Fitch Affirms Children's Hospital of Orange County's (CA) Rev Bonds at 'A'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings affirms the 'A' rating on Children's Hospital of Orange County, CA's (CHOC) outstanding debt, which is listed at the end of the press release.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross revenue pledge of the obligated group (OG). The OG consists of CHOC, which accounted for 81% of total assets and 91% of total revenues of the consolidated entity, Children's HealthCare of California and Affiliates in fiscal 2014 (June 30 year-end). Fitch's analysis is based on the consolidated entity.

KEY RATING DRIVERS

STRONG MARKET POSITION: CHOC is the only dedicated pediatric provider within Orange County except for a Tenet facility that maintains approximately 25 pediatric beds. CHOC continues to grow its service area beyond Orange County through partnerships with adult hospitals and increased outpatient facilities. CHOC has also achieved HIMSS Stage 7 designation, which Fitch believes facilitates CHOC's focus on quality and safety.

MAJOR BUILDING PROJECT COMPLETE: CHOC opened its new patient tower on time and under budget in March 2013. This facility was a major undertaking for the organization which added inpatient capacity as well as a new emergency department, surgical and recovery suites, imaging and diagnostic services, laboratory and other ancillary services, which CHOC previously utilized at St. Joseph Hospital of Orange (part of St. Joseph Health System, rated 'AA-'/Stable Outlook) under a shared services agreement. As expected, fiscal 2014 performance was weak due to CHOC's transition to operating its own facility, but has improved in fiscal 2015 as management has optimized services in the new facility.

SIGNIFICANT IMPROVEMENT IN FY 2015: Strong volume growth and good expense control has resulted in solid operating profitability through the eight months ended Feb. 28, 2015. Excluding the impact of the provider fee, revenue growth increased 4.7% from the prior year period. There are additional performance improvement initiatives underway that have physician and staff engagement.

PROVIDER FEE FUNDING CREATES VOLATILITY: Not unlike other children's hospitals, CHOC is vulnerable to changes in Medi-Cal funding with 60% of gross revenues from Medi-Cal in fiscal 2014. A provider fee program has been in place since 2009 with various phases and sunset dates with the most recent phase (Phase 4) running from Jan. 1, 2014 to Dec. 31, 2016. The funding from this program has been uneven given the timing of CMS approval and only part of Phase 4 has received approval (occurred in December 2014). Since this is an important funding stream for CHOC, Fitch also analyzed CHOC's performance on a normalized provider fee funding basis assuming provider fee funds were recognized in the appropriate time periods.

LIQUIDITY EXPECTED TO IMPROVE: Liquidity has declined since 2011 mainly due to increased capital spending related to the new tower. In addition, liquidity metrics are depressed due to swap collateral posting requirements and the increase in provider fee program receivable. Liquidity is expected to improve by fiscal year end 2015 pending the receipt of provider fee payments and release of collateral with an expected swap novation.

RATING SENSITIVITIES

SUSTAINED SOLID OPERATING PERFORMANCE: Fitch expects CHOC to continue to realize the benefits of its investment in its new patient tower and maintain solid operating cash flow as additional performance improvement initiatives are achieved.

CREDIT PROFILE

CHOC is a 279 staffed-bed pediatric hospital located in Orange County, CA. Fitch's analysis is based on the consolidated entity, which includes CHOC Children's at Mission Hospital (54 licensed beds), CHOC Children's Foundation, and other related entities. Total revenue in fiscal 2014 was $554 million.

Strong Market Position

One of CHOC's main credit strengths is its strong market position. Market share was 77.8% for 2013, which has remained relatively steady the last few years after significant growth. CHOC's strong market position is due to its adult and regional partnerships and the organization is increasing its ambulatory presence especially in the fast growing Inland Empire. CHOC received pediatric trauma status as of January 2015, which should drive additional volume and further enhance its clinical programs. Also, CHOC announced an alliance with Rady Children's Hospital -San Diego (rated 'AA-'/Stable Outlook) and St. Joseph Hoag Health to explore opportunities in providing and delivering pediatric care.

CHOC is aligned with its physicians through a medical foundation model and the physician group is associated with nearly all of CHOC's admissions. CHOC is consistently recognized for excellence in pediatric care and patient safety, high quality, and exceptional experience remains top strategic priorities.

Major Building Project

CHOC opened its seven story tower in March 2013 and the building has the capacity for 142 additional beds (including shelled space). The tower included a new emergency department, surgical and recovery suites, imaging and diagnostic services, laboratory and other ancillary services. The facility cost was $558 million and sources of funding included $280 million of debt, $137 million from grants, $100 million from cash and cash flow and $41 million from philanthropy.

CHOC exhibited a timely ramp up of the facility as the organization was a new operator of several departments that were previously run by St. Joseph Hospital - Orange under a shared services agreement. After a transitional year in fiscal 2014, CHOC demonstrated gains from the efficiencies of the new facility with its dedicated pediatric focus in fiscal 2015.

