News Column

Fitch Affirms Banner Health System's (AZ) Rev Bonds at 'AA-'; Outlook Stable

July 31, 2014

SAN FRANCISCO--(BUSINESS WIRE)-- Fitch Ratings has affirmed the 'AA-' rating on Banner Health System, AZ's (Banner) outstanding debt, which is listed at the end of the press release. In addition, Fitch has withdrawn the 'AA-' rating on the series 2008B and C bonds since the debt instruments were taken private (converted to direct bank loans).

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross revenue pledge of the obligated group. The obligated group accounted for 75% of total revenue and 94% of total assets of the consolidated entity in fiscal 2013 (Dec. 31 year end). Fitch's analysis is based on the consolidated entity.

KEY RATING DRIVERS

LARGE SYSTEM WITH GOOD MARKET SHARE IN MAIN GEOGRAPHIC REGIONS: Banner is a large, regional health system with operations concentrated in the Phoenix, AZ metropolitan area. Banner's market share in the Phoenix metropolitan service area increased to 45.1% in 2013 from 42.3% in 2009 reflecting the system's investment in facilities and physicians. Fitch believes the system has been able to use its geographic concentration to its advantage as it further extends its reach into other areas of the state and is creating a platform to compete in a value based reimbursement environment.

STRONG AND CONSISTENT PROFITABILITY: Despite continued revenue pressure from lower volume, Banner has been able to maintain strong and consistent operating results that exceed Fitch's 'AA' category medians. From 2010-2013, Banner has generated operating margins between 5% and 6.1% and operating EBITDA margins between 13.1% and 14.6%, which is well in excess of the respective 'AA' category medians.

IMPROVING LIQUIDITY: Liquidity continues to improve due to solid investment returns, strong cash flow and more moderate capital spending after a period of heavy capital investment. Days cash on hand and cash to debt were 292.7 and 160.9%, respectively at March 31, 2014.

GOOD DEBT SERVICE COVERAGE: Debt service coverage is solid due to strong profitability. Debt service coverage was 5x for fiscal 2013 and 2012 and was 4.9x for the three months ended March 31, 2014.

POOR RESULTS ON RISK BASED CONTRACTS IN 2013: The Banner Health Network (BHN) was created to enter into various risk based reimbursement contracting including a Pioneer ACO and senior risk plans. Revenue from risk based contracts through BHN accounted for approximately 9% of Banner's net patient service revenue in 2013. While Fitch believes Banner's movement into risk based reimbursement contracts to be strategically positive over the long term, BHN posted a $34 million operating loss in 2013 due primarily to higher than expected claims expense and management of certain senior risk plans. Management has implemented improvement initiatives and expects BHN to be profitable in 2014.

RATING SENSITIVITIES

ACQUISITION ACTIVITY REQUIRING CAPITAL INVESTMENT: Banner has been active in growing its market reach outside of Phoenix. In June 2014, Banner acquired 177 bed Casa Grande Regional Medical Center in Casa Grande, AZ (55 miles south of Phoenix) for $87 million. Later in June Banner and University of Arizona Health Network (UAHN; revenue bonds not rated by Fitch) entered into a Principles of Agreement (PA) to combine the two organizations which would create a statewide health care organization. While Fitch views the expected strategic benefits and geographic diversity positively, the PA outlines sizeable capital investments to be made by Banner into UAHN. Banner expects to issue additional debt in fall 2014 to early 2015 to fund some of these needs. Fitch will evaluate the impact of the additional debt on the rating when financing plans are finalized.

CREDIT PROFILE

Banner Health is a large, integrated health care provider headquartered in Phoenix, AZ with operations in seven states that include 25 hospitals, over 1,000 employed physicians (Banner Medical Group), outpatient and post-acute facilities and insurance products. In 2013, Banner generated $5.1 billion in total revenue. The majority of Banner's operations are located in the Phoenix metropolitan area which accounted for over 60% of total revenue in 2013.

Growing Integrated Delivery System

In June 2014, Banner closed on the acquisition of 177-bed CGRMC which was funded by a line of credit draw. Banner expects to refinance the line of credit with permanent financing later this year. CGRMC is a financially distressed organization that went into bankruptcy for the acquisition to be completed. However, Banner expects to implement a financial turnaround fairly quickly due to the resources available now as part of the Banner system as well as reduction in the level of outmigration from the service area.

