Fitch Rates Palomar Health, CA's Series 2016 GOs 'AAA' and Revenue Bonds 'BB+'
--$213,330,000 general obligation (GO) refunding bonds series 2016A and 2016B 'AAA';
--$252,220,000 refunding revenue bonds series 2016 'BB+';
--Issuer Default Rating (IDR) 'BB+'.
In addition, Fitch affirms the 'BB+' rating on the outstanding revenue bonds and removes the bonds from Rating Watch Evolving. The Rating Outlook is Stable.
The outstanding GO bonds rated 'A+' remain on Rating Watch Evolving. The outstanding debt is listed at the end of the press release.
The series 2016 GO bonds will refund PH's callable portions of the outstanding 2005 and 2007 GO bonds and the series 2016 revenue bonds will refund the outstanding series 2009 revenue bonds. Net present value savings are significant at over 10% of refunded par for both the GO and revenue bond transactions. The GO bonds are expected to price the week of Sept. 26 and the revenue bonds are expected to price the week of Oct. 3.
PH's GO bonds are payable from an unlimited ad valorem property tax that was approved by the voters in the district in a 2004 election. The revenue bonds are secured by a gross revenue pledge of the obligated group (OG). Gross revenues exclude property tax revenue. The OG consists of PH's acute care facilities as well as other healthcare related entities but excludes Arch Health Partners (AHP), a medical foundation.
KEY RATING DRIVERS
ASSIGNMENT OF ISSUER DEFAULT RATING: Hospital districts are governmental entities that would file under Chapter 9 of the U. S. Bankruptcy code in the event of a bankruptcy filing. As such, Fitch has assigned an IDR to PH utilizing the methodology under the U. S. Tax Supported Rating Criteria together with a variation from the U. S. Nonprofit Hospitals and Health Systems Rating Criteria.
PLEDGED SPECIAL REVENUE ANALYSIS: U. S. Tax Supported Rating Criteria establishes specific standards for whether dedicated taxes can support a rating on bonds that is distinct from the IDR. Absent an opinion that the tax revenues constitute 'pledged special revenues' under Chapter 9, PH's GO bonds cannot be rated distinct from and higher than the IDR. The 'AAA' rating on the series 2016 GO refunding bonds is supported by legal opinions provided by PH's bond counsel that provide a reasonable basis for concluding that the tax revenues levied to repay the series 2016 GO bonds would be considered 'pledged special revenues' in the event of a bankruptcy of PH and not subject to automatic stay.
OUTSTANDING GO DEBT LACKS PLEDGE: The outstanding GOs remain on Rating Watch Evolving as PH's bond counsel determines whether it can opine that the outstanding debt is secured by a pledge of special revenues. The provision of this opinion would result in an upgrade of the outstanding GOs to 'AAA'. The inability to provide this opinion would result in a downgrade of the outstanding GOs to the IDR level as the outstanding GO bonds would not be protected by a pledge of the special revenues and leave them subject to the automatic stay upon a potential insolvency of PH. This determination is expected to be made over the next few months.
GROWING TAX BASE: The 'AAA' rating also reflects PH's strong, diverse and growing economic resource base. The tax base grew 171% between fiscal years 1999-2016. The district's overall debt burden is moderate relative to the tax base.
CONTINUED IMPROVED FINANCIAL PERFORMANCE: The 'BB+' IDR rating on PH reflects its weak financial profile due to its high debt burden relative to operations from a costly master facility plan and operational challenges from the opening of its new facility in 2012. Financial performance has improved year over year since fiscal 2013 (June 30 year-end) and fiscal 2016 results well exceeded budget.
CONSOLIDATION OF SERVICES: PH announced in June 2015 that it would close its downtown campus, which Fitch views favorably and believes should result in meaningful annual savings as it will allow better resource allocation within the system. The transition and consolidation of the programs from the downtown campus to PH's other two campuses was expected to occur by December 2016, but the full consolidation may not occur until June 2017 due to the state regulatory process related to construction approvals as there are construction needs to accommodate the consolidated services.
GOOD MARKET POSITION: PH's location in North San Diego County is a main credit strength. Fitch believes PH is an attractive partner in any plans to develop a larger regional network and delivery model that is able to manage population health. In addition, PH has significantly invested in its medical foundation, AHP, which provides a primary care base that will be integral in care coordination.
UPWARD RATING MOVEMENT OF IDR: Upward rating movement of the 'BB+' rating would be dependent on Palomar Health continuing to improve its financial metrics. Fitch believes this could be achievable over the next two to three years if strong operating cash flow is sustained and debt service coverage and liquidity ratios improve especially as the full benefits from the consolidation of facilities/service lines are realized.
STABLE TAX BASE: The rating on the series 2016 GO bonds is sensitive to material negative changes in the district's tax base and economy, which Fitch believes are unlikely.
