NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed and removed the ratings of Tenet Healthcare Corporation (Tenet) from Rating Watch Negative following the acquisition of Vanguard Health Systems (Vanguard). The Rating Outlook is Stable. A full list of rating actions follows at the end of this press release. The ratings apply to approximately $10.2 billion of debt.
KEY RATING DRIVERS:
-- Tenet has acquired Vanguard, a competing for-profit hospital operator, in an all-cash transaction valued at $4.3 billion. The purchase price represents 7.7x Vanguard's June 30, 2013 latest 12 months (LTM) EBITDA of $555 million. The acquisition was entirely debt funded, resulting in pro forma leverage of 5.7x at June 30, 2013.
-- Fitch views the purchase of Vanguard as strategically sound because it will enhance the geographic scope of Tenet's portfolio of acute-care hospitals and add operational diversification through Vanguard's health plan business. The strategic rationale for consolidation in the hospital industry is encouraged by reforms favoring larger, integrated systems of care delivery, including the Affordable Care Act (ACA).
-- The most important risks to Tenet's credit profile are the company's strained free cash flow (FCF) and industry lagging profitability. Vanguard has several large ongoing capital expansion projects, the funding of which will further pressure cash flows in 2014-2015.
-- Given Tenet's somewhat limited financial flexibility and the high degree of operating leverage inherent in the business model of a hospital company, persistently weak growth in organic patient utilization in the for-profit hospital sector is a concern.
-- Fitch believes the implementation of the health insurance expansion elements of the ACA will be a positive catalyst for EBITDA growth for the hospital industry starting in 2014, primarily because of a drop in the number of uninsured patients and the associated financial burden of bad debt expense.
VANGUARD ACQUISTION DRIVES HIGHER LEVERAGE
Tenet acquired Vanguard in an all-cash deal for a total consideration of $4.3 billion, including the purchase of Vanguard's public equity for $1.8 billion and the refinancing of $2.5 billion of Vanguard's net outstanding debt. The transaction was entirely debt funded; Tenet issued notes (including $1.8 billion 6% secured notes due 2020 and $2.8 billion of 8.125% unsecured notes due 2022) to finance the acquisition.
Funding of the acquisition resulted in pro forma debt-to-EBITDA of 5.7x for the combined entity, and total secured debt to EBITDA of 2.9x. Tenet does have capacity for additional debt under its debt agreements, although the capacity for debt secured pari passu to the notes is nearly exhausted. The senior secured note indentures limit the company's ability to issue additional secured debt. Secured debt is permitted up to the greater of $3.2 billion and 4.0x EBITDA. Debt secured on a basis pari passu to the secured notes is limited to the greater of $2.6 billion and 3.0x EBITDA. Considering the debt funding of the Vanguard acquisition, Fitch estimates that Tenet has about $2 billion of incremental total secured debt capacity and $150 million in pari passu secured debt capacity.
LAGGING FCF AND PROFITABILITY
The most important risk to the credit profile is strained FCF (cash from operations less dividends and capital expenditures) and industry-lagging profitability. Although Tenet continues to lag industry peers in profitability, the company's operating margins have recently improved, helped by management's strategy to aggressively grow the relatively more profitable outpatient business.
Expansion in FCF has also been aided by the recent refinancing of some of the company's most expensive debt. Despite progress in improving the business mix and reducing fixed interest expense, Tenet's FCF generation remains thin ($7 million in the LTM ended June 30, 2013) and margin expansion has stalled in recent quarters, as weak organic growth in patient volumes has weighed on profitability.
The acquisition will further pressure FCF in the near term due to Vanguard's elevated capital spending profile. Fitch expects Tenet to generate positive but thin FCF in 2013-2014, with a FCF margin below 1%. Vanguard is committed to capital investments in some of its recently acquired markets. However, the funding of these projects will support growth in EBITDA over the longer term. Some of the in-progress projects, including a heart hospital in Detroit, MI and a general acute care hospital in New Braunfels, TX, are scheduled to open in 2014, in time to coincide with the health insurance expansion of the ACA.
While Fitch does not expect Tenet to encounter any major difficulties in the integration of Vanguard it is worth noting that the company does not have a track record of integrating larger acquisitions. Most of Tenet's recent purchases have been small and focused on outpatient services. Assuming a smooth integration process, operating synergies should contribute to improved profitability post the acquisition. Tenet expects to achieve $100 million-$200 million in cost synergies, with half of the benefit realized by the end of the first full year post the acquisition.
While cost synergies are a proven component of return on investment in hospital acquisitions, Fitch conservatively discounts the amount of synergies Tenet expects to realize, with forecasted growth in EBITDA in 2014-2015 instead driven by the implementation of the ACA and organic growth in the business helped by Vanguard's expansion projects.
AFFORDABLE CARE ACT POSITIVE DRIVER IN 2014
Fitch believes the implementation of the health insurance expansion elements of the ACA will be a positive catalyst for EBITDA growth for the hospital industry in 2014-2015, primarily because of a reduction in uninsured patient volumes and the associated burden of bad debt expense. However, modeling the ACA's effects for a combined Tenet/Vanguard is difficult because of uncertainties in the assumptions of the legislation's effects on the industry.
Beginning in 2014, there will be better visibility on the influence of the ACA on the hospital industry. The open enrollment period for health insurance plans offered in the insurance exchanges started on Oct. 1. There was little information available beforehand about the expected number of enrollees and the types of coverage these individual would choose. There are also likely to be further development in the states' Medicaid expansion plans. Post the acquisition, Tenet will have 27 of its 77 acute-care hospitals in Florida and Texas, two states that do not plan to expand Medicaid eligibility on Jan. 1, 2014. This will dampen the positive effects of the insurance expansion provisions of the ACA for the company.
