Fitch Downgrades Reading Hospital (PA) Revs to 'A+'; Outlook Stable
-- $160,065,000 series A of 2012 fixed-rate bonds;
-- $91,775,000 series B of 2012 floating-rate notes (FRNs);
-- $111,670,000 series 2009A-3 fixed-rate bonds;
The Rating Outlook is Stable.
RHMC also has outstanding $220 million in 2012 series C&D variable-rate revenue bonds, which are privately placed with a commercial bank and not rated by Fitch.
Bondholders have a lien on and a security interest in the gross revenues of the obligated group, which includes Reading Health System (RHS; parent) and Reading Hospital.
KEY RATING DRIVERS
WEAK FINANCIAL PERFORMANCE DRIVES DOWNGRADE: The downgrade to 'A+' from 'AA-' reflects three years of very weak profitability (after write-downs) driven by persistent revenue cycle issues from the Epic conversion launched in February 2013. Revenues in 2013 and 2014 were most significantly affected, as a $100 million accounts receivable (AR) write-down applicable to the two years were recognized during the 2014 audit process. Financial deterioration continued in fiscal 2015 with an additional $11 million AR write-down and other challenges including a vacant CFO position and a budget that was based on inflated historical results.
STABLE CORE OPERATIONS: The Stable Outlook relies on RHS's solid underlying operations, which were sound despite dramatic financial volatility. Core operations are supported by a solid employed physician base and a primary service area (PSA) market share that has been steady at around 62% for several years.
SOLID LIQUIDITY: The Stable Outlook incorporates RHS's solid liquidity position, which remains robust for the rating despite some recent declines from weak cash flows and heightened capital spending. Liquidity is expected to weaken further in 2016 during a period of heavy capital spending and recover thereafter. Fitch believes there is sufficient room to absorb planned capital demands at the 'A+' rating.
LARGE CAPITAL PROJECTS: Capital projects are proceeding as planned, with $205.7 million of expenditures budgeted for fiscal 2016 primarily for the construction of a new surgical tower. RHS expects to fund the entire project using internal equity.
RECOVERY EXPECTED: Given strong fundamentals and a focus on financial recovery, Fitch expects Reading Health System (RHS) to return to profitability in fiscal 2016. Positive year-to-date results (three months) indicate the organization is on track to generate positive operating income. However, inability to sustain the momentum and achieve, at least, breakeven operating margin would be viewed negatively and may result in further negative rating action in light of RHS's sizable capital plans.
PROJECT EXECUTION: Fitch expects RHS to meet the current budget and timeline for its major capital projects. Material cost overruns or delays leading to a larger than anticipated erosion in liquidity could pressure the rating.
Reading Health System comprises the parent organization and various subsidiaries including Reading Hospital (713 operated-bed acute care hospital located in Reading, PA), Reading Professional Services, The Reading Hospital Medical Group, The Highlands at Wyomissing (a continuing care retirement community), Reading Health Partners (a physician group with 329 employed physicians), and RHS Foundation.
Total operating revenue was $899.7 million in the fiscal year ended June 30, 2015 (draft audit). The obligated group comprised 86% of the consolidated entity's total revenue in fiscal 2015. Fitch's analysis is based on the consolidated entity RHS.
Challenged IT Conversion
RHS rolled out its Epic platform in February 2013, and experienced extensive revenue cycle disruptions that challenged years of financial results. Management reports that the clinical side was relatively smooth, but billing/revenue cycle conversion suffered from an aggressive timeline and stressed resources. In particular, reserves for contractual allowances and denials were not properly estimated for 2013 and 2014, and led to significant overstatement of revenues while expenses continued to grow as initially budgeted.
AR began to balloon, reaching $179.9 million at FYE 2013 from $110.7 million the prior year. AR continued to grow in 2014, and at year-end, $100 million of AR was written off as escalated claims were deemed uncollectible. Approximately $56 million of net income impact was attributable to fiscal 2013, but the fiscal 2013 financial statements were not restated, whereas, the audited 2014 results reflect a $44 million write-down. Another $11 million AR write-down impacted 2015, in addition to other negative pressures including a vacant CFO position and an impractical budget that was based on inflated historical results. Management estimates $12 million in one-time expenditures for fiscal 2015, totaling $22.7 million of total nonrecurring negative variance for 2015.
