Fitch Affirms Cone Health's (NC) Hosp Revs at 'AA '& S-T Rtg at 'F1+'; Outlook Stable

NEW YORK--()--Fitch Ratings has affirmed the following bonds issued by the North Carolina Medical Care Commissions on behalf of Cone Health at 'AA':

--$54,425,000 hospital revenue refunding bonds, series 2011A;

--$47,885,000 hospital revenue bonds, series 2011B;

--$47,500,000 hospital revenue bonds, series 2004A;

--$85,200,000 hospital revenue bonds, series 2001A and B.

Additionally, Fitch has affirmed the 'F1+' rating on the outstanding variable rate debt issued by the North Carolina Medical Care Commission on behalf of Cone Health.

--$47,500,000 hospital revenue bonds, series 2004A;

--$47,885,000 hospital revenue bonds, series 2011B.

The Rating Outlook has been revised to Stable from Negative.

SECURITY:

Unsecured general obligations of the Cone Health obligated group, which includes Alamance Regional Medical Center (ARMC) following the November 2013 debt issuance. The obligated group represents approximately 86% of the system's 2014 revenues and 94% of system assets. This release considers the consolidated system.

KEY RATING DRIVERS

VASTLY IMPROVED PROFITABILITY IN 2014: The revision to Stable is based on the significant turnaround in operations in fiscal 2014 (year-end Sept. 30; unaudited, but in substantially final form), which ended with operating income of $33.4 million, exceeding budget. Fitch views the fiscal 2014 operating performance as a return to stable operating platform after the large operating loss of $49.5 million in the prior year.

MODERATE LEVERAGE: Debt service coverage returned to a strong level in 2014 with maximum annual debt service (MADS) at 5.8x, better than Fitch's 'AA' rating category median of 5.4x, and the system continues to have very modest leverage with MADS equal to 1.9% of revenues. Cone has completed its major capital improvement plan and absorbed the acquisition of ARMC. There are plans for some consolidation of capacity, but no issuance of additional debt is planned in the immediate future.

DOMINANT MARKET POSITION: The system's market position is supported by a broad placement of inpatient and outpatient service locations, enhanced by the addition of ARMC, garnering market share of 60% or better in a three-county area. The system's position is also supported by a large, loyal referral base of employed and voluntary medical staff. An additional positive is the October 2012 affiliation with Carolinas Health System (CHS). Fitch views the strong North Carolina certificate of need program as a further mitigant to competitive risk.

ADEQUATE LIQUIDITY: Cone Health maintains solid liquidity, with $912.8 million of unrestricted cash and investments at Sept. 30, 2014, translating to 260.3 days cash on hand (DCOH), cushion ratio of 34.5, and cash equal to 183% of long-term debt, all consistent with Fitch's 'AA' medians.

RATING SENSITIVITIES

STABLE OPERATING PERFORMANCE EXPECTED: Fitch believes the organization has returned to a stable operating level more in line with its historical operating profitability. Fitch expects that the system will continue to produce strong coverage, consistent with the 'AA' rating category, while maintaining solid liquidity as it continues to implement the long-range strategic plan.

CREDIT PROFILE

Cone Health is a nonprofit, integrated healthcare system headquartered in Greensboro, North Carolina, operating four acute care and two specialty hospitals, with total revenues of $1.4 billion in the fiscal year ending Sept. 30, 2014 (unaudited). ARMC was merged into the obligated group effective May 1, 2013. Cone Health is in the third year of a 10-year management agreement with CHS, a large healthcare system operating more than three dozen hospitals in North and South Carolina. The net benefit of the affiliation is estimated at approximately $20 million on an annual basis and the affiliation is viewed as a credit positive. Following the retirement of the prior CEO, Terry Akin was promoted to the CEO position effective Oct. 1, 2014. He became the system's COO in 2009.

FINANCIAL PERFORMANCE REBOUNDING

Cone Health's financial performance registered a major turnaround in 2014 as management began implementing a long-range improvement plan addressing both revenues and expenses. Cone ended the fiscal 2014 with operating income of $33.4 million, a more than $80 million improvement over the prior year, equal to an operating margin of 2.4% and operating EBITDA margin of 9.5%, slightly lower than Fitch's 'AA' category medians of 3.9% and 11%, respectively. Major reasons for the improvement in results included improved revenue cycle (cash collection increased by $47 million) working with a new billing vendor, labor productivity improvement following two reductions in force and the introduction of Lean principles in the organization, lower supply chain cost via the CHS affiliation, as well as the absence of non-recurring expenses such as those related to the ARMC merger, EPIC implementation (now almost complete), and consulting expenses. The results were attained despite lower inpatient volumes and additional pension expense of $4.5 million over the required level, part of an effort of increased pension funding in order to allow for termination of the plan within several years. Management has budgeted operating income of $26 million for fiscal 2015, equal to operating margin of 1.9% and operating EBITDA margin of 8.5%, assuming flat volumes, which Fitch believes is achievable.

