Community Health Systems (CYH) Ratings Placed on Watch Evolving by Fitch

September 19, 2016 2:31 PM EDT

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Fitch Ratings has placed the ratings of Community Health Systems, Inc. (NYSE: CYH), including the 'B' Issuer Default Rating (IDR), on Rating Watch Evolving. The ratings apply to $15.6 billion of debt outstanding at June 30, 2016. A full list of rating actions follows at the end of this release.


Strategic Review Announced: CHS announced that the company has retained advisors to conduct a strategic review of its business. The Evolving Watch reflects uncertainty as to the credit profile implications of the outcome of the review. At this time, there are few details of the timing and likely resolution of the review. If the review does culminate in a transaction, the effect on the ratings will depend on the business profile implications and the resultant capital structure. Fitch believes there is also a heightened risk of management distraction during the review, which increases the likelihood of a downgrade of the ratings based on continued deterioration in operating trends, particularly organic growth in patient volumes.

Repositioning Hospital Portfolio: Prior to announcement of the strategic review, CHS was engaged in efforts to reposition its portfolio of hospitals in larger and faster-growing markets. Earlier in 2016, the company spun off 38 hospitals into a separate, publicly traded entity, and announced plans to divest another 12 hospitals before the end of the year. Repositioning the portfolio should help CHS's organic volume growth by reducing exposure to lower acuity patients. This strategy is aligned with secular trends in healthcare delivery, which are resulting in more patients being treated in outpatient settings.

Persistent Operational Challenges: CHS acquired rival hospital operator Health Management Associates (HMA) in a 2014 deal that added about $7 billion of debt to CHS's capital structure. Since the close of the transaction, growth in EBITDA has been hampered by operational issues at the HMA hospitals, and ongoing government investigations and lawsuits. In second quarter 2016 (2Q16), CHS recognized a $1.4 billion goodwill impairment charge, reflecting lower earnings prospects for the company's hospitals than at the time of the HMA acquisition.

Restructuring Proceeds Reduce Debt: Progress towards deleveraging has been slow since the HMA acquisition; total debt/EBITDA is about 6.4x, versus 5.2x prior to it. So far in 2016, CHS has paid down about $1.5 billion of debt with the proceeds from the spin-off of Quorum Health Corporation (QHC) and the sale of a minority interest in several hospitals in Las Vegas. This was the first substantial debt repayment since the HMA acquisition. Prior to announcement of the strategic review, management said CHS plans to divest another 12 hospitals before the end of 2016, and expects to apply the proceeds to debt reduction. If the company were to execute on those divestitures as planned, Fitch would expect debt to be about $2.3 billion lower at the close of 2016 versus the January 2016 level, which is equal to about one-turn of EBITDA.

More Profitable Hospital Portfolio: Fitch's respective $2.38 billion and $2.26 billion EBITDA forecasts for CHS for 2016 and 2017 reflect the loss of a cumulative $380 million in EBITDA as a result of the company's portfolio pruning. The largest portion of EBITDA divested was the 38 hospitals involved in the QHC spin-off.

Headwinds to Lower Acute Volumes: CHS's legacy hospital portfolio is exposed to rural markets and therefore headwinds to lower acuity patient volumes. Volume trends in these markets are highly susceptible to weak macro-economic conditions and seasonal influences on flu and respiratory cases. Health insurers and government payors have been increasing scrutiny of short-stay admissions and preventable hospital readmissions. CHS has made some headway in turning around the company's hospital industry-lagging volume trends, but these challenges have proven difficult to overcome.

Progress in Resolution of Legal Issues: CHS has been dealing with government investigations and lawsuits related to the issue of short-stay hospital admissions. CHS has made good progress in resolving the legal issues facing the legacy CHS hospitals, which did not involve financial fines significant enough to threaten financial flexibility and provided some comfort that the scope of the potential HMA fines or penalties will be similarly manageable.


Fitch's key assumptions within the rating case for CHS include:

--Top-line declines 5.3% and 8.7% in 2016 and 2017, respectively, reflects completed and planned hospital divestitures. Underlying same-hospital growth of 2%-3% is driven primarily by pricing.

--EBITDA before deduction of non-controlling interest and including equity earnings of affiliates of $2.38 billion and $2.26 billion in 2016 and 2017, respectively, assumes that operating EBITDA margin recovers about 50 bps by the end of 2017 versus the June 30, 2016 latest 12 months (LTM) level, mostly as the result of divesting less-profitable hospitals.

