Fitch Affirms Meritus Medical Center's (MD) Revs at 'BBB'; Outlook Stable

NEW YORK--()--Fitch Ratings affirms the 'BBB' rating on the approximately $256.3 million series 2008 bonds issued by Maryland Health and Higher Educational Facilities Authority on behalf of Meritus Medical Center (Meritus; f/k/a Meritus Health).

The Rating Outlook is Stable.

SECURITY

The bonds are secured by mortgage, gross receipts pledge, and debt service reserve fund.

KEY RATING DRIVERS

EXTENSION OF THE TPR PROGRAM: Maryland Health Care Cost Review Commission's (HSCRC) Total Patient Revenue (TPR) reimbursement methodology program was approved for another three year period to run through fiscal year end 2016. The program provides revenue predictability for hospitals participating in the program by guaranteeing a predetermined level of revenue, regardless of volume or case mix, but is adjusted for population demographics, bad debt and inflation.

WEAKER 2014 INTERIM RESULTS: For the Dec. 31 2013 six month interim period, Meritus reported a loss of $1.5 million (negative 0.8% operating margin), after solid performance in fiscal 2013, which ended with an operating gain of $7.9 million (2.1% operating margin). The primary driver behind the operating loss was an increase in volume, which has a negative financial impact under TPR, unless accompanied by a concomitant decrease in expenses.

FORMATION OF A REGIONAL ALLIANCE: Fitch views positively the recent formation of a regional alliance with two area hospitals, intended to produce benefits in terms of quality, population health management and lower cost of care over time.

ELEVATED DEBT BURDEN: Meritus's debt burden is high due to the large debt issuance in connection with a replacement facility that opened in 2010. Coverage of maximum annual debt service (MADS) by EBITDA was 2.5x in fiscal 2013 and was 2.0x though the six-month interim period ended Dec. 31, 2013. MADS as percent of revenues and debt to capitalization, while slowly declining, are still high at 5.8% and 54% respectively.

RATING SENSITIVITIES

NEED FOR OPERATIONAL IMPROVEMENT: Fitch expects Meritus to execute on its financial improvement plan with a target of reducing expenses by $10 million over the next 18 months. Failure to return to positive operating results could lead to negative rating pressure.

CREDIT PROFILE

Meritus Medical Center is a 257-bed hospital located in Hagerstown, MD. Following a corporate reorganization effective Jan. 1, 2013, Meritus Medical Center is the only member of the obligated group. Fitch's analysis is based on the consolidated system. Total system revenues in fiscal 2013 (June 30 year-end) were $371 million.

The rating affirmation reflects the organization's dominant market position of over 80% in conjunction with participation in the TPR program, which provides institutions with a predictable stream of revenue. The recent dip in operating performance, as well as the organization's elevated debt burden, albeit slowly declining, constitute the main credit concerns.

Fitch views favorably the recent formation of a regional alliance with Frederick Memorial Hospital (230 beds, Fitch rated 'BBB+'/Outlook Stable) and Western Maryland Hospital System (283 beds). The alliance will have a community board consisting of members from the three hospitals and will hire a CEO within approximately 60 days. The three member hospitals have total revenues of $1.3 billion and will eventually jointly manage revenue cycle, lab, IT, materials management, human resources and purchasing. The alliance will provide increased scale to more efficiently operate support functions and should enable the members to realize cost savings as well as jointly working on clinical quality improvements and creating a base for population health management.

WEAKER 2014 INTERIM RESULTS

Meritus's fiscal 2013 operating performance was solid and was in line with the budget and Fitch's expectation. The fiscal year ended with operating income of $7.9 million, equal to an operating margin of 2.1% and operating EBITDA margin of 12.7%, the highest since 2010 and slightly exceeded the budget of $7 million operating income. The operating results exclude the impact of an $11.3 million final non-cash pension settlement costs incurred in connection with the now terminated cash balance pension plan. Through the six months ended Dec. 31, 2013, Meritus recorded an operating loss of $1.5 million for a negative 0.8% operating margin, although the operating EBITDA margin, at 9.2%, was consistent with the 'BBB' median of 9%. The operating loss was driven mainly by higher than expected inpatient volumes - a hefty increase of 6.9%, which negatively impacted Meritus under the TPR program and resulted in an estimated $3 million negative impact on operations.

Some of the volume increase included avoidable admissions and readmissions (regulatory agencies estimate these as potentially 20% of inpatient volume). Other issues driving the operating loss through the interim period include higher observations days and increase in charity expense and sequestration costs. A financial improvement plan was put in action in January 2014 addressing the avoidable admissions and readmissions problem, as well as implementing a cost reduction effort to reduce expenses by $10 million over the next 18 months. A reduction of 100 positions, but not affecting patient care, has already been implemented through a combination of reduction in force and elimination of vacant positions, which should have a $4.2 million positive impact in the current fiscal year and $8 million annual impact going forward. Management is also renegotiating certain contracts, closed an underutilized urgent care center and sold its five retail pharmacies. While the financial improvement is expected to return the organization to a 3% operating margin by fiscal 2015, management projects to end the 2014 fiscal year with a $4 million operating gain, a 1% operating margin, short of the budgeted $6.5 million.

ELEVATED DEBT BURDEN

The high debt position remains the major credit concern. MADS at 5.8% as a percent of revenues is high for the rating category, compared to the 'BBB' median of 3.5%, and EBITDA coverage of MADS ($21.4 million, including capitalized leases) of 2.0x through the six-month interim period is lower than the median of 3.1x. Meritus's long-term indebtedness is all fixed rate, and the issuer has no swaps. Given the high debt burden, Meritus will need to demonstrate improved operating performance in the near term or negative rating action is likely to occur. With a new replacement facility, Meritus's capital budget is a fairly modest at $11 million for fiscal 2014, which is less than 50% of its depreciation expense, and half is for IT.

MIXED LIQUIDITY

Unrestricted cash and investments have grown to $136.7 million at Dec. 31, 2013 from $110 million at 2012 fiscal year end, translating to 144 days cash on hand (DCOH), consistent with the 'BBB' median. Contributing to the liquidity improvement was good cash flow, as well as the sale of a pharmacy for $0.4 million and $1.7 million distribution from Meritus's participation in Premier group purchasing. Cushion ratio and cash to debt at 6.4x and 54% are slowly improving, but still lagging the category medians. A spike in days in accounts receivable (DAR) has also been addressed and DAR now declined to 50.4 days from a high of 68.5 days a year ago.

DISCLOSURE

Meritus covenants to disclose audited and quarterly financial and utilization statements to the Municipal Securities Rulemaking Board's EMMA system.

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

Applicable Criteria and Related Research:

--'U.S. Nonprofit Hospitals and Health Systems Rating Criteria', May 20, 2013;

--'Revenue-Supported Rating Criteria', June 3, 2013.

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=708361

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=709499

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=826010

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Contacts

Fitch Ratings
Primary Analyst
Eva Thein
Senior Director
+1-212-908-0674
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Emily Wadhwani
Director
+1-312-368-3347
or
Committee Chairperson
Emily Wong
Senior Director
+1-415-732-5620
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526 (New York
elizabeth.fogerty@fitchratings.com

Sharing

Contacts

Fitch Ratings
Primary Analyst
Eva Thein
Senior Director
+1-212-908-0674
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Emily Wadhwani
Director
+1-312-368-3347
or
Committee Chairperson
Emily Wong
Senior Director
+1-415-732-5620
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526 (New York
elizabeth.fogerty@fitchratings.com