Fitch Rates King's Daughters Medical Center (KY) Series 2016A Bonds 'A-'; Outlook Negative

CHICAGO--(BUSINESS WIRE)-- Fitch Ratings has assigned an 'A-' rating to the following bonds expected to be issued on behalf of King's Daughters Medical Center (KDMC):

--$75,000,000 City of Ashland, Kentucky medical center revenue bonds, series 2016A.

Additionally, Fitch has affirmed the 'A-' rating on $228.6 million of bonds issued by the Kentucky Economic Development Finance Authority and the City of Ashland (KY) on behalf of KDMC.

The series 2016A bonds will be issued as tax-exempt fixed-rate bonds. In conjunction with the series 2016A issuance, KDMC will issue approximately $50 million of series 2016B variable rate bonds which will be privately placed with BB&T. Combined bond proceeds will be used to refund KDMC's outstanding series 2014 bonds, reimburse for prior capital expenditures and pay costs of issuance. Pro forma maximum annual debt service (MADS) is expected to equal $16.3 million. The bonds are expected to price the week of Sept. 5 through negotiation.

The Rating Outlook is Negative.

SECURITY

Bond payments are secured by a pledge of the gross receipts of the obligated group and a mortgage interest in certain property including the acute care hospital.

KEY RATING DRIVERS

REBOUNDING PROFITABILITY: The rating affirmation reflects KDMC's improving operating profitability with operating EBITDA margin increasing from 3% in fiscal 2014 to 6.7% in fiscal 2015 and 7.8% in the eight month interim period ending May 31, 2016 (the interim period).

WEAKENED LIQUIDITY: The Negative Outlook reflects the continued decrease in liquidity metrics with unrestricted cash and investments decreasing 12.4% since fiscal 2014 through May 31, 2016. Pro forma unrestricted liquidity is expected to increase by approximately $18 million to $202 million due to reimbursement proceeds and the release of swap-related collateral.

IMPROVING COVERAGE: Reflective of the rebounding operating profitability, pro forma MADS coverage by operating EBITDA increased from 0.9x in fiscal 2014 to 1.8x in fiscal 2015 and 2.2x in the interim period.

DECLINING UTILIZATION: Inpatient and outpatient utilization decreased between fiscal 2011 and fiscal 2015, resulting in both an erosion of operating revenue and market share. Volumes appear to be stabilizing in the interim period with increased outpatient volumes.

RATING SENSITIVITIES

IMPROVED FINANCIAL PROFILE: Fitch expects that King's Daughters Medical Center's operating profitability will continue to improve to levels sufficient to produce coverage consistent with the rating category and that unrestricted liquidity metrics will improve due to the improved cash flows and low capital spending levels. Failure to improve profitability or liquidity metrics will result in negative rating pressure.

STABILIZED VOLUMES AND REVENUE: Additionally, Fitch expects that volumes and patient revenue will stabilize going forward. Continued deterioration in patient volumes and net patient revenues could result in negative rating pressure.

CREDIT PROFILE

KDMC operates a 465-staffed bed regional tertiary referral center located in Ashland, KY, approximately 120 miles east of Lexington, KY and 120 miles south of Columbus, OH. Additional operations include KDMC Ohio (a 10 licensed bed hospital that opened February 2013), six urgent care centers, a long-term and short-term care facility, an ambulance transport company, an integrated physicians group, a research foundation and a philanthropic foundation. Total operating revenue decreased 7.7% since fiscal 2013 to $448.3 million in fiscal 2015.

KDMC and the U.S. Department of Justice (DOJ) entered into a final settlement agreement in May 2014. The DOJ initiated an investigation of KDMC in 2011 for alleged violations of the False Claims Act related to KDMC's levels of cardiac stent and catheter procedures between 2006 and 2011. The government contended that the number of procedures was high, indicating that unnecessary procedures were performed. KDMC denied the DOJ's allegations. While no civil or criminal charges were ever filed against KDMC, KDMC entered into a settlement agreement with the DOJ to end the investigation. Under the terms of the agreement, KDMC paid a $40.9 million settlement to the DOJ and signed a corporate integrity agreement but did not admit to any wrongdoing.

REBOUNDING PROFITABILITY

The rating affirmation reflects KDMC's improving operating profitability. Profitability has incrementally improved since deteriorating in fiscal 2013. Operating EBITDA margins averaged 10.2% between fiscal years 2010 and 2012 but declined to a weak 3.1% in fiscal 2013. Management implemented an operating improvement plan in late fiscal 2013.

After a slow start, profitability stabilized in fiscal 2014 with operating EBITDA equal to 3% (excluding $3.9 million of non-recurring severance and restructuring expenses), slightly below management's budgeted target of 3.3%. Operating EBITDA margin improved in fiscal 2015 and the interim period, increasing to 6.7% and 7.8%, respectively. However, operating EBITDA margin remains light relative to Fitch's 'A' category median of 10.3%.

