Fitch Rates Sutter Health, CA's Series 2016B&C Rev Bonds 'AA-'; Outlook Stable

SAN FRANCISCO--()--Fitch Ratings has assigned an 'AA-' rating to the following bonds issued by the California Health Facilities Financing Authority on behalf of Sutter Health (Sutter):

--Approximately $743.9 million revenue refunding bonds, series 2016B;

--Approximately $100 million revenue bonds, series 2016C.

In addition, Fitch has affirmed Sutter's outstanding debt, which is listed at the end of this release, at 'AA-'.

The series 2016B&C bonds will be fixed rate and will refinance the outstanding series 2007A, 2005, and 2003 bonds and provide $100 million of new money for reimbursement of prior capital expenditures. Sutter has $100 million of series 2013A taxable bonds, which will be redeemed on its mandatory tender date of Aug. 15, 2016. The series 2016B&C bonds are expected to price the week of July 18.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross revenue pledge of the obligated group.

KEY RATING DRIVERS

STRONG OPERATING PLATFORM: Sutter is a large system with a concentrated geographic presence in Northern California. Its physician alignment strategies, Epic implementation, and formation of a health plan should position the organization well as it focuses on transitioning from the fee for service model to total cost of care. Sutter is undergoing a consolidation of its operating units from five regions to two, which should be complete by 2017.

SIZABLE SYSTEM TRANSFORMATION INVESTMENTS: Sutter has significantly invested in support function consolidation, care management initiatives, and a health plan, which is expected to improve efficiency, lower its cost structure, and transform healthcare delivery across the system. Operating EBITDA margins have consistently been around 10% since 2014.

DELIBERATELY LOWER LIQUIDITY: Sutter has a weaker liquidity position compared to Fitch's 'AA' category medians due to its longstanding philosophy of deploying free cash flow into capital investments and pension funding, which otherwise would have increased days cash on hand. In addition, Sutter maintains a 100% fixed rate debt profile.

LARGE CAPITAL PLAN: Sutter has significantly invested in capital mainly driven by state seismic requirements in addition to the implementation of its common electronic medical record (Epic). Sutter has successfully constructed and opened nine new hospitals and the last major projects are the San Francisco facilities. The capital plan for 2016-2020 totals $4.8 billion and will be funded from debt and cash flow.

ADEQUATE DEBT SERVICE COVERAGE: With the refinancing, pro forma MADS drops to $244.2 million from $254.3 million. There is no increase in debt with this issuance since the series 2013A bonds will be redeemed in August 2016. Debt service coverage is adequate at 4.3x in 2015 and 5.3x in 2014 compared to the 'AA' category median of 5.7x.

RATING SENSITIVITIES

FINANCIAL FLEXIBILITY: Fitch believes Sutter Health has financial flexibility at its rating level due to its size and scale and views Sutter Health's strategic investments favorably, which should further differentiate the organization in the changing healthcare industry.

CREDIT PROFILE

Headquartered in Sacramento, California, Sutter is a large, integrated healthcare provider that since 2009, was organized into five regions: Central Valley, East Bay, Peninsula Coastal, Sacramento Sierra, West Bay. Each region has an aligned medical foundation and affiliated surgery centers. The regions are being consolidated into two operating units, Sutter Health Bay Area and Sutter Health Valley Area, which should be completed by 2017. The change is expected to streamline decision making, coordinate resources, and leverage economies of scale.

Sutter's other services include home health and hospice, long-term care, and medical research and education. The obligated group accounted for 93% of total assets and 96% of total revenue of the consolidated entity in fiscal 2015 (Dec. 31 year end). Fitch's analysis is based on the consolidated entity. Sutter's total revenue in fiscal 2015 was $11 billion.

System Transformation Investments

The organization is preparing for anticipated changes to the delivery and financing of healthcare, where Sutter is expected to be accountable for patient clinical outcomes, service experience and overall cost of care. Fitch believes Sutter's operating platform with its geographic concentration, physician alignment and electronic medical record should position the organization well in the new environment.

Sutter has made significant investments to fund several system initiatives targeting the organization's healthcare delivery models and business support functions. These one-time investments have largely been expended and have yielded $372 million of savings to date.

Sutter's health plan (Sutter Health Plus) is still in the early stages of operations and started offering coverage in 2014. There has been good growth in the number of lives, with over 36,000 compared to 5,000 in the beginning. The health plan is expected to complement current health plan relationships and not replace any current payer arrangements.

Fitch views management's strategic initiatives favorably and believes it should allow the system to better coordinate and deliver care in the most cost effective setting, strengthen its competitive position, and prepare it to manage population health.

Consistent Operating Cash Flow

After a weak 2013 due to several large one-time items related to the system strategic investments, profitability rebounded in 2014 and has been sustained through the three months ended March 31, 2016. Operating EBITDA margins were 9.8% through the three months ended March 31, 2016 compared to 9.3% in 2015, 10.5% in 2014, and 6.8% in 2013. Operating margin declined in 2015 due to increased depreciation and interest expense related to its capital plan.

Revenue growth has been solid with acute care hospital revenue up 8.6% in 2015 from the prior year, while the medical foundations revenue was up 8.8% and home care was up 10.5% over the same time period.

Similar to many California hospitals, Sutter has been a net beneficiary under the California provider fee program, receiving a net benefit of $94 million in 2012, $122 million in 2013, $117 million in 2014, and $113 million in 2015. Management expects the provider fee program to remain in place over the longer term. The program has a current expiration date of December 2016, and there will be a ballot initiative in November 2016 to eliminate the law's end date.

Deliberately Lower Liquidity

At March 31, 2016, Sutter had $4.6 billion of unrestricted cash and investments, which improved from $4.1 billion at fiscal year end 2015 mainly due to the reimbursement financing in February 2016. Liquidity metrics are weak for its rating level with 160.8 days cash on hand and 108.6% cash to debt at March 31, 2016. These metrics have always been an outlier in Fitch's rated portfolio for its rating level due to Sutter's philosophy in deploying cash to its pension plan and funding the majority of its capital needs with cash flow. Historically, Sutter maintained 100% funded status in its pension plan but has since eased this requirement especially as Sutter enters a period of heavy capital spending as it completes its San Francisco projects. Sutter maintains a wellfunded pension plan, and it was 93% funded as of Dec. 31, 2015.

Large Capital Plan

Sutter has spent a considerable amount of capital due to state mandated seismic requirements with all major hospital replacements complete in each region except for San Francisco. After a 10-year negotiation with the city, Sutter has started the construction of two new hospital buildings that includes a 274-bed (up to 304) hospital at Van Ness and Geary (former Cathedral Hill) and a 120-bed hospital on the St. Luke's campus with a total project cost of $2.565 billion. The construction projects are utilizing an integrated form of agreement, which aligns the incentives of the parties involved (general contractor, subcontractors, architects, designers, consultants) with a risk/reward arrangement to facilitate an on time and on budget project. Both projects are slightly favorable to budget, and the Van Ness and Geary project (36% complete) is on time while the St. Luke's facility (37% complete) is expected to open four months early. The Van Ness and Geary location will replace the current CPMC Pacific and California campuses and will open in February 2019 and the St. Luke's project will open in October 2018.

The capital plan for 2016-2020 totals $4.8 billion from 2016-2020 and unrestricted cash and investments are projected to grow over this period as cash flow exceeds capital spending. In addition to the San Francisco seismic requirements, other spending includes discretionary projects, ambulatory clinics, routine, and information technology. Management has stated that capital spending will be scaled back if cash flow is not sufficient to fund the capital plan.

Capital Structure

Total debt outstanding at March 31, 2016 is approximately $4.3 billion. Total debt outstanding remains unchanged after this financing with the planned redemption of the $100 million series 2013A put bonds that have a mandatory tender date in August 2016. The debt profile is conservative and is 100% fixed rate. The only uncommitted capital will be $100 million of series 2013B with a mandatory tender date in August 2018 and $100 million of series 2013C bonds with a mandatory tender date in August 2020.

Fitch used pro forma MADS of $244.2 million, which was provided by the underwriters. MADS dropped from the current $254.3 million due to savings from the refinancing. The structure of the $100 million series 2016C has not been determined yet, but the pro forma MADS assumes the same amortization as the redeemed series 2013A bonds.

The debt burden is manageable with MADS accounting for 2.2% of 2015 revenue. MADS coverage per Fitch's calculation (excluding unrealized gains/losses on investments) was 4.3x in 2015, 5.3x in 2014 and 3.2x in 2013. Through the three months ended March 31, 2016, debt service coverage dropped to 3.8x due to negative investment performance. Sutter's debt service coverage per MTI definitions includes unrealized gains/losses on investments and was calculated at 4x in 2015.

Disclosure

Sutter covenants to provide annual disclosure within six months of fiscal year end. Sutter will provide quarterly disclosure within 75 days of quarter end for the first three quarters at the request of a bondholder. Annual and quarterly disclosure has been available on Municipal Rule Making Board's EMMA system.

Fitch has affirmed the following Sutter Health bonds at 'AA-':

--$475,445,000 California Health Facilities Financing Authority revenue bonds series 2016A;

--$189,165,000 California Health Facilities Financing Authority revenue bonds, series 2015A;

--$450,000,000 California Health Facilities Financing Authority revenue bonds, series 2013A;

--$100,000,000 Sutter Health taxable bonds, series 2013A;

--$100,000,000 Sutter Health taxable bonds, series 2013B;

--$100,000,000 Sutter Health taxable bonds, series 2013C.

--$275,000,000 California Statewide Communities Development Authority revenue bonds, series 2011A;

--$475,000,000 California Health Facilities Financing Authority revenue bonds, series 2011B;

--$36,535,000 California Statewide Communities Development Authority revenue bonds, series 2011C;

--$310,300,000 California Health Facilities Financing Authority revenue bonds, series 2011D;

--$118,510,000 California Statewide Communities Development Authority revenue bonds, series 2012A;

--$200,535,000 California Health Facilities Financing Authority revenue bonds, series 2008A;

--$252,675,000 California Statewide Communities Development Authority revenue bonds, series 2008B;

--$47,325,000 California Statewide Communities Development Authority revenue bonds, series 2008C;

--$756,410,000 California Health Facilities Financing Authority revenue bonds, series 2007A;

--$47,430,000 California Statewide Communities Development Authority revenue bonds, series 2005B&C (insured: Ambac);

--$68,600,000 California Statewide Communities Development Authority revenue bonds, series 2004C&D (insured: Assured Guaranty);

--$95,840,000 California Statewide Communities Development Authority revenue bonds, series 2003A&B (insured: Ambac).

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=1008281

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1008281

Endorsement Policy

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

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

Contacts

Fitch Ratings
Primary Analyst
Emily Wong
Senior Director
+1-415-732-5620
Fitch Ratings, Inc.
650 California Street
San Francisco, CA 94108
or
Secondary Analyst
Olga Beck
Director
+1-212 908-0772
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 Street
San Francisco, CA 94108
or
Secondary Analyst
Olga Beck
Director
+1-212 908-0772
or
Committee Chairperson
Jim LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
elizabeth.fogerty@fitchratings.com