News Column

Fitch Downgrades PeaceHealth Bonds to 'A+'; Outlook Stable

February 20, 2014

Fitch Ratings has assigned an 'A+' rating to the following bonds:

--Approximately $66 millionOregon Facilities Authority refunding revenue bonds (PeaceHealth Project), series A;

--$42 millionWashington Health Care Facilities Authority refunding revenue bonds, series 2014A (PeaceHealth).

In addition, Fitch has downgraded the rating on PeaceHealth's outstanding debt (listed at the end of the press release) to 'A+' from 'AA-'.

The Rating Outlook is revised to Stable from Negative.

The series 2014 fixed rate bonds will be used to refinance PeaceHealth's series 2001 Oregon bonds and Southwest Medical Center's (SWMC) series 1999 bonds. The bonds are expected to price the week of Feb. 24.

SECURITY

The bonds are secured by a gross revenue pledge of the obligated group (OG). The OG accounted for 99 percent of total assets and 97 percent of total revenue of the consolidated entity in fiscal 2013 (June 30 year-end). Fitch's analysis is based on the consolidated entity.

KEY RATING DRIVERS

INCREASED LEVERAGE: The rating downgrade is driven largely by PeaceHealth's increased leverage as $176 million of additional debt was issued through a direct bank loan in fall 2013 to fund its investment in Epic. The increased leverage combined with PeaceHealth's compressed profitability reflects a financial profile that is no longer consistent with Fitch's 'AA' category medians.

LIGHT PROFITABILITY: PeaceHealth's profitability declined in fiscal 2012 and 2013 with margins that are light relative to the 'A' category medians. Fiscal 2013 performance dropped from the prior year due to flat net patient revenue from lower volume and a one- time accrual for its defined contribution plan. Profitability has improved through the interim period despite continued decline in volume, especially in its Columbia Network due to the termination of a Kaiser contract. Management has targeted $130 million of performance improvement for fiscal 2014, which Fitch believes is achievable.

SIZABLE CAPITAL PLANS: PeaceHealth has been committed to rebuilding its balance sheet after the significant investment in its replacement facility in Eugene, OR in 2008. After several years of light capital spending, capital expenditures are projected to increase to $200-300 million annually in fiscal 2014-2019 compared to under $150 million annually in fiscal 2009-2013. However, management has stated that the capital plan is flexible and spending will be contingent on cash flow. The only major item that is committed is the investment in Epic.

DOMINANT MARKET POSITION: PeaceHealth's primary rating strength continues to be its geographic diversity and the dominant market position in its major service areas. PeaceHealth is structured into three networks: Columbia Network (Longview/Vancouver, WA), Oregon West Network (Eugene/Springfield/Florence, OR) and Northwest Network (Bellingham, WA and Alaska facilities), where the system held market share positions of 59 percent, 76 percent and 86 percent, respectively.

GOOD LIQUIDITY: PeaceHealth's liquidity metrics have significantly improved and are somewhat driven by its additional debt issuance as the funds from the debt issuance are included in unrestricted cash and investments. This amount is invested separately with a low volatility, highly liquid investment strategy. Days cash on hand compares favorably to the 'A' category median, which is necessary given PeaceHealth's operational pressures related to lost volume in the Columbia Network and the Epic implementation.

STRATEGIC INITIATIVES UNDERWAY: There are several initiatives underway especially focused on the improvement of the Columbia Network, which will depend on its ability to build a platform that will be successful in recapturing the loss volume from the termination of the Kaiser contract. Other initiatives include continued focus on physician alignment and investment in information technology. PeaceHealth recently formed an IPA with the Vancouver Clinic (largest physician group in the service area) to be able to offer risk based contracting. The investment in Epic is expected to improve operational efficiency with workflow standardization and a common platform across the system.

RATING SENSITIVITIES

OPERATIONAL PRESSURES AHEAD: Fitch believes PeaceHealth's profitability will continue to be compressed over the near term as the realization of initiatives in the Columbia Network is expected to take two to three years. In addition, management plans to expense approximately 50 percent of the $277 million Epic implementation costs, which will have a drag on performance over the next three years. A further deterioration in operating performance than projected or capital spending outside of its affordability could lead to further downward rating pressure.

CREDIT PROFILE

PeaceHealth is a multi-state health care system with nine acute care hospitals operating a total of 1,570 licensed beds in Washington, Oregon, and Alaska and had total revenue of $2.2 billion in fiscal 2013. PeaceHealth recently revised its legal structure so that its sole corporate parent is PeaceHealth Networks. Currently, there is no activity at the parent level but the structure was created to foster merger/affiliation opportunities with non- Catholic providers.

Weak Profitability

Since fiscal 2011, PeaceHealth's profitability metrics have lagged Fitch's 'AA' and 'A' category medians. In fiscal 2013, PeaceHealth had an operating margin of negative 0.3 percent and operating EBITDA margin of 8.5 percent compared to the prior year with 0.8 percent and 9.5 percent, respectively. Net patient revenue has been flat with a 2.2 percent reduction in admissions and 4.5 percent reduction in surgeries in fiscal 2013 from the prior year. Through the six months ended Dec. 31, 2013, PeaceHealth had a 1.7 percent operating margin and 9.8 percent operating EBITDA margin compared to 1.6 percent and 10.1 percent, respectively, the same prior year period and performance through fiscal 2014 year to date is ahead of budget. In addition, there continues to be pressure on governmental reimbursement and PeaceHealth is a net payer into both the Oregon and Washington state assessment programs.

