OREANDA-NEWS. Fitch Ratings assigns a 'BBB-' rating to approximately $29 million of series 2016A bonds issued by the Educational Building Authority of the City of Montgomery on behalf of Faulkner University (Faulkner). The bonds are expected to be sold via negotiation during the week of Aug. 1.

The Rating Outlook is Stable.

Proceeds from the series 2016A bonds will refund Faulkner's series 2007 and series 2011 bonds, provide $4 million in funding for a new 88-bed housing project, and pay issuance costs.

SECURITY

The bonds are secured by pledged revenues, auxiliary revenues, and legally-available funds of Faulkner. Pledged revenues include all tuition, fees, receipts, revenues, rentals, income (including investment income), and other moneys received from any source, including all operating and non-operating revenues. In addition, the bonds will have a fully cash-funded debt service reserve fund (DSRF) sized at the lesser of maximum annual debt service (MADS), 125% of average annual debt service (AADS), or 10% of par value. Further, the bonds will have a mortgage on the main campus in Montgomery, Alabama.

KEY RATING DRIVERS

'BBB-' RATING CHARACTERISTICS: Faulkner University's 'BBB-' rating reflects this mission-driven institution's niche market with relatively stable demand levels, an experienced management team, adequate financial cushion for the category, and sound leverage position. Counterbalancing factors include inconsistent operations that are highly reliant on student-generated revenues.

FLUCTUATING DEMAND: Faulkner's mission and various program offerings have attracted a diverse student body. Although undergraduate demand has fluctuated over the past three years, the university remains proactive with enrollment management, which should result in growth in the fall 2016 freshman class. Graduate enrollment has continued to grow steadily.

INCONSISTENT OPERATIONS: Faulkner has had a track record of operating margins that have ranged from +13.8% (fiscal 2011) to -8.2% (fiscal 2014). Fiscal 2016 is projected to result in a deficit (although better results than in fiscal 2014) due to ongoing payments with a terminated consulting contract; and, Faulkner will likely generate at least balanced operations in fiscal 2017 and a surplus in fiscal 2018.

SLIM FINANCIAL CUSHION: The university's liquidity, when compared to operating expenses and pro forma debt, are light for the 'BBB-' rating level; and, unaudited results for fiscal 2016 indicate a weakening of balance sheet resources from the prior year.

SOUND LEVERAGE: Faulkner's debt coverage metrics are in line with rating-category peers. The university's conservative capital planning with level debt service and lack of additional debt plans are viewed positively.

RATING SENSITIVITIES

BALANCE SHEET RESOURCES: Declining liquidity levels for Faulkner University could negatively impact the rating. Any further weakening of its balance sheet would be viewed negatively by Fitch.

IMPROVED OPERATIONS: The current 'BBB-' rating is predicated on improved operations in fiscal 2017, largely based on steady enrollment and realizing savings associated with the online platform. The failure to achieve at least balanced operations by fiscal 2018 could result in negative rating pressure.

CREDIT PROFILE

Faulkner University is a private, coeducational non-profit institution affiliated with the Church of Christ. Founded in 1942 as the Montgomery Bible School, Faulkner's main campus sits on 105 acres in Alabama's state capital and is home to five colleges and schools, specializing in Arts and Sciences, Business, Biblical Studies, Education, and Law. The Thomas Goode Jones School of Law started independently in 1928, was acquired by Faulkner in 1983, and is only one of three ABA-accredited law schools in the state of Alabama. The university was first accredited in 1971 by the Southern Association of Colleges and Schools and currently offers 31 distinctive majors and 64 degrees. Most Faulkner students are required to live on-campus until age 21; and total housing occupancy was over 99% as of fall 2015.

In addition, the university owns and operates extended campuses in Huntsville and Birmingham, while also leasing an extended campus in Mobile. All three extended campuses aim to serve adults and working professionals. Increased competition from online universities has subsequently contributed to enrollment declines within Faulkner's extended campuses while encouraging the university to start its own online program in fall 2013 that currently offers 18 degree programs. Moreover, Faulkner has engaged in partnership agreements with 14 learning sites and community colleges across Alabama, offering junior and senior level courses towards bachelor-level degrees.

From Fitch's perspective, Faulkner has not been a historically strong fundraiser. The university reports they are proactively altering their advancement strategy led by Faulkner's new President and new Vice President of Advancement. Fitch will monitor the success of the university's efforts, including any fundraising campaigns that may transpire.

FLUCTUATING DEMAND

Since fall 2010, steadily increasing graduate enrollment (e. g. 698 headcount in fall 2015) at Faulkner has been offset by fluctuating undergraduate enrollment, with fall 2015 representing the lowest level of undergraduate headcount (2,564) over the past six years. Similar trends were observed for both the Montgomery and extended campuses. The freshman matriculation rate since fall 2010 has declined; however, the number of matriculants has consistently been above 300 students annually. Based on preliminary results, management expects fall 2016's incoming class to be larger than the prior year.

