Fitch Rates Tenet's $750MM Second Lien Secured Notes 'B-/RR5'

NEW YORK--()--Fitch Ratings has assigned a 'B-/RR5' rating to Tenet Healthcare Corp.'s $750 million 7.5% senior secured second lien notes. About $500 million of the proceeds will be used to pay down balances outstanding on Tenet's asset based lending (ABL) facility, which was drawn to fund litigation settlements during fourth-quarter 2016. The senior secured first lien notes have been downgraded to 'BB-/RR2' from 'BB/RR1' because of lower recovery prospects for the lenders in a hypothetical bankruptcy scenario. A full list of rating actions is at the end of this release. The Rating Outlook is Stable.

KEY RATING DRIVERS

Favorable Operating Profile: Tenet is among the largest for-profit operators of acute care hospitals in the U.S., and following the acquisition of a majority ownership interest in United Surgical Partners International (USPI) in 2015, the largest operator of ambulatory surgery and imaging centers. Scale is increasingly important as U.S. healthcare providers seek efficiencies to offset the effects of an overall constrained reimbursement environment.

Lengthy Deleveraging Horizon: Debt funding of the USPI transaction prolonged the deleveraging horizon Fitch considered following Tenet's 2013 acquisition of Vanguard Health Systems, Inc. Deleveraging has been slow because it relies primarily on EBITDA growth. Tenet's weak FCF limits the company's ability to repay debt.

FCF Persistently Weak: Improved profitability and lower cash interest expense following the refinancing of high-cost debt are contributing to slightly improving FCF, but the level remains weak, both on an absolute basis and compared with the company's peer group. Project-related capex was a heavy use of CFO in recent years. Management expects to spend about $150 million less in 2017 following the completion of in-progress construction projects. Fitch's ratings case forecast builds in a more conservative estimate of $100 million of savings from reduced capital expenditures as a tailwind to FCF in 2017.

Uncertain Future of the Affordable Care Act: Hospital industry management teams are contending with a very dynamic regulatory environment made more complicated by the results of the presidential election. It would not be crushing to the acute care hospital sector if the insurance expansion elements of the ACA are rolled back under a Trump administration, but it has been a boost to a sector that is facing a host of other secular challenges to profitability.

KEY ASSUMPTIONS

Fitch's key assumptions within the rating case for Tenet include:

--Top-line growth of about 5% 2016 and 3-5% in 2017-2019; assumes low single digit organic growth in the hospital operations segment and mid-single digit organic growth in the Conifer Health Solutions and ambulatory care segments;

--This growth forecast assumes no major changes in the regulatory environment or broad macro-economic trends and is driven by flat government pricing, low to mid single digit increases in commercial pricing, tepid but positive volume growth in the hospital segment

and better volume growth in the ambulatory segment;

--Operating EBITDA margin (Fitch EBITDA calculation excludes income from affiliates) of 11.9% in 2016 and expanding slightly through the forecast period;

--Tenet will spend about $1.3 billion to acquire the remaining 43.7% interest in the USPI joint venture through 2020;

--Capital expenditures of $890 million in 2016, declining to about $785 million in 2017;

--FCF (CFO less capital expenditures and dividends to associates and minorities) is positive at the end of 2016, and the 2016-2019 FCF margin is about 1-2%;

--2016 debt balance is pro forma for $750 million second lien note issuance, otherwise no major change in debt balance in 2017-2019;

--Total debt to EBITDA after dividends to associates and minorities is 7.2x at the end of 2016 and declines to about 6.2x by 2019.

RATING SENSITIVITIES

Maintenance of Tenet's 'B' IDR considers gross debt/EBITDA after dividends to associates and minorities declining to about 6.2x over the next several years as a result of growth in EBITDA. Maintenance of the rating also considers that Tenet will make continued slow progress in expanding operating and FCF margins.

A reversal in positive trends could result in a negative rating action, particularly if coupled with capital deployment that requires additional debt funding. Specifically, gross debt/EBITDA after dividends to associates and minorities durably above 7.0x coupled with a cash flow deficit that requires incremental debt funding are likely to cause a downgrade to 'B-'. An expectation of gross debt/EBITDA after dividends to associates and minorities sustained near 5.5x and a FCF margin of 3%-4% could result in an upgrade to 'B+'.

