[November 18, 2014]

Fitch Affirms Duke University Health System (NC) Revs at 'AA'; Outlook Stable

Fitch Ratings has affirmed the 'AA' rating on the following revenue bonds issued by the North Carolina Medical Care Commission on behalf of Duke University Health System (DUHS):

--$180 million series 2009A health care facilities revenue bonds;

--$120 million series 2010A health care facilities revenue bonds;

--$287.6 million series 2012A health care facilities revenue bonds.

The Rating Outlook is Stable.

SECURITY

Debt payments are unsecured, general obligations of the obligated group.

KEY RATING DRIVERS:

ROBUST OPERATING PROFITABILITY: Despite being compressed by a $65 million non-cash reserve adjustment, operating profitability remained strong in fiscal 2014 with operating EBITDA margin equal to 10.8%. Excluding the non-cash reserve adjustment, operating EBITDA margin would have equaled 12.9%.

MANAGEABLE DEBT BURDEN: DUHS' debt burden remains manageable with MADS equal to 3.1% of operating revenues and MADS coverage by EBITDA equal to 5.9x in fiscal 2014, despite the negative impact of the non-cash reserves.

STRONG LIQUIDITY POSITION: Unrestricted liquidity remains strong with 423.2 days cash on hand, 34.1x cushion ratio and 225.8% cash to debt. A planned transfer of $510 million to Duke University in fiscal 2017 is not expected to materially impact future liquidity metrics and is expected to be offset by strong cash flows and decreased capital needs in fiscal years 2015 and 2016.

LEADING CLINICAL REPUTATION: DUHS benefits from a strong national clinical reputation and its academic affiliation with Duke University School of Medicine, one of the nation's leading medical schools.

RATING SENSITIVITIES

MAINTAINED CREDIT PROFILE: Fitch expects that DUHS will maintain its current credit profile and that cash flows will be sufficient to offset the planned fund transfer to Duke University in fiscal 2017 without materially impacting liquidity metrics.

CREDIT SUMMARY:

Based in Durham, NC, DUHS is a large integrated delivery system with three hospitals, several operating subsidiaries and total operating revenues of $2.6 billion in fiscal 2014. The three hospitals consist of: Duke University Hospital, with 957 licensed acute care and specialty beds located in Durham, N.C.; Duke Regional Hospital, 369 licensed beds located in Durham; and Duke Raleigh Hospital, 186 licensed beds located in Raleigh. Additional operations include home care and hospice services; a primary care practice with 190 providers at 27 locations; and 68 clinics and ambulatory care centers. Fitch's analysis is based upon DUHS' consolidated financial statements. The credit group accounted for 94.1% of total consolidated operating revenues and over 95.1% of consolidated total assets in fiscal year 2014.

ROBUST OPERATING PROFITABILITY

Operating profitability was negatively impacted by a $65 million non-cash reserve adjustment related to a slowdown in accounts receivable collections, thereby decreasing operating revenue. Despite the non-cash reserves, operating profitability remained solid with operating EBITDA margin equal to 10.8% relative to Fitch's 'AA' category median of 11%. While solid, this is below historical levels. Excluding the $65 million reserve, operating EBITDA margin equaled 12.9%.

The slowdown in accounts receivable collections was primarily due to a slowdown in collections associated with DUHS' implementation of a new electronic medical record system. The slowdown in collections led to the reserve adjustment. The issues were further complicated by challenges experienced by he implementation of a new claims processing system by North Carolina's Medicaid program (NC Tracks) and challenges experienced by Blue Cross Blue Shield of North Carolina (BCBSNC) in implementing a new IT system. The Epic related issues have mostly been resolved while the NC Tracks and BCBSNC issues have improved.

Management has been consistently focused on operating improvement initiatives since 2008, achieving approximately $160 million in operating improvements through fiscal 2013. DUHS' latest operating improvement initiative targets an additional $200 million in improvements, of which management expects to achieve $67 million in cumulative improvements by the end of fiscal 2015. Major focus areas include care redesign, clinical operations, supply chain and revenue cycle.

MANAGEABLE DEBT BURDEN

DUHS' debt burden remains manageable with MADS equal to 3.1% of fiscal 2014 operating revenue relative to Fitch's 'AA' category median of 2.6%. Despite the compressed profitability in fiscal 2014 due to the non-cash reserves, MADS coverage by EBITDA remained solid at 5.9x, exceeding Fitch's 'AA' category median of 5.4x.

STRONG LIQUIDITY POSITION

Unrestricted cash and investments increased 31.7% since fiscal 2012 to $2.7 billion at June 30, 2014 despite strong capital spending which averaged 269% of depreciation during the period and equaled 155.5% in fiscal 2014. The growth in liquidity is primarily due to strong cash flows and investment returns. Liquidity growth was hampered by the aforementioned slowdown in accounts receivable collections which caused days in accounts receivable to increase to 55.4 at June 30, 2014 from 46.7 at June 30, 2013.

Liquidity metrics are strong across the board and provide a strong resource for timely payment of principal and interest with 423.2 days cash on hand, 34.1x cushion ratio and 225.8% cash to debt, all of which exceed Fitch's 'AA' category medians of 277.1 days, 26.5x and 178.5%.

As part of its relationship with Duke University and the School of Medicine, DUHS provides support to the University in the form of cash equity transfers. Total unrestricted transfers equaled $69.1 million and $56.5 million in fiscal years 2014 and 2013, respectively. DUHS plans to complete a one-time transfer of $510 million to the university on July 1, 2016 to fund future support. Given projected cash flow levels and decreased future capital needs, Fitch does not expect the transfer to have a material impact on DUHS' liquidity metrics.

LEADING CLINICAL REPUTATION

DUHS' strong clinical reputation and academic affiliation with one of the nation's leading medical schools are additional credit positives. Duke University Hospital (DUH), DUHS' flagship facility, has been consistently ranked as one of the top hospitals in the nation for over a decade. The strong clinical reputation is supported by the high acuity of services provided at DUH, evidenced by a high Medicare case mix index of 2.2, and is bolstered by DUHS' solid market share in its primary service area. Additionally, DUH is the principal teaching affiliate of Duke University School of Medicine, which is consistently recognized as one of the nation's top medical schools. The strong clinical reputation and academic affiliation are viewed as credit strengths due to their positive impacts on patient demand as well as physician recruiting and alignment initiatives.

DEBT PROFILE

Total debt outstanding equaled $1.2 billion at June 30, 2014 and was comprised of 55% underlying fixed rate bonds and 45% underlying variable rate bonds. The variable rate bonds are swapped to fixed rate through three fixed payor swaps and are directly placed with a bank. The direct placement covenants are substantially similar to those contained in the master trust indenture. In addition to the three fixed payor swaps, DUHS is counterparty to a basis swap.

DISCLOSURE

DUHS covenants to provide annual and quarterly financial disclosure within 180 days and 60 days. Disclosure is provided through the Municipal Securities Rulemaking Board's EMMA system.

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

Applicable Criteria and Related Research:

--'Nonprofit Hospitals and Health Systems Rating Criteria', May 20, 2014.

Applicable Criteria and Related Research:

U.S. Nonprofit Hospitals and Health Systems Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=746860

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=927015

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