TEXT-Fitch affirms University Health System, Tenn. revs at 'BBB+'
Jan 24 - Fitch Ratings has affirmed the 'BBB+' rating on $220.7 million Health Educational and Housing Facility Board of the County of Knox (TN) (University Health System, Inc.) series 2007 revenue bonds. The Rating Outlook is Stable. SECURITY Debt payments are secured by a pledge of the gross revenues of the obligated group. SENSITIVITY/RATING DRIVERS STRONG MARKET PRESENCE: University Health System (UHS) is the area's only academic medical center with a regional draw providing tertiary and quaternary services, some of which are provided exclusively by UHS. UHS was able to slightly increase its market share despite the recent entrance of for-profit competition (HMA) in the market. HISTORICALLY MARGINAL OPERATING PERFORMANCE: Operating performance in fiscal 2011 (year end Dec. 31) with operating margin of 1.6% was slightly stronger than prior years, but still below Fitch's 'BBB' rating median. Management projects to end fiscal 2012 with a relatively weak operating margin of 0.7%. The ability to leverage its close alignment with physicians and a major focus on standardization should result in stronger operating performance. END OF LARGE CAPITAL SPENDING: Days cash on hand (DCOH) of 125.7 days at Sept. 30, 2012 and cash to debt equal to 66.3% are weaker than Fitch's 'BBB' respective rating category medians of 138.9 and 82.7%. However, UHS completed a major facility update and has no major projects planned for the near term, which should enable the organization to improve its balance sheet. Capital spending is projected to be approximately 80% of depreciation expense for the next three years. CHALLENGING PAYOR MIX: UHS's payor mix has been stable over time, but TennCare, Tennessee's thinly funded Medicaid program accounts for a high 17% of gross revenues. UHS, as an essential access hospital, benefits from TennCare monies allocated to safety net hospitals and also receives some monies from the cigarette tax allocated to hospitals with Level I trauma designation. WHAT COULD TRIGGER A RATING ACTION NEED TO GENERATE BETTER OPERATING PERFORMANCE: It is Fitch's expectation that with the completion of UHS's investment in its facility, the organization should produce a stronger level of operating performance due to its strategic initiatives, which should ultimately lead to a stronger balance sheet. The failure to generate operating results more in line with the 'BBB' rating category medians may lead to negative rating action. CREDIT PROFILE UHS operates in a competitive market with its major competition consisting of Covenant Health (rated 'A' by Fitch) and the recent entrant for-profit Tenova (subsidiary of HMA), which purchased the former Mercy Health System. UHS was able to increase its market share slightly to 14% from 13%, the highest of any individual hospital in the Knoxville market, despite an overall decline in discharges in the service area. Volumes on the inpatient side declined 1% in fiscal 2011, after several years of continuous increases, but were 0.6% higher for the nine-month interim period ended Sept. 30, 2012. Outpatient volumes in 2012 continued to be solid including a 6% increase in outpatient surgeries and 9% increase in emergency department visits. UHS is somewhat insulated from HMA's entry by virtue of having a medical staff which primarily admits only to UHS. UHS's maximum annual debt service (MADS) coverage by EBITDA and operating EBITDA of 2.1 times (x) and 1.7x, respectively, through the nine-month interim period are adequate, but below the respective category medians of 2.8x and 2.5x (Fitch includes in the long-term debt and MADS the entire $50 million of the variable series 2010 bank qualified bond issue, even though UHS's financial statements reflect only the amounts drawn to date; to date only $0.9 million remains to be drawn). MADS as a percentage of revenues is elevated at 4.0%, as compared to the 'BBB' category median of 3.3%, and cash to debt at 64% is lower than the category median of 83%. As UHS completed a major update of its facility and faces no significant capital needs over the near term, Fitch expects that the debt load metrics will moderate over time. UHS has a relatively conservative debt structure with 82% fixed-rate debt. The variable series 2010 bonds issued as a direct bank purchase have a 2043 final maturity, but the bank has a right to call the bonds in 2017. Fitch views the organization's $186 million of unrestricted cash and investments as a sufficient hedge against this risk. UHS's cash decreased to $186.3 million at Sept. 30, 2012, equal to 125.7 DCOH, from $198.4 million (142.1 DCOH) at 2011 fiscal year end, primarily as the organization reduced its payables. Fitch notes UHS's conservative asset allocation with approximately 70% of investments in fixed income. UHS has one fixed-to-variable-rate swap ($176 million notional par) with a negative mark-to-market of $0.5 million as of the end of December 2012 and no collateral posting was required ($10 million threshold). For fiscal 2011, UHS recorded operating income of $8.7 million (operating margin of 1.6%), an improvement over the $2.5 million in the prior year (0.5% operating margin). Fiscal 2011 operating income included $4.5 million of meaningful use stimulus funds for its investments in an electronic health record. For the nine-month interim period ended Sept. 30, 2012, UHS reported operating income of $0.8 million, but management expects to end the year with $4.1 million (0.7% operating margin) as a further $3.3 million of stimulus funds will be recorded before fiscal year end. STABLE OUTLOOK The Stable Outlook is based on Fitch's expectation that UHS's financial profile should improve as its major capital investment is complete and operating improvement initiatives are underway. However, Fitch notes that UHS's financial profile has historically been weak for its rating level and the failure to improve performance would likely result in negative rating pressure. UHS is a 514 staffed-bed academic teaching facility which provides a diverse array of clinical services to 21 counties in eastern Tennessee. UHS had total operating revenues of $541 million in fiscal 2011 and covenants to provide bondholders with annual and quarterly financial disclosure through the Municipal Securities Rulemaking Board EMMA system. UHS also provides management discussion and analysis and utilization statistics with their quarterly financials which management updates on an annual basis. Fitch believes that UHS's disclosure practices are very good. Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings. Applicable Criteria and Related Research: --'Revenue-Supported Rating Criteria', dated June 12, 2012 --'Nonprofit Hospitals and Health Systems, dated July 23, 2012 Applicable Criteria and Related Research: Revenue-Supported Rating Criteria Nonprofit Hospitals and Health Systems Rating Criteria