Fitch Rates Banner Health (AZ) Series 2016A Bonds 'AA-'; Outlook Stable

CHICAGO--(BUSINESS WIRE)-- Fitch Ratings has assigned an 'AA-' rating to the expected issuance of approximately $766,135,000 Maricopa County Industrial Development Authority (AZ) revenue bonds series 2016A issued on behalf Banner Health (Banner). In addition, Fitch affirms the 'AA-' on Banner's outstanding debt (listed at the end of the press release) and the 'F1+' rating on approximately $100 million taxable commercial paper notes series 2015 based on self liquidity.

The Rating Outlook is Stable.

The series 2016A bonds will be fixed rate and will refund a portion of outstanding series 2008A&D bonds. The bonds are expected to price the week of Oct. 3.

SECURITY

The bonds are secured by a gross revenue pledge of the obligated group. The obligated group accounted for 79% of total revenue of the consolidated entity in fiscal 2015 (Dec. 31 year-end).

KEY RATING DRIVERS

STRONG OPERATING PERFORMANCE: The affirmation of the 'AA-' reflects Banner's strong operating performance through the six months ended June 30, 2016, with core operations performing very well, which has given Banner some cushion as it absorbs losses related to the Tucson operations (University of Arizona Health Network [UAHN]) acquisition as of Feb. 28, 2015) as well as ongoing challenges in its insurance division. Strong performance is attributable to continued volume growth as well as increased graduate medical education funding. Operating margin was 5.2% through the six months ended June 30, 2016, compared to 1.8% in fiscal 2015 (year-end Dec. 30) and 4.9% in 2014.

EXPANDED GEOGRAPHIC FOOTPRINT: One of Banner's main credit strengths is its strong market position in the Phoenix metropolitan area and its expanded geographic footprint in the state. Historically, Banner's operations have been primarily concentrated in the Phoenix, AZ metropolitan area. The acquisition of UAHN expands Banner's presence into the Tucson metropolitan market and has turned Banner into a statewide network with 82% of Arizona's population having access to Banner physicians and facilities. Banner continues to expand its network and recently announced a planned acquisition of an existing urgent care business that has 32 sites in Arizona.

NEAR TERM STRESS FROM STRATEGIC INITIATIVES: There are two main stresses on the organization - the Tucson operations and performance of the insurance division. The Tucson operations have had larger operating losses and a slower turnaround timetable than originally projected. Issues that have hampered results include replacement of key physician leadership in key clinical programs, adjustments in clinical compensation and a poorly functioning IT system. The insurance division continues to operate at a slight loss but is key to Banner's strategy and move to value based reimbursement.

WEAKENED LIQUIDITY: At June 30, 2016, Banner had $4 billion in unrestricted cash and investments, which equated to 213.8 days cash on hand (DCOH) and 138.6% cash to debt compared to the 'AA' category medians of 277.4 and 197.9%, respectively. This has dropped from 300.9 DCOH and 156.6% cash to debt at Dec. 31, 2014 due primarily to the cost of the UAHN acquisition, which was funded by debt and cash as well as collateral posting requirements under its swap contracts.

ELEVATED CAPITAL SPENDING: Banner's five year capital plan is high at $3 billion reflecting Banner's growing service area population in Phoenix as well as capital commitments that are part of the UAHN merger. Fitch believes that additional debt capacity will be dependent on Banner's ability to maintain operating margins around 3%-4%.

RATING SENSITIVITIES

EXECUTION OF STRATEGIC IMPERATIVES: There is less flexibility at the current rating level for negative variance relative to plan. A sustained deterioration in financial performance, although not expected, could lead to negative rating pressure.

CREDIT PROFILE

Banner Health is a large, integrated health care provider headquartered in Phoenix, AZ with operations in seven states that include 28 hospitals, three large multi-specialty medical groups with 1,275 employed physicians, outpatient and post-acute facilities and insurance products. In 2015, Banner generated $7 billion in total revenue. Fitch's analysis is based on the consolidated financial results of Banner which includes various non-obligated entities.

Good Market Footprint

Banner has had a long standing strong market position in the greater Phoenix metropolitan area and maintains the leading market share at 44% for the first six months of 2015 compared to the next closest competitor, Dignity Health with 17%. Banner continues to pursue strategic acquisitions and expects to close on the acquisition of Urgent Care Extra by Oct. 1, 2016, which will be funded from cash ($85 million). Urgent Care Extra has 32 facilities throughout Arizona with plans to add 12 more. Very strong operations of the core Phoenix facilities led by physician recruitment and growth of its academic medicine brand and development of its institutes model has led to solid volume growth. There are significant capital needs at the main campus, Banner - University Medical Center - Phoenix (BUMCP; fka Good Samaritan Medical Center).

Strong Operating Performance

With the exception of 2015 when the dilutive effects of the UAHN acquisition impacted overall profitability, Banner's historical financial performance has been very solid. Through the six months ended June 30, 2016, operating performance for the consolidated entity has rebounded even with the losses of Tucson and the insurance division. Operating margin was 5.2% ($200 million operating income) compared to 1.8% in 2015, 4.9% in 2014 and 5% in 2013. Banner also benefited from increased graduate medical education funding through the six months ended June 30, 2016, which totaled $38.6 million. Banner is projecting to maintain 3%-4% operating margin going forward.

Not included in the projections are expected benefits from the 'The Imagine Project', which started in July 2016. The project is in partnership with McKinsey and Company and will evaluate new capabilities to transform the organization with a focus on consumer experience and support the continued transition to value-based revenue models.

