Fitch Rates Oaklawn Hospital (MI) Series 2016 Revenue Bonds 'BBB-'; Outlook Stable
Bond proceeds will refund Oaklawn's series 2009A&B and series 2010A bonds and term loans (which represent essentially all of Oaklawn's current debt outstanding), provide funds to finance capital projects, provide funds to terminate Oaklawn's swaps, and pay the costs of issuance. The bonds are expected to price the week of Oct. 17 via negotiation.
The Rating Outlook is Stable.
Debt payments are to be secured by a gross revenue pledge of the obligated group. Oaklawn's main receipts account will be subject to an account control agreement that will facilitate the Master Trustee's ability to gain control over the gross revenue upon the occurrence of certain events of default. A mortgage pledge is also included on Oaklawn's acute care hospital in Marshall, MI. A debt service reserve fund (DSRF) is not expected.
KEY RATING DRIVERS
NICE REBOUND IN OPERATING MARGINS IN FISCAL 2015 AND 2016: Under new management, Oaklawn's operating margins improved noticeably in fiscal 2015 (11.3% operating EBITDA margin) and fiscal 2016 (10.8%) after operating losses in fiscal 2013 and 2014. Even during the down years, Oaklawn's operating EBITDA margin remained sound relative to other 'BBB-' credits.
ADEQUATE DEBT RATIOS: Oaklawn's pro forma debt ratios are adequate, with 3.0x maximum annual debt service (MADS) coverage and 4.0% MADS-to-total revenue.
LIMITED DEBT EQUIVALENTS: Oaklawn has only limited operating leases and does not have a defined benefit pension plan, which bolsters its debt profile.
MIXED LIQUIDITY: With cash on hand of 144 days, Oaklawn's liquidity position relative to scope of operations is adequate. Pro forma cash-to-debt of 53%, however, is modest for the rating category.
SMALL PROVIDER: With less than $130 million in operating revenue, Oaklawn is considerably smaller than the 'BBB' median of nearly $450 million. Moreover, Oaklawn is surrounded by a number of larger health systems in the broader service area.
OPERATING STABILITY EXPECTED: Given its strong market position in a good service area, very high quality scores, and operating track-record, Fitch expects Oaklawn Hospital to maintain operating EBITDA margins at levels sufficient to sustain coverage metrics consistent with the rating and to bolster liquidity ratios over time.
Oaklawn is a 78-staffed bed community hospital located in Marshall, MI, at the intersection of I-94 and I-69. Marshall is located in south-central Michigan, approximately 13 miles east of Battle Creek, 36 miles east of Kalamazoo, 47 miles southwest of Lansing, and 33 miles west of Jackson. Oaklawn generated just over $125 million in operating revenue in fiscal 2016.
Market Leader with Competition in Broader Service Area
Oaklawn is the market share leader of a primary service area that covers the eastern two-thirds of Calhoun County and small portions of Eaton, Jackson, and Branch counties. The hospital faces competition in the broader area, most notably from Bronson Healthcare's Bronson Battle Creek Hospital (BBC, located approximately 13 miles west in Battle Creek). For the nine-month period January-September 2015, Oaklawn captured 32.2% inpatient market share (excluding tertiary and rehabilitation), compared to BBC with 23.7%. In 2014, the last full year for which data are available, Oaklawn captured 30.9% and BBC captured 27.2%. BBC's market share data exclude Bronson's flagship referral center Bronson Methodist Hospital (located 36 miles west of Marshall in Kalamazoo). Henry Ford Allegiance Health (a member of Henry Ford Health System) captures the number three position in the market with approximately 10% share.
Nice Rebound in Operating Margins in Fiscal 2015 and 2016
Under a new senior executive team, Oaklawn's operating margins improved noticeably in fiscal 2015 and 2016. In fiscal 2013 (March 31 year-end), Oaklawn recorded an operating margin of -2.1%, which continued in fiscal 2014 with an operating margin of -4.7%. The operating EBITDA margin measured 7.3% in fiscal 2013 and 6.8% in fiscal 2014. The losses in 2013 resulted from significant volume declines in February and March 2013 and an accounting error that was discovered at the end of fiscal 2013 that failed to reconcile correctly reimbursement offsets related to a commercial contract.
