-- U.S.-based hospital operator Prospect Medical Holdings Inc. is paying a 100% debt-financed dividend to its owners. The dividend is being funded through a $100 million add-on to Prospect’s existing senior secured notes.
-- This unexpected event is inconsistent with our expectation that Prospect’s financial profile was on a path to improve.
-- We are revising the outlook on the ‘B’ corporate credit rating to stable from positive. We are affirming the corporate credit rating as well as our ‘B-’ issue-level rating on the senior secured debt.
-- The stable rating outlook reflects our view of the company’s more aggressive financial policy and our belief that the company’s financial risk profile will remain “aggressive” for the foreseeable future.
On Nov. 8, 2012, Standard & Poor’s Ratings Services revised its rating outlook on Los Angeles, Calif.-based Prospect Medical Holdings Inc. to stable from positive. We also affirmed the ‘B’ corporate credit rating. The issue-level rating on the senior secured notes is ‘B-’ (one notch below the corporate credit rating), with a recovery rating of ‘5’, indicating our expectation for modest (10% to 30%) recovery in the event of payment default. Rationale The ratings on Prospect Medical Holdings Inc. reflect the company’s “vulnerable” business risk profile (based on our criteria).
The company has a relatively undiversified business portfolio, a concentration of risk in a small number of hospitals, and a significant exposure to third-party reimbursement risk. We consider the financial risk profile as “aggressive,” reflecting our expectation for pro forma leverage of about 4.5x and that it will remain above 4x through 2013. This measure incorporates the inherent risks associated with the company’s reliance on the various provider tax and disproportionate share payment programs that could have a large impact on Prospect’s financial risk profile. Prospect owns and operates seven hospitals, five of which are in southern California, and a medical group business.
The ratings reflect our expectation of an estimated 20% increase in revenue in fiscal-year 2012. This estimate includes a partial year of the Nix Health Care System operations (acquisition closed Feb. 1, 2012), an adjustment for an accounting change for the provision for bad debts, our expectation for Medicare and Medicaid disproportionate share payments, gross receipts from the provider fee program in California, and receipts from the new program replacing the Upper Payment Limit Program in Texas. We expect Prospect to recognize a significant amount of revenue from these sources in the fourth quarter of fiscal-year 2012.
We expect these events to be the major catalysts driving EBITDA up to about $100 million for 2012, compared with $60 million in 2011. We expect the resultant leverage of about 3x and about $10 million to $15 million of free cash flow after capital expenditures. For 2013, we expect total revenue to increase about 8%. This measure includes the impact of a full year of the operations of Nix. We expect some improvement in patient volume as a result of operational improvements and new service offerings at the Brotman facility, coupled with minimal rate increases to support a 3% to 4% organic growth rate of its hospital business.
With the Nix acquisition completed, we do not expect Prospect to make any additional acquisitions in the next year, but believe the company will focus on integrating Nix and on further improving the financial performance of Brotman Medical Center. We expect Prospect’s EBITDA margin will be about 15% in 2013, about the same level as what we expect for 2012. We expect the new debt issued in the first fiscal quarter of 2013 to cause leverage to increase to about 4.5x. The ability of Prospect to sustain its financial risk profile is highly dependent on the future of California and Texas’ supplemental payments, states from which Prospect receives significant subsidy payments. While we are highly confident in the estimations of payments Prospect will receive over the next year or so, the long-term future of these programs is unclear.
We view Prospect’s business risk as “vulnerable” because of its small, undiversified portfolio of only seven hospitals, five of which are in Southern California. The company’s medical group business generates about one-third of total revenues, a figure we expect will decline over time because we expect management will focus its growth efforts on the hospital segment. Although the Nix acquisition modestly eased Prospect’s concentration in California from 100% of revenues down to 85% on a pro forma basis, reimbursement risk from third-party payors is a very influential factor affecting future earnings and cash flow. If reimbursement declines or lags expense increases, Prospect’s total profitability could decline if supplemental payments do not overcome this potential deficit. Prospect’s medical group business is also vulnerable to cuts in the Medicare Advantage program and to capitation risk, although this risk is reduced by sub-capitation.
We view Prospect’s liquidity as adequate, with cash inflows likely to exceed mandatory uses over the next couple of years. Our assessment of the company’s liquidity profile incorporates the following expectations and assumptions:
-- We expect sources of liquidity to exceed uses by 1.75x.
-- Sources exceed uses even if EBITDA declines by 20%.
-- Sources of liquidity include about $45 million of unadjusted operating cash flow before capital expenses. We expect Prospect to have excess cash reserves that they can use to supplement liquidity needs.
-- We expect Prospect to have full availability of its $50 million revolving credit facility.
-- We expect uses of cash to include capital expenditures averaging $10 million to $15 million per year. We expect Prospect to generate about $25 million of free cash flow. This excludes both the proceeds of the pending debt financing proceeds and the use of those proceeds to pay a dividend.
-- Prospect does not have any significant debt maturities until 2019.
-- We expect the cushion on bank covenants to remain above 15%. Recovery analysis Our issue-level rating on Prospect’s senior secured notes is ‘B-’ (one notch below the corporate credit rating on Prospect Medical), with a recovery rating of ‘5’, indicating the expectation for modest (10% to 30%) recovery in the event of a payment default.
The rating outlook is stable. We expect that the company’s low single-digit organic growth rate coupled with the risks and uncertainty associated with its supplemental payments from Medicare and Medicaid will result in little change in the company’s financial risk profile. This view incorporates our belief that reducing leverage is not as high a priority as we previously believed given the additional debt incurred to pay a dividend to its owners only a short time after the repayment of preferred stock held by the same parties.
Although unlikely because of our view that reimbursement pressure and risks associated with disproportionate share payments limit growth prospects, we believe a rating upgrade is possible if the company can reduce leverage below 3.5x and increase funds from operations to total debt to around 20%. Absent any change in financial policy that would favor debt repayment, we believe it would take an increase in its margin of over 500 basis points to achieve this level. However, we could lower our rating if Prospect’s financials deteriorate to the point where it does not produce free cash flow and leverage increases to above 5x, resulting in thin available liquidity and covenant issues.
We believe a 200-basis-point margin decline, possibly resulting from cuts to Medicare or Medicaid, including disproportionate share payments, could cause this to occur.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Criteria Guidelines For Recovery Ratings, Aug. 10, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
Ratings Affirmed; Outlook Revision
Prospect Medical Holdings Inc.
Corporate Credit Rating B/Stable/-- B/Positive/--
$425M senior secured notes B- B-
Recovery Rating 5 5