Despite growing applications and acceptances, fall 2013 yielded far fewer students than the prior two years for the university. In response to lower-than-expected matriculants, Faulkner deliberately recruited more student athletes (i. e. almost half of the ultimate new student enrollment) in fall 2014. Retention issues resulting from academic and behavioral issues of student athletes within certain programs (who were recruited mostly during the prior year) led to lower fall 2015 enrollment levels. Going forward, enrollment management will continue to ratchet down its student athlete recruitment.

The university is in the midst of a multi-phase, 10-year (fiscal 2012-2022) enrollment management plan in order to improve retention (and overall enrollment levels) while lowering the tuition discount rate (26% institution-wide, including graduate programs, at fiscal 2015). New academic programs and strategic initiatives under the plan are expected to drive additional enrollment growth. Ultimately, Faulkner hopes to incorporate tuition increases and target the tuition discount rates for freshmen and seniors at 43% and 30%, respectively. Fitch views the growth plans as presented as potentially pressuring operations if supplementary cash flow from new programs are not realized as expected. Fitch will monitor such progress.

Given the recent history of demand fluctuation (and the strong revenue reliance to student-generated revenues for the university), Fitch will actively monitor Faulkner's strategic plan to manage enrollment.

FLUCTUATING OPERATING PERFORMANCE

Faulkner's revenues are concentrated in student derived tuition and fees (88.1% in fiscal 2015), which is not uncommon for private institutions. As such, the university's rating is significantly dependent on its ability to manage enrollment levels.

Operations have been historically positive since fiscal 2011, with an operating margin (including the endowment draw) averaging about 2.1% during fiscal 2011-2015. However, GAAP-based operations in fiscal 2014 were significantly negative (-8.2%), which management attributed to enrollment declines in several programs beginning in fall 2013 coupled with consulting services expenses for the creation of new academic programs (especially in online education).

While the aforementioned influx of new students in fall 2014 helped to generate positive operations (+1.2%) in fiscal 2015, management projects another deficit in fiscal 2016 (albeit not as negative as fiscal 2014) due to the related student retention issues as well as costs associated with terminating the online education consulting services contract.

Fitch will continue to monitor Faulkner's ability to generate surplus operations in line with financial projections. Failure to generate breakeven operating margins in fiscal 2017 and return to positive operations by fiscal 2018 could pressure the rating.

SLIM LIQUIDITY

Faulkner's balance sheet resources are limited and have been slim since at least fiscal 2011. Available funds (defined by Fitch as cash and investments not permanently restricted) totaled about $18.6 million in fiscal 2015 and covered operating expenses and pro forma long-term debt by an adequate 43% and 57%, respectively. Faulkner's slim financial cushion lags most of the 'BBB' category peer group.

Based on unaudited fiscal 2016 results, management reports that the university's balance sheet resources at May 31, 2016 have weakened over the previous year, predominantly due to expenses paid for consulting services. Any further weakening of Faulkner's financial cushion would be viewed negatively by Fitch; and, consistently slim liquidity metrics may result in a below-investment grade rating for the university.

SOUND POST-ISSUANCE LEVERAGE

Under the plan of finance, Faulkner will refinance its multi-lien debt structure with 100% series 2016 fixed rate debt in the form of the series 2016A bonds and a direct bank loan (not Fitch-rated). Specifically, the series 2016A bonds will refund Faulkner's outstanding series 2007 and 2011 bonds (both of which were issued by the Educational Building Authority of the City of Montgomery) while also providing $4 million for a new 88-bed housing project. The 2016 direct bank loan will refund the series 2009 bonds and series 2011 direct bank loan.

Post issuance, Faulkner's debt will total about $33 million, including the $4.2 million series 2016 direct bank loan issued on parity with the series 2016A bonds. The net effect of the series 2016A bonds and 2016 direct bank loan will be relatively level annual debt service at approximately $2 million annually. The Master Trust Indenture (MTI) provides that the bonds will have a fully cash-funded DSRF that will most likely be sized at MADS. The direct bank loan will additionally be secured by two commercial properties owned by Faulkner; and both the series 2016A bonds and the direct bank loan will be secured by a mortgage on the university's main Montgomery campus. Covenants in the MTI include the university having a debt service coverage ratio of 1.2x as well as 60 days cash on hand.

Bank documents were not yet available; however, management indicated that financial covenants under the bank documents would mirror those in the MTI and that there are no additional non-financial related covenants that could trigger a cross default and an acceleration of all parity debt under the events of default.

The university projects it will exceed its financial covenants in fiscal 2016 and 2017; and, Fitch will monitor Faulkner's ability to comply with all covenants.

Pro forma MADS burden is moderate but manageable at about 5% of fiscal 2015 operating revenues and covered by a sound 2.2x of fiscal 2015 net operating income. However, issuance of additional debt without a commensurate increase in liquid resources could pressure the rating.