Fitch Ratings has downgraded the following outstanding bonds issued by Palomar Health, CA (Palomar) to 'BB+' from 'BBB-'.
Series 2016 and 2017 refunding revenue bonds;
Series 2007A, 2009A 2010A general obligation (GO) bonds,
Series 2017 and 2021 issued by California Municipal Finance Authority on behalf of Palomar Health, and 2022 (taxable), 2022 COPs.
Fitch has also downgraded Palomar's Issuer Default Rating (IDR) to 'BB+' from 'BBB-' and its series 2016A & B unlimited tax GO (ULTGO) bonds to 'A' from 'A+'.
The Rating Outlook is Negative for all series of debt.
RATING ACTIONS
Entity / Debt
Rating
Prior
Palomar Health (CA)
LT IDR
BB+
Downgrade
BBB-
Palomar Health (CA) /General Obligation - Unlimited Tax - Dedicated Tax/1 LT
LT
A
Downgrade
A+
Palomar Health (CA) /General Obligation - Unlimited Tax/1 LT
LT
BB+
Downgrade
BBB-
Palomar Health (CA) /General Revenues/1 LT
LT
BB+
Downgrade
BBB-
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VIEW ADDITIONAL RATING DETAILS
The rating downgrade to 'BB+' reflects Palomar's challenged financial performance over the past 18 months. This resulted in an operating income loss of approximately $44.5 million (negative 4.2% operating margin and 9.5% operating EBITDA margin) in fiscal 2023 (June 30; audited), which is inclusive of tax-supported revenues and expenses. The weaker performance was driven by various factors, including declining volumes, heightened labor and supplies expenses that are primarily related to post-pandemic inflationary pressures, and programmatic delays. The district's debt burden is very high, which is characterized as weak with an 26.2% unrestricted cash to adjusted debt position and 93.6% debt to capitalization ratio (exclusive of the GO bonds).
The downgrade of Palomar's ULTGO bonds to 'A' reflects Fitch's assessment that the pledged revenues for repayment of these bonds meet the definition of 'pledged special revenues' under the U.S. Bankruptcy Code. As such, the bond's security protections warrant a rating of up to five notches higher than the district's IDR.
The Negative Outlook incorporates the persistent operational challenges Palomar confronts as management navigates through a period of financial uncertainty. If management is able to succeed on a number of strategic and operational priorities, which would result in improved operating performance and improvements to unrestricted balance sheet resources, a return to a Stable Outlook would be considered.
Credit strengths include the district's sizable market position, historical track-record of good cashflow generation, and diverse tax base. The unlimited nature of the tax levy offsets potential risk regarding tax base volatility.
SECURITY
The revenue bonds are secured by a gross revenue pledge (excludes restricted property tax revenues) of the obligated group (OG). The OG consists of PH's acute care facilities, Palomar Health Medical Group (PHMG) and other healthcare-related entities. The GO bonds are secured by unlimited ad valorem taxes (ULT) levied on all taxable property within the district.
KEY RATING DRIVERS
Revenue Defensibility - 'bbb'
Sizeable Market Position in Competitive Service Area; Pressured Volumes Impacting Performance
Palomar's midrange revenue defensibility reflects the organization's sizeable market position, good breadth of services in an expanding service area, and high but relatively manageable exposure to Medi-Cal and self-pay, which accounted for more than 26% of gross revenues in fiscal 2023. The district maintains a sizeable market position in its primary service area (approximately 42% as of 2021), which has been historically supported by strategic partnerships with Rady Children's Hospital for pediatrics and Kindred Healthcare for rehabilitation and behavioral health.
Palomar's primary competitors are Scripps Health, Sharp HealthCare, Kaiser Permanente, and University of California - San Diego Health. The district's market share has declined over the last several years, while competitors' market positions have remained stable or improved, which Fitch views as a potential credit risk. With the intense competition for services, volumes have declined in discharges, outpatient surgeries, and emergency department visits, which have all negatively impacted overall financial performance.
Fitch still views Palomar's healthcare services as essential to North San Diego County as the district maintains the only trauma center, NICU and inpatient behavioral health unit within the county boundaries. The district serves the communities within an 800-square-mile area, with its trauma center covering more than 2,200 square miles of South Riverside and North San Diego counties. However, Fitch will continue to monitor the trajectory of the organization's market presence and volume trends, as well as the subsequent impact upon performance.
Ad valorem tax revenues do not improve Palomar's revenue defensibility because of the limited contribution to operations and the lack of an available taxing margin. As such, Fitch does not view Palomar's taxing margin as a revenue enhancement. Total tax revenues collected in fiscal 2023 totaled nearly $70 million, of which $48 million was levied to support debt service payments of the GO bonds.
