OREANDA-NEWS. Fitch Ratings affirms Beaumont Independent School District, Texas' (the district) outstanding unlimited tax (ULT) bonds as follows:

--$379 million outstanding ULT bonds at 'BBB+'.

The Rating Outlook remains Negative.

SECURITY

The bonds are payable from an unlimited property tax levied annually (distinct from the district's operating levy) against all taxable property within the district. Additional security is provided by the Texas Permanent School Fund (PSF) guaranty, whose bond guaranty program is rated 'AAA' by Fitch.

KEY RATING DRIVERS

IMPROVING FINANCIAL PERFORMANCE: The 'BBB+' rating and Negative Outlook reflect the district's improved but still evolving financial picture after prior fiscal years' budgetary overspending, fraud, and the lack of adherence to financial controls and reporting requirements. State oversight of operations in the form of an appointed board of managers provides some assurance of stability.

CONCENTRATED TAX BASE: An additional credit risk is a tax base heavily concentrated in the petrochemical industry. The leading taxpayer, Exxon Mobil Corporation, provides a high 19% of taxable assessed value (TAV). TAV has grown modestly in recent fiscal years.

ABOVE-AVERAGE DEBT; MODERATE CARRYING COSTS: Overall debt levels are above average and principal amortization of the district's direct debt is slow. Carrying costs are expected to remain moderate given the lack of new debt plans, a level debt service schedule, and the bulk of its employer pension costs paid for by the state.

RATING SENSITIVITIES
MATERIAL CHANGE TO FINANCES: Rating stability and/or positive rating action remains contingent upon the district's continued ability to restore reserves and improve the issues that have been cited as key audit findings. The rating is sensitive to deterioration in financial operations, including an inability to improve procedures that led to the audit findings.
CREDIT PROFILE
The district is part of the larger Beaumont-Port Arthur metropolitan statistical area (MSA), a four-county region in southeast Texas whose economy is primarily supported by petroleum-related industries. District enrollment has remained fairly stable, although a modest 2% decline was realized in fiscal 2015 with average daily attendance (ADA) estimated at about 17,623. Wealth and income indices are below state and national averages.

FINANCIAL MISMANAGEMENT LED TO STATE TAKEOVER
An interim Superintendent and a board of managers appointed by the Texas Education Agency (TEA or state) Commissioner have been responsible for operations and governance of the district for nearly two years, replacing the existing superintendent and elected board of trustees. This decision was due in part to the severe financial management issues that had been highlighted as a result of an earlier FBI embezzlement investigation. The board was charged by the Commissioner to not only oversee district operations, but to correct identified deficiencies and implement structural and procedural improvement strategies for long-term, positive change.

Despite the takeover, hiring of experienced, permanent leadership in many key areas has been relatively recent. Many positions remained temporarily filled, open, or yet to be created until calendar year 2015, including the superintendent, a chief financial officer (replacing the interim finance director), executive director of special education, federal (Title 1) grants director, an internal auditor, a controller, and purchasing director.

Fitch believes the board of managers has been moderately successful to date in righting the district's position for the near- to intermediate-term, although other issues are yet to be fully resolved. This causes Fitch some concern which is expressed in our Outlook on the credit. This board is expected to remain in its supervisory role through May 2017, at which time an election for a new board of trustees is anticipated.

The rating reflects Fitch's expectation of management stability despite this future transition. This assessment is based on the positive position of experienced, knowledgeable key district leadership already in place, likely heightened scrutiny of candidates due to prior governance issues, and TEA oversight comparable to all districts.

INTERNAL LIQUIDITY SUFFICIENT; MODEST CUSHION RESTORED
The external audit firm that began in conjunction with the start of the Board of Managers in 2014 was charged to complete the district's most recent audits (fiscals 2013-2015). Completion of both the fiscal 2013 and 2014 audits was delayed in large part to the significant audit and investigation work required. Unrestricted reserves totaled a much reduced $7 million or about 4% of spending at fiscal 2013 year-end. The use of about $19 million in reserves and a $4.7 million prior period adjustment were due to a combination of unbudgeted pay-go capital spending, embezzled funds, and higher than budgeted spending on personnel. Fiscal 2013 results also lacked an audit opinion, as external auditors were unable to obtain sufficient, appropriate, audit evidence.

Fiscal 2014 and 2015 audits include 'qualified' opinions due to the inability to validate capital assets and inventory. However, Fitch has confirmed with the district's external auditor the material statement of cash and adequacy of information with which the auditor ascertained the cash position. General fund cash/investments increased to $26.8 million or just over 2 months of spending in fiscal 2015 from a very low $5.6 million the prior year. About $12 million of this sizeable increase was due to the year's net operating surplus with the remainder a result of cash swept from some funds outside the general fund. Fiscal 2015 unrestricted reserves rose to $11.4 million or 8% of spending from a negative $536,000 in fiscal 2014.

The $152 million fiscal 2016 operating budget was adopted with a $7 million surplus, anticipating a slight enrollment decrease. Budgeted spending grew about 6% or nearly $9 million. Management indicates revenue and ADA are running in line with budget while expenditures are down slightly; year-end results are currently projected to modestly exceed budget. Preliminary fiscal 2017 budget plans anticipates minimal spending growth according to management.

