Fitch Rates UPMC's 2014A and 2014B Revs 'AA-'; Outlook Negative

NEW YORK--()--Fitch Ratings assigns an 'AA-' rating to the following series of bonds expected to be issued on behalf of University of Pittsburg Medical Center (UPMC):

--$350,000,000 Pennsylvania Economic Development Financing Authority (PEDFA) revenue bonds series 2014A;

--$50,000,000 Monroeville Finance Authority (Allegheny County, PA) revenue bonds series 2014B.

Fitch also affirms the 'AA-' rating on UPMC's outstanding parity debt (issued through the Pennsylvania Higher Educational Facilities Authority, Allegheny County Hospital Development Authority, University of Pittsburgh Medical Center, Monroeville Finance Authority and Pennsylvania Economic Development Financing Authority.

The Rating Outlook is maintained at Negative.

The series 2014A and 2014B bonds are expected to be issued as fixed-rate bonds and sold via negotiation the week of Sept. 8, 2014. Proceeds of the 2014 bonds will be used to fund $150 million of UPMC capital expenditures and the remaining proceeds will refund selected maturities of outstanding bond series: $167 million of the $179.6 million September 1, 2014 bullet maturity of the 2008A series (with the remaining being paid from UPMC cash), $50 million of the series 2008B June 15, 2018 bullet maturity and $19.85 million August 15, 2034 term bond of the series 2009A. The 2014A bonds will have a July 1, 2045 final maturity and the 2014B bonds will have a July 1, 2035 final maturity; maximum annual debt service (MADS) of $312.3 million on all outstanding indebtedness occurs in 2015. Debt service reserve funds will not be funded in connection with the 2014 bonds.

SECURITY

The bonds are secured by a revenue pledge of the Obligated Group. UPMC standardized its bond covenants under the 2007 Master Trust Indenture (2007 MTI), and the series 2014 bonds will constitute parity debt under the 2007 MTI. UPMC (the parent corporation), UPMC Presbyterian Shadyside, Magee-Womens Hospital of University of Pittsburgh Medical Center, UPMC Passavant and UPMC St. Margaret are members of an obligated group under the 2007 MTI. The Obligated Group accounted for 29% of system revenues in 2014.

KEY RATING DRIVERS

INCREASED COMPETITIVE PRESSURE: The maintenance of the Outlook at Negative is based on the heightened competitive environment for managed care lives in the western Pennsylvania market as a result of the formation of the Allegheny Health Network (AHN), combining the dominant Western Pennsylvania insurer Highmark with the former WPAHS hospitals and several other community providers. However, the recent signing of the Highmark UPMC Consent Decree will have the effect of moderating the impact of the non-renewal of the Highmark contract on UPMC, and the organization has shown progress towards implementing a strategy that successfully reduces its dependence on Highmark commercial insurance members.

MARKET LEADER IN WESTERN PENNSYLVANIA: UPMC's main credit strength is its dominant market share of the Western Pennsylvania market with an estimated 61% share in Allegheny County and a 42% share of the 10 immediately surrounding counties, which has increased in 2014. Additionally, Fitch views UPMC's revenue diversification, which includes the insurance division generating over 40% of system revenues, as a credit positive.

COMPRESSED PROFITABILITY: UPMC's generated operating income of $60.2 million in fiscal 2014 (year-end June 30), equal to an operating margin of 0.5%, slightly lower than the budgeted 1%. However, UPMC generated a solid $602. 9 million cash-flow from operations, double that of the prior year. Management has lowered their expectation of operating margin for the next five years to below 1%, but has forecasted cash-flow to remain solid, generating sufficient debt service coverage in the mid-3% range.

MANAGEABLE DEBT BURDEN AND STABLE LIQUIDITY: The system's leverage remains manageable with MADS remaining at a moderate 2.7% of revenues and MADS coverage of pro forma debt by EBITDA of 3 times (x). UPMC has completed its major capital investments and plans only a moderate level of borrowing over the next five years roughly equal to principal debt amortization, which is not expected to materially increase long-term debt beyond the current level of approximately $3.1 billion. While historically lower than Fitch's 'AA' medians, UPMC's days cash on hand (DCOH) were stable at 132.9 days at June 30, 2014 and cash to pro-forma debt is 120.6%.

RATING SENSITIVITIES

NEED TO MAINTAIN STRONG OPERATING CASHFLOW: The maintenance of the 'AA-' rating is contingent on UPMC maintaining its historically strong operating cash-flow. Going forward, this is partially dependent on the ability to execute on the strategy of replacing some of the expected loss of volume to Highmark with volumes generated from contracts with the national insurers and its own Health Plan. The Negative Outlook reflects the uncertainty regarding the shift in the commercial enrollment market in the 2015 benefit year. Fitch expects greater clarity within the next 12-18 months.

CREDIT PROFILE

UPMC is the largest healthcare system in Pennsylvania, the largest employer in the region, and one of the largest nongovernmental employers in the state. It is also one of the world's leading organ transplant centers and one of the largest cancer networks in the country. The system is affiliated with the University of Pittsburgh of the Commonwealth System of Higher Education (University), which is among the top 10 recipients of National Institutes of Health research funding.

UPMC owns and operates more than 20 hospitals in Pennsylvania with close to 5,000 beds in service and more than 400 clinical locations in the region. With a total revenue base of $11.4 billion in 2014, 60,000 employees, including approximately 3,500 employed physicians and 2.3 million covered lives in its network of health insurance plans, UPMC ranks as one of the largest integrated healthcare delivery networks in the country. UPMC recently divested its ownership of UPMC Beacon in Ireland, paying 20 million euros, which was the amount guaranteed by UPMC, but decreasing its long term debt by $231 million.

