News Column

Fitch Affirms City of Hope, CA's Rev Bonds at 'AA-/F1+'

June 6, 2014

SAN FRANCISCO--(BUSINESS WIRE)-- Fitch Ratings affirms the AA-/F1+ rating on the following City of Hope's outstanding debt:

--$350,000,000 City of Hope Direct Obligation Notes series 2013 (taxable) at 'AA-';

--$234,600,000California Health Facilities Financing Authority, revenue bonds (City of Hope) series 2012A at 'AA-';

--$65,000,000California Health Facilities Financing Authority, variable rate revenue bonds (City of Hope) series 2012B and 2012C at 'AA-/F1+'.

The Rating Outlook is Stable.

SECURITY

Gross receivables of the obligated group, excluding royalty receivables. The obligated group includes City of Hope, City of Hope National Medical Center, The Beckman Research Institute, and City of Hope Medical Foundation. The obligated group accounted for over 99% of total assets and over 97% of total revenue of the consolidated entity.

KEY RATING DRIVERS

HIGHLY SPECIALIZED SERVICES: City of Hope is nationally known for its cancer care and its position in a highly competitive market is differentiated by its focus on translational research. The organization has been successful in capitalizing its intellectual property with the receipt of a significant stream of royalty income. City of Hope is the market leader in three inpatient cancer service lines - hematology, prostate and ENT, and has a dominant market share in bone marrow transplants (BMT).

STRONG BALANCE SHEET AND PROFITABILITY: City of Hope's balance sheet has grown significantly over the last five years and liquidity ratios are favorable for the rating level. Profitability has also been strong due to good volume growth, receipt of royalty revenue, ongoing fundraising and focus on expense management. The debt burden is somewhat high for the rating level due to the issuance of additional debt in 2013. Future debt capacity is likely limited at the current rating level.

IMPLEMENTATION OF STRATEGIC PLAN: The organization implemented a new 10-year strategic plan in 2012 that seeks to sustain City of Hope's current financial performance over the next decade. Key plan components include expansion of community and ambulatory capabilities, enhancement of clinical service lines, and cost reduction of clinical and research activities. Fitch views the strategic plan favorably as it addresses the backfill of the expected reduction in royalty revenue with the 2018 expiration of its Cabilly patents. City of Hope has been successful in the implementation of its plan over the first two years with the growth of its hematologic and transplantation programs, expanded presence in outlying southern California communities, continued growth of its medical foundation and continued expense management.

SIZABLE CAPITAL PLAN: City of Hope's 10-year capital plan is sizable and totals $921.4 million. The majority of capital spending addresses community and ambulatory expansion initiatives ($421.4 million) and investments in information technology systems ($319 million). Financing sources include approximately $350 million from the 2013 bond issue and the remaining from operating cash flow. Fitch expects City of Hope to maintain strong cash flow generation to support its sizable capital needs. The 10-year plan includes $87 million of capital expenditures that were spent in fiscal 2013.

STRONG FUNDRAISING ABILITY: City of Hope recently completed a $1 billion capital campaign and will announce another campaign shortly. Its fundraising ability provides additional financial flexibility and the organization is focused on enhancing its national reputation.

RATING SENSITIVITIES

EXPIRATION OF LUCRATIVE PATENT: Fitch expects that City of Hope will maintain current profitability and liquidity trends over the medium term as it executes on its long-term strategic plan. Over the longer term Fitch's main concern is the anticipated loss of royalty income (net of approximately $170 million in fiscal 2013) beginning in fiscal 2019 compared to a current operating income of $135 million (fiscal 2013; Sept. 30 year end). The execution of the strategic plan will be key to maintaining the current rating.

CREDIT PROFILE

City of Hope is a prominent and nationally recognized biomedical research, treatment, and teaching institution dedicated to the comprehensive treatment of cancer. The organization comprises the City of Hope Medical Center, the City of Hope Medical Foundation, and the Beckman Research Institute. The Medical Center owns and operates a 217-licensed bed acute care tertiary referral facility. The Medical Foundation is aligned with the Medical Center, with over 200 affiliated physicians employed by the City of Hope Medical Group and operates various outpatient clinic facilities. The Beckman Research Institute owns and operates a number of major research facilities on City of Hope's main campus and conducts basic scientific research in support of and in conjunction with the patient care activities of the Medical Center and the Medical Foundation.

Strong Balance Sheet and Profitability

City of Hope has a strong balance sheet and sustained solid profitability, which should provide the organization some flexibility as it implements its strategic plan and prepares for the anticipated loss of a royalty revenue stream from an expiring patent.

As of March 31, 2014, City of Hope had $1.8 billion unrestricted cash and investments, which translated to 631.6 days cash on hand and 258% cash-to-debt compared to Fitch's respective 'AA' category medians of 254.3 days, and 173.6%. The balance sheet has grown significantly from $713 million unrestricted cash and investments at fiscal year-end 2009 due to strong profitability and good investment returns. In addition, the proceeds from the $350 million taxable debt issuance in 2013 was invested in City of Hope's long term investment portfolio and included in unrestricted cash and investments.

Total operating revenue in 2013 includes $778 million net patient service revenue (58% of total revenue), $248.5 million royalty income (19%), $82 million research grants (6%), $86 million unrestricted contributions and net assets released from restrictions (6%) and other revenue. The royalty income stream has totaled over $1 billion since 2006 and 97% of the royalty stream is derived from the Cabilly patents. The Cabilly patents expire in 2018 and the net impact on City of Hope's income statement is approximately $170 million as a third of the royalty stream belongs to the inventors (operating expense).

