[October 05, 2016]

Fitch Affirms Kendall, Kane & Will Counties Community USD 308, (IL)'s Rating at 'AA'; Outlook Stable

Fitch Ratings has affirmed at 'AA' the Issuer Default Rating (IDR) of the Kendall, Kane & Will Counties Community Unit School District 308 (USD), IL, and has affirmed the 'AA' rating on the following series of GO bonds:

--$103.42 million unlimited tax general obligation (ULTGO) refunding school bonds, series 2016

The Rating Outlook is Stable.

SECURITY

The bonds are payable from the district's full faith and credit and an unlimited ad valorem tax on all taxable property within the district.

KEY RATING DRIVERS

Affirmation of the 'AA' Issuer Default Rating (IDR) and the 'AA' ratings on the district's GO bonds reflects a low long-term liability burden compared to the economic resource base and exceptionally strong gap-closing capacity due to solid control over expenditures, supported by a strong likelihood of declining fixed costs, and satisfactory reserves. Despite minimal independent revenue-raising flexibility under Illinois law, a solid history of revenue gains linked to state aid growth is likely to continue while enrollments rise. An expanding population and excess capacity of 4,800 seats are likely to support further enrollments gains.

Economic Resource Base

The district is located 45 miles west of Chicago at the outermost edge of the city's suburbs in what had been a predominantly rural area prior to the mid-1990s. The district is situated primarily in Kendall County, but includes small portions of neighboring Kane and Will counties. During the decade from 2000 to 2010, Kendall was the fastest-growing county in the U.S. in terms of its population. As a result, district enrollments increased substantially, and the district issued a significant amount of debt in order to construct new schools and enlarge existing facilities. Enrollments have continued to rise post-2010, increasing by 8.4% from 2011 through 2015 to reach 18,043 students. Management anticipates further enrollment gains due to excess capacity.

Revenue Framework: 'a' factor assessment

The school district's independent revenue-raising ability is extremely limited due to Illinois' PTELL legislation, which limits property tax levy growth to the lesser of CPI or 5% per annum and, secondly, from rate caps in place for all but one operating fund. Nevertheless, the district's revenue growth history has been very strong as the result of ample increases in state aid to support rising enrollments. Fitch expects future revenue growth to be healthy.

Expenditure Framework: 'aa' factor assessment

Major spending items are likely to grow in line with, or slightly above, revenues in the absence of policy action, requiring active budget management. Spending flexibility is satisfactory and should improve because of the district's debt restructuring plan, which is estimated to reduce carrying costs to approximately 16% of expenditures from 19% in fiscal 2015.

Long-Term Liability Burden: 'aaa' factor assessment

The long-term liability burden is low as measured against the aggregate personal income of district residents, benefitting from a negligible unfunded pension liability. Wealth levels are above average and population growth is strong. Direct debt represents the bulk of the liability burden. Fitch notes that outstanding debt in all likelihood peaked several years ago at about $435 million.

Operating Performance: 'aaa' factor assessment

Despite minimal declines in reserves since 2012, the district retains ample financial flexibility given its solid ability to reduce costs to offset the revenue declines likely to be caused by a modest recession. Fund balances are healthy and the district has a history of prudent budgeting.

RATING SENSITIVITIES

STATUTORY CHANGES: The rating is sensitive to changes in Illinois' statutory framework for financing K-12 education. The easing or repeal of the revenue-raising constraints connected with PTELL could place positive pressure on the ratings. No such statutory changes are presently under discussion, however.

FAILURE TO MAINTAIN FINANCIAL FLEXIBILITY: If the district is unable to manage operations on an ongoing basis such that fiscal reserves are maintained at adequate levels and budgetary flexibility supported, then this could place negative pressure on the ratings.

INTEGRATION OF FORMER CO-OP: The rating is sensitive to the execution risk the district faces in merging the former Kendall County Special Education Cooperative into its own operations in fiscal 2017 and beyond. If projected efficiencies don't materialize, then the costs associated with a larger staff could place pressure on operating performance.

CREDIT PROFILE

Kendall was the fastest-growing U.S. county by population in the last decade, as the number of residents grew by 110% to 114,000 in 2010 from 55,000 in 2000 due to plentiful affordable land for new residential construction as farmers sold lots to homebuilders. The county then led Illinois in the number of home foreclosures in the five years after the property market downturn, although the local housing market has rebounded since 2010. The district's economy reflects a mix of agriculture, manufacturing, commercial and public enterprises. Caterpillar, Inc. (IDR 'A'/Stable Outlook) is the area's largest employer with a staff that accounts for about 3% of Kendall County's total employment. The unemployment rate is below the U.S. average. Wealth levels are high: per capita personal income was $113,676 in 2015 compared to $50,295 for Illinois residents - or more than 200% of the state average. Median household income is also high. Poverty is low at 3% of residents. Nearly 39% of county residents hold a bachelor's degree or higher compared to 33% of Illinois residents.

