News Column

Fitch Affirms Sutter Health, CA's Rev Bonds at 'AA-'; Outlook Stable

May 9, 2014

SAN FRANCISCO--(BUSINESS WIRE)-- Fitch Ratings has affirmed the 'AA-' rating on Sutter Health, CA's (Sutter) outstanding debt, which is listed at the end of the press release.

The Rating Outlook is Stable.

SECURITY

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 recent 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.

SIZABLE SYSTEM TRANSFORMATION INVESTMENTS: Sutter is investing in support function consolidation, care management initiatives, and a health plan, which is expected to enhance performance, lower its cost structure, and transform healthcare delivery across the system. Profitability is expected to be pressured over the near term due to these one-time costs, but these investments are projected to improve cash flow over the longer term.

WEAKER PROFITABILITY IN FISCAL 2013: Sutter's operating performance declined in fiscal 2013 with weak operating cash flow for the rating level. However, adjusting for one-time items, cash flow is improved but still down compared to historical performance.

GOOD FISCAL MANAGEMENT: Sutter has historically had weaker liquidity metrics compared to Fitch's AA category medians, however, management has a long standing philosophy of deploying its free cash flow into capital investments and fully funding its pension plan, which otherwise would have increased days cash on hand. Despite this, days cash on hand have improved year over year. 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 and the majority of its large scale hospital replacements are complete or near complete. The only major projects remaining are for the San Francisco facilities. Capital spending is projected to remain similar to current levels of approximately $1 billion a year for the next few years. Capital spending is funded through cash flow and Sutter generally issues additional debt for reimbursement financing. There could be a potential debt issue later this year.

RATING SENSITIVITIES

FINANCIAL FLEXIBILITY: Despite weaker performance in fiscal 2013, Fitch believes Sutter has financial flexibility at its rating level due to its size and scale and views Sutter'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 is organized into five regions - Central Valley, East Bay, Peninsula Coastal, Sacramento Sierra, West Bay with each region having an aligned medical foundation and affiliated surgery centers. 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 2013 (Dec. 31 year end). Fitch's analysis is based on the consolidated entity. Sutter's total revenue in fiscal 2013 was $9.6 billion.

System Transformation Investments

Sutter's operating platform is designed to leverage its large regional market presence together with a strong physician alignment strategy to yield a robust and diverse revenue source. 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. To these ends, Sutter is undertaking significant investments to fund several system initiatives targeting the organization's healthcare delivery models and business support functions. These one-time investments, totaling $575 million and lasting through 2017, will integrate the organization's IT platforms, reengineer healthcare delivery processes, lower the cost structure, increase efficiency and enhance performance.

In addition, Sutter just started its health plan operations and currently has a small membership with gradual growth plans. The health plan is not participating in the exchanges and is currently being offered in certain regions in its infancy stage. Fitch views management's actions positively and believes these investments 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.

Weak Profitability in Fiscal 2013

Sutter posted an operating loss in fiscal 2013 and weaker operating cash flow margins due to several one-time items. Operating margin was negative 0.3% in fiscal 2013 compared to 5.6% in fiscal 2012 and operating EBITDA margin dropped to 6.8% from 11.3% the prior year. The major one-time items include expenses related to system strategic investments and information technology, as well as an $83 million increase in depreciation due to San Francisco's project design and pre-construction resizing. Without the one-time items in fiscal 2013 (including the exclusion of $23 million of meaningful use funds), Fitch estimates the operating margin would be 3.2% and operating EBITDA margin would be 10.3%.

Based on first quarter 2014 performance, management expects to end the year with performance similar to fiscal 2013 without the one-time items, which Fitch believes is attainable.

Fitch notes that 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 fiscal 2012 and $122 million in fiscal 2013. Sutter has budgeted a similar amount for fiscal 2014, which is expected in the latter part of the year as the program extension is still awaiting CMS approval.

Improving Liquidity

At Dec. 31, 2013, Sutter had $4.3 billion of unrestricted cash and investments, which translated to 173.2 days cash on hand and 113.9% cash to debt compared to Fitch's 'AA' medians of 254.3 and 173.6%, respectively. Sutter's liquidity metrics have historically been very low when compared to Fitch's AA category medians, however, there has been significant improvement over the last five years. In addition, Sutter's demand on liquidity is minimal due to its conservative debt profile and fully-funded pension plan.

Large Capital Plan

Sutter has spent a considerable amount of capital with major hospital replacements complete or near 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 in San Francisco that includes a 274-bed (up to 304) hospital at Cathedral Hill and a 120-bed hospital on the St. Luke's campus with a total project cost of $2.1 billion. The San Francisco facilities are expected to open in the second quarter of 2019.

Future projected capital spending totals approximately $1 billion a year for the next few years. In addition to seismic requirements, other spending includes discretionary projects, routine, and information technology. Management stated that capital spending will be scaled back if cash flow is not sufficient to fund the capital plan.

Capital Structure

Sutter had $3.7 billion of outstanding debt as of March 31, 2014, which is 100% fixed rate. Sutter issued $300 million series 2013A-C taxable bonds, which are structured with mandatory tender dates in August 2016, 2018, and 2020 of $100 million each. Maximum annual debt service (MADS) of $231 million was calculated according to the master trust indenture treatment for balloon maturities. Fitch believes Sutter has good market access and solid liquidity to handle the mandatory tenders.

The debt burden is moderate with MADS accounting for 2.4% of fiscal 2013 revenue. Fitch notes that Sutter's debt service coverage calculation includes unrealized gains/losses on investments. MADS coverage per Fitch's calculation (excluding unrealized gains/losses on investments) was 3.4x in fiscal 2013 compared to 4.9x in fiscal 2012 and 5.8x in fiscal 2011 and the AA category median of 5x. Without the one-time items in fiscal 2013, MADS coverage improves to 4.8x.

Disclosure

Sutter covenants to provide annual disclosure within 180 days 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-':

--$47,930,000California Statewide Communities Development Authority (CA) revenue bonds, series 2003A;

--$47,910,000California Statewide Communities Development Authority (CA) revenue bonds, series 2003B;

--$45,175,000California Statewide Communities Development Authority (CA) revenue bonds, series 2004C;

--$26,265,000California Statewide Communities Development Authority (CA) revenue bonds, series 2004D;

--$224,460,000California Statewide Communities Development Authority (CA) revenue bonds, series 2005A;

--$23,715,000California Statewide Communities Development Authority (CA) revenue bonds, series 2005B;

--$23,715,000California Statewide Communities Development Authority (CA) revenue bonds, series 2005C;

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

--$228,820,000California Health Facilities Financing Authority (CA) revenue bonds, series 2008A;

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

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

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

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

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

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

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

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

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

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

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

Additional information is available at 'www.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://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=708361

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=829480

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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

Michael Burger, +1 415-659-5470

Director

or

Committee Chairperson

Jim LeBuhn, +1 312-368-2059

Senior Director

or

Media Relations:

Elizabeth Fogerty, +1 212-908-0526

elizabeth.fogerty@fitchratings.com

Source: Fitch Ratings


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