As of Nov. 4, 2019, S&P Global Ratings maintains 22 ratings on Arizona charter schools. In 1994, Arizona became the 11th state in the nation to enact a charter school law, and today there are about 550 charter schools in the state serving more than 200,000 students, or approximately 17% of the state's K-12 public school students. Only 23% of our Arizona charter school ratings are investment grade compared with 44% for the sector as a whole and the lowest rating maintained is 'B+'. We believe the weaker rating distribution primarily stems from the lighter financial operations associated with the robust growth of charter schools and networks in the Maricopa County area (where 86% of our rated charter schools are located), in which we see student enrollment increasing rapidly at newer campuses with minimal operating histories. Despite strong demand and a favorable charter school environment, we believe this rapid growth can lead to volatility in the operating profiles of schools, and a relatively higher debt burden, which is reflected in the weaker financial metrics.

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We view Arizona as a generally charter friendly state and despite some recent developments, it has experienced some of the strongest charter school enrollment growth in the nation. The Republican governor was re-elected in 2018 and the legislature remains Republican-led. The governor supports charter schools and voucher programs, but has discussed backing charter school reforms, based on increased transparency and accountability. The state authorizer's new financial framework, which was recently adopted in July 2019 and is being rolled out in fiscal 2020, is a testament to this commitment. In addition, voters rejected a ballot initiative that would have allowed a modest school choice program to expand. Arizona's state superintendent of public instruction-elect is a Democrat succeeding a Republican. She was a speech therapist who worked in school districts, and during the campaign, she emphasized her time in the classroom and her goal to make charter schools more accountable. We will monitor any future legislative initiatives for potential credit implications.

Arizona does not have a cap on public charter school growth, and compared to other states, Arizona has relatively longer charter terms, with a 15-year initial term and renewal contracts of up to 20 years. Authorizers are still required to review schools at five-year intervals. In 2018, Arizona allowed qualifying public schools or charter schools to obtain favorable financing through the state's public school credit enhancement program. Unlike states such as Colorado, Texas, and Utah, which stipulate a minimum rating threshold before acceptance into the program, this program accepts any qualifying achievement district school (public district or charter school) designated an 'A' rated school. Ultimately, the state's enhancement program must have at least 75% of schools rated 'BB-' or higher. Schools that qualify for the enhancement program carry the state's program rating (AA-). For more information, please see our analysis on the Arizona Public School Credit Enhancement Program, published May, 5, 2017, on RatingsDirect.

Authorizer Framework

• There are three authorizing options for charter schools in Arizona. Applicants can go through the state board of education, the ASBCS, or a higher education institution, such as a university under the jurisdiction of the Arizona board of regents, or a community college district. The ASBCS is the state's largest independent authorizer and oversees more than 500 public charter schools throughout the state. Currently, the state board of education has a self-imposed moratorium on charter authorizing, so the ASBCS oversees all schools approved by both state boards.
• The ASBCS was created through legislation in 1994 to grant charter status to qualifying applicants and to oversee public charter schools. All of our rated charter schools in the state are authorized by the ASBCS. In our view, the prevalence of non-school district authorizers eliminates the inherent conflict of interest that is typical when local school districts serve as authorizers and compete for students and funding.
• Arizona charter schools are authorized initially for a 15-year term, and state law dictates the maximum length of renewal contracts to 20 years. The state board of education may approve any charter schools transferring charters, which we view favorably, as it provides flexibility for schools.
• Arizona charter law provides general guidance on the process for authorization, renewal, revocation and appeals. However, this policy and the approval criteria do not apply uniformly to all authorizers. For example, the statewide authorizer process established by the ASBCS provides a standardized application and review process, and details its approval criteria; however, this does not similarly apply to higher educational institution authorizers. The law requires charter sponsors to review a charter school at five-year intervals using performance framework adopted by the sponsor. This includes an academic performance expectation, operational performance expectation, and financial performance expectation set forth in the performance framework.
• The ASBCS' new financial framework focuses on various financial metrics to ensure the charter holder's ability to continue operating. A performance rating will be assigned for schools consisting of: "Meets Standard", "Approaches Standard", and "Below Standard". These individual measures then roll up to an overall performance rating of "Good Standing", "Adequate Standing", or "Intervention". A charter holder is placed on "Intervention" if the school has one or more measures rated "Below Standard". A charter school that falls into the "Intervention" category is subject to the financial intervention process, which provides the board the ability to revoke or terminate contracts if the school does not demonstrate improved performance. We view the changes positively, as previously the ASBCS did not have the authority to close a school based on financial performance, however it was given the statutory authority in the 2018 legislative session. The new framework is expected to improve financial transparency and oversight. Initial feedback from our rated universe is that the new framework won't cause much (if any) impact in terms of additional costs for rated charter schools. These charter schools already track many of the financial metrics newly mandated by the ASBCS and are required to adhere to a majority of them as stipulated in bond covenants. We understand the board does not expect to make any non-renewal or revocation decisions based on financial performance until a charter holder's fiscal 2020 audit has been reviewed in fiscal 2021.

