OREANDA-NEWS. Fitch Ratings has assigned an 'AA-' rating to the Pennsylvania Higher Educational Facilities Authority's approximately \$99.7 million series AQ bonds to be issued on behalf of the Pennsylvania State System of Higher Education (PASSHE).

The bonds are expected to sell competitively on or about April 27. Bond proceeds will be used to current refund series AC bonds and advance refund series AE bonds.

In addition, Fitch has downgraded the rating on PASSHE's approximately \$860 million of currently outstanding revenue bonds to 'AA-' from 'AA'.

The Rating Outlook has been revised to Stable from Negative.

SECURITY

PASSHE's payment obligations pursuant to a loan agreement with the issuer are an unsecured general obligation of the system.

KEY RATING DRIVERS

RATING DOWNGRADE: The rating downgrade reflects PASSHE's weakened GAAP-based operating margins and Fitch's belief that a declining number of high school graduates; an uncertain commonwealth funding environment; and employee compensation and other expense growth will continue to pressure the system.

SOUND MARKET POSITION: PASSHE's broad reach in the commonwealth of Pennsylvania promotes overall credit strength and stability consistent with the rating category. The system's 14 universities and various degree programs in more than 120 areas of study make it Pennsylvania's largest provider of higher education.

SOLID FINANCIAL CUSHION: Solid balance sheet resources continue to support the rating. Fitch-calculated ratios of available funds to fiscal 2014 operating expenses (63.9%) and pro forma debt (124.2%) compare favorably to rating category medians. Including off-balance sheet student housing debt more than halves the latter ratio, but it remains within range of the medians at 55.9%.

PRESSURED DEBT SERVICE COVERAGE: Compressed operating margins have pressured debt service and MADS coverage to a low 1.1x and 1.0x, respectively, in fiscal 2014. However, the system's moderate MADS burden (5.3%) and limited debt plans provide some comfort.

RATING SENSITIVITIES

OPERATING MARGINS KEY: Consistently negative GAAP-based operating margins, coupled with the deterioration of balance sheet resources, could yield additional rating pressure. By contrast, a return to positive operating margins resulting from enrollment growth could yield positive rating action.

HOUSING DEBT: Significant financial or operational stress at the system's off-balance sheet housing units, while not currently expected, could pressure the rating.

CREDIT PROFILE

PASSHE is the commonwealth of Pennsylvania's (GO bonds rated 'AA-'/Outlook Stable by Fitch) largest higher education provider. Moreover, its universities offer the lowest cost four-year baccalaureate degree programs in the commonwealth. The system includes 14 universities, four branch campuses, several regional centers, and the McKeever Environmental Learning Center.

RATING DOWNGRADE

Negative GAAP-based operating margins in each of the past two fiscal years and various revenue- and expense-related hurdles drive the rating downgrade. Operating margins on a full accrual basis registered negative 1.7% and negative 3% in fiscal years 2013 and 2014, respectively, following an average of 1.6% the preceding three years. However, PASSHE's scale and affordability as a broad-based higher education system, the financial flexibility its strong balance sheet provides, and its typically positive cash flows on a cash basis should provide rating stability at the current level.

UNEVEN ENROLLMENT TRENDS

Enrollment pressures reflecting, in part, a declining number of high school graduates have contributed to recent operating pressures. Moreover, the Western Interstate Commission for Higher Education projects uneven trends over the next several years; commonwealth high school graduates reach a 1997-2028 low of 136,000 (2020) from a peak of 150,000 (2010).

Full-time equivalent enrollment has declined by an average of negative 2.4% annually since fiscal 2010 to 97,394 in fiscal 2015. Preliminary fall 2015 application and admissions data through March 2015 suggest continued trends.

UNCERTAIN COMMONWEALTH FUNDING ENVIRONMENT

An uncertain commonwealth funding environment presents additional challenges heading into fiscal 2016. PASSHE recently committed to a non-binding tuition freeze in exchange for a proposed \$45.3 million of increased commonwealth support; the first half of the governor's two-year plan to restore PASSHE's prior levels of funding. However, the timing of the commonwealth budget and adopted state appropriation levels could ultimately present system budgetary challenges.

State appropriations have remained flat since fiscal 2012 at \$412.8 million (21.1% of fiscal 2014 unrestricted operating revenues), after having been reduced by \$90.6 million in fiscal 2012. PASSHE reports that fiscal 2015 commonwealth funding approximates the fiscal 1998 level.

TUITION INCREASES PROVIDE SOME OFFSET

The system's focus on affordability somewhat limits its ability to implement outsized tuition increases. However, an average of 5.2% annual tuition and mandatory fee increases since fiscal 2010 has helped offset flat commonwealth funding levels to some extent. Fiscal 2015 average tuition and mandatory fees increased to \$9,418, which compares favorably to regional institutions.

General tuition rates, which are set by the PASSHE Board of Governors, are typically tied to the inflation rate. System members are authorized to increase fees, subject to the approval of each university's council of trustees.

COMPENSATION COST PRESSURES

Contractual increases for compensation drive PASSHE's operating expense growth, untied to operating revenues. PASSHE has eight collective bargaining agreements representing 87% of the employees. Most contracts expire at fiscal 2015 yearend, and related fiscal 2016 costs are undetermined. PASSHE's fiscal years 2010-2014 average rate of unrestricted operating expense growth (2.1% annually) doubled that of operating revenues (1.1%).

SOLID BALANCE SHEET REOURCES

The system's available funds provide considerable support at the current rating level, in light of its considerable operating pressures. Addressing imbalances over the past several years principally with budgetary adjustments, including workforce reductions, has helped maintain available funds at a tight average of \$1.27 billion annually since fiscal 2012.

Fiscal 2014 available funds (\$1.29 billion) covered unrestricted operating expenses and pro forma debt by 63.9% and 124.2%, respectively. Both ratios compare favorably to the respective rating category medians of 51.2% and 85.6%.

OFF-BALANCE SHEET DEBT ADJUSTMENT

PASSHE reports that direct system financial support for off-balance sheet student housing projects across its campuses (22,413 total beds) has never been required. Occupancy levels remain sound and continue to contribute toward adequate debt service coverage, despite enrollment pressures. Moreover, privatized housing debt is nearing its peak, due to master planning from prior years and stalled enrollment growth more recently.

Adjusting for approximately \$1.265 billion of privatized student housing debt at fiscal 2014 yearend more than halves the ratio of available funds to pro forma debt. However, at 55.9%, the ratio remains within range of category medians. Privatized student housing debt is structured to be nonrecourse to the system.

MODERATE DEBT BURDEN

Debt service coverage has weakened with the system's broader operating pressures to a low 1.3x and 1.1x in fiscal years 2013 and 2014, respectively. However, entirely fixed-rate debt provides for greater overall budgetary stability, and a moderate debt burden provides some comfort. Pro forma MADS occurring in 2020 (\$103.5 million) represents 5.3% of fiscal 2014 unrestricted operating revenues.

Expected issuance through fiscal 2016 totals a manageable \$75 million to \$125 million, including a possible project to finance the purchase of an off-balance sheet housing project at California University for operating expense savings.