Wake Forest: Health In Tobacco Country

Includes: RAI
by: Charles Margolis

Wake Forest University taxable bonds issued in August 2012, due in 2025, currently stand out on the secondary bond market. These Wake Forest University bonds were part of a large $125M issuance. The Wake Forest University corporate bonds currently yield 3.89%, while the 10-year Treasury yield is 3.04%.

This article will compare Wake Forest University's taxable corporate bonds with municipal bonds, issued for Wake Forest Baptist Obligated Group. Wake Forest Baptist encompasses the university's medical programs. While independent, the university is directly tied into the health alliance.

This article will also examine Wake Forest's tobacco heritage, in relation to overall debt. The university is 1 of 4 competitive North Carolina schools, commonly regarded as Tobacco Road. Wake Forest University is literally located in the backyard of the historic Reynolds family home.

Wake Forest Bonds

Here you can see how the Wake Forest University taxable bonds, issued in August 2012, compare to municipal bonds, issued by North Carolina Medical Care Commission.

credit rating year issued / amount issued price yield
Wake Fst Univ 2012 Taxable Bd 2.754% 2025, Make Whole Call (cusip: 931009AB0) -/AA 2012 / $5M 89.87 3.89%
North Carolina Med Care Commn Ref Rev Bds 2012 B, Wake Forest Baptist Medical Ctr, 2033 Cont Call 12/01/22@Par, Sink 12/01/28@Par, Cond Call, Extr Call (cusip: 65821DNE7) A1/A+ 2012 / $21.7M 87.53 4.99%
North Carolina Med Care Commn Ref Rev Bds 2012 A, Wake Forest Baptist Medical Ctr, 2045 Cont Call 12/01/22@Par, Sink 12/01/39@Par, Cond Call, Extr Call (cusip: 65821DMM0) A1/A+ 2012 / $88.4M 87.29 4.78%

Here are the muni bonds' official statement and the university taxable bonds' offering memorandum.

The muni bonds were downgraded by Moody's from Aa3 to A1 in March 2013. S&P followed suit, with a downgrade from AA- to A+ in November 2013. Moody's noted the municipal bonds, issued for Wake Forest Baptist, in their report:

Increase in leverage following the Series 2012A-D financings; earlier projected debt-to-cash flow of 3.4 times and Moody's-adjusted maximum annual debt service coverage of 5.2 times in FY 2013 will likely not be achieved

The listing for the Wake Forest University taxable bonds does not show a Moody's credit rating. However, the bonds' offering memorandum lists an Aa3 rating. Moody's most recent announcement on Wake Forest University appears to have left the Aa3 rating intact and affirmed a stable outlook, as of July 2012.

In terms of credit rating, Wake Forest University appears more solid. Many investors would avoid Wake Forest Baptist Obligated Group municipal debt. The credit rating downgrades are illustrative of the fundamental differences between universities and healthcare businesses, at this point.

Defining Institutions

North Carolina Medical Care Commission issued about $370M, in new debt for Wake Forest Baptist Obligated Group in November 2012. Over the past couple years the top organization within Wake Forest Baptist, Wake Forest University Baptist Medical Center, simplified its name and brand.

Relative to Wake Forest's official paperwork, the rebranding is complicated. Basically the Wake Forest University Baptist Medical Center is now Wake Forest Baptist Medical Center (subtracting the word "university.") The overall brand is now Wake Forest Baptist Health.

Wake Forest Baptist Health's rebranding page contains a video showing the Wake Forest University Baptist Medical Center "has a new name," Wake Forest Baptist Health. However, the core leading organization remains the medical center, now: Wake Forest Baptist Medical Center.

The Wake Forest Baptist Health rebranding page further explains:

Our goal with rebranding is to continuously strengthen this institution, indeed, to build an academic medical center with a school of medicine that will continue to inspire pride and even awe among those of us privileged to work and learn here...

This brand development and implementation will cost about $3.5 million. An initial assessment of the implementation shows that with a single brand name, Wake Forest Baptist will see financial benefits over the production costs of multiple differing brands...

The new names are considered part of the brand of the institution but are not legal name changes. The current names used on official documents will not change. For example, medical students will still have Wake Forest University School of Medicine on their diplomas.