In October 2013, Kaiser terminated its contract with PeaceHealth's facilities in the Columbia Network and Kaiser has been redirecting that volume to its newly opened facility in the Portland metropolitan market as well as to a local competing facility, which recently signed a Kaiser contract. Kaiser volumes at PeaceHealth's Columbia Network facilities are down 75 percent. In response, PeaceHealth is developing alternative payor strategies to capture some of the lost volume. In addition, there was a reduction in force of approximately 500 FTEs in the Columbia Network in Sept. 2013. Management has targeted $130 million of systemwide operational improvement in fiscal 2014 which Fitch believes is achievable.

PeaceHealth is almost complete with the ambulatory implementation of Epic and the remaining investment is for the inpatient side, at a total cost of $277 million from fiscal 2014-2018. Profitability is expected to be compressed over the next three years as the system will be expensing about half of the cost over the next three years. Operating EBITDA margins are projected between 9-9.7 percent for fiscal 2014-2016 with Epic costs compared to 9.5-11.2 percent without Epic costs.

Good Liquidity

PeaceHealth's liquidity metrics are good for the rating level with $1.38 billion unrestricted cash and investments at Dec. 31, 2013. Liquidity metrics of 256.0 days cash on hand, a 17.3x cushion ratio (based on pro forma MADS and 126.1 percent cash to pro forma debt compare favorably to the respective 'A' category medians of 196.3, 15.6x and 129.2 percent.

Strong Market Position

PeaceHealth's main credit strength is its system's geographic diversity and leading / dominant market position in most of its service areas in Washington, Oregon and Alaska. Fitch views the revenue diversity favorably with the Oregon West Network accounting for 36.2 percent of consolidated revenue in fiscal 2013, Columbia Network with 35 percent and Northwest Network with 23.5 percent. The system has been making a substantial investment in physician alignment and its clinical information system in an effort to position the system for value based reimbursement models and population health management capabilities. PeaceHealth currently has experience with full risk Medicaid capitated lives. Its ability to successfully recapture the lost volume through alternative payor strategies is critical to improving financial performance and would demonstrate an ability to coordinate care and provide services in cost effective settings.

Increased Leverage

PeaceHealth's total pro forma debt is $1.06 billion and is 67 percent underlying fixed rate and 33 percent underlying variable rate. PeaceHealth has completed several refinancings lately and approximately 50 percent are now direct placements or bank loans. The direct placements and variable rate demand bonds (VRDBs) have a three-year term out provision and the expiration dates and counterparty exposure are staggered and diversified, which is viewed favorably. Including the impact of its swaps, PeaceHealth is 100 percent fixed rate. PeaceHealth is not posting any collateral related to its swaps.

The debt burden is moderately high with MADS as 3.7 percent compared to the 'A' category median of 3.1 percent. Given weaker profitability, historical coverage of pro forma MADS by EBITDA is light for the rating category at 2.9x and 2.6x in fiscal 2012 and 2013, respectively. Pro-forma MADS equals $79.8 million and includes a smoothing of PeaceHealth's bullet maturities ($80.65 million in 2019 for series 2008A and $50 million in 2021 for US Bank loan) as permitted under the master trust indenture. The debt service schedule is not level and MADS occurs in 2017, 2031, and 2032.

Disclosure

PeaceHealth has covenanted to provide annual audited financial statements to each Electronic Municipal Market Access (EMMA) within 150 days of each fiscal year end and unaudited quarterly financial statements (including a consolidated balance sheet, income statement, statement of cash flows, and utilization statistics) within 60 days of each fiscal quarter end.

Outstanding Debt:

--$96,375,000Oregon Facilities Authority (OR) (PeaceHealth) revenue bonds series 2009A;

--$79,220,000Washington Health Care Facilities Authority (WA) (PeaceHealth) revenue bonds series 2009;

--$145,975,000Oregon Facilities Authority (OR) (PeaceHealth) revenue bonds series 2008A&B (LOC: U.S. Bank National Association)

--$80,650,000Washington Health Care Facilities Authority (WA) (PeaceHealth) revenue bonds series 2008A;

--$70,000,000Oregon Health, Housing, Educational, & Cultural Facilities Authority (OR) (PeaceHealth) revenue bonds series 2001 (insured: Ambac Assurance Corp.);

--$2,515,000Oregon Health, Housing, Educational, & Cultural Facilities Authority (OR) (PeaceHealth) revenue bonds series 1995.

Additional information is available at 'fitchratings.com'.

Applicable Criteria and Related Research:

--'Nonprofit Hospitals and Health Systems Rating Criteria', dated May 20, 2013.

Applicable Criteria and Related Research:

U.S. Nonprofit Hospitals and Health Systems Rating Criteria

http://fitchratings.com/creditdesk/reports/ report_frame.cfm?rpt_id=708361

Additional Disclosure

Solicitation Status

http://fitchratings.com/gws/en/disclosure/ solicitation?pr_id=820678

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