OREANDA-NEWS. Fitch Ratings has downgraded to 'BB+' from 'BBB-' the rating for following Housing and Redevelopment Authority of the City of Saint Paul, Minnesota bonds, issued on behalf of HealthEast Care System (HealthEast):

--$149.2 million hospital revenue bonds, series 2015A.

The Rating Outlook is Stable.

The bonds are secured by a security interest in gross receivables of the obligated group and a mortgage on the obligated group's primary hospital facilities.


ABSENCE OF SUSTAINED IMPROVEMENT: The downgrade to 'BB+' reflects the lack of improvement in HealthEast's profitability, which has underperformed Fitch's expectations, and which is necessary to improve the weak liquidity position. Fitch's prior rating affirmations and Stable Outlooks were based on expectations that operating margins would improve to near 3% and HealthEast missed its profitability targets in fiscal 2015 and through the six month interim period (ended Feb. 29, 2016). Further, the corporation's current physician alignment strategy is likely to inhibit any meaningful improvement in financial results over the near to medium term.

LIMITED LIQUIDITY CUSHION: HealthEast's liquidity metrics have been consistently low and more reflective of a 'BB+' rated credit. HealthEast had $173.8 million in unrestricted cash and investments at fiscal year-end 2015 (Aug. 31, 2015) which translated to 69 days cash on hand (DCOH) and cash to debt of 50.7%, both considerably below the 'BBB' category medians but in line with targets that were presented during Fitch's last review in May 2015.

EXPECTED CONTINUED INVESTMENT IN PHYSICIANS: A key strategic initiative for HealthEast in its current five-year plan is to grow primary care, provide better access to health care and continue to build its clinically integrated network to prepare for population health. To this end, HealthEast invested heavily in this strategy in the first quarter of 2016 ($5.6 million) and will continue to do so in the last half of 2016 and in 2017. The ongoing investment will constrain cash growth in the short term, but management expects that the initiative will boost utilization in future periods.

Due to start-up costs related to the physician growth strategy in the first quarter, HealthEast posted a low 3.0% EBITDA margin in the first quarter, but then improved cash flow to 7.4% in the second quarter and again in the third quarter as a result of management's actions in increasing productivity and reducing discretionary spending throughout the system. Management is projecting a 6.5% EBITDA margin in fiscal 2016, just below the 7.2% margin for fiscal 2015. While Fitch views the correction in 2016 favorably, we note that 2016 will result in another year of lower than expected profitability.

COMPETITIVE BUT FAVORABLE MARKET: HealthEast maintains a leading market position in its competitive St. Paul service area, and benefits from the solid socioeconomic characteristics in the area. Inpatient market share was 30.4% in the east metro primary service area as of 2015, followed by 27.6% for Allina (rated 'AA-' with a Stable Outlook by Fitch) and 23.3% for HealthPartners. HealthEast's main competitors are Allina's United Hospital and HealthPartners' Regions Hospital, both located in downtown St. Paul.


IMPROVED LIQUIDITY AND PROFITABILITY: A rating upgrade will be considered if HealthEast can demonstrate that its strategic investments and initiatives have resulted in a higher level of operating profitability which will allow for an improvement in liquidity metrics that are more consistent with an investment grade category rating.

The HealthEast system includes three acute care hospitals and a long-term acute care hospital (LTACH) in the St. Paul area, 14 outpatient clinics, over 1,100 medical staff members, and approximately 7,300 employees. St. Joseph's Hospital is located in downtown St. Paul with 239 staffed beds, St. John's Hospital is located in a suburb of St. Paul with 184 staffed beds, and Woodwinds Hospital is located in a suburb of St. Paul with 86 staffed beds. HealthEast also has a long-term acute care hospital, Bethesda Hospital, with 126 staffed beds. The system generated $974 million in total revenues in fiscal 2015 (year ended Aug. 31).

Fitch's analysis is based on the consolidated system, which includes all three acute care hospitals, the LTACH, the employed medical group, and other controlled affiliates. The obligated group (OG) consists of the corporate parent, the three acute care facilities and the LTACH, which together generated 85.7% of total revenues in fiscal 2015. The consolidated system results are considerably weaker than the OG financials because it includes the losses in the non-obligated group entity, HealthEast Medical Research Institute, which employs most of the primary care providers at the clinics as well as hospital-based providers.