Provider Fee

California enacted a hospital provider fee program in 2009 to draw down additional federal funds for Medi-Cal services. Phase I of the program covered April 1, 2009 to Dec. 31, 2010 and resulted in a net benefit of $47.1 million; Phase II covered Jan. 1, 2011 to June 30, 2011 with a net benefit of $21 million, Phase III covered July 1, 2011 to Dec 31, 2013 with a net benefit of $86.2 million and Phase 4 covers Jan. 1, 2014 to Dec. 31, 2016 with a net benefit of $213.9 million. Only a portion of Phase 4 has been approved. Given the timing of approvals, the GAAP treatment of the provider fee resulted in a net benefit of $47 million in fiscal 2011, $37.6 million in fiscal 2012, $52.3 million in fiscal 2013, $8.3 million in fiscal 2014, and $42 million through the eight months ended Feb. 28, 2015. Assuming normalized provider fee funding (funding in respective time periods), the net benefit would be $34.4 million in fiscal 2011, $34.5 million in fiscal 2012, $34.5 million in fiscal 2013, $52.9 million in fiscal 2014, $47.5 million through the eight months ended Feb. 28, 2015.

Improved Operating Performance in FY 2015

As expected, fiscal 2014 was weak due to the transition to its new facility with a negative 5.7% operating margin, 7.2% operating EBITDA margin, and 1.7x MADS coverage. During late fiscal year 2014, CHOC had a reduction in force that resulted in $4.2 million of severance costs. In fiscal 2015, operating performance significantly improved due mainly to increased volume and higher acuity, better referrals within its capitated lives, and reduction in costs. Operating margin was 5.7%, operating EBITDA margin was 16.3% and MADS coverage was 4.4x through the eight months ended Feb. 28, 2015 compared to the A category medians of 2.5%, 9.5% and 3.8x, respectively. Operating performance is expected to remain solid as there are various value improvement initiatives underway that are expected to be realized in fiscal 2016 and 2017 including improved labor productivity and reduction in non-labor expense. The operating margin budget for fiscal 2015 is 5.2% (assumes normalized provider fee funding) and CHOC is well ahead of budget.

Operating margin (assuming normalized provider fee funding) would be 10.9% in fiscal 2011, 8.3% in fiscal 2012, negative 0.4% in fiscal 2013, 2.1% in fiscal 2014, and 6.9% through the eight months ended Feb. 28, 2015.

Liquidity Expected to Improve

Total unrestricted cash and investments at February 28, 2015 were $269.8 million which translated to a light 167.4 days cash on hand and 76.1% cash to debt as compared to the 'A' category median of 199.2 and 131.2%. However, liquidity is expected to improve by year end pending the receipt of $34 million related to provider fee receivable (total of $56.7 million as of Feb. 28, 2015) and $20 million release of collateral through a swap novation. CHOC will add counterparties to its existing swaps to spread the collateral threshold among more counterparties. Total swap collateral posted at Feb. 28, 2015 was $49.1 million compared to $34.4 million at FYE 2014, $28.3 million at FYE 2013 and $56.7 million at FYE 2012.

Including the additional $54 million of cash expected by FYE 2015, CHOC's days cash on hand and cash to debt metrics would improve to 200.9 and 91.4%, respectively. Capital needs are moderate and mainly focused on strategic investments. The capital budget for FY 2015 totals $41 million and ongoing capital needs are expected to total $29-45 million annually.

Debt Profile

Total debt is $371 million and the debt mix of outstanding bonds is 65% underlying fixed rate and 35% underlying variable rate demand bonds (VRDBs). Including its three fixed payor swaps, CHOC's debt profile is 100% fixed rate (over hedged by $106.4 million). The swaps have a collateral posting threshold of $10 million.

CHOC's $125 million of VRDBs are supported by a LOC from U.S. Bank and the expiration date is Dec. 31, 2018. Under the LOC agreement, if there is a draw on the LOC, the term-out period is three years.

Debt burden has moderated with MADS accounting for 3.9% of total revenue through the eight months ended Feb. 28, 2015 compared to 4.8% in fiscal 2011. MADS of $26.3 million occurs in 2016 and drops to about $24 million in 2020.

Disclosure

CHOC provides annual disclosure within 150 days of fiscal year end and quarterly disclosure within 60 days of quarter end for the first three quarters. Disclosure is available on EMMA.

Outstanding Debt:

--$105,180,000 California Health Facilities Financing Authority (CA) (Children's Hospital of Orange County) revenue bonds series 2011A;

--$128,428,000 California Health Facilities Financing Authority (CA) (Children's Hospital of Orange County) revenue bonds series 2009A;

--$124,950,000 California Health Facilities Financing Authority (CA) (Children's Hospital of Orange County) variable-rate revenue bonds series 2009B-D*.

*The series 2009B-D bonds are variable rate demand bonds supported by a letter of credit from U.S. Bank.

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

Applicable Criteria and Related Research:

--'Revenue-Supported Rating Criteria', dated June 16, 2014;

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

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

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

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=984057

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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
Michael Burger
Director
+1 415-659-5470
or
Committee Chairperson
Jim 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
Emily Wong
Senior Director
+1 415-732-5620
Fitch Ratings, Inc.
650 California St.
San Francisco, CA 94108
or
Secondary Analyst
Michael Burger
Director
+1 415-659-5470
or
Committee Chairperson
Jim LeBuhn
Senior Director
+1 312-368-2059
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com