Profitability is strong with an operating income of $135 million in fiscal 2013 (11.2% operating margin) and $117 million (10.4% operating margin) in fiscal 2012. Operating performance remained strong through the six months ended March 31, 2014 with a 6.1% operating margin. Profitability has been driven by strong volume growth especially in BMT cases, which have been above forecasted levels as well as the growth in outpatient visits driven by its alignment with its physicians through a medical foundation model. Profitability was also aided by the provider fee, which accounted for a net benefit of $23 million in fiscal 2013 and $49 million in fiscal 2012.

Expanding Clinical Reach

The market for highly specialized cancer care in City of Hope's primary service area remains fragmented and competitive. City of Hope faces strong competition for inpatient services from Cedars-Sinai Medical Center (rated 'A+' by Fitch), Ronald Reagan UCLA Medical Center, Keck Medical Center at USC and Hoag Memorial Medical Center. City of Hope has a leading market share in hematology, prostate, and ENT inpatient service lines.

City of Hope has been successful in expanding its clinical reach by partnering with various community hospitals and operating outpatient facilities in outlying areas and providing access to City of Hope's expertise to an expanded population. City of Hope has an arrangement with Kaiser to perform Kaiser's transplant cases in Southern California. In addition, City of Hope announced that it is in negotiation with Providence Health Services to develop an oncology partnership in the Southern California region. After a difficult start, the Medical Foundation, now in its third year, has been instrumental in aligning physicians with City of Hope and engaging more physicians at the leadership level.

Proactive Strategic Plan

City of Hope's 10-year strategic plan adopted in 2012 was designed to respond to operational and financial challenges related to healthcare reform and an expiring royalty revenue stream. The plan focuses on leveraging City of Hope's national reputation in key service lines to expand both inpatient and outpatient operations, investing in translational research capabilities, and prioritizing philanthropy.

On the clinical side, City of Hope will expand its signature programs in hematology and bone marrow transplants, selectively invest in solid tumor programs, and expand community sites in existing and new strategic markets. Research strategies will focus on growing signature research programs in diabetes and stem cell research, reinforcing translational research infrastructures, and cultivating funding and philanthropic support of cancer research.

The strategic plan also incorporates revenue enhancement and cost reduction initiatives necessary to maintain financial performance. City of Hope plans to add additional outpatient sites, in addition to increasing inpatient capacity by reducing length of stay. Efforts are in place to reduce expenses by 5% and 4% in 2014 and 2015, respectively, and 1% each year thereafter.

In the second year of its strategic plan, City of Hope has exceeded its volume projection in hematology and BMT, grown its presence in outlying communities, maintained expenses below budgeted levels, moved the recovery of BMT patients to a lower-cost setting, and prioritized its pipeline of promising compounds that will receive a higher percentage of investment and resources.

Conservative Debt Profile

Total debt outstanding at March 31, 2014 was $689 million and includes a $42 million 10 year capital lease for office space. The bonded debt portfolio is 90% underlying fixed rate and 10% underlying variable rate demand bonds (VRDBs). The VRDBs are supported by City of Hope's self-liquidity.

City of Hope has two floating to fixed rate swaps, which do not require collateral posting at the current mark to market valuation. Including its swaps, the debt profile is 100% fixed rate.

City of Hope issued $350 million of taxable bonds in 2013 to take advantage of the current interest rate environment and unrestricted cash and investments will be inflated over the next few years as bond proceeds will be held on the balance sheet until spending on its capital plan ramps up and a new ambulatory facility is expected to break ground in 18 - 24 months.

The series 2013 taxable bonds are structured as one bullet maturity in 2043 and the MADS of $48.3 million incorporates the amortization of the series 2013 bonds consistent with the treatment of balloon indebtedness under the master trust indenture and also includes the debt service on the capital lease.

City of Hope's debt burden is above average for its rating level as MADS accounted for 4% of total revenue in fiscal 2013 compared to the AA category median of 2.6%. Debt service coverage is solid at 5.6x in fiscal 2013 compared to 4.8x in fiscal 2012 and was 4.3x for the six months ended March 31, 2014.

Short-Term Rating Based on Self-Liquidity

The 'F1+' short-term rating is supported by the adequacy of City of Hope's highly liquid resources available to fund any un-remarketed puts on $65 million in weekly VRDBs. Based on Fitch's rating criteria on self-liquidity; City of Hope has sufficient liquid resources to cover the maximum tender exposure on any given date. City of Hope has liquidation procedures in place detailing the process by which internal funds would be liquidated to meet the tender obligations.

Disclosure

City of Hope covenants to provide an annual audit within 150 days of fiscal year-end and quarterly disclosure within 60 days of quarter-end for the first three quarters and within 75 days of fourth quarter-end via the MSRB's EMMA system.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Nonprofit Hospitals and Health Systems Rating Criteria'(May 20, 2014);

--Rating U.S. Public Finance Short Term Debt' (Dec. 9, 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=746860

Rating U.S. Public Finance Short-Term Debt

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724680

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=833450

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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

Gary Sokolow, +1-212-908-9186

Director

or

Committee Chairperson

Eva Thein, +1-212-908-0674

Senior Director

or

Media Relations, New York

Elizabeth Fogerty, +1-212-908-0526

elizabeth.fogerty@fitchratings.com

Source: Fitch Ratings


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