News Column

Fitch Affirms Loma Linda University Medical Center's (CA) Rev Bonds at 'BBB-'; Stable Outlook

August 6, 2014

SAN FRANCISCO--(BUSINESS WIRE)-- Fitch Ratings has affirmed the 'BBB-' rating on Loma Linda University Medical Center's (LLUMC) outstanding debt, which is listed at the end of this press release.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross revenue pledge and mortgage pledge of the obligated group (OG), which consists of LLUMC. In addition, there is a debt service reserve fund. LLUMC accounted for 91.7% of total assets ($1.5 billion) and 86.7% of total revenues ($1.4 billion) of the consolidated entity in 2013 (Dec. 31 fiscal year end; draft audit). Fitch's analysis is based on the consolidated entity, Loma Linda University Medical Center and Affiliates (system).

KEY RATING DRIVERS

CASHFLOW SAVINGS EXPECTED FROM MURIETTA FINANCING: LLUMC has significantly invested in LLUMC- Murietta (non-obligated; Murietta), a 106-bed community hospital located in Murietta, CA which was financed through a real estate investment trust (REIT) and reflected as an operating lease on the system's financials. LLUMC has negotiated a buyout with the REIT, which will be financed through a $200 million debt issuance and will generate annual cash flow savings relative to current lease expense. The financing will initially be funded by a bridge loan that has 366 day term and will be refinanced in the fall with an overall restructuring of LLUMC's debt profile.

CHALLENGING PAYOR MIX: The system has been challenged by its unfavorable payor mix and over 40% of its gross revenues are from Medi-Cal and there has been a noticeable shift in more Medicaid and less self pay with the implementation of the Patient Protection and Affordable Care Act (PPACA). Given the high Medi-Cal burden, LLUMC's profitability and cash flow have benefited from the state provider fee program, which has been in place since 2010 (payments retroactive in April 2009) and was extended for another three years to December 2016, which Fitch views favorably as it should net LLUMC $259 million over the three years.

LOOMING CAPITAL NEEDS: LLUMC has significant capital needs that need to be addressed due to state seismic requirements. The master facilities plan includes two new patient towers (adult and children's) at a total cost of $800 million-$850 million. Sources of funding include a mix of debt, cash flow, philanthropy and state funding. Philanthropy has been successful and between state funding and philanthropy - the funding sources for the children's hospital portion have been raised.

WEAK LIQUIDITY: The system's balance sheet has historically been weak and has been depressed due to pending receivables from the state related to the provider fee program. LLUMC converted all its variable rate demand bonds to direct bank loans, which is viewed favorably. Other items impacting liquidity include swap collateral posting and ongoing transfers to other related entities (physician faculty group).

DECLINE IN FINANCIAL PERFORMANCE IN 2013: The system's performance declined in 2013 driven by Epic implementation costs higher than budget, higher supplies expense from non-compliance with the 340b program, which was rectified in 2013 and reentry to the program should result in savings of $1 million a month, as well as flat volume. However, through the five month interim period ended May 31, 2014 profitability has improved with 3.3% operating margin and 9.6% operating EBITDA margin. Further, Fitch believes the recent change in senior leadership is an opportunity for enhanced financial discipline.

RATING SENSITIVITIES

DEBT RESTRUCTURING IN FALL KEY TO MAINTAINING RATING: The 'BBB-' rating is maintained despite the further dilution in LLUMC's already weak balance sheet since the Murietta financing is an exchange of existing liabilities. LLUMC has plans to restructure the majority of its debt portfolio in the fall of 2014, which will also include the refinancing of the Murietta bridge loan. Fitch views this as key to maintaining the rating as the restructuring should result in significant cash flow relief and a reduction in maximum annual debt service (MADS).

SEISMIC REQUIREMENTS ARE ONEROUS: A Negative Rating Outlook is precluded at this time as LLUMC is evaluating several options related to its upcoming capital needs. Fitch does not believe the system has debt capacity based on its current financial profile.