WEAK ORGANIC OPERATING TRENDS
The for-profit hospital industry has been experiencing weak organic operating trends since the trough of the 2007-2009 recession. Conditions have been particularly challenging in the urban markets where Tenet and Vanguard's hospitals are located because of higher levels of Medicaid and uninsured patients (which are less profitable than those with commercial health insurance). Vanguard is also highly exposed to trends in Medicaid through the company's health plan business. The decision by the state of Arizona to cut Medicaid payments rates to providers and cap enrollment has recently been a headwind to that company's operations.
Fitch does not forecast an improvement in organic operating trends in the hospital industry in the second half of 2013. In addition to weak economic conditions, other factors including pressure by commercial and government payors and a growing consumer share of healthcare spending are constraining growth in healthcare utilization. The 2% sequestration of Medicare payments and reforms to Medicare reimbursement required by the ACA will also continue to weigh on top-line growth.
Maintenance of the 'B' IDR will require an expectation of debt-to-EBITDA dropping to near 5.0x by mid-2015. There could be a tolerance for higher leverage at the 'B' IDR (up to 5.5x total debt to EBITDA) assuming the expectation of improvement in the FCF profile. An expectation of an improving FCF profile could be supported by:
--Positive developments in the insurance expansion required by the ACA, such as strong participation in the health insurance exchanges or more state governments opting into Medicaid expansion;
--Evidence of some stabilization of organic operating trends in Tenet's largest hospital markets;
--The on-time and on-budget completion of Vanguard's schedule of capital projects.
The Stable Rating Outlook reflects Fitch's belief that the 5.0x leverage target is achievable based mostly on EBITDA expansion driven by the ACA and organic growth in the business, as opposed to the realization of synergies or the application of cash to debt reduction. Given Tenet's strained FCF, opportunities to pay-down debt are limited. The company has recently been more aggressive in returning cash to shareholders, and has indicated that it will continue to make share repurchases post the acquisition. If the company chooses to fund share repurchase with debt and delay deleveraging, it could result in a downgrade of the ratings. A Positive Rating Outlook is unlikely over the next two-to-three years.
DEBT ISSUE RATINGS:
Fitch has affirmed Tenet's ratings as follows:
--Issuer Default Rating at 'B';
--Senior secured credit facility and senior secured notes at 'BB/RR1';
--Senior unsecured notes at 'B-/RR5'.
The Recovery Ratings (RRs) reflect Fitch's expectation that the enterprise value of Tenet will be maximized in a restructuring scenario (going concern), rather than a liquidation. The recovery analysis is pro forma for the Vanguard acquisition, including the contribution of Vanguard's EBITDA and the debt issued to fund the transaction.
Fitch estimates a post-default EBITDA for Tenet of $1.2 million, which is a 35% haircut from the June 30, 2013 LTM EBITDA level of $1.8 billion. A 35% haircut represents roughly the level of EBITDA decline that results in 1.0x coverage of Fitch's estimate of Tenet's fixed charges adjusted for Vanguard in a distressed scenario, including interest and rent expense and maintenance-related capital expenditures.
Fitch then applies a 6.5x multiple to post-default EBITDA, resulting in a post-default EV of $7.6 billion for Tenet. The multiple is based on observation of both recent transactions/takeout and public market multiples in the healthcare industry. It represents a haircut from recent transaction multiples, which have been ~8.0x, but is close to recent public market multiples.
Fitch applies a waterfall analysis to the post-default EV based on the relative claims of the debt in the capital structure. Administrative claims are assumed to consume 10% of post-default EV. Fitch assumes that Tenet would draw $400 million or 50% of the available capacity on the $800 million revolver in a bankruptcy scenario, and includes that amount in the claims waterfall. The revolver is collateralized by patient accounts receivable, and Fitch assumes a reduction in the borrowing base in a distressed scenario, limiting the amount Tenet can draw on the facility.
The 'BB/RR1' rating for Tenet's secured debt (which includes the bank credit facility and the senior secured notes) reflects Fitch's expectation of 100% recovery under a bankruptcy scenario. The 'B-/RR5' rating on the unsecured notes reflects Fitch's expectations of recovery of 25% of outstanding principal.
The bank facility is assumed to be fully recovered before the secured notes. The bank facility is secured by a first-priority lien on the patient accounts receivable of all of the borrower's wholly owned hospital subsidiaries while the secured notes are secured by the capital stock of the operating subsidiaries, making the notes structurally subordinate to the bank facility with respect to the accounts receivable collateral.
Total debt of $10.2 billion consists primarily of:
Senior unsecured notes:
--$60 million due 2014;
--$474 million due 2015;
--$300 million due 2020;
--$750 million due 2020;
--$2.8 billion due 2022;
--$430 million due 2031.
Senior secured notes:
--$1.041 billion due 2018;
--$1.8 billion due 2020;
--$500 million due 2020;
--$850 million due 2021
--$1.05 billion due 2021.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'The Affordable Care Act and Healthcare Providers: Assessing the Potential Impact' (May 1, 2013);
--'Hospitals Credit Diagnosis' (Sept. 27, 2013);
--'High-Yield Healthcare Checkup' (Jan. 30, 2013);
--'2013 Outlook: U.S. Healthcare' (Nov. 29, 2012);
--'Corporate Rating Methodology' (Aug. 5, 2013).
Applicable Criteria and Related Research:
The Affordable Care Act and Healthcare Providers (Assessing the Potential Impact)
Hospitals' Credit Diagnosis: Escalating Industry Consolidation Pressures Credit Profiles
High-Yield Healthcare Checkup: Comprehensive Analysis of High-Yield U.S. Healthcare Companies
2013 Outlook: U.S. Healthcare -- Navigating a Dynamic Operating and Regulatory Environment
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage