Fitch Affirms Palomar Health, CA's Rev Bonds at 'BB+'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings has affirmed the 'BB+' rating on Palomar Health, CA's (PH) 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 obligated group is comprised of PH's acute care facilities as well as other healthcare related entities but excludes Arch Health Partners (AHP), a medical foundation. AHP was de-consolidated from the audit in fiscal 2014 (June 30 fiscal year end) so the OG and the consolidated entity were the same in fiscal 2014.

KEY RATING DRIVERS

REBOUND IN FINANCIAL PERFORMANCE: Since Fitch's last rating review in January 2015, PH continues to sustain its trend in improved operating cash flow through the nine months ended March 31, 2015. The improved financial performance to date has been driven by increased volume, cost reductions (primarily reduction in force), as well as the sale of non-core assets. Although liquidity has improved from a low in fiscal 2013, liquidity metrics remain weak.

NON-INVESTMENT GRADE FINANCIAL PROFILE: After stabilizing its performance in fiscal 2014, PH's financial profile is characteristic of a non-investment grade credit with weak liquidity and high debt burden. At March 31, 2015, PH had 80.5 days cash on hand and 23.5% cash to debt (revenue bonds only). Operating EBITDA margins compare favorably against the non-investment grade medians with a 10.6% operating EBITDA margin through the nine months ended March 31, 2015 and 10.2% in fiscal 2014, which led to adequate MADS coverage of 1.8x and 1.7x, for the respective time periods.

SIGNIFICANT CAPITAL INVESTMENT COMPLETE: In August 2012, PH opened its 288-bed Palomar Medical Center (PMC) in Escondido, California. The opening and subsequent relocation of most service lines from its downtown campus to PMC was the centerpiece of PH's significant $1.06 billion facilities master plan. PH has an agreement with Kaiser Permanente (rated 'A+') to provide bed capacity, and Kaiser volume has consistently been under budget although it has recently increased. PH recently made an announcement that it will close its downtown facility and consolidate the services to its other two campuses, which Fitch views favorably. This is expected to result in approximately $20 million of annual savings. The consolidation of services is expected to be complete by the end of the year and PH is evaluating options for the downtown facility.

GOOD MARKET POSITION: Fitch believes PH's main credit strength is its location in North San Diego County, which makes it an attractive partner in any plans to develop a larger regional network and delivery model that is able to manage population health. In addition, PH has significantly invested in its medical foundation, AHP, which provides a primary care base that will be integral in care coordination.

RATING SENSITIVITIES

SUSTAINED SOLID OPERATING CASH FLOW: The maintenance of the current rating is dependent on Palomar Health's ability to sustain its solid operating cash flow due to additional operational initiatives that are underway. Despite the large investment in its facilities master plan, continued pressure on capital spending will likely hinder liquidity growth. These include the ongoing strategic investments in Arch Health Partners as well as potential pressure to build out shelled space capacity at Palomar Medical Center due to the consolidation of services. A reversal in improvement in operating cash flow or a decline in liquidity would likely result in negative rating pressure.

CREDIT PROFILE

PH is a California hospital district that operates three hospitals in northern San Diego County. For fiscal 2014, PH's consolidated audited results excluded its medical foundation, AHP (80 physicians and 10 physician extenders), and numbers for fiscal 2013 were restated for comparative purposes. Total operating revenue in fiscal 2014 was $628 million. There was a change in executive leadership as of August 2014 with the prior CFO promoted to CEO. A strategic planning process is underway for the system.

Rebound in Financial Performance

PH implemented several turnaround initiatives to stem the losses from fiscal 2013 due to challenges with the transition to its new facility in August 2012. The benefits from these initiatives were realized in fiscal 2014 with a $17 million improvement in operating cash flow driven mainly by a reduction in force. PH continues to focus on reducing its cost per adjusted discharge with plans to lower this further in fiscal 2015. In fiscal 2014, operating income was negative $26.2 million compared to negative $36.2 million the prior year and operating losses are primarily driven by high depreciation and interest expense. Operating cash flow is solid with operating EBITDA margin of 10.2% in fiscal 2014 compared to 7.7% in fiscal 2013 and 10.6% for the nine months ended March 31, 2015. PH has budgeted an operating EBITDA margin of 12.1% for fiscal 2015 and ongoing operational initiatives include improved patient throughput, reduction in cost per adjusted discharge, supply savings, as well as further reduction in labor costs. PH is slightly behind budget for the nine months ended March 31, 2015 but expects to meet its full year budget by fiscal year end.

Opening of Palomar Medical Center

In August 2012, PH opened its new 288-bed Palomar Medical Center (PMC) in North San Diego County and successfully relocated the majority of its service lines to the new hospital from its downtown Escondido facility. PMC was the key component of PH's sizable $1.06 billion facilities master plan, which also included expanding its Pomerado Hospital (Pomerado) in Poway and building outpatient satellite clinics. PH has a total of 629 licensed acute care beds and all the acute care facilities are seismically compliant.