Also in June 2014, Banner signed a PA with UAHN located in Tucson, AZ which states a goal of creating a statewide system that provides high quality care through a 30-year commitment to University of Arizona'sCollege of Medicine teaching programs in addition to investing capital in UAHN's facilities. Banner's expected financial commitments at closing include approximately $146 million to defease UAHN's debt, $500 million of capital investment over five years , creation of a $300 million endowment to support clinical and translational research, in addition to providing operating support for the academic enterprise. This transaction is expected to close by the end of the year. Fitch will assess the impact on the rating at the time the transaction and financing details are available.

As part of its overall strategic plan, Banner has been very proactive in readying the organization for payment reform, coordinated delivery of care, and population health management. Banner created BHN to enter into various full risk and shared risk contracts with a total of approximately 169k average members. Although BHN's performance in 2013 was below expectations, Fitch believes management's initiatives to return BHN to profitability in 2014 is attainable and that its experience and education in managing these risk based contracts is strategically beneficial.

Solid Financial Profile

Banner's overall financial profile is solid with improving liquidity, strong and consistent profitability and good debt service coverage. Despite weak volumes related to the continued shift to observation cases in addition to lower inpatient surgical and outpatient volume, Banner's operating income exceeded its budget. In 2013, Banner had a 5% operating margin ($254 million operating income) compared to 5.9% the prior year. Through the three months ended March 31, 2014, operating margin was 6.3% compared to 6.6% the same prior year period.

Liquidity has improved consistently since 2010 with $3.7 billion in unrestricted cash and investments at March 31, 2014. Capital spending has moderated to 1.3x depreciation expense and 0.8x depreciation expense in 2013 and 2012, respectively. Fitch views this as appropriate after a period of heavy capital investment from 2004-2009, which should allow it to build some capacity for its future capital needs. Banner has already made the investment in an electronic medical record and is one of a small percentage of hospitals to reach HIMSS stage 7. The only major project currently is a new emergency room at Good Samaritan Medical Center in addition to the acquisition activity.

Banner's leverage metrics have moderated over the last few years and MADS accounted for 3% of total revenue from 3.4% in 2010. MADS is $157 million and debt service is fairly level.

Debt Profile

Total outstanding debt at March 31, 2014 was $2.3 billion and is all fixed rate including its swaps (60% underlying fixed rate, 40% underlying variable rate). Of the variable rate, $400 million are indexed floaters, $176.6 million are direct bank loans (at indexed floating rate) and $359 million are variable rate demand bonds. Banner is overhedged with $1.37 billion in notional amount of fixed payer swaps outstanding. Total collateral posting at March 31, 2014 was $137 million.

Disclosure

Banner covenants to provide audits within 150 days of fiscal year end and quarterly disclosure within 60 days of quarter end for the first three quarters. Banner's financial reporting is excellent. Disclosure is timely and complete. Interim financial statements are presented in an audit format and include a management discussion and analysis. Furthermore, Banner hosts quarterly investor calls.

Outstanding Debt

$67,840,000Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2012B (taxable)

$179,090,000Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2012A

$67,905,000Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008H (LOC: Northern Trust Company (The)) & bank bonds

$86,900,000Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008G (LOC: Wells Fargo Bank, N.A.) & bank bonds

$92,090,000Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008F (LOC: JPMorgan Chase Bank, N.A.) & bank bonds

$112,310,000Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008E (LOC: Bank of America, N.A.) & bank bonds

$754,195,000Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2008D

$209,675,000Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2008A

$400,000,000Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2007B

$135,350,000Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2007A

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

Applicable Criteria and Related Research:

--'Nonprofit Hospitals and Health Systems Rating Criteria', dated May 20, 2014.

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

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=843320

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Fitch Ratings

Primary Analyst

Emily Wong

Senior Director

+1-415-732-5620

Fitch Ratings, Inc.

650 California St.

San Francisco, CA 94108

or

Secondary Analyst

James LeBuhn

Senior Director

+1-312-368-2059

or

Committee Chairperson

Dennis Pidherny

Managing Director

+1-212-908-0738

or

Media Relations

Elizabeth Fogerty, New York, +1-212-908-0526

elizabeth.fogerty@fitchratings.com


Source: Fitch Ratings


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