Fitch Rates Duke University Health System's (NC) Series 2016D Bonds 'AA'; Outlook Stable

CHICAGO--()--Fitch Ratings has assigned a 'AA' rating to the following bonds expected to be issued by the North Carolina Medical Care Commission (the Commission) on behalf of Duke University Health System (DUHS):

--$121,975,000 health care facilities revenue refunding bonds series 2016D.

Additionally, Fitch has affirmed the 'AA' rating on approximately $567 million of revenue bonds issued by the Commission on behalf of DUHS.

The series 2016D bonds will be issued as tax-exempt fixed-rate bonds. Bond proceeds will be used to advance refund the series 2010A bonds and pay costs of issuance. Pro forma maximum annual debt service (MADS) is expected to equal $79.4 million. The bonds are expected to price the week of August 1 through negotiation.

The Rating Outlook is Stable.

SECURITY

Debt payments are unsecured, general obligations of the obligated group.

KEY RATING DRIVERS

ROBUST OPERATING PROFITABILITY: Operating profitability has been extremely strong with operating EBITDA equal to 17.8% in fiscal 2015 and 16.4% in the nine-month interim period ending March 31, 2016 (the interim period), easily exceeding Fitch's 'AA' category median of 11.5%.

MANAGEABLE DEBT BURDEN: The system's manageable pro forma debt burden, with pro forma MADS equal to 2.6% of fiscal 2015 operating revenues, and robust cash flow produced strong MADS coverage by EBITDA of 8.1x in fiscal 2015 and 7.4x in the interim period.

STRONG LIQUIDITY POSITION: Unrestricted liquidity remains strong with 385.9 days cash on hand, 35.7x cushion ratio and 239% cash-to-debt at March 31, 2016. With a planned transfer of $510 million to Duke University in fiscal 2017, projected liquidity metrics remain favorable compared to Fitch's 'AA' category medians.

LEADING CLINICAL REPUTATION: DUHS maintains a strong national reputation and an academic affiliation with Duke University School of Medicine, one of the nation's leading medical schools.

RATING SENSITIVITIES

CREDIT PROFILE MAINTAINED: Fitch expects that Duke University Health System's cash flow will be sufficient to offset both the planned fund transfer to Duke University in fiscal 2017 and potential capital plans without materially impacting the system's overall credit profile.

CREDIT PROFILE

DUHS is a large integrated delivery system, based in Durham, NC, with total operating revenues of $3.1 billion in fiscal 2015. Operations include three hospitals, home care and hospice services, a large primary care practice and ambulatory care centers. Fitch's analysis is based upon DUHS' consolidated financial statements. The credit group accounted for 94% of total consolidated operating revenues and 95% of consolidated total assets in fiscal 2015.

ROBUST OPERATING PROFITABILITY

The system achieved record operating profitability in fiscal 2015 with operating and operating EBITDA margin equal to 11.6% and 17.8%, respectively. Profitability has been consistently strong with operating EBITDA averaging a robust 14.2% since fiscal 2009, exceeding Fitch's 'AA' category median of 11.5%. The strong operating profitability continued in the interim period, with operating EBITDA equal to 16.4%. The robust operating profitability reflects continued cost management initiatives, increased volumes, strengthened acuity, enhanced collection processes and clinical documentation improvements.

Management has been consistently focused on operating improvement initiatives since 2008, achieving approximately $160 million in annual operating improvements through fiscal 2013. DUHS' latest operating improvement initiative targets an additional $200 million in annual improvements. Major focus areas include care redesign, clinical operations, supply chain and revenue cycle.

The North Carolina Medicaid program is currently undergoing a transition that may impact DSH funding. DUHS received an average of $78 million per year of net Medicaid DSH funding in fiscal years 2013 through 2015.

