Fitch Rates University Health System's (TN) Series 2016 Rev Bonds 'BBB+'; Outlook Stable
The bonds are expected to sell via negotiation the week of October 10. Bond proceeds will refund a portion of series 2007 bonds, provide funds to finance University Health System's (UHS) expansion projects, and pay the costs of issuance. The remaining portion of the series 2007 bonds is expected to be refunded in early 2017.
In addition, Fitch has affirmed the 'BBB+' rating on the series 2007 Health, Educational and Housing Facility Board of the County of Knox (TN) bonds.
The Rating Outlook is Stable.
Debt payments are secured by a pledge of the gross revenues of the obligated group.
KEY RATING DRIVERS
GROWING MARKET PRESENCE: UHS is the area's only academic medical center (AMC) with a broad regional draw providing tertiary and quaternary services. UHS has benefited from strong volume growth leading to market share gains over multiple years.
GROWTH FUELS NEED FOR CAPITAL: While UHS's routine capital spending over the next three years is expected to be in-line with depreciation expense, UHS is adding an additional $71 million of expansion projects to accommodate rapid volume growth.
GENERALLY STABLE OPERATING RESULTS: UHS's operating EBITDA margin has been stable in the 7% range in recent years. The operating EBITDA margin has softened somewhat through six-months (through June 30) FY 2016 (5.5%, unaudited), compared to 6.2% for the same period fiscal 2015. Full-year results are expected to improve, and Fitch expects margins in-line with historical trends over the long term.
SOMEWHAT MODEST PRO FORMA DEBT COVERAGE: UHS's pro forma debt coverage is slightly modest at the 'BBB+' rating category. Pro forma maximum annual debt service (MADS) coverage is 2.8x based on FY 2015 results (2.3x based on six-months FY 2016). UHS's debt burden is favorable, as pro forma MADS as a percentage of revenue is less than 3%.
MODEST LIQUIDITY: UHS's balance sheet metrics are weaker than 'BBB' medians. Cash on hand measured 139 days at fiscal year end (FYE) 2015 (Dec. 31) and 112 days at June 30, 2016. Pro forma cash-to-debt is 74% based on liquidity at June 30, 2016. Fitch expects liquidity growth over time.
OPERATING STABILITY EXPECTED: Fitch expects University Health System (UHS) to maintain operating EBITDA margins in-line with historical trends to generate cash flow sufficient to maintain adequate debt coverage. Fitch expects UHS's liquidity ratios to improve over time. Sustained deterioration in operating performance and weaker coverage could pressure the rating.
Located in Knoxville, UHS is a 609-bed AMC affiliated with the University of Tennessee (UHS and UT are legally separate). UHS provides a diverse array of clinical services to 21 counties in eastern Tennessee, including many exclusive high-acuity tertiary and quaternary procedures. UHS generated more than $775 million of operating revenues in fiscal 2015, an increase of nearly 10% over 2014 and 35% since 2012.
Exclusive AMC in Competitive Area
While UHS operates in a competitive market, it offers exclusive high-acuity services as the area's only AMC. UHS's key competitors are all multi-facility systems: Covenant Health (rated 'A'); and for-profit Tennova Healthcare (a member of Community Health System (CHS)).
Rapid Volume Growth Fuels Market Share Gains
UHS has benefited from steady market share growth in recent years in its 21-county metropolitan service area. In 2015, UHS captured 16.7% share, up from 15.6% in 2014 and 13.6% in 2010. UHS is the largest individual hospital in the Knoxville market. Collectively, Covenant is the market share leader, with 39.7% share in 2015, followed by the Tennova hospitals with 17.7% share.
UHS's market share growth has been fueled by rapid volume gains. Between 2012 and 2015, inpatient admissions increased 16%, inpatient surgeries 10%, and outpatient surgeries 13%. Likewise, observation stays have increased 38% since 2013. Volume growth has resulted from UHS's recent facility upgrades and continued successful physician recruitment to the closely aligned large medical staff located on the UHS campus.