CREDIT PROFILE

LLUMC is an 881 licensed bed academic medical center located in Loma Linda, CA, 60 miles east of Los Angeles. LLUMC houses the nation's first hospital-based proton treatment center for cancer. LLUMC is the only member of the obligated group and includes four hospitals - University Hospital, Children's Hospital, East Campus Hospital, and the Heart and Surgical Hospital. Other non-obligated group affiliates include Loma Linda University Behavioral Medicine Center, Loma Linda University Children's Hospital Foundation, Loma Linda Healthcare Properties, LLUMC - Murrieta, and Loma Linda University - Urgent Care. The total system has 1,076 licensed beds. The 2013 audit is expected to be finalized in mid-August.

Weaker Fiscal 2013 Results

The system's profitability declined to 2.4% ($34.5 million operating income) in 2013 from 4.3% in 2012 and 6% in 2011 and has improved to 3.3% through the five months ended May 31, 2014. Performance in 2013 was impacted by Epic implementation costs over budget, higher supplies expense from the noncompliance in the 340b drug program, as well as flat volume. Murietta's performance also continues to be a drag on the overall performance with a negative $31.6 million bottom line in 2013 but has improved from negative $51 million in 2012 and negative $61 million in 2011. Murietta is projected to be profitable in 2015, which Fitch believes is attainable with the reduction in capital costs as well as several operational improvement initiatives implemented with the assistance of HFS Consultants. Murietta's 2012 audit had a going concern opinion and the 2013 audit is currently being finalized and may reflect a going concern opinion again.

Updated financial projections for the system are not yet available, however, LLUMC's operating margin budget (excluding provider fee) in 2014 is 1.3%, which Fitch expects the organization to exceed as many of the issues affecting 2013 performance are viewed as non-recurring. Actual results will be more favorable with the receipt of the provider fee; however, the timing of the approvals of the different components of the program will impact the amount that will be recorded in 2014. LLUMC's budget includes a net benefit of $83 million (7.5% operating margin with provider fee). In addition, profitability will improve with the elimination of the $24 million annual rent expense with the REIT buyout.

Major Beneficiary of Provider Fee

California enacted a hospital provider fee in 2010 to draw down additional federal funds for Medi-Cal services. Given LLUMC's high Medi-Cal load, LLUMC has been a major beneficiary of the program, which has boosted profitability. The 2010 provider fee (for the period April 2009 to December 2010) resulted in a net benefit of $85 million in 2010. Two subsequent periods were approved with a net benefit of $43 million in 2011, $63 million in 2012 and $87 million in 2013. The provider fee was set to expire in December 2013 and was extended for a three-year period through December 2016. Fitch views this favorably as it should net LLUMC approximately $259 million over the three years.

LLUMC's operating performance without the provider fee is very weak and supplemental funding is necessary to offset this burden. LLUMC receives approximately $30 million a year in disproportionate share funds (DSH) and DSH funding in 2014 was higher than expected.

Significant Opportunity with Regional Growth Strategy

LLUMC's main credit strength continues to be its leading market share position and role as an academic medical center. LLUMC is the market share leader in its primary service area in the Inland Empire (San Bernardino and Riverside counties). It offers quaternary and tertiary services and has the only level-I trauma center and level-III neonatal intensive care unit in the service area. LLUMC's Medicare case mix index is very high at 1.98. LLUMC expects market share to be approximately 10.2% in 2013 from 10% in 2012 compared to the next closest competitor, Kaiser-Fontana, with 6% market share. Market share should continue to increase especially as LLUMC continues to capture outmigration from the Murrieta market.

Fitch believes LLUMC has a major area of opportunity with its investment in the Murrieta market. LLUMC opened its new 106 bed hospital in Murrieta in April 2011 in a market that has traditionally seen a lot of outmigration. Since its opening, volumes have continued to increase. The run rate of operating losses has decreased and there is significant population growth of a favorable payor mix in this region. LLUMC's ability to capitalize on this investment will be key to an improved overall financial profile of the system.

