Fitch Affirms University Health System, TN's Revs at 'BBB+'; Outlook Stable

Fitch Ratings has affirmed the 'BBB+' rating on the $208.4 million Health, Educational and Housing Facility Board of the County of Knox (TN) (University Health System, Inc.) series 2007 revenue bonds.

The Rating Outlook is Stable.

SECURITY

Debt payments are secured by a pledge of the gross revenues of the obligated group.

KEY RATING DRIVERS

STRONG MARKET PRESENCE: University Health System (UHS) is the area's only academic medical center with a regional draw providing tertiary and quaternary services, some of which are unique to UHS. UHS's market share has increased in a market of shrinking volumes, and the utilization trend has been strong, to a large degree owing to its significant clinical integration with its large medical staff.

HISTORICALLY WEAK OPERATING PERFORMANCE: UHS slightly exceeded its budget in fiscal 2012 (year end Dec. 31) with operating margin of 0.7%, but operating results historically fell below Fitch's 'BBB' rating median. Management projects to end fiscal 2013 with operating margin of 0.8%. Coverage of maximum annual debt service (MADS) by EBITDA was 2.2x though the third quarter ended Sept. 30, 2013 (the interim period); adequate, but slightly lower than the category median.

MODERATE CAPITAL NEEDS: UHS's balance sheet metrics are weaker than Fitch's 'BBB' medians, but UHS completed a major facility update and has no major projects planned for the near term, which should enable the organization to improve its balance sheet. At Sept. 30, 2013, days cash on hand (DCOH) were 130 days and cash-to-debt was at 76.7%.

POTENTIAL INCREASE IN COMPETITIVE LANDSCAPE: The entrance of the for-profit Community Health System (CHS), which recently acquired Health Management Associates (HMA), the parent of Tennessee-based Tennova Healthcare (Tennova), may introduce more competitive pressure into the market.

RATING SENSITIVITIES

NEED TO GENERATE SOLID OPERATING PERFORMANCE: The moderate capital spending going forward should enable the organization to produce a stronger level of operating performance, which should ultimately lead to a stronger balance sheet, more consistent with the rating category. Deterioration in operating performance resulting in lower coverage could lead to downward rating pressure.

CREDIT PROFILE

UHS is a 514 staffed-bed academic teaching facility which provides a diverse array of clinical services to 21 counties in eastern Tennessee. UHS had revenues of $574.8 million in fiscal 2012, an increase of 6.3% over the prior year.

Historically Weak Operating Performance

UHS's operating performance has historically been weaker than the category median, as management invested in programs, clinical integration and facility expansion. For fiscal 2012, UHS recorded operating income of $3.8 million (operating margin of 0.7% and operating EBITDA margin of 7%), a decline from the prior year, which had an operating gain of $8.7 million. Operating gain through the third quarter of 2013 was $2.3 million, equal to an operating margin of 0.5% and operating EBITDA margin of 6.8%. UHS's recent volume trend was unusually robust with admissions increasing by 1.5% in fiscal 2012 and 6.5% through the third quarter of fiscal 2013 (ended Sept. 30). Outpatient surgeries increased by 3.7% and emergency department (ED) visits were 7.6% higher though the third quarter of 2013. Despite the strong volume growth, operating performance was pressured by Medicare sequestration and by the lack of rate increases from TennCare. Management is projecting to end 2013 with approximately $4.8 million gain from operations (0.8% operating margin), exceeding the $2.2 million budgeted gain. The budget for 2014 is breakeven, but management has always budgeted conservatively and believes that it will be exceeded.

Manageable Debt Load

UHS's MADS coverage by EBITDA and operating EBITDA of 2.2x and 2.0x, respectively, through the nine-month interim period are adequate, but below the respective category medians of 3.1x and 2.7x. MADS as a percentage of revenues, which had been elevated, has been moderating and at 3.5% is now consistent with the 'BBB' median. Liquidity is mixed, with cushion ratio of 9.8x consistent with the median, but DCOH of 130 days and cash-to-debt of 76.7% are both lower than the respective medians of 144.7 days and 91.7%. As UHS completed a major update of its facility and faces no significant capital needs over the near term, Fitch expects that the debt load metrics will further moderate over time. The capital budget is approximately $23 million annually for the next three years, roughly equal to the system's depreciation expense.

UHS has a relatively conservative debt structure with 82% fixed-rate debt. The variable series 2010 bonds issued as a direct bank purchase have a 2043 final maturity, but the bank has a right to call the bonds in 2017. Fitch views the organization's $211 million of unrestricted cash and investments as a sufficient hedge against this risk. Fitch notes UHS's conservative asset allocation with approximately 70% of investments in fixed income. UHS has one fixed-to-variable-rate swap ($176 million notional par) with a negative mark-to-market of $4.4 million as of the end of December 2013 and no collateral posting was required ($10 million threshold).

Market Dynamics

UHS operates in a competitive market; its major competition is Covenant Health (rated 'A' by Fitch) and Tennova (subsidiary of HMA), which is in the process of being acquired by Community Health System. UHS was able to increase its market share in each of the last five years and its 15% market share is the highest of any individual hospital in the Knoxville market. While the area is competitive and may become more so with CHS's entry into the market, it is more likely that initially the competitive pressure will focus more on Covenant Health, as some of the Tennova and Covenant's facilities share medical staffs. UHS also has the broadest array of services, some of which are unique, and a closed, highly aligned medical staff of close to 500 physicians located on the UHS campus. In preparation for population care management, the organization has put major focus on quality, efficiency and standardization of processes, with approximately 60% of all care processes under standardized pathways by end of 2014.

Disclosure

UHS covenants to provide bondholders with annual and quarterly financial disclosure through the Municipal Securities Rulemaking Board EMMA system. UHS also provides management discussion and analysis and utilization statistics with their quarterly financials.

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)

--'Revenue-Supported Rating Criteria' (June 3, 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

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=709499

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=816970

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.

Fitch Ratings, Inc.
Primary Analyst
Eva Thein, [phone]
Senior Director
Fitch Ratings, Inc.
One State Street Plaza
New York, NY 10004
or
Secondary Analyst
Jennifer Kim, [phone]
Committee Chairperson
or
Emily Wong, [phone]
Senior Director
or
Media Relations
Elizabeth Fogerty, [phone]
[e-mail]