[February 05, 2014]

Fitch Downgrades University of California General Rev Bonds to 'AA'; Outlook Stable

Fitch Ratings downgrades its long-term rating on the Regents of the University of California's (UC) general revenue bonds (GRBs) to 'AA' from 'AA+'. At the same time, Fitch downgrades UC's limited project revenue bonds (LPRBs) and medical center pooled revenue bonds (MCPRBs) to 'AA-' from 'AA', and affirms its short-term 'F1+' rating as detailed at the end of this release.

The Rating Outlook is Stable.

SECURITY

GRBs are secured primarily by a broad pledge of UC's unencumbered revenues, namely gross tuition and fees, indirect cost recovery revenues, and auxiliary receipts. LPRBs are secured by a junior lien on the gross revenues of LPRB-financed projects, subordinate to debt service on GRBs. MCPRBs are a limited obligation of UC, secured by the revenues derived from the operation of its five medical centers.

KEY RATING DRIVERS

LACK OF ANTICIPATED PROGRESS: The downgrade reflects UC's slower than anticipated progress towards stabilizing its operating performance. The university's operating margin (on a full accrual basis) remained negative in fiscal 2013, falling slightly to negative 8.9% from negative 8.4% in fiscal 2012; its sixth consecutive year of an operating deficit. Fitch had anticipated improvement in fiscal 2013 over fiscal 2012 results.

EXCEPTIONAL REPUTATION: The rating continues to be underpinned by UC's strong reputation for academics, research and medical care that continues to promote consistently strong student demand and selective admissions, and growing patient volumes. On the academic side, this is despite considerable increases in student charges over the past several years, although a tuition freeze has been in effect for the past two years.

SOLID FINANCIAL CUSHION: Substantial balance sheet resources, diverse revenues, and a manageable debt burden despite an increase in financial leverage over the past decade, partially offset UC's negative operating results, significant pension and retiree health benefit liabilities, and substantial capital needs.

STABILIZING STATE FUNDING: Following several years of cuts, slightly improved funding in fiscal 2014 should provide a level of stability to UC's operating budget over the near term. Partly offsetting the steep decline in funding over the past few years is the university's limited reliance on the state for operating support and the timely measures taken by UC's seasoned management team during times of state fiscal stress.

RESOURCE SUFFICIENCY: The 'F1+' rating is based on UC's ability to cover the maximum potential liquidity demands presented by its variable-rate debt programs by at least 1.25x from internal resources, including cash and highly liquid, highly rated investments.

RATING SENSITIVITIES

MARGIN IMPROVEMENT: Rating stability is predicated on UC's ability to stem operating losses, with annual improvement towards returning to a near-breakeven level of performance. The Stable Outlook assumes that operating improvement will be evidenced in fiscal 2014, supported by the implementation of various university initiatives to control expenses and the state's improved fiscal position.

BALANCE SHEET PRESERVATION: Fitch expects UC to maintain balance sheet liquidity at or near current levels, which is particularly important given its sizeable future capital needs, portions of which will likely continue to be debt-financed.

CREDIT PROFILE

Chartered in 1868, UC is a comprehensive graduate research university with 10 campuses located in Berkeley, Davis, Irvine, Los Angeles, Merced, Riverside, San Diego, Santa Barbara, Santa Cruz, and a graduate campus in San Francisco for health sciences. It also operates five academic medical centers, four law schools, and a 135,000-acre statewide agricultural and natural resources division. UC's exceptional reputation is the basis for its strong demand and selective admissions. Fiscal 2013 enrollment totaled 238,156 students. Applications continue to grow, with more than 183,000 applicants applying to UC campuses for the fall 2014 term, up almost 5% from the prior fall term. The university's overall acceptance rate remains fairly selective at about 59% for fiscal 2013.

Slower than Anticipated Operating Improvement

UC's operating margin slipped slightly in fiscal 2013 to negative 8.9% from negative 8.4% in fiscal 2012, the university's sixth consecutive year with an operating deficit (on a full accrual basis). Fitch had expected operating improvement in fiscal 2013 as was noted in prior rating reports. The systemic mismatch between revenue and expenses and lack of expected progress towards margin improvement are the primary drivers of the rating downgrade.

The Stable Rating Outlook reflects Fitch expectation of marginal operating improvment for fiscal 2014 and beyond, based on the improved state funding environment and modest enrollment growth, coupled with past tuition increases, and positive fiscal impact expected to be realized through various cost-saving initiatives. Fitch also views positively the strong emphasis on system-wide cost containment and budgetary initiatives that UC's new president, Janet Napolitano, has implemented. While she has only been in office since fall 2013, these timely actions should serve UC well following several very challenging years for the university. These initiatives are in addition to various other programs implemented by UC to curtail expense growth and boost revenues via improved efficiencies across the system's 10 campuses.

