Fitch Affirms Rady Children's (CA) Rev Bonds at 'AA-'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings has affirmed the 'AA-' rating on Rady Children's outstanding debt, which is listed at the end of this press release.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a general revenue pledge of the obligated group (OG). The OG includes the parent organization and the hospital. The OG comprised 95.8% of total revenue and 94.8% of total assets of the consolidated entity in fiscal 2015 (June 30 year end). Fitch's analysis is based on the consolidated entity.

KEY RATING DRIVERS

SUSTAINED STRONG FINANCIAL PROFILE: After the rating upgrade to 'AA-' in October 2014, Rady Children's financial performance continues to be consistently strong and exceed the 'AA' category median ratios with further growth in liquidity, very strong profitability and improved debt metrics. Strong financial performance has been driven by record volume due to growth in strategic programs and improvements in throughput, receipt of provider fee funds, and ongoing expense management.

DOMINANT MARKET POSITION: Rady Children's holds a dominant 90% market share in its primary service area of San Diego County and market share is strong due to its adult partnerships and physician alignment initiatives. In fiscal 2015, Rady Children's added a heart transplant program and those cases were previously outmigrating to Los Angeles or San Francisco.

ACADEMIC AND PHYSICIAN ALIGNMENT: Rady Children's is affiliated with the University of California, San Diego (UCSD) and serves as the primary pediatric teaching hospital for UCSD School of Medicine. This clinical affiliation is a major driver of Rady Children's enhanced reputation due to its teaching and research activities. Rady Children's has an exclusive arrangement through its medical practice foundation with a medical group whose members are mostly employed by UCSD and includes the majority of the pediatric specialists in the market. Rady Children's is also aligned with various independent primary care physicians through physician management services and managed care contracting.

STRATEGIC GROWTH INITIATIVES: Rady Children's is investing in several areas including genomics, the fast growing Murrieta market, and in alternative payment strategies. Fitch believes Rady Children's strong financial position gives the organization financial flexibility to undertake these initiatives, which will require initial investment. Capital plans are manageable and there are no additional debt plans.

HIGH EXPOSURE TO MEDI-CAL: Similar to all children's hospitals, Rady Children's has a high exposure to Medi-Cal, which accounted for 46.6% of its gross revenues in fiscal 2015. However, given this exposure, Rady Children's has significantly benefited from the provider fee program, which has been extended through December 2016.

RATING SENSITIVITIES

SUSTAINED PERFORMANCE: Fitch believes there could be further positive rating movement if Rady Children's sustains its strong financial profile through the execution of its growth strategies and manages a smooth transition with a new chief financial officer expected by the end of the calendar year.

CREDIT PROFILE

Rady Children's is a freestanding children's hospital located in San Diego, CA and operates 520 beds. Rady Children's is the largest children's hospital in the state and is the region's only pediatric trauma facility and serves as the pediatric tertiary and quaternary referral center. Total revenue in fiscal 2015 (June 30 year end; audit) was $1.02 billion.

Dominant Market Position

Rady Children's enjoys a strong regional reputation and a dominant market share for high-end pediatric healthcare services in San Diego, Southern Riverside, and Imperial Counties. Fitch views Rady Children's operating footprint and market share as key credit strengths. Rady Children's market share was 90% and Kaiser has the next highest portion of the remaining market share. Rady Children's market share is driven by its geographic footprint with access points from Murrieta to Chula Vista and physician alignment.

Rady Children's has had a relationship with Universal Health Services at Rancho Springs Medical Center in Murrieta since 2012 (manage 13 NICU beds) and this area (Inland Empire) is fast growing. Rady Children's opened a pediatric emergency room track at this location in July 2015 and will be adding a new 66,000 square foot building by 2017 to enhance outpatient services. This outpatient services building is expected to cost approximately $34 million.

Rady Children's is aligned with physicians in the market through its integrated delivery system strategy and has a single contracted system that includes the pediatric subspecialists in its medical foundation in addition to community pediatricians in the region. It is pursuing a Restricted Knox Keene license to enter into more risk based contracting, which will be done in partnership with Children's Hospital of Orange County (CHOC; 'A'/Outlook Stable). Rady Children's and CHOC formed an alliance in June 2013 to evaluate areas of opportunity to provide cost effective and high quality care to children in their respective markets.

In August 2014, with a $120 million gift from Ernest Rady, Rady Children's established a genomics institute, which will leverage its relationship with UCSD scientists and clinicians to translate research findings into treatments. The institute will require support in the first five years as senior researchers and their teams are recruited. CEO Dr. Stephen Kingsmore and two Principal Investigators have been recruited in the past year. The hospital has committed $40 million to the institute; however, ongoing support of the institute is expected from philanthropy.

Strong Financial Profile

Rady Children's financial profile has been consistently strong over the last four years driven by increased volume through its strategic growth initiatives, expense management, and benefit from the provider fee. Rady Children's added proton therapy services during fiscal 2014 through a partnership with Scripps Health ('AA'/Outlook Stable). Other volume related initiatives include improving the throughput in its emergency room and significantly decreasing the left without being seen metric. These initiatives led to record volume figures in inpatient, emergency room and urgent care. Urgent care visits were up 16% in fiscal 2015 from the prior year, emergency room visits increased 20.6%, and admissions grew by 8.3%.

