OREANDA-NEWS. Fitch Ratings has downgraded the following bonds issued by the North Carolina Medical Care Commission on behalf of Rex Healthcare, Inc. (Rex) to 'A+' from 'AA-'

--$50 million revenue bonds, series 2015A;

--$100.2 million revenue and revenue refunding bonds, series 2010A.

Rex also has outstanding approximately $99.7 million of series 2015B variable rate revenue bonds that are directly placed with TD Bank and not rated by Fitch.

The Rating Outlook is revised to Stable from Negative.

SECURITY

The bonds are secured by a pledge of and lien on the accounts receivable and the proceeds thereof derived from the ownership and operation of the obligated group (Rex Healthcare, Inc. and the Hospital).

KEY RATING DRIVERS

CONTINUED DILUTION OF FINANCIAL CUSHION: The rating downgrade to 'A+' reflects the continued dilution of Rex's liquidity metrics since Fitch's last review in 2015. Ongoing cash transfers to its parent, University of North Carolina Health Care System (UNCHCS) combined with elevated capital spending have resulted in liquidity metrics that are no longer consistent with a 'AA' category rating. At Dec. 31, 2016 (unaudited), Rex had unrestricted cash and investments of approximately $317.9 million, which translated into 128.7 days cash on hand (DCOH) and 118.9% cash to debt. The current liquidity metrics represent significant decline from 155.5 DCOH and 158.8% cash-to-debt at FYE 2015 and are expected to be further pressured during fiscal 2017.

LARGE CAPITAL SPENDING PLAN: Rex operates in a very competitive market, necessitating large capital spend to maintain its leading position. As such, Rex's long-term capital plan is large as the organization plans to spend an additional approximate $300 million in fiscal 2017-2019 on various items, including the construction of its Holly Spring Hospital (estimated cost $86 million). While Rex plans to finance the majority of its remaining capital budget through operations, it has not ruled out the possibility of issuing additional debt to finance the construction of Holly Springs Hospital.

IMPROVED OPERATING PROFILE: Rex has experienced improvement in its operating performance over the past 18 months. For fiscal 2016 (year-end June 30), Rex recorded operating income of $75.8 million, an over $30 million improvement from the prior year. This equated to a 7.9% operating margin and 12% operating EBITDA margin. Rex has sustained this performance into fiscal 2017, posting a 7.2% operating margin and a 10.7% operating EBITDA margin for the six months ended Dec. 31, 2016.

MANAGEABLE DEBT BURDEN: Certain of Rex's debt metrics are elevated compared to 'A' category medians. However, consolidated maximum annual debt service (MADS) of $16.1 million represented a very low 1.7% of fiscal 2016 revenues, which compared favorably against Fitch's 'A' category median of 2.7%. Moreover, recent improvements in profitability levels support solid MADS coverage of 7.4x by EBITDA and 7.1x by operating EBITDA in fiscal 2016.

MEMBER OF UNC HEALTH SYSTEM: UNCHCS (not rated by Fitch) is Rex's sole corporate member and Rex is operated as part of UNCHCS, including systemwide strategic and capital planning. Following the transfer of most of Rex's investment portfolio to the UNC Management Company (UNCMC) in 2016, the organizations are operationally consolidated, but Rex and UNCHCS remain separately obligated on their own respective debt. Overall, Fitch views the tight relationship between Rex and UNCHCS as a key credit strength.

RATING SENSITIVITIES

MAINTENANCE OF OPERATING PROFILE: Due to the continued dilution of Rex Healthcare, Inc.'s (Rex) liquidity metrics, Fitch expects Rex to maintain EBITDA margins in line with fiscal 2017's interim performance. Any material deterioration in operating performance could put negative pressure on the rating.

MAINTENANCE OF BALANCE SHEET: Rex's long-term capital plan is large, as the organization expects to spend approximately $300 million in fiscal 2017-2019 on various projects. Further erosion of balance sheet metrics due to additional debt or continued deterioration in liquidity position would be viewed negatively.

CREDIT PROFILE

Rex operates a 433-licensed bed acute care tertiary hospital and two nursing care facilities with 227 beds. Rex is a controlled affiliate of UNCHCS, which operates a 929-bed academic medical center located in Chapel Hill, NC. In fiscal 2016, Rex had total revenues of approximately $954 million.

OPERATING PROFILE

For fiscal 2016, Rex recorded operating income of $75.8 million, an over $30 million improvement from $43.3 million the prior year. This equated to a 7.9% operating margin and 12% operating EBITDA margin, both of which are in excess of Fitch's 'A' category medians of 3.8% and 10.3%, respectively. Rex has continued this strong performance into fiscal 2017, posting a 7.2% operating margin and a 10.7% operating EBITDA margin for the six months ended Dec. 31, 2016 (unaudited).

This improved profitability has mostly been achieved through growth in Rex's revenue base, which grew $100 million in fiscal 2016 from $853 million in fiscal 2015. Management attributes this enhanced revenue base to growth in utilization in certain key service lines; an increased Medicare Case Mix Index; and expanded geographic reach, due its continued affiliation with UNCHCS. Management has also implemented a program of targeted expense reductions, which are expected to generate $58 million in ongoing savings.

MEMBER OF UNCHCS

UNCHCS approves Rex's board and Rex benefits from being part of UNCHCS. In addition to benefits from a strategic and resource allocation perspective, UNCHCS assists in negotiation of managed care contracts and approves operating and capital plans. Fitch believes that Rex's position as a part of the UNCHCS system has resulted in strong historical performance and is a key credit strength.

WEAK LIQUIDITY

Ongoing cash transfers to UNCHCS and elevated capital spending have resulted in significant dilution of Rex's liquidity metrics. At Dec. 31, 2016 (unaudited), Rex had unrestricted cash and investments of approximately $317.9 million, representing a decline from $340.2 million at fiscal year-end 2016. This level of cash and investments translated into 128.7 days cash on hand (DCOH) and 118.9% cash to debt. Each of these liquidity metrics is very weak compared to their respective Fitch's 'A' category medians of 215.5 DCOH and 148.6% and are expected to dilute further as Rex executes its large capital spending plan through the end of fiscal 2017.

Fitch views Rex's limited balance sheet cushion as a primary credit concern, indicating a limited financial cushion to absorb unforeseen spending needs. It is critical that Rex maintain EBITDA margins in line with fiscal 2017's interim performance to generate satisfactory levels of debt service coverage.

DEBT PROFILE

On a consolidated basis, Rex had approximately $267 million in debt outstanding as of Dec. 31, 2016. Of this total debt, approximately 64% was fixed rate and 36% was variable rate. Rex does not have any swap exposure.

In addition to Rex's cash-to-debt metric, its debt-to-capitalization of 39.5% at the end of fiscal 2016 is slightly elevated compared to Fitch's 'A' category median of 36%. However, consolidated maximum annual debt service (MADS) of $16.1 million represented a very low 1.7% of fiscal 2016 revenues, which compared favorably against Fitch's 'A' category median of 2.7%. Moreover, recent improvements in profitability levels support robust MADS coverage of 7.4x by EBITDA and 7.1x by operating EBITDA in fiscal 2016.

Fitch therefore considers Rex's current debt burden to be manageable, but notes that it has very limited capacity for additional debt at the current rating level, given its significant dilution in balance sheet cushion.

Rex's debt service coverage ratio calculations exclude transfers to UNCHCS, which totaled approximately $29 million in fiscal 2016 and $33 million in fiscal 2015. Rex contributes sizeable asset transfers to UNCHCS, which are ultimately dilutive to Rex's financial profile. However, management expects system transfers to moderate to approximately $14.1 million by 2019.