Stable, Somewhat Modest Operating Margins
UHS's operating margins have been stable in recent years. Between 2012 and 2015, the operating margin ranged between 0.7% and 1.7% and the operating EBITDA margin between 6.8% and 7.2%. While stable, these margins are somewhat modest compared to the 'BBB' median operating EBITDA margin of 8.7%. Historically modest margins reflect management's philosophy of investing in programs, clinical integration and facility expansion to accommodate considerable volume gains. Results are more modest in interim fiscal 2016. Through six months fiscal 2016 (through June 30, unaudited) UHS's operating EBITDA margin measured 5.5%, compared to 6.2% for the same period fiscal 2015 (UHS's full-year results tend to exceed interims). UHS's budgets historically have been conservative; Fitch expects UHS to maintain operating margins at least in-line with historical trends.
Manageable Debt Load, Somewhat Modest Coverage
UHS's pro forma debt coverage is slightly modest for the 'BBB+' rating level. With a pro forma MADS of $21.8 million, MADS coverage is 2.8x based on FY 2015 results and 2.3x based on six-months FY 2016 ('BBB' median is 3.0x). Pro forma debt-to-EBITDA is 5.4x based on FY 2015 results and 6.5x based on six-months FY 2016 ('BBB' median is 4.3x). UHS's debt burden is favorable, as pro forma MADS as a percentage of revenue is 2.8% ('BBB' median is 3.6%).
Total pro forma debt is expected to be $326.5 million and will be approximately 86% fixed rate and 14% variable rate. The variable-rate debt is in two series of direct bank purchase bonds with Regions Bank (series 2015A) and SunTrust (series 2014). UHS also has fixed-rate direct bank purchase debt with Regions Bank (series 2015B). Financial covenants include minimum debt service coverage of 1.20x and 60 days cash on hand.
UHS has one basis swap with a notional amount of $176 million. Morgan Stanley is the counterparty. The swap matures in April 2029. The net termination value of the swap is a positive $5.1 million to UHS; UHS is required to post collateral if the mark-to-market is above a negative $10 million.
UHS's balance sheet metrics are weaker than 'BBB' medians. At FYE 2015 (Dec. 31), UHS had $279 million of unrestricted cash and investments, which increased from $257 million at FYE 2014. Cash declined at June 30, 2016, however, to $241 million. Fitch notes that liquidity at the fiscal year end tends to peak (e. g., cash measured $230 million at June 30, 2015); consequently we expect liquidity growth by FYE 2016. Cash on hand measured 139 days at FYE 2015 and 112 days at June 30, 2016. Pro forma cash-to-debt is 74%, based on liquidity at June 30, 2016. Pro forma cushion ratio is 11.1x, in-line with the 'BBB' median of 11.7x.
Fitch expects liquidity growth over time, as operating stability is expected, capital spending plans are manageable beyond the current expansion projects, and UHS does not have a defined benefit pension plan. UHS has a very conservative investment allocation, with 89% of unrestricted cash and investments in cash or fixed income and no exposure to alternative investments.
Growth Fuels Demand for Capital Spending
UHS's routine three-year capital spending plan continues to be just over $30 million per year from 2016-2018. This is roughly in-line with depreciation expense ($29.5 million in FY 2015). Due to rapid volume growth, UHS has $71 million of additional facility expansion projects planned. Key expansions projects include: (a) build out five additional floors of shelled space; (b) NICU and neuro ICU upgrades; (c) convert two floors to acute care; and (d) infrastructure and equipment investments. As a result, UHS will continue to increase staffed bed capacity. Longer-term capital spending plans are expected to be manageable and no additional new money debt is planned beyond the current issuance.
UHS covenants to provide bondholders with annual and quarterly financial disclosure through the Municipal Securities Rulemaking Board EMMA system. UHS also provides management discussion and analysis and utilization statistics with their quarterly financials.