OREANDA-NEWS. Fitch Ratings has assigned a 'BB' rating to $34.6 million of City of Anderson, Indiana economic development revenue refunding bonds, series 2017 issued on behalf of Anderson University (AU).

The bonds are expected to sell via negotiation as early as the week of February 13. Proceeds will refund AU's outstanding series 2007 and series 2015 bonds and pay costs of issuance.

In addition, Fitch has downgraded $34.0 million of City of Anderson, Indiana economic development revenue refunding and improvement bonds, series 2007 issued on behalf of AU to 'BB' from 'BB+'.

The Rating Outlook has been revised to Stable from Negative.

SECURITY

The bonds are a general obligation of the obligated group (AU is the sole member) payable from any legally available funds. The bonds are secured under a new master indenture by a pledge of the university's gross revenues and a mortgage on its core campus property. In addition, the bonds will feature a cash-funded debt service reserve.

KEY RATING DRIVERS

WEAKENED FINANCIAL PROFILE: The downgrade reflects weaker operating performance in fiscal 2016 and a decline in balance sheet resources, which are limited. A trend of deterioration in operating results has been driven by consistent enrollment declines but mitigated by aggressive management of expenses. AU expects results to improve somewhat but remain negative on a GAAP basis in fiscal 2017.

ENROLLMENT LOWER BUT STABILIZING: Total enrollment continued to decline in fall 2016 but should stabilize by fall 2017. Incoming class sizes have now been generally level for four years; accordingly, the class graduating in spring 2017 will roughly match the incoming fall 2017 class in size. Retention efforts and programmatic adjustments to maintain market alignment also support stabilizing enrollment.

REFUNDING EXTENDS DEBT: The refunding transaction will generate savings, but it also extends final maturity by four years and lowers annual debt service between 2018 to 2020; AU should cover debt service comfortably over that period (about 1.8x from fiscal 2016 results). Debt service increases to $3.3 million in fiscal 2021, by which time AU expects to have improved its operating performance.

LONG-TERM COVERAGE SUFFICIENT: AU's debt burden remains moderately high, with pro forma maximum annual debt service (MADS, occurs in fiscal 2021) equal to 7.2% of fiscal 2016 operating revenue. Coverage of pro forma MADS from fiscal 2016 operations would be slim but sufficient at 1.1x.

RATING SENSITIVITIES

STABLE ENROLLMENT: Anderson University's (AU) student population has declined consistently in recent years. Additional enrollment declines would stress its ability to achieve structural budgetary balance and could result in further negative rating action.

OPERATING IMPROVEMENT: AU expects operating results to improve but remain negative in fiscal 2017. Failure to improve operating results toward breakeven, in advance of higher annual debt service starting in fiscal 2021, could negatively pressure the rating.

CREDIT PROFILE

Founded in 1917, Anderson University is a small Christian university located in Anderson, IN (35 miles northeast of Indianapolis). AU was founded by and is affiliated with the Church of God (Anderson, IN) (COG); it is the only college affiliated with the COG in the Midwest. The university offers around 60 undergraduate majors as well as graduate programs in business, music, nursing, and theology. The university also maintains a Department of Adult Studies that offers bachelor and associate degrees for adult students.

FINANCIAL PROFILE DRIVES DOWNGRADE

AU's operating performance has weakened consistently over the past five years, from an operating margin of 1.7% in fiscal 2011 to a deficit of 4.2% in fiscal 2016. This trend reflects a 10.4% enrollment-driven decline in net tuition revenue since fiscal 2011, partially offset by aggressive expense management. Positively, AU has cut operating expenses by about 3.9% over the same period and has made structural budgetary changes to mitigate its revenue challenges.

Management believes fiscal 2016 was a low point for operating performance and expects improved, though still negative, results in fiscal 2017. A level fall 2016 incoming class has resulted in net tuition revenue ahead of budget to date. In addition, AU recorded $2.5 million of upfront costs in fiscal 2016 related to a voluntary retirement initiative; these expenses will not recur in 2017. Fitch believes some improvement in operating results in 2017 and 2018 will be necessary to maintain the rating and to prepare for debt costs that will increase by fiscal 2021.

