its three primary operating funds reaching \\$152 million, or 5.6% of revenues, in fiscal 2019. This plan was adopted in December 2014, before recent revenue-raising actions by the city council, discussed further below.

Charter school enrollment continues to grow, consuming larger portions of the district's operating budget as the district makes per-pupil payments to charter schools based on a state formula. In fiscal 2015 (unaudited) charter school payments made up nearly 38% of general fund expenditures, up from 18% in fiscal 2009. In its five-year financial plan, SDP estimated charter schools would account for \\$140 million of an anticipated \\$282 million in new costs by 2019.

Escalating pension payments are another fiscal pressure point. As with charter schools, pension costs are dictated by state law with steep increases in recent years and another one anticipated in fiscal 2017. Under current law, increases in following years should moderate but by fiscal 2019, SDP's five year financial plan projects pensions will account for \\$75 million of the \\$282 million in additional costs.

District officials believe that their recent expenditure control efforts (including school closures and layoffs) bring them to a bare minimum service level, and are seeking significant additional funding. Additional resources could also stem the flow of district residents to charter schools and alleviate cost pressure.

In the last several years, the city of Philadelphia (general obligation bonds rated 'A-' with a Stable Outlook) made significant recurring contributions to SDP with tax and fee increases including \\$70 million enacted for fiscal 2016. With state legislative support, the city also began directing \\$120 million in a local sales tax levy to the district and implemented a new cigarette tax. In contrast, beyond assenting to these local tax changes, commonwealth funding increases have been minimal.


The lack of a full-year commonwealth budget creates significant uncertainty for all school districts in Pennsylvania. SDP is particularly exposed given its significant reliance (approximately 50% of budgetary operating revenues) on state aid.

The district borrowed \\$300 million in tax revenue anticipation notes (TRANs) at the start of the current fiscal year for its normal cash flow needs, and added an additional \\$525 million as the state's budget impasse continued (all via private placement). The partial commonwealth budget enacted at the end of calendar year 2015 provided six months of basic education funding (BEF) to school districts (the primary stream of state aid) and a full year of funding in other categories including special education and transportation.

SDP repaid \\$250 million of TRANs in January following the partial commonwealth budget, with the \\$575 million balance due on June 1. Fitch believes that the commonwealth remains committed to supporting its school districts, as evidenced by passage of the partial budget and close engagement with fiscally challenged districts. Fitch anticipates Pennsylvania will make every effort to ensure SDP is able to meet its debt service obligations. However, the lack of a full budget creates liquidity pressures and operating uncertainty warranting the continued negative outlook for the district.

A key point of contention in the ongoing commonwealth budget impasse is the extent of increased BEF and its distribution across school districts. All key parties agree that some increase should be included in a final budget agreement, but they differ on the magnitude and how it should be paid for. Conservatively, SDP's most recent fiscal 2016 forecast and its current five-year financial plan project no increase in commonwealth funding from the prior year.


Overall debt ratios are above average at over \\$4,700 per capita and a high 8.1% of market value. Amortization is slightly below average at approximately 50% in 10 years.

SDP's pension costs will nearly double from fiscal 2015 to fiscal 2019 under current law. The district is hoping for relief from statewide pension reform, and the issue is part of the ongoing budget negotiations. SDP participates in a state-sponsored plan (Public School Employees Retirement System) with approximately 67% of employer contributions made by the state through appropriations to the district. The plan is currently approximately 60% 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 16% of governmental spending, though this will grow with increased pension costs.


The Philadelphia School District is the nation's eighth largest school district and the largest in the commonwealth, with fiscal year 2015 enrollment of 207,000 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. As of fall 2014, 71,183 students within SDP enrolled in charter schools with 64,301 enrolled in brick and mortar charters within the district, 6,619 in cyber charters (essentially online schools intended mainly for alternative students), and 263 in charters outside of SDP. In fall 2008, SPD charter school enrollment was just below 35,458. Non-charter school enrollment declined nearly 18% since then.

As both a city and county and with an estimated population of approximately 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 down from past levels, the city's December 2015 unemployment rate of 5.4% remains high as does the poverty rate at 26% of the population. Income levels on both a per capita and median household level are well below state and national levels.