NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the 'A+' long-term rating on approximately $6.4 billion of CHI's outstanding long-term debt and affirmed the 'F1+' short-term ratings on $1.1 billion of debt additionally supported by CHI's self-liquidity.
The Rating Outlook is revised to Negative from Stable.
Unsecured general obligation of the CHI Credit Group.
KEY RATING DRIVERS
WEAKENED CORE OPERATING PERFORMANCE: The Outlook Revision to Negative from Stable reflects continued challenges in improving overall core operating performance, which was affected heavily by losses in certain market-based organizations (MBOs). About breakeven operating margin in the fiscal year ended June 30, 2014 was significantly below the budgeted 1.9%, primarily driven by large losses in Kentucky operations as well as higher than budgeted IT expenditures. Through the four month interim period ended Oct. 31, 2014, profitability deteriorated further to a negative 1.9% operating margin largely due to revenue shortfalls in Nebraska and continued IT expenses over budget.
NEED TO EXECUTE MBO STRATEGY: Fitch believes CHI's strategy to focus resources and investments in select MBOs to build sufficient size and scale in order to develop and/or participate in value-based reimbursement and population management programs is appropriate. While the highly pressured financial position elevates the inherent execution risk of repositioning the system, Fitch expects that CHI should begin recognizing benefits from investments made to date and make meaningful progress towards thriving under the changing revenue and reimbursement models prompted by healthcare reform.
DECLINE IN LIQUIDITY: Unrestricted cash and investments totaled $6.6 billion at Oct. 31, 2014, below Fitch's expected level of above $7 billion. While overall liquidity metrics compare unfavorably against Fitch's 'A' medians and days cash on hand of 169 marks one of the lowest points in CHI's recent financial history, 13.1x cushion ratio and 82.3% cash to debt are relatively consistent with Fitch's projections at the time of last rating action and are adequate for the current rating.
CONSISTENT DEBT SERVICE COVERAGE: The affirmation of the 'A+' rating is supported by consistent coverage of maximum annual debt service (MADS) by EBITDA of 2.6x in fiscal 2014 and 2.5x in the interim period. Despite weak profitability ratios, growing revenue base and sound realized investment gains allowed for maintenance of adequate coverage for the current rating.
SUFFICIENT LIQUIDITY TO SUPPORT SHORT-TERM RATING: CHI has sufficient liquidity in the form of highly liquid unrestricted cash and investments and dedicated lines of credit to support the short-term rating of 'F1+'. As of Oct. 31, 2014, CHI's ratio of eligible cash and investments to variable-rate obligations exceeded Fitch's criteria threshold of 1.25x.
RETURN TO PROFITABILITY: Management is implementing detailed long-range plans to promote system-wide efficiencies which are expected to return the system to historical profitability and rebuild balance sheet liquidity over the next 2 - 3 years. The rating affirmation reflects Fitch's belief that progress in improving CHI's financial performance over the next 12-18 months, with an eventual return to historical levels (> 9.0% operating EBITDA margins), is possible. An inability to improve profitability over the outlook period will lead to a downgrade.
LIMITED DEBT CAPACITY: Fitch believes there is little room for additional debt at the 'A+' rating without significant improvement in cash flow.
SHORT TERM RATING LINKAGE: A downgrade of CHI's long-term rating to below 'A+' would trigger a corresponding lowering of CHI's short-term rating.
CHI is one of the largest not-for-profit integrated healthcare delivery system in the U.S. The system sponsors 11 markets in 18 states, consisting of 105 acute care hospitals (30 of which are designated as critical access hospitals); numerous long-term care, assisted living and residential facilities; two community health service organizations; and two nursing colleges. The consolidated system generated $13.8 billion in total operating revenues in the fiscal year ended June 30, 2014.
Continued Weak profitability
The Negative Outlook reflects the continued challenges in turning around core operating performance, resulting in large variances from budgeted results. In fiscal 2014, operating and operating EBITDA margins were 0% and 6.8% respectively, compared to the 'A' category medians of 2.5% and 9.5%. Further weakening was experienced in the four-month interim period in fiscal 2015, with operating and operating EBITDA margins of negative 1.9% and positive 5.2%, respectively.
Fiscal 2014 was heavily impacted by shortfalls in the Kentucky market, which posted a negative 10% operating margin (over $100 million under budget). Management's current priority involves developing stronger partnership with the University of Louisville, stabilizing operations, building out the KentuckyOne medical group, and further developing its clinically integrated network. Operations appear to be on a turnaround track with positive operating EBITDA margins in the fiscal 2015 interim period compared to losses in prior years.
Losses in fiscal 2015 have been largely driven by IT expenditures, unfavorable investment returns related to First Initiatives Insurance Ltd., and revenue shortfalls in Nebraska, where a contract dispute resulted in termination of the Blue Cross Blue Shield contract on Sept. 1, 2014. While plans are underway to mitigate the losses and reach a resolution, a significant amount of risk remains as the contract remains under negotiation and volume shortfalls continue to impact top-line revenues.
Management has a number of clinical and operational excellence plans in place with savings projected to be approximately $283 million in fiscal 2015 and $345 million in fiscal 2016, which falls at the low-range of potential opportunities. Fitch notes that CHI exceeded its 2014 savings target of $141 million and anticipates similar results in fiscal 2015.
