OREANDA-NEWS. Fitch Ratings has downgraded to 'A-' from 'A' various series of bonds issued on behalf of the obligated group of Covenant Health (CH) by the Massachusetts Development Finance Agency, the Massachusetts Health & Educational Facilities Authority, and the New Hampshire Health & Education Facilities Authority.

The Rating Outlook remains Negative.

The bonds are secured by a gross revenue pledge of the obligated group and a mortgage pledge on St. Joseph Hospital in Nashua, NH.


WEAKER PERFORMANCE PERSISTS: The downgrade reflects CH's very thin operating margins for the rating category. CH generated approximately breakeven operating margins over the last four audited years, including a negative 1.5% in fiscal 2015. Its operating EBITDA margin averaged a weak 5.6% over the same period, relative to a median of 10.3%, and maximum annual debt service (MADS) coverage averaged 2.6x relative to Fitch's 'A' category median of 4.2x.

NEGATIVE OUTLOOK: The Negative Outlook reflects the continued weakness in CH's performance, although it has improved slightly in 1Q2016, the potential for a debt issuance to fund an information technology installation, and the execution risk on a number of initiatives that CH is undertaking to improve its performance.

STRONG LIQUIDTY: Most of CH's unrestricted liquidity metrics are on the upper end of the 'A' category. The 'A-' rating is based largely on the strength of CH's unrestricted liquidity, which Fitch views as providing financial flexibility as CH addresses its operating challenges, even as the financial performance remains materially below 'A' category medians.

MIXED MARKET POSITION: CH has some geographic and revenue diversity, operating in five states from Pennsylvania to Maine, while providing a full continuum of care ranging from acute care to long-term care services. However, CH operates in fairly competitive markets, especially its three acute care hospitals. Two are in Maine, which has not expanded Medicaid, and none of the three are the market share leader in their respective markets.


IMPROVEMENT INITIATIVES UNDERWAY: Covenant Health System (CH) is implementing a number of revenue and expense initiatives aimed at improving performance. Successful execution of these initiatives is critical for CH to be able to maintain its current 'A-' rating and for future revision of the Outlook to Stable.

POTENTIAL DEBT ISSUANCE: CH is in the process of implementing an Epic software installation that would likely require additional debt or the use of a sizable equity contribution. Negative rating pressure could also potentially result from the final funding structure for the project and CH's operational performance at that time. CH has little debt capacity, given the current level of its financial performance.

CH consists of three acute care hospitals (St. Joseph Hospital in Nashua, NH, St. Joseph Hospital in Bangor, ME, and St. Mary's Health System in Lewiston, ME) and 12 skilled nursing and assisted living facilities located in the states of Rhode Island, Maine, Massachusetts, and Pennsylvania. CH also manages five long-term care facilities and is affiliated with 10 other long-term care providers.

The obligated group made up only approximately 58% of total assets and 40% of total revenues of the system in fiscal 2015. Fitch's analysis continues to be based on the consolidated system, which had total revenue of $613.2 million in fiscal 2015.

Financial Performance
CH posted a negative 1.5% operating margin and a 4.2% operating EBITDA margin in 2015, which was lower than 2014's 0.1% operating margin and 6.2% operating EBITDA and much below Fitch's 'A' category medians of 3.6% and 10.3%, respectively. The weaker operating performance in 2015 was driven largely by revenue and volume targets not being met. In 2016, CH used a more conservative budgeting process, with realistic volume and revenues assumptions, and operational results have improved. In 1Q16, CH had a negative 1% operating margin and a 4.6% EBITDA, which is much improved over 1Q15 when CH generated a negative 3.4% operating margin and a 2.5% operating EBITDA margin.

CH is implementing a larger turnaround plan to improve operations, including initiatives around supply and revenue cycle. The effort is being assisted by the use of consultants. The results of these initiatives should further improve CH's financial results.

In addition to the focus on operational improvement, CH is moving forward on a number of other system initiatives including enhancing its clinical relationships with other hospitals, which has helped CH recruit physicians in key service lines such as cardiology and orthopedics; creating an integrated physician network to broaden its physician alignment with both employed and community physicians; and centralizing other services and corporate functions for greater efficiencies.

Fitch views these initiatives positively and as an appropriate response to changes in the healthcare environment. Fitch's concern is that implementation of the initiatives is occurring simultaneously while CH is also aiming to improve its financial performance. Further concern relates to an expected large IT implementation project expected to begin within the next year.

Investments in new IT systems have proven to be strategically and economically accretive for health systems once fully operational, but there is a sizable capital cost and often near term stress on financial performance during implementation and rollout. CH management has stated that it would need to see operational improvement before it would move forward on issuing debt for the IT project. However, the Negative Outlook reflects concerns regarding the project and the need to improve performance.

Liquidity a Key Credit Strength
CH had $381 million in unrestricted cash and investments at March 31, 2016, which equated to 227.4 day cash on hand and 185.4% cash to debt, both above Fitch's 'A' category medians of 205.3 day and 143.7%. In spite of the weaker operating performance, CH has been able to maintain its strong liquidity position, and investment income from the balance sheet has helped prop up debt service coverage.

CH's strong liquidity position provides some financial cushion at the current rating level, as CH works to improve operations, as well as could be used as a resource to reduce the need to issue debt to fund the IT project. CH has very little debt capacity, given its thin debt service coverage metrics, unless its operational performance improves. However, Fitch will consider the strong balance sheet in its analysis should the turnaround plan take longer than expected to show results.

Debt Profile
CH's debt structure is nearly 100% fixed-rate, which Fitch views as a credit positive, lending further stability to CH's balance sheet.

In addition, CH's debt burden is relatively manageable for the rating level. MADS as a percentage of revenue of 2.9% at March 31, 2016 compares well to Fitch's 'A' category median of 2.8%. However, debt to EBTIDA was elevated at 5.8x, relative to a median of 3x, reflecting the weaker operating performance. CH's EBITDA MADS coverage was 1.9x and its operating EBITDA coverage was 1.6x in the first quarter of 2016, both of which trailed category medians.

The relatively manageable debt burden as reflected in MADS as a percentage of revenue is a key credit factor, indicating that even a modest improvement in performance should be able to bring the debt to EBITDA metric more in line with the category median and increase the level of CH's debt service coverage.

Continuing Disclosure
CH covenants to provide bondholders with annual audited financials and quarterly disclosure (which includes management discussion and analysis, balance sheet, income statement, and utilization statistics).