I called Wake Forest Baptist Health and talked to their CEO's office, a representative there said "Wake Forest Baptist Medical Center is the lead organization." The Wake Forest Baptist Health website clarifies the Wake Forest Baptist Medical Center:

comprises the medical education and research components of Wake Forest School of Medicine; the integrated clinical structure and consumer brand Wake Forest Baptist Health; the commercialization of research discoveries through Wake Forest Innovations, and a network of affiliated community-based hospitals, physician practices, outpatient services and other medical facilities.

At this point you might wonder where the name Wake Forest came from. The original home of Wake Forest University was Wake Forest, North Carolina, named for Wake County, which was named for Margaret Wake Tryon, the wife of the royal governor of North Carolina from 1765-1771.

Wake Forest Obligated Group

Let's take a look at the institutions that form the Wake Forest Baptist Obligated group. They are shaded in gold in the chart below. The diagram below appears on page A-3 of appendix A, in the municipal bonds' official statement:

Notice the university owned 50% of the medical center and was the sole member of Wake Forest University Health Sciences. Pay particular attention the Wake Forest Baptist framework, which includes every organization in the gray box.

Though the hierarchy might be considered complicated, investors simply need to know Wake Forest Baptist Health is the new brand. Wake Forest Baptist Medical Center is the name of the facility, and the organization no longer promotes the Wake Forest University Baptist Medical Center name. Legally and traditionally the school of medicine still uses "university."

Investors experienced with complex health institutions know medical programs and schools often have complex structures. In this case bond listings, on different secondary markets, are using Wake Forest Baptist and Wake Forest Baptist Medical Center interchangeably. Technically the muni bonds were issued to the Wake Forest Baptist Obligated Group.

Wake Forest Municipal Bonds

North Carolina Medical Care Commission issued $231M in municipal bonds, Series 2012A-B for Wake Forest Baptist Obligated Group in November 2012. Another $59M Series 2012C and estimated $80M Series 2012D municipal bonds brought the total issuance to about $370M. The prospectus states in bold:

The University is not a Member of the Obligated Group under the Master Indenture referenced in the front part of this Official Statement nor is the University part of the Combined Group or Wake Forest Baptist.

The muni bond prospectus lists a total of $7.3B outstanding debt, issued by the North Carolina Medical Care Commission, for various institutions, including the Wake Forest Baptist Obligated Group (now headed up by Wake Forest Baptist Health.) Whereas the 2012A-B muni bonds are fixed rate the 2012C-D bonds have floating rates.

Notice the muni bonds have sinking funds and are continuously callable, beginning 2022. The Wake Forest University bonds have a make whole call and both the taxable bonds and muni bonds have 5 bond minimums.

Wake Forest University And Wake Forest University Health Sciences

Wake Forest University is comprised of 6 schools:

  1. Undergraduate College
  2. Graduate School
  3. School of Business
  4. School of Divinity
  5. School of Law
  6. School of Medicine

The Wake Forest School of Medicine (Bowman Gray School of Medicine) was established in 1902 and currently boasts 1,100 full-time faculty. Wake Forest Baptist Medical Center "comprises the medical education and research components of Wake Forest School of Medicine." Wake Forest University Health Sciences was founded in November 2001.

Wake Forest University's most recent Form 990, which ran through June 2012, showed $879M net assets. Program service revenue totaled $322M up from $296M the prior year. Total revenue was down $37M, to $422.8M due to less contributions and lower investment income from the prior year.

The school's June 2013 consolidated finacial statement, page 5, shows net assets went up to $1.031B. Notice the consolidated financial statement includes Wake Forest University Health Sciences, between the Wake Forest University and Wake Forest University Health Sciences net assets were $1.693B, through June 2013, up from $1.598B the prior year. The $95M gain in net assets was primarily attributed to gains in non-operating activities, such as excess investment returns, unrealized gains on interest rate swaps, and $21M more restricted contributions versus the prior year.

Operating deficit was $7.4M compared to a $31M operating excess the prior year. This was due to higher employee salaries and benefits, up $37M from 2012.

Wake Forest: History of New Names

(click to enlarge)

Wake Forest University was known as Wake Forest College from 1838 to 1967. The School of Medicine was originally named in honor of the president of Reynolds Tobacco, Bowman Gray.

Here is the Wake Forest Baptist Medical Center, today:

In 1997 North Carolina Baptist Hospital and Wake Forest University changed the name of their medical center to Wake Forest University Baptist Medical Center. North Carolina Baptist Hospital files a separate Form 990 and lists Wake Forest Baptist Health as its website.