Strategic MBO Development Continues
Fitch views CHI's size, scale and geographic diversity as positive credit factors, which allow for greater economies of scale and efficiency as well as providing a certain level of insulation from negative changes in specific markets or states. Management continues to implement its 'Next Era of Healthy Communities' business strategy in anticipation of the upcoming incentives and rewards of health care reform. The fundamental elements of its overall strategy focus on improvement in clinical quality and outcomes aided by a robust IT platform, research capabilities, tight expense control, and the development of a more comprehensive care continuum outside of its acute care operations to manage community and population health. The strategy includes a plan to reposition the system to establish sufficient size and scale in its key markets in order to develop and/or participate in value-based reimbursement and population management programs. As a result, the system has been active in mergers, acquisitions, and divestitures, and each MBO presence has been fortified with expanding geographic reach.
The most notable investment in recent years, the Texas market, has been progressing as planned with a significant network developed in less than two years. Thus far, CHI has acquired St. Luke's Episcopal Health System (June 2013), Memorial Health System of East Texas (June 2014), and Sylvania Franciscan Health (November 2014). Additionally, CHI has built key affiliations including Baylor College of Medicine, Texas Heart Institute, and Texas Children's Hospital. Management notes that significant opportunities remain to improve efficiency, control costs, and expand its ambulatory presence in the region. In fiscal 2014, CHI's Texas operations generated 9% of total operating revenues.
Other acquisitions in the last two years include acute care facilities in North Dakota, Arkansas, and Washington. While the pace of acquisition activity has pressured financial performance in recent periods, Fitch believes it is consistent with management's articulated strategy of building market relevance in its existing markets to facilitate population health management and care delivery transformation.
Weakened but Adequate Liquidity
Unrestricted cash and investments totaled $6.6 billion at October 31, 2014, which is below Fitch's expectation of above $7 billion, and days' cash on hand remaining closer to 200 days. Days cash on hand declined to 169 days from a recent high of 270 days at FYE 2011, representing combined impacts of weakened cash flows, elevated capital expenditures, and expense base growth that has significantly outpaced liquidity growth. Liquidity against debt levels are unfavorable against the medians but relatively unchanged from one year ago with 13.1x cushion ratio and 82.3% cash to debt.
The affirmation of the 'F1+' short-term rating is supported by the adequacy of CHI's highly liquid resources, which are available to fund any un-remarketed puts on the following: $163.3 million in weekly VRDBs, $358.2 million of Windows VRDBs, and up to $881 million in CP ($591.7 million drawn as of December 15, 2014). CHI has directed dealers to tranche maturities so that no more than $200 million matures within any five-day period.
At Oct. 31, 2014, CHI had approximately $2.3 billion of highly liquid, unrestricted cash and fixed income securities, and dedicated working capital lines available. CHI has total funding sources available to meet the tender exposure in excess of Fitch's 'F1+' threshold of 1.25x. Fitch has received a written internal procedures letter from the organization, which outlines internal policies to meet any funding requirements.
Robust Capital Plans
Capital spending is expected to remain elevated, with $1.4 billion budgeted for fiscal 2015. Investment in IT continues to be the dominant component (35% of total) and 26% is allocated for facility repositioning and expansion and 25% for strategic growth. Historically, CHI has funded the majority of its capital needs from operational cash flow and long-term debt. This level of capital spending is well in excess of depreciation expense. Fitch expects that capital spending can be flexed in response to changes in profitability and market conditions.
As of Oct. 31, 2014, CHI had outstanding $8.5 billion in total debt, which includes $482.4 million in commercial paper and $957 million in non-Capital Obligation Debt. Approximately 76% of debt is fixed and 24% are issued as a variety of floating rate products (weekly VRDBs, windows VRDBs, FRNs, and commercial paper). Fitch notes that an additional $109 million was drawn on CP to refund Memorial Health System of East Texas debt on November 20, 2014 and $591.7 million was outstanding as of December 15, 2014.
Despite weakened profitability ratios, coverage of MADS was relatively consistent at 2.6x in fiscal 2014 and 2.5x in the 2015 interim period, reflecting an overall expanded revenue base. MADS as a percentage of revenue of 3.6% is only modestly higher than the 'A' median of 3.1%.
Fitch uses a MADS of $499.1 million, which incorporates a smoothing of bullet maturity structure. Without smoothing, MADS increases to $847.5 million occurring in 2018, decreasing MADS coverage in 2014 and YTD 2015 to 1.6x and 1.5x, respectively. Fitch notes that this amortization structure is becoming more common among tax-exempt borrowers. CHI's historical market access and balance sheet liquidity somewhat mitigate concerns.
CHI's swap portfolio represented an aggregate notional amount of $1.4 billion as of October 31, 2014, which includes seven floating-to-fixed CHI swaps, four St. Luke's Health System swaps, two Memorial Health System of East Texas swaps, and one St. Alexius Medical Center swap. Counterparties are UBS, JPMorgan, BLB, Morgan Stanley, Piper Jaffray, and US Bank. At October 31, 2014, the swaps had an approximate mark to market of negative $278 million with $173 million of collateral posted.
CHI bond covenants require quarterly and annual disclosure to bondholders. Disclosure has been excellent, including detailed statements with management discussion and analysis which are available on CHI's website at 'www.catholichealthinitiatives.net' or at 'www.dacbond.com'.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Revenue Supported Rating Criteria' (June 16, 2014);
--'U.S. Nonprofit Hospitals and Health Systems Rating Criteria' (May 30, 2014);
--'Rating U.S. Public Finance Short-Term Debt' (Dec. 9, 2013).
Applicable Criteria and Related Research:
Revenue-Supported Rating Criteria
U.S. Nonprofit Hospitals and Health Systems Rating Criteria
Rating U.S. Public Finance Short-Term Debt