UAHN Transaction

As of Feb. 28, 2015, Banner acquired two medical centers in Tucson, the faculty practice plan of University of Arizona Colleges of Medicine, and three health plans. Banner and the University of Arizona, Colleges of Medicine have a 30-year Academic Affiliation Agreement in place with two 15-year terms. The acquisition has solidified Banner's role in academic medicine and the entities have been rebranded as Banner - University Medicine and include BUMCP and Banner - University Medical Center - Tucson (BUMCT; fka University of Arizona Medical Center - University Campus).

Banner was aware of UAHN's financial challenges at the time of acquisition and the need for a turnaround, however, losses are now greater than expected and the expected timeframe for breakeven performance is 2018. Larger than expected losses resulted from a need to rebuild several key clinical programs as a result of loss of physician leadership, a poorly functioning IT system, and readjusting salaries and wages to market rates. The performance improvement plan includes specific targets for the hospital and practice plan operations, with a goal of breakeven performance by 2018. There have been some savings in shared services but areas of focus include revenue cycle, acute care efficiency, reducing length of stay, growing service lines, clinic optimization, and contract increases.

Participation in Risk Based Contracts

Banner has been proactive in the move to risk based contracts and plans to significantly grow its health plan operations. The Banner Health Network (BHN) was created to enter into various risk based reimbursement contracting including a Pioneer ACO and Medicare Advantage plans. In addition, the UAHN acquisition included three health plans. Overall health plan performance continues to miss targets driven by losses in the BHN plans. Management will need to balance membership growth with better clinical case management, changes in certain payer risk sharing arrangements and investment in technology to improve efforts in population health management.

Elevated Capital Spending

Banner has consistently invested in its facilities and its clinical IT system to meet the growing population and demand for its clinical services. The five year capital plan is high at $3 billion and includes the $500 million capital commitment for the Tucson facilities as well as investment in BUMCP. Major projects at BUMCP include a new and expanded emergency room, a 40-bed observation unit, and four additional operating rooms that should be complete by early 2018, as well as a new 16 story bed tower with 280 beds, which should be complete by the end of 2018.

The project at BUMCT includes 670,000 square feet of new space and renovation of 75,000 of existing space. The new facility will include the main entry, diagnostic and treatment, cardiac catheterization, 17 operating rooms, and 204 private rooms. There will be shelled space for five additional operating rooms and 24 beds. The new facility is expected to be complete by the end of first quarter 2019 and the renovation of the existing facility is expected to be complete by the end of the first quarter 2020.

Part of the Tucson capital commitment will be spent at BUMCT's North Campus, which will include a new multispecialty health center that will include various specialty clinics, imaging, lab, and radiation/oncology. This project is expected to be complete by the end of 2017.

The entire capital plan is not committed and spending/additional debt plans will depend on operating performance.

Debt Profile

Total debt outstanding as of August 2016 is $2.9 billion and includes 51% underlying fixed rate and 49% underlying variable rate. Including its swaps, 97% of the debt is fixed rate. Banner's uncommitted capital includes LOC backed VRDBs and direct bank loans. All of the covenants in the bank/LOC agreements are standardized, but contain additional covenants than what is in the MTI.

The series 2016A refinancing results in significant savings. Pro forma maximum annual debt service (MADS) is projected to decline to $175 million from the current $188 million. Through the six months ended June 30, 2016, coverage of pro forma MADS by EBITDA was 5.4x compared to 4.5x in 2015 and 2014, respectively, and is consistent with the 'AA' category median of 6x.

Banner novated its fixed payer swaps in May 2015 and increased the number of counterparties, which spread the collateral threshold among six counterparties from four and reduced the amount of collateral posting required. Banner's collateral posting as of Sept. 16, 2016 was $180 million.

Self Liquidity Rating

The affirmation of the 'F1+' short-term rating is supported by the adequacy of Banner's highly liquid resources available to fund any unremarketed puts on the $100 million commercial paper (series 2015F). Based on Fitch's rating criteria related to self-liquidity, Banner's position of eligible cash and investments available for same-day settlement easily exceeds Fitch's 1.25x requirement to cover the maximum tender exposure on any given date.

Disclosure

Banner covenants to provide audits within 150 days of fiscal year end and quarterly disclosure within 60 days of quarter end for the first three quarters. Banner's financial reporting is excellent. Furthermore, Banner hosts periodic investor calls.

Debt rated by Fitch:

--$94,100,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds, series 2015A;

--$100,630,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2015B (LOC: Bank of Tokyo-Mitsubishi UFJ, Ltd.) & bank bonds;

--100,630,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2015C (LOC: Bank of America, N.A.) & bank bonds;

--$200,600,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2014A;

--$67,840,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2012B (taxable);

--$179,090,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2012A;

--$63,550,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008H (LOC: Northern Trust Company (The)) & bank bonds;

--$81,325,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008G (LOC: Wells Fargo Bank, N.A.) & bank bonds;

--$86,185,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008F (LOC: JPMorgan Chase Bank, N.A.) & bank bonds;

--$105,060,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008E (LOC: Bank of America, N.A.) & bank bonds;

--$717,935,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2008D;

--$204,440,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2008A;

--$400,000,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2007B;

--$11,110,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2007A.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)https://www.fitchratings.com/site/re/750012

U.S. Nonprofit Hospitals and Health Systems Rating Criteria (pub. 09 Jun 2015)https://www.fitchratings.com/site/re/866807

Additional Disclosures

Dodd-Frank Rating Information Disclosure Formhttps://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1012200

Solicitation Statushttps://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1012200

Endorsement Policyhttps://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31

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