The state provider fee program has resulted in a net benefit of $49.4 million in fiscal 2012, $41.8 million in fiscal 2013, $12.3 million in fiscal 2014, and $67.5 million in fiscal 2015. The variability in the figures is due to the timing of the approval of various components of the program by CMS. The current program is for Jan. 1, 2014-Dec. 31, 2016, and management expects to book $65.1 million in fiscal 2016 and $34.1 million in fiscal 2017. A ballot initiative is expected in November 2016 to create a permanent provider fee program.

Management views operating performance both with and without the provider fee, and operating profitability without these funds is still favorable. Operating margin in fiscal 2015 was 10.6% compared to 5.2% in fiscal 2014 and 9.4% in fiscal 2013. Fiscal 2015 performance exceeded budget.

Liquidity continues to grow and has been driven by strong cash flow aided by the receipt of provider fee revenue and modest capital outlay. Total unrestricted cash and investments was $906.6 million at Sept. 30, 2015, which equated to 414.9 days cash on hand and 231.3% cash to debt, despite the downturn in investment performance.

Manageable Capital Needs

Rady Children's invested significantly in its plant in fiscal 2009-2011, with the opening of a new acute care pavilion in October 2010, addressing deferred capital needs, and installing Epic. Capital spending has been below 1x depreciation expense over the last four years and the three year capital plan includes a higher level of spending with $81.7 million projected in fiscal 2016, $93.3 million in fiscal 2017, and $75.3 million in fiscal 2018. Major projects include the outpatient services building in Murrieta as well as an educational office building on the main campus. Rady Children's also has $31.3 million in remaining Proposition 3 funding (voter approved state general obligation bonds to fund construction projects at children's hospitals). Fitch believes that even with the anticipated higher level of capital spending, the additional funding is manageable due to Rady Children's strong cash flow.

Moderate Debt Burden

Total outstanding debt as of June 30, 2015 is $398 million with 45% underlying fixed-rate bonds and 55% underlying variable-rate bonds. Rady Children's has converted most of its letter of credit (LOC)-backed variable-rate demand bonds (VRDBs) to direct bank loans that have initial put dates in October 2017, September 2018, and June 2019. There were no changes in financial covenants from what was in the LOC reimbursement agreements. The covenants vary but the most restrictive include maintaining 120 days cash on hand and 1.25x debt service coverage and less than 60% debt to capitalization. Of its variable-rate exposure, $50.6 million remains LOC-backed VRDBs (series 2008C; LOC from Northern Trust that expires July 2020).

Including its swaps, the debt profile is 100% fixed rate. As of June 30, 2015, Rady Children's was posting approximately $42 million of collateral related to the swaps.

Maximum annual debt service (MADS) coverage is strong at 8.8x in fiscal 2015, compared to 6.1x in fiscal 2014, 7.6x in fiscal 2013 and the 'AA' category median of 5.7x. The debt burden has reduced with the growth in total revenue and MADS as a percentage of revenue is now 2.2% down from 4.4% in fiscal 2009. Debt service is level and MADS is $22.6 million.

Disclosure

Rady Children's covenants to provide annual audited financial information within 120 days of fiscal year end and unaudited quarterly financial information within 60 days of quarter end for the first three quarters and within 90 days for the fourth quarter to the Municipal Securities Rulemaking Board's EMMA system. The audit is completed quickly after fiscal year end and was released in early September for fiscal 2015.

Fitch has affirmed the following outstanding debt at 'AA-':

--$96,890,000 California Health Facilities Financing Authority (CA) (Rady Children's Hospital-San Diego) revenue bonds series 2011;

--$50,575,000 California Statewide Communities Development Authority (CA) (Rady Children's Hospital-San Diego) variable-rate revenue bonds series 2008C;

--$28,230,000 California Statewide Communities Development Authority (CA) (Rady Children's Hospital-San Diego) revenue refunding bonds series 2006B;

--$39,670,000 California Statewide Communities Development Authority (CA) (Rady Children's Hospital-San Diego) revenue refunding bonds series 2006A.

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

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Nonprofit Hospitals and Health Systems Rating Criteria (pub. 09 Jun 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=866807

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=995366

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=995366

Endorsement Policy

https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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Contacts

Fitch Ratings
Primary Analyst
Emily Wong
Senior Director
+1-415-732-5620
Fitch Ratings, Inc.
650 California St.
San Francisco, CA 94108
or
Secondary Analyst
Emily Wadhwani
Director
+1-312-368-3347
or
Committee Chairperson
Jim LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations
Sandro Scenga, +1 212-908-0278
sandro.scenga@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Emily Wong
Senior Director
+1-415-732-5620
Fitch Ratings, Inc.
650 California St.
San Francisco, CA 94108
or
Secondary Analyst
Emily Wadhwani
Director
+1-312-368-3347
or
Committee Chairperson
Jim LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations
Sandro Scenga, +1 212-908-0278
sandro.scenga@fitchratings.com