KDMC's core operations have significantly improved when adjusted to exclude DOJ-related expenses and consulting engagement fees. Excluding DOJ-related expenses and consulting engagement fees, operating EBITDA margin equaled 4% in fiscal 2014 and increased to 8.7% in fiscal 2015 and 9.9% in the interim period. The consulting engagement is expected to cease in fiscal 2016 and the DOJ-related expenses are expected to materially decrease in fiscal 2018.

WEAKENED LIQUIDITY

The Negative Outlook reflects the continued decline in unrestricted liquidity through May 31, 2016. Fitch had expected liquidity to strengthen due to improving profitability and low capital spending subsequent to KDMC's $40.9 million DOJ settlement payment in fiscal 2014. However, unrestricted cash and investments decreased $26 million (12.4%) since fiscal 2014 to $184.5 million at May 31, 2016 despite modest capital spending and improving profitability. The decrease is due to approximately $28 million of swap collateral posted and unrealized investment losses. Ongoing malpractice allegations related to the DOJ investigation could negatively impact liquidity.

The series 2016 plan of finance will bolster unrestricted liquidity by approximately $18 million, including $10 million in reimbursement proceeds. Additionally, KDMC is in the process of terminating approximately $8 million of fixed payor swaps and novating the remainder of its fixed payor swaps to a new counterparty. The swap termination fee is expected to equal approximately $10 million. The new swap counterparty will not have a collateral posting requirement, resulting in the release of $28 million in swap collateral to KDMC. Of the $28 million released, $10 million will be used to repay a line of credit that KDMC drew on to a portion of the posted collateral.

Despite the net $18 million increase, pro forma unrestricted liquidity metrics remain light relative to Fitch's 'A' category medians. Pro forma unrestricted liquidity is expected to increase to $202.5 million equating to 169.5 day cash on hand, 12.4x cushion ratio and 84.7% cash to pro forma debt, comparing unfavorably to Fitch's 'A' category medians of 205.3, 18.5x and 143.7%.

IMPROVING COVERAGE

Pro forma MADS coverage by EBITDA declined to 1.5x in 2013, but has improved with the rebounding profitability. Pro forma MADS coverage by EBITDA slightly improved to 1.6x in fiscal 2014 before increasing to 2.7x in fiscal 2015 and 2.8x in the interim period. Excluding the DOJ and consulting expenses, pro forma MADS coverage by EBITDA would have equaled 1.9x, 3.2x and 3.4x, respectively. Pro forma MADS is equal to 3.6% of fiscal 2015 operating revenue. However, continued declines in operating revenue could increase the system's debt burden and negatively impact coverage ratios.

DECLINING UTILIZATION AND MARKET SHARE

Inpatient and outpatient utilization has materially decreased. Inpatient admissions and surgeries decreased 10% per year between fiscal 2013 and fiscal 2015 while outpatient surgeries decreased 8% per year. The decreasing utilization reflects a combination of the negative impact of the DOJ investigation and reputational damage in the community resulting from a reduction in force implemented in fiscal 2013 in addition to national utilization trends and the effects of high deductible health plans. Volumes appear to be stabilizing in the interim period.

Reflecting the declining utilization, KDMC's operating revenue decreased an average of 7% per year since fiscal 2012. Additionally, the system's leading market share in its primary service area decreased each year since fiscal 2010, declining from 39.5% in fiscal 2010 to 33.9% in fiscal 2014 (the most recent year for which data is available). However, management believes that KDMC's market share has stabilized and increased subsequent to the DOJ settlement. The service area remains challenging and is characterized by flat to declining population levels and low median household income levels relative to both state and national averages.

DEBT PROFILE

Subsequent to the series 2016A/B bond issuance, KDMC will have approximately $234 million of total debt outstanding. The pro forma bond portfolio will be comprised of 79% underlying fixed rate bonds and 21% underlying variable rate bonds. As previously described, KDMC will be counterparty to three fixed payor swaps with a total notional amount of $50 million post issuance, effectively converting 20% of KDMC's bonds to synthetic fixed rates.

DISCLOSURE

KDMC covenants to provide annual disclosure within 150 days of the fiscal year-end and quarterly disclosure within 45 days of quarter-end. Disclosure is provided through the Municipal Securities Rulemaking Board's EMMA website.

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 Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1010798

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1010798

Endorsement Policy

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

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Fitch Ratings
Primary Analyst
Adam Kates
Director
+1-312-368-3180
Fitch Ratings, Inc.
70 W. Madison Street
Chicago, IL 60602
or
Secondary Analyst
Gary Sokolow
Director
+1-212-908-9186
or
Committee Chairperson
Eva Thein
Senior Director
+1-212-908-0674
or
Media Relations:
Elizabeth Fogerty, +1 212-908-0526
[email protected]

Source: Fitch Ratings

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