Fitch Affirms HealthEast (MN) Revs at 'BBB-'; Outlook Stable

Fitch Ratings has affirmed the 'BBB-' rating on the following St. Paul Housing & Redevelopment Authority bonds, issued on behalf of HealthEast Care System (HealthEast):

--$200.3 million series 2005;

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a pledge of gross revenues of the obligated group, a mortgage on obligated group property, and a debt service reserve.

KEY RATING DRIVERS

STEADY OPERATING IMPROVEMENTS: HealthEast's operating performance and profitability has shown steady year-over-year improvement since 2009, due in part to strategic initiatives around lean (value based improvement) and clinical quality. For fiscal 2013, HealthEast outperformed its budget with a 7.9% operating EBITDA margin, well ahead of the 4.7% generated in fiscal 2009. Fiscal 2014's operating profitability will be negatively impacted by HealthEast's Epic electronic health record (EHR) project, but fiscal 2015 should demonstrate recovery in cash flow.

STRONG MARKET POSITION: HealthEast has maintained a leading and stable market position in the St. Paul service area, and benefits from the solid socioeconomic characteristics in the area. Inpatient market share was 32% in the east metro primary service area as of mid-2013, followed by 26.4% for HealthPartners and 22.4% for Allina (rated 'AA-' with a Stable Outlook by Fitch).

LIQUIDITY REMAINS LIGHT: HealthEast's liquidity position remains light for the rating category, with ratios that are well below Fitch's 'BBB' category medians. However, HealthEast has demonstrated consistent improvement, growing liquidity to 80 days of cash on hand (DCOH) and 64.4% cash to debt at fiscal 2013, up from 45.1 DCOH and 35.3% in 2009. Upon completion of its electronic health record (EHR) project, further improvement in liquidity is expected.

INCREASED LEVERAGE MANAGEABLE: As expected, HealthEast added $60 million in debt during calendar 2013 to help finance its $142 million EHR project, bringing total debt to $317 million as of the three-month interim period ended Nov. 30, 2013. MADS increased to $37 million from $29 million and equaled 3.9% of revenue in the interim period, against Fitch's 'BBB' category median of 3.5%.

RATING SENSITIVITIES

POSITIVE TRAJECTORY EXPECTED TO CONTINUE: HealthEast has produced positive trends in profitability and steady balance sheet improvement since 2008, however, its liquidity coverage ratios remain light for the rating level. In addition, HealthEast's EHR project is underway which will likely pressure profitability in fiscal 2014. Fitch expects continued improvement beyond 2014, and positive rating action would be dependent on continued improvement in liquidity and coverage metrics.

CREDIT PROFILE

HealthEast is an integrated healthcare system located in St Paul, MN, incorporated in 1986. The system includes three acute care hospitals and a long-term acute care hospital (LTACH) in the St. Paul area, 15 outpatient clinics, over 1,200 medical staff members, and approximately 7,400 employees. St. Joseph's Hospital is located in downtown St. Paul with 239 staffed beds, St. John's Hospital is located in a suburb of St. Paul with 184 staffed beds, and Woodwinds Hospital is located in a suburb of St. Paul with 86 staffed beds. HealthEast also has a long-term acute care hospital, Bethesda Hospital, with 126 staffed beds. The system generated $946.2 million in total revenues in fiscal 2013 (year ended Aug. 31).

Fitch's analysis is based on the consolidated system, which includes all three acute care hospitals, the LTACH, the employed medical group, the HealthEast Foundation, and other controlled affiliates. The obligated group (OG) is comprised of the corporate parent, the three acute care facilities and the LTACH, which together represented 93% of total assets and generated 84% of total revenues as of Nov. 30 2013. Per the MTI definition, the HealthEast OG produced 5.17x coverage of actual debt service and 3.58x coverage of maximum debt service in fiscal 2013. The covenant calculation excludes non-recurring items.

HealthEast covenants require annual disclosure within 120 days and quarterly disclosure within 45 days to the Municipal Securities Rulemaking Board's EMMA system. Disclosure includes detailed financial statements, volume statistics, payor mix, and management discussion and analysis.

STEADY IMPROVEMENT IN FINANCIAL PROFILE

The strategic initiatives around value based improvement (VBI), lean practices, and clinical quality have begun to yield results, as demonstrated by improved fiscal 2013 and interim 2014 performance. HealthEast produced a 3.6% operating margin (including non-recurring Epic costs of $4.4 million) in fiscal 2013, which improved further to 4.0% in the three-months ended Nov. 30, 2013. Fiscal 2014's budget calls for more significant EHR implementation expenses, narrowing operating margin to 1.1% and operating EBITDA to 5.8%. Still, these impacts are expected to wane during fiscal 2015.

Steady cash flow has also bolstered HealthEast's balance sheet, though liquidity metrics remain light for the rating. Upon completion of the $142 million Epic EHR project ($104 million will be capitalized, $38 million expensed), HealthEast's capital outlays are expected to decline significantly to between $23 - 25 million annually. No additional debt is expected, and HealthEast's capital structure is very conservative with 100% fixed rate debt, no swaps, and a frozen pension plan funded at 75.2%.

Despite the improving profitability, coverage of maximum annual debt service (MADS) remains light due to the increase in debt in 2013. MADS coverage was 2.3x by EBTIDA through the interim period compared to 2.2x at fiscal 2013, below Fitch's 'BBB' category median of 3.1x. Fitch has included non-recurring Epic costs in its coverage calculations, and MADS of $37.4 million is inclusive of all consolidated long term obligations. The aggregate debt service schedule is front loaded and MADS drops to $16 million in 2024. As of Nov. 30, 2013 HealthEast had $317.4 million in total long term debt, comprised of $200.3 million of fixed rate term bonds, $45.9 million of series 2012 fixed rate refunding debt placed with GE Capital, JP Morgan Chase and Siemens, and $60 million in taxable fixed rate debt placed with GE Capital which matures July 31, 2021. The direct placement covenants are consistent with those of the master trust indenture.

NEAR-TERM IMPLEMENTATION RISK

With only limited balance sheet strength to withstand operating volatility, Fitch will monitor the implementation of an enterprise-wide EHR during 2014 and its impact to operating cash flow or accounts/receivable and cash balances. While some limited impact is budgeted, Fitch expects a return to nearly 80 DCOH and 3% operating margin during fiscal 2015.

Fitch notes that to reduce balance sheet risk in preparation for fiscal 2014's Epic implementation, HealthEast moved its investments into 100% cash and fixed income allocations as of fiscal 2013. Fitch views this positively given limited balance sheet strength and the expected short-term impact to accounts receivable during revenue cycle system go-live events in June and December 2014.

STRATEGIC DIRECTION

HealthEast expects fiscal 2014 to be a low-point for balance sheet and profitability levels. However, relatively low capital needs coupled with realized operating gains should allow HealthEast to return to its historical trend of consistent improvement in fiscal 2015 and beyond. Leadership continues to implement its strategic initiatives, which are expected to support steady operating profitability from 2014-2018. Its partnership with the 70+ physician group Entira to form an accountable care organization (ACO) and high value narrow network products are viewed positively, as it will help support efforts around clinical integration and alignment, ambulatory market reach, and reducing referral leakage.

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

Applicable Criteria and Related Research:

--'U.S. Nonprofit Hospitals and Health Systems Rating Criteria', (May 20, 2013).

Applicable Criteria and Related Research:

U.S. Nonprofit Hospitals and Health Systems Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=708361

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=817311

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