LIMITED BALANCE SHEET CUSHION

AU's balance sheet resources provide limited financial cushion but are adequate for the rating category. Available funds (defined as cash and investments less permanently restricted net assets) totaled $5.9 million at May 31, 2016. As reported, available funds equaled 12.1% of operating expenses and 11.7% of pro forma debt, both weak for the 'BB' rating category. However, Fitch's standard calculation understates AU's unrestricted cash and investments by about $11.7 million.

Certain of AU's permanent endowment funds have accumulated investment losses and are "underwater" relative to the booked value of the corpus. However, accounting rules require deduction of such losses from unrestricted, rather than from permanently restricted, endowment. Adjusting for this, Fitch estimates AU's unrestricted cash and investments would meet or exceed 30% of operating expenses and debt, more in line with rating category peers.

ENROLLMENT EXPECTED TO STABILIZE

AU's headcount enrollment has fallen 14.5% from a peak of 2,611 in fall 2011 to 2,232 in fall 2016. The trend reflects a competitive environment, price sensitivity among students and AU's overlap with nearby public institutions with lower costs of attendance. However, management expects enrollment to stabilize by fall 2017 due to stable incoming class sizes and improving overall retention rates. Incoming freshman classes have ranged from 463 to 486 in the past four cycles, and preliminary results suggest a similar class size is likely for fall 2017. This would cause enrollment to stabilize, as the incoming class would replace a graduating class of comparable size.

Under a new marketing and admissions team, the university is pursuing several strategies to bolster enrollment including further student retention initiatives, enhanced marketing efforts and tools, targeted student aid, curricular changes to ease the process for transfer students, and programmatic adjustments to align with market demand.

Stabilizing enrollment is critical to maintain the rating level. Fitch believes AU has the capacity to right-size its offerings and budget to the current enrollment level, but further enrollment declines would make structural budgetary balance unlikely and would result in further negative rating action.

REFUNDING EXTENDS MATURITY

The refunding transaction will generate savings, but it will also restructure principal payments to provide some near-term relief. Final maturity will be extended by four years to October 2036 and principal deferrals will lower annual debt service to about $2 million from fiscal 2018 to fiscal 2020. AU should cover its debt service comfortably over this deferral period; Fitch estimates fiscal 2016 results would have generated about 1.8x coverage of fiscal 2020 debt service.

The principal deferral eases near-term financial pressure on AU as it works to stabilize its enrollment and balance its budget; Fitch considers this a credit positive. In fiscal 2021, however, debt service increases to MADS of $3.3 million. By this time, AU will need to have improved operations to build resources and generate sound coverage of the higher debt service level in order to maintain the rating.

LONG-TERM COVERAGE TIGHT BUT SUFFICIENT

AU's debt burden remains moderately high after the deferral period, with MADS equal to 7.2% of fiscal 2016 operating revenue. Coverage of pro forma MADS from fiscal 2016 operations would be slim but sufficient at 1.1x. Fitch believes AU's ability to cover its higher long-term debt load from fiscal 2016 operations mitigates the risk of the debt service hike in 2021. Budgetary improvement achieved to date in fiscal 2017, even before enrollment has fully stabilized, suggests AU should be able to manage its post-deferral debt load. In addition, AU is in the planning phases for a new capital campaign and has a good fundraising track record for its size. There are no plans for additional debt or major internally funded capital projects at this time.

DATA NOTES AND ADJUSTMENTS

The Flagship Enterprise Center (FEC) is a regional business incubator and small business lender created through a partnership between AU and the City of Anderson. It is consolidated as a controlled affiliate on AU's financial statements based on AU's ability to appoint a majority of the FEC's board. However, FEC resources are not available to support AU operations, and its liabilities are non-recourse to AU. Fitch therefore evaluates AU's financial profile based on the university's core enterprises, excluding the FEC's activities and resources.

AU's audited financial statements present detailed consolidating statements, allowing Fitch to exclude FEC activities and resources. Fitch typically calculates operating performance for private universities on the basis of unrestricted operating activity only. However, because AU's consolidating statements do not classify activities by restriction, Fitch has evaluated AU's operating performance based on its total activities excluding the FEC. Fitch does not believe this approach has a material effect on operating results or trends for AU.