Credit Fundamentals

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The majority (59%, or 13) of our rated schools are networks with multiple campuses, while the rest are stand-alone operators. Given the good growth in the school-age population that supports demand for educational services, many of the charter schools we rate continue to expand at a rapid pace, but have incurred substantial debt to finance this growth. Generally, median ratios for our Arizona charter schools lag those of schools in other states and across the sector, reflecting the aforementioned growth risk. We note that despite average financial metrics that are weaker compared to national medians, there are five higher-rated Arizona charter school ratings at the 'BBB-' and 'BBB' rating levels. These schools stand out, primarily given their longer operating histories and consistent track record of sound financial performance, which help to mitigate the school's relatively smaller enrollment base.

What we're watching

Growing state economy supports per pupil funding.   According to data from the U.S. Bureau of Economic Analysis, Arizona's 2018 real gross domestic product growth rate was the fourth-highest in the nation. Healthy non-farm employment growth across diverse sectors is projected to continue for the foreseeable future, as the state expands its manufacturing and professional services sectors, in addition to construction, due to its relatively low costs and growing workforce. In our view, this is likely to support additional education funding increases for the K-12 sector, including charter schools. Per-pupil funding has risen over the past few years; it increased by 4.4% in fiscal 2019 and is increasing by a similar amount in fiscal 2020, which we view favorably.

Disparity in funding.   Unlike Arizona's traditional public schools, charter schools are not funded by local property taxes--local bonds and overrides--even if their students reside in a district that has passed a property tax levy. Also, charter schools do not receive state funding for capital or some types of maintenance and operations costs. Per pupil funding for Arizona charter schools is calculated according to a similar formula used to calculate funding for traditional public schools. This includes all funds (federal, state, and local), yet disparity in per pupil funding levels between traditional public schools and charter schools persists, with charter schools receiving an average of approximately $1,000 per student less compared with traditional public schools based on data from the fiscal 2018 joint legislative budget committee.

Healthy demographics.   The state's population growth has strengthened due to net migration from other states given increased job prospects, affordable housing prices, and a favorable climate. Even during the downturn, the state's population growth remained above that of the U.S., and continues to outpace the nation on a one-, five-, and 10-year basis. The state ranked fourth for population growth between July 2017 and July 2018, with a growth rate of 1.7%. Maricopa County, where 86% of our rated charter schools are located, is among the top 10 most populous counties in the nation and saw the second-largest growth in population between 2010 and 2018. The county's minor school-age population is extremely strong at about 1.5 million, with projections indicating a five-year growth rate of 1.2% through 2024. We expect favorable demographics to support enrollment growth at rated charter schools with solid student demand, although there could be some signs of slowing growth attributed to an aging population and some competition among charter schools and district schools

Teacher shortage.   The state has a massive teacher shortage demonstrated by high vacancies and unfilled positions largely due to low pay. To resolve demands for a teacher pay raise from teachers in mid-2018, the state's fiscal 2019 budget included $272 million to fund salary increases, leading to an 11.3% ($478 million) increase in total education funding in 2019. The state anticipates additional education funding increases of $388 million and $385 million in fiscal years 2020 and 2021, respectively. The governor's plan reiterates his commitment to raise teacher salaries by 20% by 2020. The plan includes a 10% teacher salary increase (over fiscal 2018 levels) given in the fiscal 2019 state funding, a 5% increase (over fiscal 2019 levels) given in fiscal 2020 state funding, and the final 5% increase (over fiscal 2020 levels) in the fiscal 2021 state funding. The funding for charter school teacher raises is factored into the base-level school funding formula. In our view, a shortage of skilled teachers could impair academic outcomes for charter schools that we rate. Increased competition for teachers and the potential financial implications could also pose a credit risk.