--Free cash flow (FCF) margin recovers to 1.4% in 2016 and 2.5% in 2017, benefiting from lower cash interest expense due to debt repayment, and lower capital intensity based on management's projections for capital expenditures of about 4% of revenues in 2016.

--The company divests another 12 hospitals in late 2016, raises net proceeds of $850 million and uses the cash to repay debt; thereafter, debt levels are fairly constant through the projection period assuming minimal cash towards acquisitions and share repurchases.

--Total debt/EBITDA is sustained between 6.0x and 6.5x.


Maintenance of the 'B' Issuer Default Rating (IDR) considers CHS maintaining total debt/EBITDA at or below 6.5x, an operating EBITDA margin of at least 12% and an FCF margin of 1%-2%. A downgrade could result from leverage sustained above 6.5x and a breakeven FCF margin. Risks to the operating outlook include the inability of management to execute on operational improvements necessary to improve organic volume growth and profitability. This could be evidenced by difficultly completing the remaining planned divestitures and associated debt pay-down, negative growth in organic adjusted admissions, and/or lack of progress toward resolution of HMA's legal issues.]

At June 30, 2016, sources of liquidity included $461 million of cash on hand, $935 million of available capacity on the senior secured credit facility cash flow revolver and LTM FCF of about $64 million. CHS's EBITDA/interest paid is solid for the 'B' rating category at 3.3x and the company had adequate operating cushion under the bank facility financial maintenance covenants, one of which requires net secured debt leverage maintained at or below 4.25x. Despite a forecasted decline in EBITDA, Fitch expects the company to remain in compliance with the financial maintenance covenants through the projection period. Upcoming debt maturities include the A/R facility maturing in 2017 with $673 million outstanding at June 30, 2016, and $1.5 billion in bank term loans and $700 million of secured notes maturing in 2018.


Fitch has placed the following ratings on Evolving Watch:

Community Health Systems, Inc.:
--IDR 'B'.

CHS/Community Health Systems, Inc.:
--Senior secured credit facility 'BB-/RR2';
--Senior secured notes 'BB-/RR2';
--Senior unsecured notes 'B/RR4'.

The 'BB-/RR2' rating for CHS's secured debt (which includes the bank term loans, revolver and senior secured notes) reflects Fitch's expectations for 72% recovery under a hypothetical bankruptcy scenario. The 'B/RR4' rating on CHS's $6.1 billion senior unsecured notes reflects Fitch's expectations for principal recovery of 36%.

In the U.S. healthcare sector, Fitch consistently uses a going-concern approach to valuation as opposed to assuming a liquidation value; intrinsic value is assumed to be greater than liquidation value for these companies, implying that the most likely outcome post-default would be reorganization rather than liquidation.

The going-concern cash flow (measured by EBITDA) estimate assumes an initial deterioration that provokes a default which is somewhat offset by corrective actions that would take place during restructuring. Fitch assumes a 37% discount to its 2016 forecasted EBITDA less distributions to non-controlling interests of $2.3 billion for CHS, resulting in a post-default cash flow estimate of $1.4 billion.

Fitch applies a 7x multiple to CHS's post-default cash flow estimate of $1.4 billion, resulting in a going concern enterprise value (EV) of $10.1 billion. The 7x multiple is based on observation of both recent transactions/takeout and public market multiples in the healthcare industry. Administrative claims are assumed to consume 10%, or about $1 billion of going concern EV, which is a standard assumption in Fitch's recovery analysis. Also standard in its analysis, Fitch assumes that CHS would fully draw the $1 billion available balance on its bank credit revolver in a bankruptcy scenario and includes that amount in the claims waterfall.

Fitch applies a waterfall analysis to the going-concern EV based on the relative claims of the debt in the capital structure. Fitch estimates EV available for claims of $9 billion, net of a standard assumption of 10% for administrative claims. At June 30 2016, about 60% of consolidated net revenue resides in the guarantor group, so Fitch assumes that 60% of the going-concern EV, or $5.4 billion, is recovered by first-lien secured holders, leaving $3.6 billion of non-collateral value to be distributed to unsecured claimants. Based on $9.5 billion of total secured claims (which includes the bank term loans, revolver and senior secured notes), the resulting first-lien secured deficiency claim of $4.1 billion is added to $6.1 billion of senior unsecured claims, resulting in $10.2 billion of total unsecured claims, recovery of which is assumed on a pro rata basis.

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