Officials emphasized that the name changes are part of a major realignment plan designed to preserve and strengthen the Medical Center's "core mission" of medical education, research and patient care. - Wake Forest University (1997)

Per the diagram in the muni bond official statement, Wake Forest University Baptist Medical Center owned 50% of what was still legally North Carolina Baptist Hospital.

Cost of Rebranding

The rebranding was budgeted at $3.5M. The medical center reported a $68M operational loss in Q3 of FY 2012:

Stock investment gains of $54.6 million helped offset much of the operational revenue loss.

Still, the operational loss was $13.2 million higher than the $49.6 million it reported Dec. 31 - Winston-Salem Journal

It seems Wake Forest Baptist is striving to attain a level of excellence within reach of its credit. A small downgrade certainly has an effect, though some would consider the maneuver acceptable. Furthermore, many bond investors have been conservative, given low yields. Though, obviously bond investors would much prefer a stable outlook, or an upgrade, to a downgrade.

It is imperative the medical institution work towards net income rather than losses. It does appear the work taken on by Wake Forest Baptist and Wake Forest Baptist Health is of the utmost importance to the well being of patients. Overall the hurdles faced by the medical group seem daunting, compared to the university's. The medical group is appealing because it appears to be focused on providing top level care.

Wake Forest Baptist Health announced 950 job cuts in 2012 and stated operational losses were due to the implementation of a complicated electronic medical system, which initially caused some "disruptions."

The losses stem largely from disruptions to Wake Forest Baptist's outpatient clinics from the launch of the Epic system in late September, which caused a drastic and prolonged decrease in patient volumes. Additionally, the... Epic system also impacts the medical center's billing, but those revenues are likely just delayed, while those revenues from lower volumes are likely lost. - The Business Journal

Education Versus Healthcare

Investors should take note of the major differences between an educational institution and a health institution, financially speaking. Wake Forest Baptist Health's Medical Center Campus is a Level I Trauma Center with 885 beds. The medical center's newly expanded cancer center is a National Cancer Institute advanced comprehensive center. The medical center's Brenner's Children's Hospital has 160 beds.

The cancer center's specialties include:

  • Brain Tumor Center of Excellence
  • Breast Cancer Center of Excellence
  • Prostate Cancer Center
  • Clinical Research
  • Gamma Knife (for brain surgery)
  • Leukemia

An advanced comprehensive cancer center is the top designation of the NCI. While clearly Wake Forest Baptist Medical Center is home to an impressive grouping of health initiatives, they come at a cost. Currently the center's operational losses coincided with a credit rating downgrade.

Moody's noted:

Decline in unrestricted cash and investments to $1.018 billion as of December 31, 2012, from $1.141 billion at the end of FY 2012; $99 million draw on operating line of credit to address increase in receivables aids absolute cash balance...

Both Wake Forest University and Wake Forest Baptist are complex operations. Not only is there further potential for strain upon the medical center, investors should keep in mind interest rates are rising from historic lows. The medical center took on more debt, at low rates, now the muni bonds are about 12.5% under par.

Initial investors, in both the university and medical center bonds, have seen declines. Not only have rates bounced up, the medical center's credit rating took a hit.

The Need For Modernization

Improvements and expansions are a necessity for top-of-the-line health institutions, such as Wake Forest Baptist Health. Though I find a $3.5M price tag, for a rebranding, to be costly. The medical center believes eventually the changes will yield more efficient operations. It is possible a more conservative implementation of a name change could have been accomplished, especially given the fact the names have been changed before.

Wake Forest University, thus far, has not had an outlook adjustment or a downgrade. While the university is focused on education, the medical center simultaneously teaches medical students and treats patients.

Wake Forest University was founded in 1834 and currently charges $44,200 for undergraduate students, per year. The school has about 4,800 undergrad students.

... the University provides need-based scholarships and grants to 37% of undergraduates. For the 2013-14 academic year, students with need received an average award of $38,500, which included scholarship and grant funds of $29,700. - Wake Forest Director of Financial Aid

Notice the Student Financial Aid Office, at Wake Forest University, states "the James W. Denmark Loan Fund is the oldest college loan program in the United States." The loan fund's Form 990 shows net assets of $3.8M, as of the most recent published filing.

