Fitch Downgrades University Health System (TN) Revs to 'BBB+'; Outlook Stable

NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded to 'BBB+' from 'A-' the Health, Educational and Housing Facility Board of the County of Knox, Tennessee's approximately $232,700,000 series 2007 revenue bonds (University Health System, Inc.). The Rating Outlook is Stable.

The downgrade is substantially based on University Health System's (UHS) weakening overall profitability profile driven by the declining trend in core operating performance over the last three years, combined with a competitive market. UHS' credit strengths remain relatively stable and unchanged and include its status as the regional referral center providing a wide array, as well as several exclusive services to the East Tennessee region; its role as the primary teaching facility for the University of Tennessee Graduate School of Medicine; and its large 450-active physician strong medical staff. In the past, these qualitative factors along with more stable operating performance served to substantially offset UHS' financial metrics that have historically been below the 'A' category. UHS' diminished core operating profitability stems from attenuated TennCare funding, reduced indigent care subsidies and increased charity care costs, and ongoing investment in selected service lines. While UHS' core credit strengths remain stable and substantial, the operating profitability erosion, combined with Fitch's general expectation for a continuation of the sector's difficult operating environment, have tempered Fitch's assessment of the likelihood for sufficient near-term profitability improvement to sustain a higher rating.

For the fiscal year ended Dec. 31, 2008, UHS recorded an operating loss of $5.5 million (a negative 1.1% operating margin), the first year since 2002 with a negative operating performance. Both operating and EBITDA margins, however, have been declining since fiscal 2006 and operating margin continues to be negative for the first quarter ended March 31, 2009. The inadequacy of TennCare reimbursement, representing 16% of UHS' revenues, has historically been viewed by Fitch as a credit risk. Management has taken steps to address the deterioration in operating performance, both with the help of outside consultants to benchmark operating performance and by addressing compensation and staffing levels internally, including a staff reduction implemented in March 2009. The UHS board approved breakeven operating performance for the current fiscal year to allow time for implementation of various cost, efficiency and programmatic issues.

Additional credit weaknesses include UHS' relatively high debt burden, its light coverage of maximum annual debt service (2.2 times in 2008) and its recapitalization efforts as a percentage of depreciation averaging 109.7% over the past three fiscal years, well below 'A' category medians. Owing to a 2006 decision to monetize non-core assets, aided by a conservative investment policy, UHS was able to increase its cash reserves to $138.2 million as of March 31, 2009, equal to 113 days cash from $104.6 million, 98 days cash on hand, in 2006. The sale of the air ambulance service (with UHS maintaining the clinical control over the operations) and the sale of a home health agency added $25 million to cash reserves, and management is in the process of structuring the sale of five medical office buildings, anticipated to close in 2010, which should achieve the realization of meeting the $60 million goal for the asset monetization plan.

Fitch notes that UHS' recent utilization trends have been strong, particularly on the outpatient side, with Emergency Department volumes up by a robust 10.5% last year and outpatient surgeries increasing by 7.5%. Inpatient admissions increased by 2.2% in 2008, partially as a result of the closure of the East Tennessee Baptist Hospital. Both UHS and Covenant Health System (rated 'A' by Fitch) have increased their market share in 2008 as a result of the closure. A slight decrease in inpatient surgery was the result of capacity and throughput issues, which are being addressed. UHS broke ground last fall for the construction of the first heart hospital to be built in Knoxville, which will further help to differentiate UHS' cardiac programs from its competitors and also provide additional intensive care capacity. The $25 million cost of the heart hospital is being funded from the proceeds of the series 2007 bond issue and will not require additional capital outlay by UHS. No other significant capital plans are contemplated in the near future. UHS has, by strengthening its centers of excellence, expanded its regional role, as reflected in the increase of the percentage of patients admitted from outside of Knox County to 60% from 50%. Despite the January 2008 merger of St. Mary's Health System with Baptist Health System of East Tennessee forming Mercy Health Partners, whose parent is the Cincinnati based Catholic Healthcare Partners (rated 'AA-' by Fitch) and the subsequent closure of the Baptist Hospital of East Tennessee downtown facility to inpatient services, the service area remains highly competitive.

UHS has no variable rate debt exposure, all of its long-term debt is fixed rate. UHS has a basis swap with Morgan Stanley with a notional amount of $176 million, which had a negative mark to market value of $9.5 million at May 28, 2009, but has provided positive cash flow to UHS.

The Stable outlook reflects Fitch's belief that UHS can successfully implement the improvement plan and return the organization to a positive operating performance. A return to a 1.5% operating margin is expected by the 2010 fiscal year.

UHS is a 486-staffed bed academic teaching facility which provides a diverse and relatively complex array of clinical services to 21 counties in eastern Tennessee. UHS had total operating revenues of $481 million in fiscal 2008. UHS covenants to provide bondholders with quarterly and annual financial disclosure (including management discussion and analysis) to the NRMSIRs.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.