OUTSTANDING GO RATING: The rating on the outstanding GO bonds could be upgraded to 'AAA' if the pledge of special revenues is extended to the outstanding GO bonds as confirmed by a satisfactory legal opinion. If PH's counsel is unable to opine that the outstanding GOs are secured by a pledge of special revenues, then the outstanding GO bonds will be downgraded to the IDR level.
PH is California's largest local health care district serving approximately 539,000 residents over approximately 800 square miles of northern inland San Diego County. The service area is primarily residential, with some light industrial and commercial activity.
PH owns and operates two hospitals in northern San Diego County: 288-bed Palomar Medical Center in Escondido that opened in August 2012 and 107-bed Pomerado Hospital in Poway; as well as a downtown campus hospital that is currently in transition to close. PH also has Villa Pomerado - a 129-bed skilled nursing facility that is located adjacent to Pomerado Hospital.
In June 2015, PH announced that it would close its Palomar Health Downtown campus (295 licensed beds), and the transition of services to its other two facilities is underway. These services include labor and delivery, behavioral health, acute rehab, and radiation therapy. The standby emergency department closed in March 2016.
Arch Health Partners (Arch) is a medical foundation with over 80 physicians in seven clinic locations. Arch is not a member of the OG. Fitch's financial analysis is based on the consolidated entity and excludes the GO bonds and related property tax revenue and interest expense since the GO debt is self-supporting. Total operating revenue in fiscal 2016 (June 30 year end; draft audit) was $776 million.
'AAA' RATING REFLECTS PLEDGED SPECIAL REVENUES
Fitch believes that taxes levied for bond repayment for the series 2016 GO bonds would be considered pledged special revenues under the U. S. bankruptcy code, and therefore the lien on pledged revenues would survive and would not be subject to the automatic stay (i. e. payment interruption) in the event PH were to file for bankruptcy. Fitch has reviewed and analyzed legal opinions provided by PH's bond counsel and believes they provide a reasonable basis to conclude that these revenues would be treated as pledged special revenues due to certain provisions of the state constitution (primarily Proposition 13), which limit and direct the use of pledged property tax revenues for bond repayment and the explicit pledge associated with the series 2016 GO bonds.
As a result, Fitch analyzes the series 2016 GO bonds as dedicated tax bonds. This analysis focuses on the district's economy, tax base, and debt burden relative to the tax base without regard to financial operations, because Fitch believes that bondholders are insulated from any operating risk of the district. Fitch typically calculates the ratio of available revenues to debt service for dedicated tax bonds, but the unlimited nature of the tax rate pledge on the district's bonds eliminates the need for such calculations.
GROWING TAX BASE
The district's tax base is strong having grown 171% between fiscal years 1999-2016. An almost 6% recessionary decline through fiscal 2013 was more than offset by a strong 17% rebound. The tax base reached an all-time high taxable assessed valuation (TAV) of nearly $72 billion in fiscal 2016.
The district's service area retains good potential for long-term growth due to its location, availability of relatively affordable land for development, and a growing labor force. Property taxpayer concentration is very low with the top 10 taxpayers accounting for less than 3% of fiscal 2016 TAV. Over half of the tax base is residential.
Wealth levels within the district vary considerably. The district reports that the median household income in its northern primary service area is approximately $55,000 whereas the median household income in its southern primary service area is almost $95,000. Nevertheless, all residents are well located to benefit from employment opportunities in the growing, diverse economies of both San Diego and southern Orange counties.
In fiscal 2015, the district's overall debt burden was moderate relative to both personal income (approximately 11%) and the district's tax base (approximately 4% of taxable assessed valuation). Direct debt amortization is slow at approximately 37% in 10 years (when interest, including accreted interest on the district's capital appreciation bonds is included). The district's current GO bond authorization is exhausted and the district has no plans to seek voter authorization for additional GO bonding capacity.
FINANCIAL OPERATIONS IMPROVING
PH was in a turnaround situation from fiscal 2013 due to large losses related to challenges with the transition to the new facility, which opened in August 2012. However, performance has stabilized and is on an upward trajectory with a strong operating EBITDA margin in fiscal 2016 of 9.7% that exceeded budget compared to 7.3% in fiscal 2015, 6.7% in fiscal 2014 and 4.8% in fiscal 2013. Ongoing operational improvement initiatives are in the areas of patient throughput, supply savings, revenue cycle, and process improvement.
PH has several strategic partnerships with other providers including Rady Children's (revenue bonds rated 'AA-') to provide pediatric and NICU services, Kindred Rehab to manage acute rehab services, and Kaiser (revenue bonds rated 'A+') to provide guaranteed hospital bed capacity at PMC for Kaiser health plan members.
CAMPUS CONSOLIDATION PLAN
In June 2015, PH announced that it would be closing its downtown campus and consolidating all services within PMC, Pomerado Hospital or other current facilities (i. e. some outpatient services moved to PH's San Marcos outpatient building). All services were expected to be consolidated by the end of 2016 but now likely to be June 2017 as there are construction needs associated with the consolidation and there have been delays in receiving the necessary state regulatory approvals related to the construction. The full benefits of the transition will not be realized until at least fiscal 2018.