Management took corrective actions in fiscal 2014 to improve operating results. Actions included: the new CEO (who started just before the accounting issue was identified) brought on a new CFO and other key finance members; and the engagement of a turnaround consultant during 2014 who helped to improve accounts receivables, identify Lean process efficiencies, and enact other cost management initiatives including the hospital's first ever layoff. Operating performance also benefited from strong surgical volume gains resulting from a new surgery center that opened in 2012 and the recruitment of key physicians, particularly a very profitable neurosurgeon (who now accounts for approximately 10% of system revenue, suggesting a high reliance on one doctor). Despite the improvements, fiscal 2014 operating margins remained suppressed, due in part to the costs associated with the turnaround consultant.
Operating profitability improved significantly in fiscal 2015 as a result of the improvement efforts. Oaklawn's operating margin and operating EBITDA margin increased to 1.4% and 11.3%, respectively. Operating gains were sustained in fiscal 2016 with a 1.9% operating margin and 10.8% operating EBITDA margin, comparing favorably with Fitch's 'BBB' median operating and operating EBITDA margins of 1.5% and 8.7%, respectively.
Fitch expects Oaklawn to sustain operating margins at least in-line with 'BBB' medians, although not necessarily at the levels achieved in fiscal 2015 and fiscal 2016. Through five-months of fiscal 2017 (as of August 2016), the system recorded an operating margin of -0.8% and operating EBITDA margin of 8.0% (-0.9% and 8.7%, respectively, budgeted for the five-month period). Softer margins in the interim period were due to decreased inpatient admissions, a shift from commercial payors to Medicaid, and supply cost growth exceeding revenue growth. The inpatient declines were expected as a group of ortho physicians left the staff. Oaklawn subsequently has recruited replacement physicians. Fitch expects full-year fiscal 2016 operating margins to exceed five-month results.
Adequate Debt Ratios
Oaklawn's pro forma debt ratios are adequate for the rating. Based on fiscal 2016 results and including the series 2016 bonds, with a pro forma MADS of $5.1 million, MADS coverage from EBITDA equaled 3.0x and is consistent with Fitch's 'BBB' median of 3.0x. Pro forma debt-to-EBITDA is somewhat high at 5.7x relative to Fitch's 'BBB' median of 4.3x. Pro forma debt load is manageable as MADS as a percentage of revenue is 4.0% ('BBB' median is 3.6%).
After the issuance of the series 2016 bonds, Oaklawn will go from essentially all variable rate debt to all fixed rate debt. The plan of finance includes terminating Oaklawn's existing swaps with an expected termination fee of approximately $3 million. Financial covenants are expected to include minimum debt service coverage (1.10x consultant call-in, 1.00x event of default) and minimum cash on hand (60 days consultant call-in, 45 days event of default). Oaklawn also has a maximum debt-to-capitalization covenant of 60% in place through 2020 when the series 2008 bonds mature.
Oaklawn's comparative debt position is bolstered because of its lack of debt equivalents. For example, the hospital does not have a defined benefit pension plan or material operating leases.
At fiscal year-end (FYE) 2016, Oaklawn had just under $46 million of unrestricted cash and investments. Relative to the system's scope of operations, this translated to an adequate cash on hand of 144 days ('BBB' median is 161 days). Pro forma cash-to-debt and cushion ratio of 53% and 9.0x, however, are modest ('BBB' medians are 91% and 11.7x, respectively). Fitch expects liquidity ratios to improve over time based on expected operating results, manageable capital spending plans, and the fact that Oaklawn does not have a defined benefit pension plan.
Manageable Capital Spending
Oaklawn's capital spending plans are manageable in the coming years. The system's average age of plant measured a favorably low 9.7 years at FYE 2016 ('BBB' median is 11.6 years). Oaklawn has approximately $48 million of capital plans between FY 2017 and FY 2020, with no major "bricks and mortar" projects. This translates to a capital spending ratio of approximately 1.0x. Highlighted projects include build out of shelled operating room space, an emergency department redesign, CT and MRI investments, and land purchases for future ambulatory growth. Oaklawn does not have additional new money debt plans in the near term beyond the current issuance.
Oaklawn covenants to provide bondholders with annual and quarterly financial disclosure through the Municipal Securities Rulemaking Board EMMA system. Quarterly reports are to be reported by the 15th of the second month following the quarter end, while audits are to be reported within four months of the fiscal year end.