LIQUIDITY

Tenet's liquidity profile is adequate aside from persistently weak FCF. At Sept. 30, 2016, liquidity was provided by $649 million of cash on hand and $998 million of availability on the $1 billion capacity bank revolver with LTM FCF of negative $43 million. There are no significant debt maturities until 2018, and compliance with financial maintenance covenants is not a concern. LTM EBITDA/interest paid equals 2.4x.

Tenet's debt agreements do not include financial maintenance covenants aside from a 1.5x fixed charge coverage ratio test in the bank agreement that is only in effect during a liquidity event, which is whenever available credit as calculated based on the bank agreement definitions is less than $100 million. The first lien secured note indentures do limit the company's ability to issue additional secured debt, which is permitted up to the greater of $3.2 billion and 4.0x EBITDA. Debt secured on a pari passu basis to the first lien secured notes is limited to the greater of $2.6 billion and 3.0x EBITDA.

FULL LIST OF RATING ACTIONS

Fitch has taken the following rating actions:

Tenet Healthcare Corp.

--Long-term IDR affirmed at 'B';

--Senior secured ABL facility affirmed at 'BB/RR1';

--Senior secured first lien notes downgraded to 'BB-/RR2' from 'BB/RR1';

--Senior unsecured notes affirmed at 'B-/RR5';

--Senior secured second lien notes rated 'B-/RR5'.

The Rating Outlook is Stable.

The 'BB/RR1' and 'BB-/RR2' ratings for Tenet's ABL facility and the senior secured first lien notes reflects Fitch's expectation of 100% recovery for the ABL facility and 86% recovery for the first lien secured notes, respectively, under a bankruptcy scenario. The 'B-/RR5' rating on the senior secured second lien notes and senior unsecured notes reflects Fitch's expectations of recovery of 30% of outstanding principal. The ABL facility is assumed to be fully recovered before the other secured debt in the capital structure. The ABL 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 first and second lien secured notes are secured by the capital stock of the operating subsidiaries, making the notes structurally subordinate to the ABL facility with respect to the accounts receivable collateral.

Fitch's estimates an enterprise value (EV) on a going concern basis of $8.3 billion for Tenet, net of a standard deduction of 10% for administrative claims. The EV assumption is based on a 38% haircut to LTM EBITDA after dividends to associates and minorities. Fitch then applies a 7.0x multiple based on observation of both recent transactions/takeout and public market multiples in the healthcare industry.

Fitch assumes that Tenet would draw $500 million or 50% of the available capacity on the $1 billion ABL facility 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.

Based on the definitions of the secured debt agreements, Fitch believes that the group of operating subsidiaries that guarantee the secured debt excludes any non-wholly owned and non-domestic subsidiaries, and therefore does not encompass most of the value of the Conifer and ambulatory care segments. At Sept. 30, 2016, about 65% of consolidated LTM EBITDA was contributed by the hospital operations segment, and Fitch uses this value as a proxy to determine the rough value of the secured debt collateral of $5.4 billion. Fitch assumes this amount is completely consumed by the ABL facility and the first lien lenders, leaving $2.9 billion of residual value to be distributed to the remaining $1.2 billion of first lien claims, the second lien secured and unsecured claims.

The downgrade of the first lien notes to 'BB-/RR2' from 'BB/RR1' occurred because the remaining $1.2 billion portion of the first lien notes and the entire amount of the second lien notes are treated as unsecured deficiency claims in Fitch's waterfall analysis, and these claims are pari passu with the $7.8 billion of senior unsecured note claims. The addition of the $750 million of second lien notes increased the total amount of the unsecured deficiency claims, depressing the pro rata recovery of the first lien notes.

Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:

--Historical and projected EBITDA is adjusted to add back non-cash stock based compensation. In 2015, Fitch added back $69 million in non-cash stock based compensation to the EBITDA calculation.

Additional information is available at www.fitchratings.com

Applicable Criteria

Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)

https://www.fitchratings.com/site/re/885629

Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 05 Apr 2016)

https://www.fitchratings.com/site/re/879564

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1014967

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https://www.fitchratings.com/regulatory

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Contacts

Fitch Ratings, Inc.
Primary Analyst
Megan Neuburger, CFA
Managing Director
+1-212-908-0501
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Britton Costa, CFA
Director
+1-212-908-0524
or
Committee Chairperson
Peter Molica
Senior Director
+1-212-908-0288
or
Media Relations
Alyssa Castelli, +1-212-908-0540
alyssa.castelli@fitchratings.com