DOMINANT MARKET POSITION

Cone Health commands a dominant market share in Guilford, Rockingham and Alamance counties ranging between 60%-70%, supported by a highly integrated clinical network, Triad Health Network (THN), with 875 physicians, of whom approximately 40% are employed and over a third are in primary care. THN qualified as an ACO and is one of the largest ACO's in CMS's shared savings program with approximately 70,000 enrollees under various contracts, including Medicare Advantage. THN was one of the highest recipients of dollars under the CMS shared savings program last year - $10.6 million.

CONSOLIDATION OF CAPACITY

The system has initiated a strategic planning process with the goal to consolidate certain women's and children's services and concentrate them at the Moses Cone campus and to update and rationalize behavioral services, and potentially reduce some excess capacity. The plan will require capital investment needed to renovate and create spaces needed for the restructured services in the range of $150 million-$175 million between 2016-2019, but planning is only in the initial stages. Management does not plan to commit any capital investments toward these projects during the current fiscal year. The projects would be initiated at the earliest at the very end of the 2015 calendar year.

MODERATE LEVERAGE

Fitch views Cone Health's moderate leverage as credit positive, with MADS representing a low 1.9% of revenues and debt to capitalization of only 25%, both favorable to Fitch medians of 2.6% and 31%. After weak debt service coverage in fiscal 2013, the return to solid operating performance generated solid 5.8x coverage of MADS by EBITDA in 2014, better than Fitch median of 5.4x. Capital needs going forward are projected to be manageable with projected capital investment close to depreciation expense.

AFFIRMATION OF HIGHEST SHORT-TERM RATING

The affirmation of the 'F1+' short-term rating is based on the availability of highly liquid securities to cover potential maximum liquidity demands presented by Cone Health's outstanding series 2004A weekly variable rate demand bonds (VRDBs) and the series 2011B bonds in the window mode. Cone Health meets Fitch's criteria for assigning short-term ratings based on internal liquidity, requiring coverage of unremarked puts of the maximum tender exposure of the self-liquidity supported debt by a minimum of 1.25x based on Cone Health's cash and highly liquid investments.

Cone Health has procedures in place detailing the process by which internal funds would be liquidated to meet the tender obligations. The 'F1+' rating for the 2011B bonds takes into account Cone Health's sufficient unrestricted liquidity in addition to market access at its rating level relative to the series 2011B bonds in the window mode, which provides more flexibility to fund an unremarketed tender (180 days beyond the 30-day remarketing period).

DEBT PROFILE

Cone Health has approximately 41% of its debt in fixed-rate mode (additionally 28% of the variable rated debt has been synthetically fixed) and several bank commitments have been renegotiated with extended renewal dates. The risk associated with the $88.8 million bullet in 2024, as well as other put, interest rate, and bank renewal risk, is adequately offset by strong liquidity position with 260.3 DCOH and the system leadership's demonstrated ability to effectively manage its debt and swap portfolio. Cone Health has two swaps with notional par of $133.2 million with a negative mark-to-market of $17.1 million at Sept. 30, 2014.

DISCLOSURE

Cone Health covenants to provide annual disclosure no later than 120 days after each fiscal year end and quarterly disclosure no later than 60 days after each quarter end to the Municipal Securities Rulemaking Board's EMMA system.

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

Applicable Criteria and Related Research:

--'Nonprofit Hospitals and Health Systems Rating Criteria' (May 30, 2014);

--'Criteria for Assigning Short-Term Ratings Based on Internal Liquidity'(June 13, 2013);

--'Rating U.S. Municipal Short-Term Debt' (Jan. 7, 2015).

Applicable Criteria and Related Research:

Rating U.S. Public Finance Short-Term Debt

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=846969

Criteria for Assigning Short-Term Ratings Based on Internal Liquidity -- Effective June 2013 to Dec. 9, 2013

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=708640

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=976555

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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
Emily Wadhwani
Associate Director
+1 312-368-3347
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
Emily Wadhwani
Associate Director
+1 312-368-3347
or
Committee Chairperson
James LeBuhn
Senior Director
+1 312-368-2059
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com