The last recession has had a lingering impact on taxable assessed valuation (AV), which declined by over 6% annually in 2012, 2013 and 2014 before shrinking by a further 0.3% in 2015. In part, continued AV declines into the middle of this decade reflect the staggered pace of reassessments in Illinois, where property values are reassessed on a three-year cycle that tends to prolong both upward and downward movements in housing values. Management reports that AV returned to growth in 2016, rising by 4.6%. The population has expanded by 9,000 residents, or 8%, since 2010, indicating the district's continued attractiveness to commuters relocating from Chicago's inner-ring suburbs.

Revenue Framework

General fund revenues are split almost evenly between local property taxes (42%) and state aid (50%) as of fiscal 2015. Over time, state aid has become the larger source of revenue as local home values and AV declined and the district reached the limits of its taxing capacity across its major funds due to the tax rate caps in place on each fund. At the same time, general state aid grew rapidly in tandem with enrollments. As recently as fiscal 2012, property taxes contributed 54% of general fund revenues and state aid was 36%. A portion of moneys classified as state aid are on-behalf payments to the Illinois Teachers Retirement Fund (TRF) that Illinois makes on behalf of the district. Recording these moneys in the general fund is an accounting convention, as the funds are not available to the district.

Revenues are positioned to continue growing at a rapid clip in light of continued enrollment growth in the district since 2010. The district's 2000-2010 building program was designed to allow for significant future enrollment growth. As a result, the district has capacity for an additional 4,800 students. Fiscal 2016 enrollment was 18,250, up from about 16,700 in 2012. Fitch calculates an adjusted 10-year general fund CAGR of 8.8% for the 2004-2014 period - a level well above the rate of U.S. GDP expansion for the same period. The rate of revenue growth is likely to slow somewhat as the pace of enrollment growth levels off, but Fitch expects the district's rate of revenue expansion to remain above U.S. GDP as state aid receipts increase to keep pace with enrollments, and as rebounding AVs create an opportunity for the district to generate new property tax revenues.

The district is subject to Illinois' Property Tax Extension Limitation Law (PTELL), which limits growth in school districts' annual property tax levy to the lesser of U.S. CPI, or 5%, but allowing for natural AV growth generated due to new construction. The district also has tax rate caps in place for all but one of its major operating funds, including the Education, Operations & Maintenance, Working Cash and Special Education fund. All of the rates are presently quite close to the rate caps, so the district will have to wait for AV to rise in order to lower its tax rates and thereby increase its future taxing capacity. Fitch views the district's independent legal revenue-raising ability as constrained given the multiple levels of restrictions in place that limit its power to generate new recurring revenues.

Expenditure Framework

Academic instruction, including staff salary and benefits, accounted for 75% of general fund expenditures, and 49% of total expenditures, in fiscal 2015. Debt service comprised 19% of total governmental fund expenditures in the same year.

Fitch expects the natural rate of spending growth to be in line with, to slightly above, the underlying rate of revenue growth absent policy actions, due largely to the district's robust revenue growth history and management's expectation of increased state aid transfers to cover the cost of rising enrollments. General state aid has been rising at well above the level of inflation, whereas the dstrict's largest cost centers are growing at, or close to, U.S. CPI. Under the terms of the most recent labor contracts with its four bargaining units, the district awarded teachers 2.75% to 3% pay raises that included annual step increases, while custodians received 1.5%, transportation staff 1.75%, and support staff (which includes secretaries and teaching assistants) raises in the 2% to 2.75% range. The teachers' contract goes out to June 2019 and the support staff contract terminates in June 2020.

The district will absorb a sizable near-term cost increase connected to the dissolution of the Kendall County Special Education Cooperative (Co-op), which became official on June 30, 2016. Previously, the district had contracted with the Co-op to service the needs of special education students. Beginning in fiscal 2017 - the current fiscal year - the district will handle special education programs in-house; staff levels are increasing 18% due to the district hiring most former Co-op employees. Management believes that it can provide the same services at a lower cost. Special education is largely state-funded in Illinois. The district has some special education taxing capacity, as the Special Ed. Fund is capped at 0.80 mills and the rate is presently set at 0.69 mills. Management's ability to handle the costs associated with the Co-op's integration while maintaining structural balance will influence future rating actions.

The district maintains a solid degree of expenditure flexibility. Fixed carrying costs for debt service, pension payments and other post-employment benefits (OPEB) trended in the 15% to 20% range between fiscals 2012 and 2015, but are expected to decline to approximately 16% per annum as a result of the district's ongoing debt restructuring initiatives. The restructuring plan focuses on lowering debt service costs for fiscal years 2017 through 2027 from an average of around $37 million per annum to $27 million per annum, thereby allowing the district to reduce property taxes levied for debt service and free up budgetary flexibility. The district's debt maturity profile is being extended by six years, which Fitch views as more consistent with the life of the assets financed.

Management has good control over headcount given that its labor contracts do not include a minimum class size provision. This leaves the district with the option of reducing staff by consolidating classes and increasing class sizes in order to close budget gaps. The current contracts do not contain re-openers, but management reports that the district and its unions have re-negotiated labor costs in the past through memoranda of understanding. Illinois' public employee labor law requires the use of interest arbitration to resolve bargaining impasses, and teachers have the right to strike in Illinois. The district's labor history has been peaceful, with no strikes or other unrest in the past 10 years.

