Fitch Ratings has affirmed the following Modesto City School District, California bond rating:

--$10.6 million general obligation bonds (election of 2001) series A at 'AA-'.

The Rating is Stable.

SECURITY

The bonds are repaid from an unlimited property tax on all taxable property within the district.

KEY RATING DRIVERS

SOUND FINANCIAL PERFORMANCE: Prudent financial management during the recession and subsequent improvements to education funding have positioned the district well financially. Fitch expects the district will draw down its currently high general fund balance to more modest levels for implementation of the new common core curriculum, deferred capital spending, employee remuneration increases, and the creation of a rainy day reserve.

WEAK ECONOMY SHOWING IMPROVEMENTS: The local economy continues to demonstrate below-average socioeconomic characteristics but the unemployment rate is declining and the tax base has recovered some of the assessed value lost during the housing-led recession.

GOOD MANAGEMENT PRACTICES: The district benefits from a conservative management team that outperforms its budgets and has demonstrated its responsiveness to changing funding conditions.

MODERATE DEBT PROFILE: The district's debt burden is moderate, amortization is rapid, and there are no medium-term plans for further debt issuances. Debt, pension, and other post-employment benefit (OPEB) carrying costs are very manageable although likely to increase as CalSTRS contribution rates rise.

RATING SENSITIVITIES

The rating is sensitive to shifts in fundamental credit characteristics, including maintenance of the district's general fund balance and reserves at a level consistent with the 'AA-' rating category. The Stable Outlook reflects Fitch's expectation that such shifts are unlikely in the near term.

CREDIT PROFILE

The Modesto City School District is located in Stanislaus County in the northern San Joaquin Valley, approximately 75 miles east of the San Francisco Bay Area. As part of Modesto City Schools, the kindergarten through grade 8 elementary school district shares a common governing board, administration, and financial operations with Modesto City High School District. The elementary school district is one of eight feeding into the geographically larger high school district. The elementary school district covers 11% of the high school district's 280 square miles and 43% of its population. The elementary school district's average daily attendance in fiscal 2015 is 14,781.

Economic factors are weak as is typical for agriculturally-concentrated economies. Modesto's October 2014 unemployment rate remains elevated at 8.5%, though down from the 10.2% recorded a year prior. The improvement was due to a combination of modest employment growth and labor force contraction. Income and educational attainment characteristics are well below state and national averages.

The elementary school district's assessed valuation (AV) declined a significant 23.4% during fiscal years 2010-2012 due to the housing-led recession. Subsequently, AV has partially recovered by 13.2% through fiscal 2015 due to an increased number of residential sales and higher prices. Further AV increases could well be slow since local property developers remain cautious about embarking upon large scale new developments. The district's fiscal 2015 tax base is highly concentrated in its top taxpayer, E&J Gallo Winery, which makes up 8.5% of AV. Top 10 taxpayer concentration is moderate at 14% of AV.

SOUND FINANCIAL PERFORMANCE

The district implemented expenditure reductions sufficiently early in the economic and funding downturn that it has been able to stabilize and grow its financial cushion since fiscal 2011. Audited results for fiscal 2014 show a $1.4 million general fund net operating surplus after transfers, the fourth year in a row of positive operations. Fiscal 2014 ended with high total and unrestricted general fund balances of $76.2 million (28.3% of spending) and $58.6 million (21.8%), respectively.

The district has benefitted from a slow rebound in its student enrollment and implementation of the state's local control funding formula (LCFF) which added $25 million to its fiscal 2015 revenues. The elementary school district has a high 88% unduplicated count of targeted students who are English language learners, socioeconomically disadvantaged, and/or foster youth. Further LCFF funding increases are expected for fiscal years 2016 and 2017.

The first interim report for fiscal 2015 projects a net general fund operating deficit after transfers of $29.7 million, followed by a further $14.2 million drawdown in fiscal 2016, and breakeven operations in fiscal 2017. Management historically has well-outperformed its budgetary and 1st interim financial projections. For example, in fiscal 2014 the district outperformed its final general fund budget by $25.9 million, largely due to underexpenditures.

However, the district expects that there will be progressive general fund drawdowns, at lesser amounts than shown in the current projections, in response to common core curriculum implementation, deferred capital needs, labor cost pressures, and a new state law that could limit school districts' general fund balances in the future. Some current general fund balance is likely to be shifted to special reserves for a rainy day fund and capital spending. Fitch will monitor any such drawdowns to determine if the remaining general fund balances in conjunction with new reserves remain appropriate for the rating category.

In addition to improved general fund revenues and strong general fund liquidity, the district also retains considerable general fund expenditure flexibility, particularly in relation to the timing of capital expenditures and the number of teaching days.

GOOD MANAGEMENT PRACTICES

The district has adhered to sound management practices, including the use of very conservative budgeting, ongoing maintenance of solid fund balances, and years of expenditure reductions during the recession. However, the school board does not have policies that are stronger than state requirements. The district has improved relations with its bargaining units, particularly since the restoration of labor concessions in fiscal years 2014 and 2015. Positively, the fiscal 2015 labor contracts were agreed prior to the beginning of that fiscal year.

The district is subject to AB1200 financial reporting procedures, as are all California school 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.

MODERATE DEBT PROFILE

The elementary school district's debt profile is moderate, as is estimated overall debt at $1,792 per capita (3.4% of AV). Principal amortization is rapid at 82.8% in 10 years, declining to a still rapid 75% when the capital appreciation bonds' accreted interest is taken into account. All of the debt is fixed rate.

The district has embarked upon a comprehensive facilities master planning process to determine its future needs relative to aging facilities and maintenance that was deferred during the recession. Beginning in fiscal 2014, the school board has agreed to set aside $5 million annually for pay-as-you-go capital funding. There is currently no intention to issue new bonds in the medium term.

The district continues to make 100% of its annually required pension contributions to both CalPERS and CalSTRS. Due to CalSTRS' currently weak funded ratio, it is anticipated that the district's annually required contribution rates will grow significantly over the next few years. The district calculates increased costs of $13.3 million during fiscal years 2015-2017.

The district funds its annual OPEB obligations on a pay-as-you-go basis (33.5% of the actuarially determined annual contribution in fiscal 2014). However, its unfunded actuarial accrued liability was a manageable $47.6 million, or approximately 0.3% of the high school district's larger AV, as of July 1, 2012 (the most recent calculation).

Cumulatively, the district's annual debt repayment, required pension contribution, and OPEB pay-as-you-go carrying costs were very affordable at 9.5% of total governmental expenditures in fiscal 2014.

Additional information is available at 'www.fitchratings.com'.

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

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

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=975175

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