According to management, no federal or state audits/investigations are underway or pending that might materially pressure the district's present financial position. Questioned costs in the audit have decreased from fiscal 2014 to fiscal 2015, although these persist as a result of numerous material weaknesses and deficiency findings in various federal and state award programs, for which TEA may yet hold the district accountable.

Management attributes many of the considerable and unresolved findings in fiscal 2015 to turn-over and incompetence in key positions, departmental understaffing, and campus level compliance/reporting issues. Fitch views possible repayment of these questioned costs as a credit risk, although also recognizes TEA has historically permitted structured, multi-year repayment plans in an effort to mitigate a severe, short-term impact on district finances.

Excluding these most recent questioned costs, TEA previously identified approximately $10 million in questioned costs from federal programs over fiscals 2013 - 2014 that may have to be refunded due primarily to the lack of prior documentation; a final determination has yet to be made. This amount is not presently booked as a liability as it is considered unlikely by senior TEA administrators and district management to require repayment according to the external auditor.

TAX BASE CONCENTRATED IN PETROCHEMICAL INDUSTRY
The district's tax base remains heavily concentration in the petrochemical industry, although this concern is mitigated to a degree by industry diversification in both production and end users as well as the key role oil refineries play in the national economy. TAV has typically grown at a modest average annual pace and increased slightly to exceed $10 billion in fiscal 2016.

Expansion by the district's largest taxpayer (an ExxonMobil refinery) has been the primary contributor to increased tax base concentration, which may grow further in the near term. The company reportedly has plans for a two-phased, total $500 million expansion in the near-term that could make the facility the largest in the United States. Top 10 taxpayers contributed 30% of TAV in fiscal 2015, led by the refinery at 19%.

Fitch believes the area may realize some modest economic softening in the near to intermediate term given the interconnectedness of the energy sector and the resulting effects from subdued exploration activity due to sustained, low oil prices. However, the state's various petrochemical centers should benefit from lower energy prices, which may serve as a partial offset to any economic softening. (For more details, see 'Fitch: Oil Price Decline Likely to Have Targeted Effect on Local Texas Economies & Revenues', dated Jan. 13, 2015).

Local property taxes comprise nearly 70% of fiscal 2015 general fund operating revenue. The district is considered property-wealthy, which provides some susceptibility to modest revenue loss as a result of declining TAV not fully offset by the state's backfill of per-pupil funding levels. Nonetheless, the per-pupil formula largely protects the district's operating revenues from the downside of sizeable TAV swings. Declines in TAV would more directly impact the debt service tax rate, in which the district maintains healthy flexibility under the $0.50 per $100 TAV new money cap.

OVERALL DEBT BURDEN ABOVE-AVERAGE; CARRYING COSTS MODERATE
Overall debt levels are above-average at approximately 5.3% of fiscal 2016 market value. Principal amortization of the district's direct debt is slow with roughly 35% retired in 10 years. The district has no outstanding bond authorization. A forensic audit that focuses on the prior 2007 bond program is expected to be finalized in the near-term. All bond projects were completed according to management, but in some cases there may have been payment in prior fiscal years to original contractors that did not complete the work. These costs are expected to be actively pursued for restitution by the district through the courts.

STATE PENSION FUNDING CONTRIBUTES TO MODERATE CARRYING COSTS
The district participates in the Teacher Retirement System of Texas (TRS), a cost-sharing multiple-employer defined benefit plan. The state assumes the vast majority of Texas school districts' net pension liabilities and the corresponding employer contributions.

Like all Texas school districts, the district is vulnerable to future policy changes by the state, as evidenced by a relatively modest 1.5% of salary contribution requirement effective fiscal 2015. Legislative changes in 2013 increased the state's annual contributions, although it remains to be seen whether this improves TRS' ratio of assets to liabilities over time.

Under GASB 68, the district reports its share of the TRS net pension liability (NPL) at $15.5 million, with fiduciary assets covering 83.3% of total pension liabilities at the plan's 8% investment rate of return assumption (approximately 75% based on a more conservative 7% investment rate of return assumption). The NPL represents less than 1% of the district's fiscal 2016 market value. Other post-employment benefit (OPEB) contributions paid by the district are also nominal, as the state and employees also pay the bulk of these costs. Carrying costs for debt service, pensions and OPEB remain moderate at 16.4% of fiscal 2015 governmental spending due primarily to the slow pace of principal amortization.

TEXAS SCHOOL FUNDING LITIGATION
A Texas district judge ruled in August 2014 that the state's school finance system is unconstitutional. The ruling, which was in response to a consolidation of six lawsuits representing 75% of Texas schoolchildren and was the second such ruling in the past two years, found the system inefficient, inequitable and underfunded. The judge also ruled that local school property taxes are effectively a statewide property tax due to lack of local discretion and therefore are unconstitutional.

The Texas attorney general has appealed the judge's latest ruling to the state supreme court. If the state school finance system is ultimately found unconstitutional, the legislature would likely follow with change intended to restore its constitutionality. Fitch would consider any changes that include additional funding for schools and more local discretion over tax rates to be a credit positive.