Long-Term Liability Burden

The district's long-term liability burden is low compared to the size of its economic resource base, which is bolstered by the high personal income levels of its residents, and is further enhanced by healthy population growth. Net debt and pension liabilities equaled about 5% of aggregate personal income in 2015, well within Fitch's 'aaa' assessment range. The metric is composed almost entirely (84%) of the district's $394 million direct debt burden, including the accreted value of capital appreciation bonds (CABs). Amortization is slow, with 37% of principal amortizing in the next 10 years. This is consistent with the life of the assets financed, as many of the district's facilities are less than 10 years old.

Rather than issuing 30-year bonds for school construction, prior to the recession the district issued 20-year bonds with an aggressive debt service schedule. The current restructuring plan focuses on lengthening some maturities to ensure greater inter-generational equity and smooth out property tax bills for the families of current students. The district has limited new-money debt plans, with $12.5 million of non-referendum bonds planned for fiscal 2017 to finance technology and capital improvements.

The district participates in the Illinois Municipal Retirement Fund (IMRF), which is an agent multi-employer defined benefit pension plan, as well as in the Illinois Teachers' Retirement System (TRS), a cost-sharing multi-employer plan. The state makes most TRS contributions on behalf of the district, while the district contributes only the employees' portion of annual pension payments. The TRS plan is badly underfunded, reporting an assets-to-liabilities ratio of 43% at June 30, 2014. Using Fitch's slightly more conservative discount rate of 7% compared to the official plan rate of 7.5%, Fitch calculates an assets-to-liabilities ratio of 41% for TRS. By contrast, the IMRF had an assets-to-liabilities ratio of 88% on the same date, as calculated by Fitch.

The bulk of the district's liability is to TRS, but its overall pension liabilities are modest given that the state is responsible for the vast majority of the district's TRS liability, with the district carrying only a small portion of this liability itself. In addition, the majority of its teaching staff is still working. As the number of retirees grows over time, Fitch expects the pension liability to grow modestly.

Operating Performance

The district has maintained adequate available fund balances both during the last recession and throughout the subsequent recovery relative to the revenue declines Fitch believes could occur as the result of a moderate economic downturn (as generated by Fitch's FAST (News - Alert) (Fitch Analytical Sensitivity Tool) model). Fitch considers the district's inherent budget flexibility to be 'midrange' based on its particular combination of revenue raising constraints (held in common with other Illinois K-12 school districts) and its relatively solid control over expenditures. Fitch expects available general fund reserves (12.6% of spending at 2015 fiscal year-end) will remain above the 'aaa' reserve safety margin level Fitch estimates for the district, which is equal to approximately 5% of general fund expenditures, even at times of economic decline.

The district has made consistent efforts to align revenues with expenditures and conserve fund balances despite a limited ability to raise property tax revenue. Unpredictable special education and health insurance costs have made budgeting difficult, however, as have state aid disbursement delays and proration at the state level.

Three mild operating deficits in fiscals 2012 through 2014 coincided with the impact of AV declines on local revenues; each deficit was around 1% of general fund spending. State aid growth counterbalanced property tax stagnation to some extent. Fiscal 2015 concluded with a narrow surplus of $417k and available reserves at $21.4 million, or 12.6% of spending. A 16.9% rise in state aid to the general fund compared to fiscal 2014 positively impacted results. Higher state aid receipts were spurred mainly by a $10 million jump in the state's on-behalf payment to TRS. Other contributing factors were 3.4% enrollment growth and lower wealth measures resulting from recent AV declines. Higher state aid revenues were largely offset by higher special education and health insurance costs, which limited growth in fund balances to $417,000.

The fiscal 2016 budget assumed a healthy $2 million general fund surplus, but did not include a teacher salary increase that was negotiated during the fiscal year. Management now estimates a $4.3 million operating deficit for fiscal 2016 caused partly by the state withholding $3 million of categorical aid past fiscal year-end. The projected deficit was also driven by the aforementioned salary increases and above-budget special education costs, similar to 2015, as the district hired added special education staff in anticipation of the Co-op's dissolution. The fiscal 2017 budget includes a 2% tax levy increase based on 0.7% CPI growth and 1.3% AV growth spurred by new construction. The district is budgeting for a $5.5 million rise in general state aid.

The 2017 budget includes a $3.2 million operating deficit in the Education Fund that would reduce available reserves to $14.9 million, equal to approximately 8.5% of general fund expenditures. All but $283,207 of the deficit is balanced with budgeted surpluses in the other funds that make up the Operating Funds group. The fiscal 2017 deficit would be entirely eliminated by the receipt of $3 million in categorical aid that the state delayed in fiscal 2016; however, the budget does not assume receipt of these moneys in the present fiscal year, allowing for positive revenue variance that would generate a sizable surplus, if realized. The district's Transportation Fund, the revenues and fund balances of which are fungible with the general fund - in common with other Illinois school districts - held an estimated $7.8 million of reserves as of July 1, 2016. These reserves could be transferred to the general fund to support operations and bolster internal liquidity by a school board vote.

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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