Due to the transition, PH has seen a large reduction in outpatient surgeries, especially related to Kaiser volume as consolidation plans finalize. For fiscal 2016, outpatient surgeries were down 14.2% from the prior year. Management does not expect this to be an ongoing issue; however, an extended delay in transition plans could cause additional financial pressure.
INVESTMENT IN ARCH HEALTH PARTNERS
PH is the sole corporate member of AHP and aligned with the medical foundation in 2010. PH has provided significant support to AHP and ongoing support is expected. However, Arch is a critical component of its integrated delivery system and PH is in the process of developing a clinically integrated network that will also align other physicians in the area.
As of June 30, 2016, unrestricted cash and investments totaled $217.7 million, which equated to 108.3 days cash on hand (DCOH) and 39.5% cash to debt, which has steadily improved from a low in fiscal 2013.
PH's DCOH covenant calculation excludes interest expense from total expenses and the bond covenant calculation for fiscal 2016 (which also excludes AHP) was 124.9 days, above the 80 DCOH covenant for the series 2006 insured bonds (65 DCOH covenant for uninsured bonds). Capital spending is elevated in fiscal 2017-2019 due to one-time capital relocation costs, additional investment in equipment and facilities, and includes the ongoing investment in AHP. Total capital expenditures are anticipated to be $41.5 million in fiscal 2017, $41 million in fiscal 2018, and $43 million in fiscal 2019.
HIGH DEBT BURDEN RELATIVE TO OPERATIONS
As of June 30, 2016, total debt outstanding was $1.16 billion and included $550.2 million of revenue bonds and $606.9 million of GO bonds. The revenue bonds are 70% fixed rate and 30% variable rate (auction mode; series 2006). PH has three fixed payor interest rate swaps with Citi related to the series 2006 bonds and the swaps are insured by Assured Guaranty. There are currently no collateral posting requirements, but if Assured Guaranty's rating falls below the 'A' category, collateral posting would be required at a zero threshold. In addition, there is an additional termination event if Assured Guaranty's rating falls below 'BBB'. The mark to market value on the swap as of June 30, 2016 was negative $38.7 million.
There are significant debt service savings with both the series 2016 GO and revenue bond transactions. The series 2016 GO bonds are expected to result in net present value savings of 16.4% of refunded par and the series 2016 revenue bonds are expected to result in net present value savings of 11.6% of refunded par.
Maximum annual debt service (MADS) on revenue bonds is expected to drop to $40.4 million from $41.4 million. Debt service coverage based on proforma MADS was 2x in fiscal 2016 and 1.4x in fiscal 2015 per Fitch's calculation compared to the BBB category of 3x. Per bond covenant calculation, debt service coverage was 2.22x for fiscal 2016 and would be 2.28x on pro forma MADS.
PROPERTY TAX REVENUE
As a California hospital district, PH receives unrestricted property tax revenues from a fixed share of the 1% property tax levied by the County of San Diego on all taxable real property in PH's boundaries that can be used for operations or capital improvements. PH received $15.1 million and $14.3 million in unrestricted property tax revenues in fiscal 2016 and 2015, respectively. This tax revenue is included in other operating revenue (accounted for 2% of total revenue). PH also receives ad valorem tax revenues generated by the separate voter-approved tax levy that is solely used for the payment of principal and interest on PH's series 2005, 2007, 2009, and 2010 GO bonds.
PH covenants to provide annual audited financial reports and unaudited quarterly financial statements to bondholders. Quarterly information, including a balance sheet, income statement, and statement of changes in net assets will be provided within 45 days after the end of each of the first three fiscal quarters.
Fitch affirms the following outstanding debt at 'BB+':
--$161,110,000 COPs series 2010;
--$229,825,000 COPs series 2009;
--$166,700,000 COPs series 2006A-C.
The following debt is rated 'A+' and on Rating Watch Evolving*:
--$59,115,000 GO bonds election of 2004 series 2005;
--$64,919,679 GO bonds election of 2004 series 2010A;
--$110,000,000 GO bonds election of 2004 series 2009A (insured: Assured Guaranty Corp.);
--$233,478,447 GO bonds election of 2004 series 2007A (insured: MBIA Insurance Corp.);
*par amounts exclude accreted interest on capital appreciation bonds.
Variation from Published Criteria
The analysis supporting the 'BB+' IDR includes a variation from Fitch's 'U. S. Nonprofit Hospitals and Health Systems Rating Criteria'. Enhanced analysis under the variation relates to the evaluation of the strength of the tax revenues available to support operations. This evaluation is supported by Fitch's 'U. S. Tax-Supported Rating Criteria' dated April 21, 2016 that includes refinements to the analysis of both tax revenue volatility, through the new Fitch Analytical Sensitivity Tool (FAST), and the value of taxing capacity relative to the issuer's potential revenue stress in a downturn.