James W. Denmark Loan Fund Form 990
Interest & dividends from investments $52,457
Interest from students $53,246
Loss on sale of investments ($6,304)
Increase value of securities $58,003
Allowance doubtful notes ($150,000)

The form states:

The Financial Aid Office at Wake Forest University determines which students qualify for financial aid. They issue the notes to the students which are signed by the student. The notes are held at Wake Forest University until the money is repaid in full. Then the paid off note is returned to the student.

While the fund is small, it is not insignificant as one financial aid opportunity available to prospective Wake Forest students. Wake Forest University is ranked #23 by U.S. News & World Report, with Princeton, Harvard, Yale, Columbia and Stanford University ranking 1-5.

Of all the universities in the U.S., #23 is fairly impressive. Of course rankings change from year to year. Thus far it appears Wake Forest University and Wake Forest Baptist have grown from historic roots. These institutions have faced numerous economic conditions in the past.

Wake Forest Proceeds

The results of both institutions' use of proceeds, from their new debt issuances, will be important for investors to follow. The muni bond prospectus shows the Series 2012A bonds' $122.8M is for "project costs," the Series 2012B bonds were to be deposited "for redemption of the bonds to be refunded" ($58M) and "payment of the taxable loan" ($63M). The Series 2012 variable rate bonds are also split between the deposit and payment aforementioned, while the Series 2012 direct purchase bonds allotted $79.9M to project costs.

The university's offering memorandum shows:

Proceeds of the 2012 Bonds will be used to (1) finance all or a portion of the cost of the Projects (defined herein), (2) pay a portion of the interest on the 2012 Bonds and (3) pay certain expenses incurred in connection with the issuance of the 2012 Bonds.

Here are the 9 listed projects:

  1. Residence Hall #1
  2. Residence Hall #2
  3. New Dining Hall
  4. Wellness Center (design and construction)
  5. Renovations to Central Heating Plant
  6. Farrell Hall (Construction 126,000 sq. ft. facility for Schools of Business)
  7. Wellness Professional Center Renovation
  8. Scales Fine Arts Center Renovation
  9. Renovations to Hearn Plaza and Kirby Hall
  10. Other Campus Improvements (renewal of other Reynolds Campus infrastructure)

Wake Forest University is about to celebrate its 180th anniversary. The university appears to be expanding, keep in mind the school was originally in a different location. So, the original facilities in Winston-Salem are approximately 65 years old. The original Wake Forest campus is used for alumni gatherings.

The municipal bond paperwork states:

In addition to relationships with other hospitals and physicians, Wake Forest Baptist may consider investments, ventures, affiliations, development and acquisition relating to other healthcare-related entities. These may include home health care, long-term care entities or operations, infusion providers, pharmaceutical providers and other health care enterprises...

Again, you can see the differences between the university and health network. It has become common for university affiliated hospital networks to buy up smaller rural hospitals and include them in their network. Whereas Wake Forest University has a main campus and is far more centralized. Of course universities do branch out too.

A university needs class rooms and space for students who live on campus. A hospital needs rooms for exams, surgeries and inpatient care.

Wake Forest in Winston-Salem

Let's take a look at the location:

In the 1940s and 1950s Wake Forest University and the School of Medicine moved east, from Wake Forest to Winston-Salem. The Reynolds family made large donations of land and money, which coincided with the move.

So, Wake Forest University gravitated to the second largest city in North Carolina. The Reynolds patriarch, R.J. Reynolds was born in 1850. He died of pancreatic cancer in 1918.

Richard J. Reynolds (1850-1918)

Wake Forest: Reynolds' Force On Tobacco Road

Mr. Reynolds was the wealthiest man in North Carolina, having built his own tobacco company in 1874. After R.J. Reynolds died, his brother William took over. In 1924 Bowman Gray became president. Gray's family donated to Wake Forest's medical school, and offered a large amount of money, if the school moved to Winston-Salem.

The Reynolds family offered a large plot of land adjacent to their estate, for Wake Forest University, if it would move too. Both schools took the Reynolds' leadership up on their offers. Today the university is affiliated with the Reynolda House Museum of American Art, at the home the family moved into shortly before R.J. Reynolds died.

