[February 04, 2013]

Fitch Rates Temecula Valley USD, CA's GOs 'AA-'; Outlook Stable

Fitch Ratings has assigned an 'AA-' rating to Temecula Valley Unified School District, California's (the district) bonds as follows:

--$35 million general obligation (GO) bonds, 2012 election, series 2013-A.

The bonds will sell via negotiated sale the week of Feb. 11. Proceeds will be used to fund technological infrastructure, building planning, classroom updates, and other improvements.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by an unlimited property tax on all taxable property within the district.

SENSITIVITY/RATING DRIVERS

ADEQUATE FINANCIAL OPERATIONS: The 'AA-' rating reflects the district's satisfactory but declining general fund balance, projected rising enrollment, years of prudent expenditure reductions, and moderate remaining expenditure flexibility. Fitch expects the district to manage its finances within its adequate fund balance policy.

FINANCIAL VULNERABILITIES REMAIN: The district's financial operations are challenged by a weak liquidity position due to substantial state funding deferrals, and high revenue concentration in state funding, which has been weak and difficult to predict. However, revenue deferrals and funding will improve in fiscal 2014 if the governor's budget is adopted as proposed.

ABOVE-AVERAGE ECONOMY: The district's local economy, located mainly in the city of Temecula, benefits from high wealth levels, unemployment materially below regional and state levels, and ready access to three large and diverse employment markets. However, the city experienced rapid growth during the housing boom and its tax base was significantly affected by the recession.

ADEQUATE DEBT PROFILE: The district's debt burden and principal amortization is moderate, its other-post employment benefit (OPEB) liability is minimal, tax rate assumptions are reasonable, and carrying costs are manageable. However, the district is exposed to the poorly funded CalSTRS pension system, debt amortization could weaken with future planned issuances, and its capital plan is quite large, though flexible as to timing.

SATISFACTORY MANAGEMENT PRACTICES: The management team is quite tenured and has exhibited a willingness and ability to cut as necessary to maintain an adequate financial cushion. Like all California schools, the district is required to publish a large amount of forward-looking financial data multiple times per year.

WHAT COULD TRIGGER A RATING ACTION

MATERIAL FUND BALANCE DRAWDOWNS: An actual or likely drawdown of the district's unrestricted general fund balance to less than 6%, the lower boundary of management's comfort zone, would result in negative rating action.

CREDIT PROFILE

The district serves a population of 143,000 in the city of Temecula (the city), surrounding cities, and unincorporated communities in southwestern Riverside County. The city experienced rapid population growth prior to the recession, fueled by its affordability and ready access to the large and diverse employment markets of Los Angeles, Orange (News - Alert) County, and San Diego. The city also has a significant tourism draw because of its wineries and a large casino.

Median household income levels are high at 135%, 128% and 150% of city, state, and national levels, respectively. October 2012 unemployment fell to 8.2% from 9.3% the year prior. This compares favorably to the county and state unemployment rates of 12% and 9.8%, respectively, but it is above the nation's 7.5% level. The district's poverty rate is very low, with just 20% of its students eligible for free or reduced price lunches, compared to 59% of students in the county.

DIVERSE TAX BASE AFFECTED BY HOUSING MARKET WEAKNESS

The city's housing market was severely affected by the recession, with Zillow house values falling from a 2005 peak of $501,000 to a low of $253,000 in 2009. Despite the tax base's lack of maturity and the severe home price decline, assessed value (AV) declined by a less dramatic 13% in fiscal 2010 and a modest 1.4% decline the year after.

Home prices since 2009 have stabilized and year-over-year home prices in December were up 10.4%. If these gains are maintained, AV growth could occur in fiscal 2014 following very slight increases in the last two fiscal years. AV growth could also benefit from a recent recovery in new construction activity.

Fitch's concerns about AV volatility are mitigated by the state's Proposition 98 funding formula. This formula mandates a minimum per pupil level of district funding. To the extent that local tax base contraction results in lost local property tax revenues, the state is obligated to replace those revenues up to the minimum funding level. However, state revenues have been subject to significant deferrals in recent years that the state has only recently begun to pay back.

ADEQUATE FINANCIAL OPERATIONS

The district's financial operations are adequate. Revenues are highly concentrated in Prop 98 revenues, as aremost California districts, and have been subject to a prolonged period of weakness. Management prudently has implemented significant expenditure reductions in response, thus retaining a satisfactory financial cushion that management nonetheless anticipates will be partially spent down over the next few years to what Fitch considers a just-adequate level of 6%-10% of expenditures from 10.9% at fiscal year end 2012.

Recent years' expenditure reductions have included teaching, management, and classified staff reductions, furlough days, a school site closure, increased class sizes, and an early retirement incentive program. Despite these reductions, a moderate amount of expenditure flexibility remains, including additional furlough days, categorical flexibility, and potential salary rollbacks.

As with most districts that have implemented significant cuts in recent years, political considerations could make it difficult to implement some or all of these legal options.