Very Weak Profitability
Reported operating margins were negative 5.3% (2015), negative 3.4% (2014), and positive 2.3% (2013). In isolating one-time items (only some of which are reflected in the statements), Fitch estimates net income adjustments of positive $22 million (2015), negative $11 million (2014), and negative $56 million (2013). Incorporating these adjustments produces operating margins of negative 2.7% (2015), negative 4.6% (2014), and negative 4.1% (2013). Adjusted revenues show a 2%-3% decline in 2013, then modest growth in 2014 and 2015. Fitch believes the adjusted profitability metrics illustrate steady underlying operations afflicted by collections issues and a disproportionately growing expense base. By resolving estimates for revenue and expense growth, RHS should be able to return to its historical profitability levels in the medium term.
For fiscal 2016, management is targeting positive operating income including performance improvements, the majority of which is carryover from fiscal 2015. Key initiatives include labor productivity improvement, supply chain savings, clinical programming opportunities, denials reduction, and observation stays re-categorization. The Stable Outlook hinges upon RHS's ability to meet its 2016 target, which Fitch believes is attainable.
Operating Platform and Market Position Remain Stable
Underlying the Stable Outlook is RHS's historically strong operating platform including an extensive delivery network that has remained solid throughout the financial turmoil. Utilization trends, though somewhat weaker in 2014, remained steady overall, and inpatient market share was solid at around 62% in the PSA and 8% in the secondary service area for several years.
A large part of its market strength is supported by Reading Health Physician Network, an extensive employed physician network with 329 physicians. Further, RHS created Reading Health Partners, a joint venture with the medical staff aimed to create a clinically integrated network among both employed and non-employed physicians at RHS.
Management's operational strategies continue to include growing select service lines to capture outmigration, building stronger relationships with regional hospitals (through AllSpire Health Partners, a consortium of seven hospitals), and updating its physical plant.
New Surgical Tower Construction
Construction of the new surgical tower continues as planned. In September 2013, RHS broke ground on a new surgical tower that will house 24 surgical suites with updated technological capabilities, expanded emergency rooms, and 150 private beds. Management expects the new tower to commence operations at the end of fiscal 2016.
The project is expected to cost approximately $343 million, with $115 million spent through fiscal 2015. Approximately $175 million is budgeted for fiscal 2016. Combined with other routine and project spending, total capital expenditure is estimated at $205.7 million in 2016, which is nearly 250% of 2015 depreciation.
All of the capital spending is expected to be funded from cash flow and equity. As a result, liquidity decline is inevitable in the near term. However, Fitch believes projected capital demands are manageable at the 'A+' rating and expects balance sheet recovery in 2017 and on.
Unrestricted cash and investments totaled $935.9 million at Sept. 30, 2015, compared to a level that had consistently been above $1 billion from 2011-2014. The decline was partly attributable to weaker cash flows, but was more heavily affected by heightened capital spending that averaged 144% of depreciation from 2013 to 2015. Days cash on hand of 396, 27.2x cushion ratio, and 158.8% cash-to-debt compare favorably against the respective 'A' medians of 205 days, 18.5x, and 143.7%.
At FYE 2015, long-term debt totaled $589.6 million with 46% underlying fixed rate and 54% underlying variable rate. Underlying variable-rate bonds consist of $91.8 million in publicly traded FRNs and $220 million in privately placed indexed loans with initial terms ranging from seven to 10 years. Debt service is relatively level at around $25 million-$27 million through 2022, then increases to over $34 million, generating a maximum annual debt service (MADS) of $34.4 million.
Although the total amount of debt has declined consistently, debt ratios have weakened due to overall financial deterioration. MADS equated to 3.8% of 2015 revenues and debt-to-EBITDA was 5.7x, compared to the respective 'A' medians of 2.8% and 3x. MADS coverage was also weak at 3x in 2015 compared to the median of 4.2x and RHS's historical coverage ratio of 4x-5x.
RHS has several swaps outstanding, but collateral posting requirements are only required if the rating is downgraded below 'A-'. As of June 30, 2015, the mark to market was negative 51.5 million.
RHS covenants to provide annual (within 150 days of fiscal year end) and quarterly (within 60 days of each quarter end) disclosure, which are posted on EMMA and DAC.