UPMC is also a part owner of Evolent, a health management company that provides knowhow, staff and management expertise in risk management to health care organizations preparing a move to value based care. Evolent has already signed on several large health care systems and Fitch believes that the company has a significant potential to grow and add to UPMC's revenue diversification.

UPMC HIGHMARK CONSENT DECREE

The maintenance of the Negative Outlook is based on the still evolving competitive situation in the managed care market in Pittsburgh and the heightened credit risk from the potential loss of some of the Highmark subscribers, who accounted for 19% of UPMC gross hospital revenues in fiscal 2014. UPMC and Highmark were unsuccessful in renegotiating a renewal of their long term contract beyond the current Dec. 31, 2014 termination date, which would have precluded Highmark commercial subscribers' in-network access to most UPMC facilities.

Pressure from the Pennsylvania governor's office and the Attorney General's office has produced the June 27, 2014 signing of a five-year Consent Decree (Decree), which will provide for a more gradual transition, allowing access for patients undergoing current treatment, and oncology, pediatric and psychiatric patients, to be able to access UPMC facilities at in-network rates during the transition period. Additionally, eight of the UPMC hospitals located either in geographic areas where UPMC is the sole provider or sole provider of services, such as Children's Hospital and Western Psychiatric Hospital, remain in-network for Highmark subscribers and out-of-network costs will be capped at 60% of charges. However, much of the Decree provisions remain subject to interpretation and the above list is by no means comprehensive or complete. The Decree affects commercial lives only, as Medicare and Medicaid populations will continue to have access to UPMC facilities at in-network rates.

UPMC has been preparing for the non-renewal of the Highmark contract for some time now and management has been implementing a plan to replace the Highmark volumes with contracts with the national insurers, which had previously had a relatively negligible share of the Pittsburgh market, including Aetna, Cigna, United and HealthAmerica. The strategy appears to be heading in the right direction as gross patient revenues from contracts with the national insurers more than doubled to 7% between 2011 and 2014, while during the same period revenues from Highmark enrollees decreased to 19% from close to 25%.

UPMC's budget for 2015 projects a potential loss of admissions. The UPMC Health Plan enrollment has been steadily increasing with current enrollment in all product categories at 2.3 million, more than doubling since 2006. The enrollment of the fully insured commercial lives in UPMC Health Plan increased by a hefty 44.7% since 2011 to 334,000 at July 1, 2014. UPMC management believes that the strong UPMC brand name, its significant employed physician component, combined with what may be a more open plan offered by the national insurers versus the narrower Highmark network, should result in a shift of a sufficient number of the former Highmark subscribers to the national insurers and UPMC Health Plan. Failure to fully realize the strategy to replace the Highmark subscribers could lead to downward rating pressure.

COMPRESSED PROFITABILITY

UPMC's financial metrics have historically been below 'AA' category medians, with the Fitch rating based to a significant degree on the system's very strong market position with an aligned medical staff and a two million plus member Health Plan. UPMC ended fiscal 2014 with operating income of $60.2 million for an operating margin of 0.5% and operating EBITDA margin of 5.6%. System revenues increased by 12.1%, both net patient revenues and health plan revenues, which accounted for 42% of total revenues. Management was able to reduce expenses, resulting in operating profit improved over the breakeven 2013 performance. Management has revised their operating margin projections to now less than the previous 1%, but a recent announcement that Pennsylvania will accept Medicaid expansion might have a slight unbudgeted positive impact.

NO INCREASE IN DEBT AND STABLE LIQUIDITY

Following the issuance of the series 2014 bonds, UPMC will have approximately 80% of its debt at fixed interest rates. Management projects that the system will be issuing between $100 million and $300 million of debt annually over the next five years, roughly equivalent to its principal amortization during those years, with the target of keeping outstanding long-term debt at the current level of approximately $3.1 billion.

Although UPMC's debt burden is moderate (pro-forma MADS equated to 2.7% of fiscal 2014 total revenue), most of its debt metrics fall below the AA category medians with 3x coverage of pro-forma MADS by EBITDA (includes $150 million of new money from the series 2014 financing) in fiscal 2014, as compared to the 'AA' category median of 5.4x, and debt to EBITDA of 3.6x in 2014 compared to the AA category median of 2.9x. MADS is calculated per MTI definitions for the treatment of several balloon payments.

Unrestricted cash and investments were reported at $3.97 billion at June 30, 2014, an increase of $474.7 million since the prior year, equating to 132.9 DCOH on hand, cushion ratio of 12.7x and cash equal to 120.6% of pro forma debt, lower than the 'AA' medians. However, there is relatively modest capital spending planned over the next couple of years, not exceeding system depreciation expense. The largest single expenditure in the $450 million capital plan for 2015 is $120 million for IT.

DISCLOSURE

UPMC's quarterly and annual disclosures to industry participants (including EMMA) have been excellent and consist of full financial statements, utilization and other information, and management's discussion and analysis of results, which Fitch views favorably.

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

Applicable Criteria and Related Research:

--'U.S. Nonprofit Hospitals and Health Systems Rating Criteria' (May 30, 2014).

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=746860

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=867315

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Contacts

Fitch Ratings
Primary Analyst
Eva Thein
Senior Director
+1-212-908-0674
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Gary Sokolow
Director
+1-212-908-9186
or
Committee Chairperson
James LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Eva Thein
Senior Director
+1-212-908-0674
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Gary Sokolow
Director
+1-212-908-9186
or
Committee Chairperson
James LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com