NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'B-/RR5' rating to Tenet Healthcare Corp.'s (Tenet) $500 million 5% senior unsecured notes due 2019. Proceeds will be used to refinance the 9.25% senior notes due 2015. The Rating Outlook is Stable. A full list of ratings follows at the end of this press release. The ratings apply to approximately $11.3 billion of debt as of March 31, 2014.
KEY RATING DRIVERS:
--During fourth-quarter 2013 Tenet acquired Vanguard Health Systems (VHS), a competing for-profit hospital operator, in an all-cash transaction valued at $4.3 billion. The acquisition was entirely debt funded, resulting in pro forma leverage of 5.7x.
--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 VHS' 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. VHS has several large ongoing capital expansion projects, the funding of which will further pressure cash flows in 2014-2015.
--Given Tenet's negative FCF profile 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.
VHS Acquisition Strategically Sound But Stresses Balance Sheet:
Tenet's fourth-quarter 2013 acquisition of VHS was entirely debt financed. The company issued $1.8 billion of secured notes and $2.8 billion of unsecured notes. This nearly exhausted its capacity for additional debt secured on a pari passu basis to the existing secured notes per the terms of the notes indentures. It also resulted in pro forma leverage of 5.7x and interest coverage of 2.6x.
On a stand-alone basis, the financial profiles of both Tenet and VHS were fairly weak relative compared to the industry peer group. Both companies had high leverage, generated weakly positive or negative FCF, and had industry-lagging EBITDA margins. Weak profitability was partly a business mix issue; Tenet's outpatient operations were historically lacking, and VHS' health plans pulled down overall profitability. In addition to weak profitability, cash generation was strained by high-cost debt and aggressive capital spending.
Fitch thinks the additional scale and broader geographic footprint resulting from the acquisition will aid the recent progress that both companies were making in addressing headwinds to their financial profiles. Synergies are a time-proven component of return on investment in hospital acquisitions, and the strategic rationale for consolidation in the industry is further encouraged by reforms favoring larger, integrated systems of care delivery, including the Affordable Care Act (ACA).
Despite the apparent benefits, Fitch believes the integration of VHS presents some risk to Tenet's credit profile. The company is forecasting that it will achieve $50 million to $100 million of EBITDA growth due to realization of cost synergies in 2014. Fitch believes this is a reasonable number based on the size of the business and the relatively lower operating margins of VHS. However, Tenet does not have a track record of successfully integrating hospital acquisitions; most of the company's recent purchases have been of small outpatient assets.
Operating Trend in-line with Broader Industry:
Tenet's Q1'14 same-hospital operating results showed the headwinds to patient volume exhibited across the industry, with admissions adjusted for outpatient activity down 0.4%, although volume growth was a more favorable 0.3% considering the contribution of Vanguard's facilities. Weak organic growth is expected to continue in 2014; Tenet's public guidance for the year includes -2% to flat growth in admissions. Despite this challenging operating environment, Fitch thinks Tenet's business profile includes several opportunities to boost profitability and generate sustainable growth in EBITDA.
The most important near-term drivers of improvement in the operating profile include Tenet's recent investment in building its outpatient capacity, the anticipated completion of some of the large capital projects in VHS' construction schedule during 2014, and growth of Tenet's Conifer Health Solutions business. All of these initiatives should contribute to sustainable growth in EBITDA and higher operating margins.
Weak FCF Profile:
Tenet's liquidity profile is adequate aside from its persistently negative FCF (equals cash from operations less capital expenditures and dividends). At March 31, 2014, liquidity was provided by $141 million of cash on hand and $825 million of availability on the $1 billion capacity bank revolver. Following the redemption of the $474 million 9.25% unsecured notes maturing in February 2015 with proceeds of the new 5% notes, near-term debt maturities are minimal. Redemption of the 2015 notes also eliminates the potential for the springing maturity of the credit facility to fourth-quarter 2014.
Tenet's limited financial flexibility, most particularly its negative FCF profile, has been the major issue constraining the company's ratings over the past several years. The rate of cash burn had been incrementally improving due to improving operating margins and the refinancing of high-cost debt, but progress reversed somewhat in 2013 and in the LTM ended March 31, 2014 Tenet produced FCF of negative $237 million. Negative FCF was partly the result of the VHS acquisition, which contributed to higher cash outflows for acquisition-related expenses, capital expenditures and interest expense in fourth-quarter 2013.
Fitch expects Tenet to generate positive but thin FCF in 2014, with an FCF margin below 1%. VHS 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. Fitch projects annual run rate capital expenditures of about $950 million in 2014 through early 2015 to support this schedule of projects before the level of spending moderates starting in mid-2015.
Maintenance of the 'B' Issuer Default Rating (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) assuming there is improvement in the FCF forecast supported by stabilization of organic operating trends in Tenet's largest hospital markets and the on-time and on-budget completion of Vanguard's schedule of capital projects.
The Stable Outlook reflects Fitch's belief that the 5.0x leverage target is achievable, based mostly on EBITDA expansion driven by 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. If the company chooses to fund share repurchases with debt and delay deleveraging, it could result in a downgrade of the ratings. A positive rating action is unlikely over the next two to three years.
DEBT ISSUE RATINGS:
Fitch currently rates Tenet as follows:
--Senior secured credit facility and senior secured notes 'BB/RR1';
--Senior unsecured notes 'B-/RR5'.
The Recovery Ratings are based on a financial distress scenario which assumes that value for Tenet's creditors will be maximized as a going concern (rather than a liquidation scenario). Fitch estimates a post-default EBITDA for Tenet of $1.1 billion, which is a 40% haircut to pro forma EBITDA of $1.825 billion considering the contribution of VHS. Fitch's post-default cash flow estimate for companies in the hospital sector considers the structure of the industry, including relatively stable and non-cyclical cash flows, a high level of exposure to cuts in government payor reimbursement that makes up 30-40% of revenues, offset by the consideration that hospital care is a critical public service.
Fitch then applies a 7.0x multiple to post-default EBITDA, resulting in a post-default enterprise value (EV) of $7.7 billion for Tenet. The multiple is based on observation of both recent transactions/takeout and public market multiples in the healthcare industry. Fitch significantly haircuts the transaction/takeout multiple assigned to healthcare providers since transactions in this part of the healthcare industry tend to command lower multiples. The 7.0x multiple also considers recent trends in the public equity market multiples for healthcare providers.
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 $500 million or 50% of the available capacity on the $1 billion 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 21% 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.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Hospitals Credit Diagnosis' (April 10, 2014);
--'High-Yield Healthcare Checkup' (April 4, 2014);
--'2014 Outlook: U.S. Healthcare' (Nov. 25, 2013);
--'For Profit Hospital Insights: Fitch's Annual Review of Bad Debt Accounting Policies and Practices' (Oct. 24, 2013);
--'Margin Preservation Strategies: Different Angles (U.S. Hospitals and Health Insurers)' (Oct. 1, 2013);
--'The Affordable Care Act and Healthcare Providers: Assessing the Potential Impact' (May 1, 2013);
--'Corporate Rating Methodology' (May 28, 2014).