MANAGEABLE DEBT BURDEN

The system's pro forma debt burden remains manageable with pro forma MADS equal to 2.6% of fiscal 2015 operating revenue relative to Fitch's 'AA' category median of 2.4%. The manageable debt burden combined with the system's robust profitability produced strong MADS coverage by EBITDA equal to 8.1x in fiscal 2015 and 7.4x in the interim period, easily exceeding Fitch's 'AA' category median of 5.7x.

STRONG LIQUIDITY POSITION

Liquidity metrics remain strong despite $229 million in academic support cash transfers to Duke University in fiscal 2015 (see below) and unrealized investment losses in fiscal 2015 and the interim period. With $2.8 billion of unrestricted cash and investments at March 31, 2016, liquidity metrics are strong across the board with 385.9 days cash on hand, 35.7x cushion ratio and 239% cash-to-debt, exceeding Fitch's 'AA' category medians of 289.4 days, 27x and 201.7%.

Capital spending may increase in fiscal years 2017 to 2020 as the system addresses potential capacity constraints due to strong volume growth. However, capital plans are preliminary. If the projects are pursued, DUHS may issue additional debt over the next two years. Fitch will assess the impact of additional debt, if any, upon DUHS' overall credit profile as more details become available.

DUHS provides academic support to Duke University and the School of Medicine. Total unrestricted transfers equaled $231 million and $69 million in fiscal years 2015 and 2014, respectively. The 2015 transfer included a one-time transfer of $150 million to the School of Medicine to support research and development. Additionally, DUHS plans to complete a transfer of $510 million to the university on July 1, 2016 to fund future support. Projected liquidity metrics remain favorable to Fitch's 'AA' category medians after inclusion of the increased academic support.

LEADING CLINICAL REPUTATION

The system's strong clinical reputation and academic affiliation with one of the nation's leading medical schools are additional credit strengths. Duke University Hospital, DUHS' flagship facility, has consistently been ranked as one of the top hospitals in the nation for over a decade. The strong clinical reputation is supported by the high acuity of services provided at Duke University Hospital, with a high Medicare case mix index of 2.3 in fiscal 2015, and is bolstered by DUHS' solid market share in its primary service area. Additionally, Duke University Hospital is the principal teaching affiliate of Duke University School of Medicine, which is consistently recognized as one of the nation's top medical schools.

DEBT PROFILE

DUHS had approximately $1.2 billion of total debt outstanding at March 31, 2016. The series 2016D bond transaction is a refunding and will not materially affect total debt levels. The debt portfolio consists of 56% underlying fixed-rate bonds and 44% underlying variable-rate bonds. The variable-rate bonds are directly placed with five banks. The direct placement covenants are substantially similar to those contained in the master trust indenture. DUHS is counterparty to a basis swap and three fixed payor swaps, effectively converting the variable-rate bonds to synthetic fixed rates. Variable-rate exposure will increase over time starting in 2017 given the amortization schedules. DUHS had $23.7 million of collateral posted related to the swaps at March 31, 2016.

DISCLOSURE

DUHS covenants to provide annual disclosure within 180 days of each fiscal year end and quarterly disclosure within 60 days of each fiscal quarter end. Disclosure is provided through the Municipal Securities Rulemaking Board's EMMA system.

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

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Nonprofit Hospitals and Health Systems Rating Criteria (pub. 09 Jun 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=866807

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1009289

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1009289

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst
Adam Kates
Director
+1-312-368-3180
Fitch Ratings, Inc.
70 West Madison St.
Chicago, IL 60602
or
Secondary Analyst
Eva Thein
Senior Director
+1-212-908-0674
or
Committee Chairperson
James LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Adam Kates
Director
+1-312-368-3180
Fitch Ratings, Inc.
70 West Madison St.
Chicago, IL 60602
or
Secondary Analyst
Eva Thein
Senior Director
+1-212-908-0674
or
Committee Chairperson
James LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations:
Elizabeth Fogerty, New York, +1 212-908-0526
Email: elizabeth.fogerty@fitchratings.com