Fitch Upgrades Mendocino County, CA's POBs to 'A'; Outlook Stable

Fitch Ratings has upgraded the following Mendocino County, CA (the county) ratings:

--$72.245 million pension obligation refunding bonds (POBs), series 2002 to 'A' from 'BBB+';

--Implied general obligation rating to 'A+' from 'A-'.

The Rating Outlook is revised to Stable from Positive.

SECURITY

The POBs are an absolute and unconditional obligation of the county imposed by law, the payment of which is not limited to any special source of funds.

KEY RATING DRIVERS

CONTINUED FINANCIAL IMPROVEMENT: The upgrade reflects improvements in the county's financial position following substantial expenditure reductions and management reforms over the last several years.

LIMITED ECONOMY: The county continues to face challenges from a long-term economic contraction that preceded the recent downturn. After falling for many years, employment levels increased modestly in the past two years while population has stagnated. In addition, wealth and income levels remain well below state and national averages.

MANAGEMENT REFORMS: The county continues to make notable progress in addressing weaknesses previously cited by Fitch. Management has raised fund balance targets and established policies to help meet these new goals, updated treasury practices, and produced its first capital improvement plan in seven years.

MODERATE DEBT; ELEVATED PENSIONS: Overall debt levels are moderate and expected to remains so given no additional planned borrowing in the intermediate term. Pension funding requirements are considerable and rising, though total carrying costs are manageable.

RATING SENSITIVITIES

LIMITED REVENUE FLEXIBILITY/ECONOMY: The rating is likely limited to the current level due to the county's constrained revenue raising ability coupled with the inherent limitations of its economic base.

CREDIT PROFILE

Mendocino County is located in northern California, along the Pacific coast, approximately 115 miles north of San Francisco. The county's estimated population of 90,000 is little changed from the 1990s and is dispersed across 3,500 square miles - a land area larger than several states.

FINANCIAL IMPROVEMENT CONTINUES

The county ended fiscal 2013 with a third consecutive year of strong general fund operating results. The operating surplus after transfers for 2013 equaled 5.1% of general fund spending, raising the unrestricted fund balance to 14% of spending ($18.7 million) from 9.4% ($12.4 million) the prior year. Year-end cash balances also rose substantially for the third consecutive year, from just $14,000 in fiscal 2010 to $27 million in 2013. As such, the ratio of cash to liabilities, less deferred revenue, stood at a healthy 7.0x.

The county's strong performance follows substantial expenditure reductions over the past several years, primarily through workforce and payroll reductions. Workforce reductions eliminated approximately one-fourth of the county's full-time employees over the past five years, while remaining employees have seen permanent wage cuts of 10% to 12.5%. The county anticipates additional modest contraction of its workforce over time through attrition. In addition, the county has eliminated other post-employment benefits (OPEB) for current and retired employees.

Management projects further, albeit smaller, additions to fund balance in fiscal 2014 and going forward, which Fitch considers reasonable given prior year expenditure reductions and revenue improvements through mid-year.

LIMITED ECONOMY

The county continues to face a long-term economic contraction that dates from the late 1990s. Population growth has been very slow over this period and employment levels dropped steadily before increasing modestly in 2012 and 2013. Tourism and wine production have provided some opportunities for growth, but overall employment and labor force levels fell by about 6% and 4%, respectively, over the past decade.

Unemployment rates for the county, which have generally been slightly higher than statewide averages, declined to 7.1% as of October 2013 based on a large decline in labor force participation and a smaller employment loss. Income and wealth indicators are weak at 72% to 84% of state and national averages.

Taxable assessed valuation (TAV) was relatively unaffected by the national housing boom and has been insulated from subsequent declines. TAV dropped by just 2.2% between 2010 and 2013 after many years of steady increases, and resumed growth (1.3%) in fiscal 2014. The local housing market is showing signs of recovery with November 2013 home values gaining 11.7% year over year though still down 36% from its peak, as reported by Zillow.

POSITIVE MANAGEMENT REFORMS

The county has made notable progress in addressing management weaknesses cited in prior rating reviews. The county adopted a general fund reserve policy in 2012 that increases targets for its stabilization, counter-cyclical and emergency reserves from a cumulative 2% to 6.35% of general fund expenditures, or a minimum of $10 million. The new policy also provided a mechanism for incremental additions to reserves until targeted levels are reached. Management expects to reach the reserve level this fiscal year or next.

The county also made substantial revisions to its investment practices in 2012, diversifying investment categories, increasing credit quality, and reducing maturities in general. These actions appear likely to improve the county's ability to meet its chief investment goal of principal protection, and to better serve its cash management needs.

The county recently adopted a five-year capital plan through fiscal 2017 after having been without one since 2006. The county faces a large backlog of capital projects due to spending deferrals during the recent downturn through fiscal 2013. The largest cost of the $37.7 million CIP is a remodel or replacement of the county jail at $21 million. The county's application for a $20 million state grant was recently denied and it plans to apply for future grants, as the facility currently has sufficient capacity. Fitch views renewed efforts to identify and prioritize capital needs as a positive development.

MODERATE DEBT; ELEVATED PENSION COSTS

Overall debt levels are moderate at $3,130 per capita or 2.8% of TAV. Amortization of direct debt is average with 60% of outstanding principle retired in 10 years. Management has no current plans for debt issuance. In addition, fiscal 2014 was the first year it did not require short-term cash flow borrowing, due to its improved financial position. Amounts borrowed for such purposes had declined by nearly one-third in fiscal 2013, providing further evidence of strengthened operations.

As of June 30, 2012, the Mendocino County Employees' Retirement Association had a funded ratio of 74%, or 67% under Fitch's alternate investment assumption of 7% returns. County contributions have increased by 86% over the past five years, largely due to lower than expected investment results.

Total pension costs, including POB debt service and pension contributions, have accounted for a growing share of governmental spending in recent years. Pension costs represented 4.5% of governmental expenditures in fiscal 2010 rising to 8.5% in 2013. As overall governmental spending has declined (due largely to workforce and payroll reductions), such fixed costs have increased as a share of remaining expenditures.

Total carrying costs for pensions, other post-employment benefits (OPEBs), and debt service were a moderate 15.7% of governmental expenditures in fiscal 2013, as compared to 11.8% in fiscal 2011. The county began a phased elimination of OPEBs in 2010 and had a minimal remaining liability of $686,000 at fiscal year-end 2013.

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.

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=816655

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