FINANCIAL CUSHION LIKELY TO NARROW TO JUST ADEQUATE

Management anticipates that fiscal 2013 general fund operations will result in an approximate $8 million fund balance drawdown, which would lower the district's financial cushion to a just-adequate $15.5 million (7.8%). This follows a $2.7 million drawdown in fiscal 2012.

The fiscal 2013 deficit reflects the district's decision to buy back 10 furlough days from its certificated and management groups (and the assumption that its classified group will reach a similar agreement in its pending negotiations). The furlough days would have saved $9 million and were implemented at the start of the year under the assumption that Proposition 30 would be rejected by voters in a state-wide November election, triggering substantial mid-year funding reductions. Voters subsequently approved Proposition 30, and no such funding reductions were implemented.

To retain an adequately sized fund balance moving forward will require closing future operational deficits now estimated at $8.8 million to $13.8 million. However, these estimates do not incorporate recent positive revenue proposals in the governor's budget and they assume that labor concessions sunset in fiscal 2014.

GOVERNOR'S BUDGET POINTS TO POTENTIALLY HIGHER REVENUES

The governor's budget proposes a 5% increase of fiscal 2014 Proposition 98 funding, by far the district's largest funding source. Actual funding, however, will not be determined until the state budget is adopted around June. The district estimates that if the budget is passed as proposed, district revenues would rise by $3 million in fiscal 2014 and $6 million in fiscal 2015.

WEAK LIQUIDITY

The district's liquidity position is weak due to its dependence on state funding, which has been subject to substantial intra-year and inter-year deferrals. The district's fiscal 2012 quick ratio (cash divided by current liabilities) is just 0.2x, down from 0.4x and 0.6x at fiscal year ends 2011 and 2010, respectively. To date the district has managed its cash flows by borrowing internally and by issuing tax revenue anticipation notes (TRANs).

For fiscal 2013 management expects to issue $55 million in TRANs (a high 28% of estimated fiscal 2013 expenditures and transfers out). Proceeds will be combined with $7.8 million of internal borrowable resources. Liquidity pressures could begin easing in fiscal 2014 due to the governor's proposal to pay down a portion of the state's funding deferrals, increase programmatic funding, and also due to the Education Protection Account (EPA) created under Proposition 30. Management has yet to see how the EPA will work in practice, however.

SATISFACTORY MANAGEMENT PRACTICES

Management practices overall are satisfactory. Financial management is quite tenured, and the district has implemented significant expenditure reductions to maintain an adequate financial cushion. However, Fitch views negatively the district's decision to buy back furlough days in fiscal 2013, and is concerned that potential increased funding levels beginning in fiscal 2014 could be absorbed by rising labor costs.

The district is subject to AB1200 financial reporting procedures, as are all California districts. These procedures require the district to perform multi-year financial forecasting multiple times per year and to comment on over 30 potential financial red flags. The district's budgets and two interim reports must be reviewed and certified internally and also by the county office of education. Qualified or Negative certifications may lead to various levels of external financial intervention. Fitch views these statewide school procedures as strong.

ADEQUATE DEBT PROFILE, LARGE CAPITAL PLAN

The district's overall debt profile is adequate. Its debt burden is moderate at $3,953 per capita (3.4% of AV), and likely to remain so even after it exhausts its large $165 million GO authorization. Debt currently amortizes at a moderate rate, with 29% and 42% of principal retiring over five and 10 years, respectively (assuming final accreted interest is treated as principal).

This issuance is composed of current interest bonds (51% of par), callable capital appreciation bonds (9%), and convertible capital appreciation bonds (CCABS) (40%).

The CCABs automatically convert to current interest bonds at fixed dates at a predetermined interest rate. The CABs and CCABS slow total debt amortization. Expected additional debt could further slow amortization, especially if the district continues to issue capital appreciation bonds (CABs). The district has not yet determined the structure of the remaining GO authorization.

The district's capital improvement master plan is very large at $325 million and includes new schools, renovations to existing schools, and other projects. The district plans to fund these improvements with GO issuances, community facility district financings, and state and federal funding. The plan is characterized as quite flexible and can move forward on the basis of funding availability.

MINIMAL OPEB LIABILITY, BUT CALSTRS PRESSURES LOOM

The district's other post-employment benefits (OPEB) liability is minimal, as the plan is open to a very small group of managers. However, the district participates in the poorly funded CalSTRS pension system, as do all schools in the state. Although the district is paying 100% of its required rate, in fiscal 2011 system contributions were equal to just 46.7% of the actuarially required rate.

CalSTRS contribution rates are set by statute and they have not been increased to reflect the weak investment return environment over the past several years. As a result, the system's Fitch-adjusted funded ratio has fallen to a low 65.7% and future contribution rates likely will need to rise substantially from current levels. It is unclear which stakeholders would face increased contribution rates, and how such increases would be implemented, but Fitch believes districts would be likely to bear at least part of the burden.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from Creditscope, Underwriter.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria' (Aug. 14, 2012);

--'U.S. Local Government Tax-Supported Rating Criteria' (Aug. 14, 2012).

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=686015

U.S. Local Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=685314

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