Financial Cushion Continues to Offset Operating Performance

Fitch believes UC's financial cushion supports the 'AA' rating. Available funds (cash and investments less nonexpendable restricted net assets) grew to a substantial $18 billion as of June 30, 2013. Available funds covered fiscal 2013 operating expenses ($27.3 billion) and debt (about $17.3 billion) by a solid 66% and 104%, respectively. Debt includes revenue bonds, commercial paper (CP), bank loans, capital leases, and non-cancellable operating leases. These liquidity metrics continue to reflect a solid financial cushion, and while comparable to Fitch's 'AA' category medians for public universities, they are below those of other institutions rated 'AA+' by Fitch. Fitch considers these liquidity metrics, when coupled with UC's consistently negative operating margin, inconsistent with an 'AA+' rating.

UC benefits from a diverse revenue base, a credit factor Fitch views favorably. Its largest funding sources include revenues derived from the operation of its medical centers (29.7% of fiscal 2013 operating revenues), grants and contracts generated by its substantial sponsored research activities (21.7%), and student-generated revenues, including tuition, fees, and auxiliary receipts (18.7%). State appropriations still represent a notable sum ($2.37 billion in fiscal 2013) although as a percent of revenues represented just 9.4%, compared to 16% in fiscal 2008.

UC does not prepare interim financial statements on a university-wide basis, making it difficult to predict fiscal 2014 results. However, the medical centers produce quarterly financial statements and continue to perform well, which provides a level of stability as they are UC's largest revenue stream.

Following several years of significant cuts, state appropriations to UC have stabilized and slightly increased for fiscal years 2013 and 2014. Fitch rates California GOs 'A' with a Stable Outlook. Fitch views the additional funding positively, although this is somewhat offset as UC did not raise tuition for 2013-2014. This was the second year of flat student charges, and the first year of the governor's proposed four-year tuition freeze.

Complex, Yet Manageable Capital Structure

UC's debt obligations have grown in recent years, but its debt burden remains manageable. Total pro forma maximum annual debt service (MADS) occurs in fiscal 2019 at roughly $1.2 billion, including UC's $286.5 million of 2013 series AH put bonds that it intends to remarket in fiscal 2019. MADS consumed a moderate 4.8% of fiscal 2013 operating revenues of $25 billion.

Fitch notes that GRBs, LPRBs and MCPRBs are each secured by separate, designated revenue streams. General revenues securing GRBs totaled a substantial $10.1 billion in fiscal 2013 compared to GRB pro forma MADS of roughly $876 million. Adjusting for the 2013 series AH put bonds, GRB average annual debt service is a more manageable $417.4 million.

Based on its large size and operating scope, UC has significant future capital needs, portions of which will likely continue to be debt-financed, including a potential issuance later this fiscal year. Due to its moderate debt burden and solid balance sheet cushion, Fitch believes UC has some debt capacity at the current rating. However, additional leverage, coupled with a lack of measurable operating improvement could further stress the university's operations.

Fitch downgrades the following ratings:

--$7.52 billion GRBs to 'AA' from 'AA+';

--$3.3 million GRBs 2011 series W (taxable Clean Renewable Energy Bonds) to 'AA' from 'AA+';

--$48.7 million California Statewide Communities Authority, Recovery Zone Economic Development Bonds (UC Merced Student Housing Phase 4) 2010 series A to 'AA' from 'AA+';

--$500 million GRBs 2011 series Y (taxable floating-rate notes) to 'AA/F1+' from 'AA+/F1+';

--$150 million GRBs 2011 series Z (taxable variable-rate demand bonds) to 'AA/F1+' from 'AA+/F1+';

--$286.5 million GRBs 2013 series AH (taxable fixed-rate notes, six-year put) to 'AA' from 'AA+';

--$600 million GRBs 2013 series AL (variable-rate demand bonds) to 'AA/F1+' from 'AA+/F1+';

--$600 million GRBs 2013 series AK (put structure) to 'AA' from 'AA+';

--$1.99 billion LPRBs to 'AA-' from 'AA';

--$2.82 billion MCPRBs to 'AA-' from 'AA';

--$2 billion taxable and tax-exempt CP program affirmed at 'F1+'.

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

Applicable Criteria and Related Research:

'U.S. College and University Rating Criteria' (May 10, 2013);

'Rating U.S. Public Finance Short-Term Debt' (December 9, 2013);

'Fitch Rates $300MM California GOs 'A'; Outlook Stable' (October 25, 2013);

'University of California' (September 16, 2013).

Applicable Criteria and Related Research:

University of California

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=644331

Rating U.S. Public Finance Short-Term Debt

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724680

U.S. College and University Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=708049

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=819697

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