Cash decreased since fiscal 2013 after HealthEast funded most of its new EHR system from operations and cash reserves. The EHR implementation was successfully launched in June 2014 with no negative impact on accounts receivables, which Fitch views favorably. Fitch includes the non-recurring expense in 2014 and 2015 related to the Epic implementation in the operating expense numbers and operating margins.

Liquidity metrics have always compared unfavorably to the 'BBB' category medians and cash to debt was 50.7% for 2015 compared to the 89.5% median. DCOH at six months (Feb. 29, 2016) is 57.7 days because of the cyclical nature of the timing of pension payments, but it is higher than it was in the six month period of fiscal 2015, and management projects that it will increase by year end to approximately the same level of 69 days as in fiscal 2015. Capital spending is expected to remain modest at approximately 90% of depreciation in the coming years, which should help the system rebuild its cash reserves in the long term.

HealthEast currently has 373 employed physicians on its medical staff and is targeting to add another 60 health providers (40 physicians) in fiscal 2016. Through April, the system had added seven primary care and eight new specialty physicians. Fitch anticipates that management will carefully monitor operations and cash flow while the system continues to pursue its growth in employed physicians. Nevertheless, it is a significant investment in the short term with HealthEast anticipating $16.2 million in expenses for 2016 for new provider compensation and other related expenses as the system continues to prepare for population health.

Management identified and implemented certain productivity improvements, reduced purchased services and reduced discretionary spending to curb operating expenses in the second and third quarters of fiscal 2016 to correct for the losses in the first quarter that resulted from HealthEast's accelerated investment in employed providers. Management has already achieved $21 million in annualized savings in 2016 through these efforts, resulting in a quick improvement to cash flow in the second and third quarter of 2016. Despite these efforts, the loss from the first quarter, along with primarily flat utilization trends in a competitive, mature market will temper the full year results in 2016.

Fitch notes that HealthEast's leverage ratios continue to be in line with the 'BBB-' rating. Maximum annual debt service (MADS) coverage ratio of 3.2x for fiscal 2015 was above the 2.7x median and MADS was a modest 2.2% of total revenue, highlighting HealthEast's manageable debt burden. HealthEast had $333.2 million in long-term debt as of Feb. 29, 2016.

HealthEast may be contemplating a modest financing in the fall of 2016 in the range of $10 million to $50 million. The financing being considered would refinance $5 million in outstanding debt, provide $14 million to buy out one of its leases and $10 million for ambulatory surgery expansion, as well as fund approximately $20 million to possibly freeze the pension plan to remove volatility risk from HealthEast's balance sheet and income statement. The pension plan, which has been frozen to new participants since December 2000, was 76% funded as of fiscal end 2015. Fitch views these preliminary plans neutrally as most of the financing being considered would address an already existing liability for HealthEast. Fitch is not incorporating the effects of any possible financing in the current rating action.

Variable rate debt makes up 43.2% of HealthEast's long-term obligations (series 2015B, C, and D bonds). These taxable bonds are directly placed with three banks, as are the fixed series 2012, 2012B and C bonds. The bonds issued in 2012 will all mature by 2023. The bonds issued in 2015 have bank loan renewal dates in 2020 and 2022. The covenants on the direct bank placements are higher than the covenants in the Master Trust Indenture, including a step up in the DCOH covenant from a current level of 40 days to 65 days as of fiscal 2018, a debt to capitalization of lower than 65% and 1.2x debt service coverage. These covenants are based on the OG which has higher debt service coverage and DCOH. The compliance certificate indicates 76.9 days for fiscal year end 2015 and 63.3 days at February 2016 for the OG. Fitch notes that HealthEast is fairly close to the debt to capitalization test, which was 57.7% at fiscal year-end 2015 and 58.8% at Feb. 29, 2016. A failure to comply with the financial covenants under the bank documents would be an event of default subject to various grace periods.

HealthEast covenants to provide annual disclosure within 150 days and quarterly disclosure within 60 days to the Municipal Securities Rulemaking Board's EMMA system. Disclosure includes detailed financial statements, volume statistics, payor mix, an operating and capital budget, and management discussion and analysis.