PH announced in late June that it will be closing its downtown facility, which maintained a stand-by emergency department, labor and delivery, behavioral, and acute rehab service lines. These service lines will be consolidated into PMC or Pomerado by the end of the year, and PH will likely maintain urgent care services downtown. Fitch views this decision favorably as it better utilizes the resources within the system and should result in $20 million of annual savings.

Volume growth has consistently missed budgeted expectations especially with its agreement with Kaiser. However, year over year growth has improved especially with more obstetric and surgery volume from Kaiser. In fiscal 2014, admissions were up 8% from prior year and through the nine months ended March 31, 2015, admissions were up 5.4% from the same prior year period. PH's bed capacity agreement with Kaiser expires in 2020 with an upcoming renewal date in mid 2015 that will decide if either/both parties want to extend the agreement beyond 2020.

Investment in Arch Health Partners

AHP is a medical foundation located in Poway, CA with nine other locations in the service area. PH is the sole corporate member of AHP and aligned with the medical foundation in 2010. PH has provided significant support to AHP over the last two years and ongoing support is expected, which will likely hinder liquidity growth.

Weak Liquidity

As of March 31, 2015, unrestricted cash and investments totaled $137.8 million, which equated to 80.5 days cash on hand and 23.5% cash to debt, which is a slight improvement from fiscal 2013 with 73.3 days and 20.6% cash to debt. PH remains challenged by high accounts receivable with 73.1 days in accounts receivable as of March 31, 2015 and there is new oversight in revenue cycle, which should improve cash collections.

PH's days cash on hand covenant calculation excludes interest expense from total expenses and the bond covenant calculation for fiscal 2014 was 91 days, above the 80 days cash on hand covenant for the series 2006 insured bonds (65 days cash on hand covenant for uninsured bonds). Management expects to be above 90 days cash on hand (per bond covenant calculation) at FYE 2015.

High Debt Burden

PH has a very high debt burden due to the funding of its facilities master plan. As of June 30, 2014, total debt outstanding was $1.1 billion and included $560 million of revenue bonds and $574 million of general obligation (GO) bonds. Fitch rates the GO bonds 'A+'. The revenue bonds are 68% fixed rate and 32% variable rate (auction mode; series 2006). MADS of $41.4 million accounted for 6.6% of total revenue in fiscal 2014 compared to the non-investment grade median of 4%.

PH has three fixed payor interest rate swaps with Citi related to the series 2006 bonds and the swaps are insured by Assured Guaranty. There are currently no collateral posting requirements, but requirements would be implemented if Assured Guaranty's rating falls below the 'A' category and would be at a zero threshold based on PH's current rating. The mark to market valuation as of June 30, 2014 was negative $26.5 million. In addition, there is an additional termination event if Assured Guaranty's rating falls below 'BBB'.

Property Tax Revenue

As a California hospital district, PH receives unrestricted property tax revenues from a fixed share of the 1% property tax levied by the County of San Diego on all taxable real property in PH's boundaries. PH received $13.5 million and $12.9 million in unrestricted property tax revenues in fiscal 2014 and 2013, respectively. This tax revenue is included in other operating revenue. PH also receives ad valorem tax revenues generated by the separate voter-approved tax levy that is pledged solely for the payment of principal and interest on PH's series 2005, 2007, 2009, and 2010 GO bonds. Fitch's financial analysis excludes the GO bonds and related property tax revenue and interest expense.

Disclosure

PH covenants to provide annual audited financial reports and unaudited quarterly financial statements to bondholders. Quarterly information, including a balance sheet, income statement, and statement of changes in net assets will be provided within 45 days after the end of each of the first three fiscal quarters.

Outstanding Palomar Health, CA Debt:

--$159,647,000 COPs series 2010;

--$228,970,000 COPs series 2009;

--$171,731,000 COPs series 2006A-C.

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=987890

Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=987890

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Contacts

Fitch Ratings
Primary Analyst:
Emily Wong, +1-415-732-5620
Senior Director
Fitch Ratings, Inc.
650 California St.
San Francisco, CA 94108
or
Secondary Analyst:
Dmitry Feofilaktov, +1-212-908-0345
Analyst
or
Committee Chairperson:
Jim LeBuhn, +1-312-368-2059
Senior Director
or
Sandro Scenga, +1-212-908-0278
Media Relations, New York
sandro.scenga@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst:
Emily Wong, +1-415-732-5620
Senior Director
Fitch Ratings, Inc.
650 California St.
San Francisco, CA 94108
or
Secondary Analyst:
Dmitry Feofilaktov, +1-212-908-0345
Analyst
or
Committee Chairperson:
Jim LeBuhn, +1-312-368-2059
Senior Director
or
Sandro Scenga, +1-212-908-0278
Media Relations, New York
sandro.scenga@fitchratings.com