When the hospital was planned, it was initially intended to be a joint venture with physicians and the construction was financed through a REIT at a cost of approximately $220 million. Due to provisions under the PPACA regarding physician ownership, LLUMC bought out the physician ownership in 2011. The facility is currently being leased under a 15-year term that expires in March 2026. The buyout of the lease is expected to result in positive cash flow of approximately $10 million a year.

LLUMC is also in discussions with other providers in the area to develop a regional accountable care network to collectively leverage the strengths of the individual providers to better provide care for the population it serves. These affiliations are expected to have minimal capital investment as the system has no debt capacity to take on additional capital requirements given its own upcoming capital needs.

Large Capital Needs

LLUMC's capital needs total approximately $1.6 billion over the next 10 years (includes Murietta financing) and are mainly driven by the state seismic compliance requirements, which would require the construction of two new patient towers. The funding sources are expected to include cash flow, additional debt, fundraising, and funds from Proposition 61 and 3 (voter-approved ballot initiatives for children's hospital construction). An additional debt issuance of approximately $500 million is expected in 2016 and management is reviewing various options related to their seismic needs. This rating action does not incorporate the potential debt issuance as details surrounding the plan of finance are still unknown. LLUMC expects the construction on the towers to begin in first quarter 2016 and complete by the fourth quarter of 2019. LLUMC recently received its largest gift in its history - a $100 million donation.

Weak Balance Sheet

Total unrestricted cash and investments at May 31, 2014 was $313 million, which translated to 84.6 days cash on hand and 59.7% cash to debt compared to the 'BBB' category medians of 144.7 and 91.7%, respectively. With the $200 million of additional debt for Murietta, pro forma cash to debt drops to 52.8%. Liquidity is lower than expected at the interim period with $48.9 million due from the state related to the provider fee. LLUMC has a 60 days cash on hand covenant.

Significant Use of Note Payables and Capital Leases

Total outstanding debt for the system was $513 million in fiscal 2013 and includes $341 million of bonded debt and $172 million of notes and capital leases. The significant use of note payables and capital leases creates a front loaded aggregate debt structure with MADS of $50.3 million in 2013.

The contemplated debt restructuring in the fall would refinance the majority of the outstanding debt and result in significant cash flow relief. It is expected that MADS would drop to $45.5 million (including refinancing of Murietta bridge loan) and debt service would be more level.

LLUMC had $105 million of variable rate demand bonds, which were converted to direct bank loans in May 2012 (series 2007B-1) and December 2013 (series 2007B-2 and 2008B). The series 2007B-1 bonds have an initial term of seven years and the series 2007B-2 and 2008B have an initial three year term. The financial covenants mirrored the covenants in the prior reimbursement agreements with the letter of credit providers. LLUMC has two fixed payor swaps for a total notional amount of $100 million, which required collateral posting of $24.8 million as of May 31, 2014 (included in other long term assets). The counterparty has the right to terminate if LLUMC's rating falls below 'BBB-'.

Debt service coverage by EBITDA is adequate for the rating level at 2.6x in 2013 compared to 2.9x in 2012 and 3.2x in 2011 and the 'BBB' category median of 3.1x. Through the five months ended May 31, 2014, coverage was 2.9x. Based on 2013 performance, debt service coverage would improve to 3.4x with the contemplated debt restructuring.

Disclosure

LLUMC covenants to provide annual audited and quarterly information for the OG to bondholders. Quarterly information, including a balance sheet, income statement, and statement of changes in net assets will be provided within 60 days after the end of each of the first three fiscal quarters.

Outstanding Debt

--$70,000,000Loma Linda, CA hospital revenue bonds (Loma Linda University Medical Center), series 2008A;

--$25,000,000Loma Linda, CA hospital variable rate revenue bonds (Loma Linda University Medical Center), series 2008B;

--$80,000,000Loma Linda (CA) (Loma Linda University Medical Center Project) variable rate hospital revenue bonds, series 2007B-1 and B-2;

--$142,089,000Loma Linda (CA) (Loma Linda University Medical Center Project) hospital revenue refunding bonds, series 2005A;

--$11,640,000Loma Linda (CA) (Loma Linda University Medical Center Project) hospital revenue refunding bonds, series 1999A.

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=846034

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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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