Hardin W. Reynolds & Sons, Hardin W. Reynolds portrait on left (circa 1870's). B&W group portrait standing: Walter, Will seated: R.J., Abram and Harbour Reynolds (1915)

All of R.J. Reynolds' brothers worked in tobacco, which was a very popular business in early America. R.J., seated far left, competed with his oldest brother Abram, seated in the middle.

R.J. Reynolds Jr. (1906-1964) source: Patrick Reynolds Collection

R.J. Reynolds Jr. became terminally ill with emphysema in his mid-50s. His son, Patrick Reynolds, leads several anti-tobacco foundations.

Patrick first spoke out publicly in 1986 against the tobacco that was the foundation of his family's fortune. In 1989, he founded the Foundation for a Smokefree America, and in 1994, launched the website, Tobaccofree.org and later, Anti-smoking.org.

Wake Forest University's location and tobacco heritage is somewhat ironic and illustrative of the relationship between corporate interests and healthcare. Wake Forest Baptist is recognized by the National Cancer Institute, and the entire health network strives for excellence.

Reynolds American (NYSE:RAI) and contemporary tobacco companies have control over one of the top causes of the worst of the worse diseases Wake Forest Baptist tries to confront. The problem being cigarettes are designed to be far more addictive than simple rolled tobacco.

Unfortunately, cigarette companies' primary goal is to sell more. If they sell less, profits could dry up. However, by selling more, the burden on healthcare is tremendously worse. Meanwhile, tobacco companies are literally adding numerous candy ingredients, ("brown sugar, caramel color, carob bean extract, carrot seed oil, chocolate liquor, cinnamon bark oil, cocoa, fig juice, glycerol, high fructose corn syrup, licorice extract, lime oil, mandarin oil, prune juice, spearmint oil") to make their products infinitely more addictive.

Informed Investing

Though every single detail is of importance, when trying to paint a comprehensive image of an institution. There is simply no way to have every detail. Clearly Wake Forest Baptist's priority should be to save lives. I believe the expected $3.5M expenditure on the name change was excessive.

Indeed $3.5M was close to 1% of the $370M in municipal debt issued. A design team had to create a new logo. Various new outdoor and indoor signs needed to be made and installed, software and websites needed to be revised, new ID cards were needed. In addition to letterhead and custom logo products, like clipboards, stethoscopes and pens.

It is unclear whether Wake Forest Baptist received competing bids for the project. However, I view the expenditure as the straw that broke the camel's back, in terms of credit rating. Specifically due to the fact investment income only narrowly buffered a massive Q3 operating loss. Denver-based Monigle Associates published a case study of the Wake Forest Baptist Health rebranding.

Source: Monigle Associates

This said, the effect on the credit rating could be viewed as an opportunity. I have no doubt Wake Forest Baptist provides excellent medical education and care. Though, an entire class could have been conducted on how to implement a name change for 50% of the amount spent on this one.

I would rather see the medical programs receive multi-million dollar projects while the "name changing team" at Wake Forest Baptist be handed a violin and a receptacle for spare change to raise funds.

I believe Wake Forest Baptist has good intentions, additionally no one is expected to work for free. Though, $3.5M is a fortune, if given to the right person it could make dramatic improvements on all of medicine.

Despite my criticism of the expected cost of the rebranding, I am interested by both Wake Forest University and Wake Forest Baptist Obligated Group debt. The University seems more stable, however, the health network appears to be working earnestly.

Investors, who focus on health related institutions, realize tobacco creates a tidal wave of burdens on healthcare. There are two opposing forces: One is against tobacco, the other profits from tobacco.

There are also groups attempting to remedy the mess created by tobacco. Wake Forest Baptist stands out in this regard, for their expertise. Though, even today there is little to nothing that can be done for the diseases that affected R.J. Reynolds and R.J. Reynolds Jr. Physicians are so busy with tobacco-related diseases, patients with conditions, like pancreatic cancer unrelated to tobacco, receive less of their valuable time. Ironically the people who could make Wake Forest Baptist's job a lot easier sit in a boardroom a few miles away at Reynolds American.

If you have any thoughts on Wake Forest, please leave a comment.

Disclosure: I am long RAI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am considering Wake Forest University corporate bonds. I am not averse to municipal bonds issued for Wake Forest Baptist Obligated Group, though am not currently considering them. This article is not a recommendation to buy, or sell. Please consult a financial adviser to determine proper allocations, if any, to educational or health care debt.