OREANDA-NEWS. Fitch Ratings has affirmed the 'BBB-' rating on San Diego County, CA's \$11.96 million of 2008 certificates of participation (COPs) issued on behalf of Arc of San Diego (Arc).

The Rating Outlook is Stable.

SECURITY

The COPs are limited obligations of San Diego County, payable by funds derived from an agreement with Arc. Arc's obligations pursuant to the agreement are a general obligation and absolute and unconditional. Arc pledges and grants a security interest in its gross revenues for such purposes. Arc further secures its payment obligations under the agreement with a security interest in certain facilities.

A debt service reserve fund is cash funded to maximum annual debt service (MADS).

KEY RATING DRIVERS

ESSENTIAL SERVICE PROVIDER: Arc provides highly essential, state-mandated services to people with disabilities. The private, not-for-profit corporation benefits from consistently solid programmatic demand and limited competition in a relatively large San Diego County service area.

BALANCE SHEET SUPPORT: Good balance sheet cushion for the rating level and a low debt burden, as well as generally adequate debt service coverage ratios, provide rating support. Moreover, Arc has no forthcoming debt financing plans.

RELIANCE ON GOVERNMENTAL PAYORS: Typically more volatile, negative operating margins highlight Arc's high sensitivity to reimbursement levels from California state agencies (California GO bonds rated 'A+'/Outlook Stable by Fitch). Arc relies heavily on governmental programs for funding.

RATING SENSITIVITIES

BALANCE SHEET PRESERVATION: Failure to preserve balance sheet resources at or near current levels could yield rating pressure, given Arc's funding fluctuations.

CREDIT PROFILE

Organized in 1951, Arc provides highly essential, state-mandated services to developmentally disabled and mentally impaired children and adults. The entity serves around 2,500 people annually at more than 20 locations throughout San Diego County.

Demand for Arc's services and programs remains strong with residential occupancy generally at full capacity. Services include adult development programs, work activity programs, vocational services, adult residential facilities, independent living/in-home services, behavior intervention, and infant/parent programs.

FINANCIAL CUSHION

Arc's good level of balance sheet resources provides rating support, particularly as compared to debt. Fitch continues to view preservation of balance sheet resources at or near current levels as critical to the rating, given the sensitivities inherent in Arc's business model.

Available funds, defined as cash and investments not permanently restricted, totaled \$10.7 million in fiscal 2014, a healthy increase of 14% from the prior year and nearly 50% from fiscal 2010. Such funds exclude \$2.5 million of cash and investments pledged as collateral for Arc's self-insured workers' compensation coverage at June 30, 2014.

Available funds covered fiscal 2014 operating expenses (\$32.8 million) and outstanding debt (\$11.9 million) by a modest 32.7% and stronger 89.9%, respectively. The cost-based nature of most of Arc's governmental reimbursement and employer contracts, whereby the associated expenses have corresponding revenues, partially mitigates the lower level of available funds to expenses.

LOW DEBT BURDEN

Arc's low debt burden further supports the rating. MADS of about \$918,000 consumed only 2.8% of fiscal 2014 unrestricted operating revenues (\$33.3 million), which was in line with prior years. MADS coverage improved to a solid 2.1x in fiscal 2014.

Fitch expects Arc's leverage position to remain manageable, as the provider has no additional debt plans. Nevertheless, adequate cash flow and debt service coverage will continue to depend on Arc's ability to navigate a sometimes volatile state reimbursement environment.

REVENUE CONCENTRATION

Arc's financial profile remains highly sensitive to overall changes in state funding levels, as more than half of its operating revenues are derived from contracts with state agencies. The state's Department of Development Services (DDS) generally accounts for 40%-45% of revenues, including 45% in fiscal 2014. Medi-Cal, the state's Medicaid program, accounts for about 12%-13% of revenues.

Workshop contracts with private employers provide some degree of revenue diversity at about one-third of the total.

REIMBURSEMENT PRESSURES EASE

The restoration of DDS rate cuts, given their relative importance to Arc's revenues, should benefit overall stability after years of reimbursement volatility and state budget deficits. Following a total 4.25% cut in reimbursement rates during fiscal years 2009-2011, rates were held flat in fiscal 2012 and increased by 3% and 1.25% in fiscal years 2013 and 2014, respectively. Though non-residential rates remained virtually flat for fiscal 2015, a potential modest increase in rates for fiscal 2016 may provide additional support. Moreover, Medi-Cal rates increased by about 3.5% in fiscal 2015, the first such change since November 2012.

IMPROVED OPERATIONS

Sustained, balanced operations, coupled with growing balance sheet resources, could be a longer-term driver of positive rating action. Arc's fiscal 2014 operating margin improved to positive 1.3%, compared with negative 1.5% the prior year for reasons noted. In addition, near breakeven fiscal 2015 interim results through February 2015 are reportedly tracking the budget.