Operating Risk - 'bbb'
Challenged Financial Performance; Satisfactory Investment in Plant
The midrange operating risk assessment reflects the organization's weaker profitability and cash flow metrics, which resulted in a 9.5% operating EBITDA margin for fiscal 2023, and down from 13.3% in fiscal 2022. Additionally, operational performance six-months through fiscal 2024 (Dec. 31, 2023; unaudited) has continued to trend weaker with Palomar recording a loss from operations of approximately $46.3 million, which translated into a negative 9.0% operating margin and 5.1% operating EBITDA margin. Fitch views the weakened and declining operating performance as a primary credit concern.
The operational challenges are due to various factors, including pressured volume trends, heightened expenses primarily from labor and supplies, and programmatic delays that have caused both expense increases and failure to meet budgeted revenues. Management plans to stabilize and improve operating performance, which if successfully achieved would help bolster operational performance and unrestricted balance sheet resources from current levels. Plans include curtailing expenses through closing certain programs, restructuring supply chain, and reducing some personnel positions.
Historically, Palomar was able to consistently maintain healthy operating performance, demonstrated by stronger operating EBITDA margins and EBITDA margins. From fiscal 2019-2022, it produced an average operating EBITDA margin of approximately 10.5%, which Fitch viewed favorably. Historical net capex has been satisfactory for the rating level with the organization spending an average of around 63% of annual depreciation expense from fiscal 2019-2022. Fiscal 2023 marked a high of capex with the organization investing approximately $82.8 million in plant (approximately 140% of depreciation), which Fitch views as a credit positive. The district's facilities are largely seismically compliant. Fitch analysts have toured the main facility in Escondido and view the campus as up-to-date.
Financial Profile - 'bb'
High Leverage Position; Declining Unrestricted Balance Sheet Resources
Palomar's weaker financial profile reflects its high debt profile and declining unrestricted balance sheet resources; however, the risk is somewhat mitigated by unlimited ad valorem property taxes to support debt service payments on the GO bonds, which constitute approximately 50% of the district's long-term debt.
Palomar's weak financial profile assessment excludes the district's GO debt. Included within total long-term debt are the organization's lease obligations, which have increased over time. Palomar only has a debt service coverage financial covenant, which was in compliance in fiscal 2023.
In fiscal 2023, Palomar had approximately $203.1 million of unrestricted cash and investments, which translated into 71.2 days' cash on hand and 15.5% cash-to-adjusted debt, which includes the GO debt. Exclusive of the GO debt, cash-to-adjusted debt is still weak but slightly improved to 26.2% as of fiscal 2023. Through the six-month interim period in fiscal 2024, unrestricted balance sheet resources further declined to an absolute balance of approximately $103.5 million, which has negatively impacted Palomar's liquidity metrics.
Fitch's forward-looking analysis shows the district's financial profile metrics being relatively stable to exhibiting slight improvement if management is able to successfully implement its various strategic initiatives and operational improvements. Following the initial revenue and portfolio stress of Fitch's scenario analysis, Fitch anticipates cash-to-adjusted debt remaining consistent with a 'bb' assessment and remain weak for the medium term.
Dedicated Tax Key Rating Drivers
The ULTGO bond rating is based on a dedicated tax analysis that considers the strength and growth prospects of the tax base, as well as the legal structure of the bonds. The bonds' structural elements and security features are sufficiently strong to warrant a rating up to five notches above the district's IDR.
Strong Tax Base: The economic resource base supporting the GO debt is diverse, growing at a healthy pace and has been very stable through the recent downturn related to the pandemic. The unlimited nature of the tax levy offsets any concern about tax base volatility.
RATING SENSITIVITIES
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade
If operating performance continues to slide resulting in further compressed margins, which negatively impacts the organization's ability to adequately reinvest in its physical plant;
If capital-related metrics (unrestricted cash to adjusted debt and debt to capitalization) materially decline from current levels;
If the district experiences a significant and long-lasting decline in the local economy and tax base resulting in material deterioration of the hospital's payor mix and tax revenue support.
Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade
If operating performance significantly improves and Palomar is able to consistently generate operating EBITDA margins around 10%-11% for a sustained period, which would support unrestricted balance sheet resource accretion;
Material improvements in Palomar's liquidity levels resulting in a consistent cash-to-adjusted debt metric of greater than 60% (exclusive of GO debt).
PROFILE
Palomar Health is California's largest public healthcare district. It is the largest trauma district in the state, covering 800 square miles in northern San Diego County. The district owns and operates two hospitals in northern San Diego County: the 286-bed Palomar Medical Center Escondido (PMCE, opened in August 2012) and the 95-bed Palomar Medical Center Poway (PMCP, opened in 1977). Palomar also owns and operates The Villas at Poway, a 129-bed skilled nursing facility adjacent to PMCP. Other related entities include PHMG, the largest health network in the region with 318 providers. PHMG is comprised of a medical foundation whose physicians operate in 19 clinics.
Fiscal 2023 (June 30 YE) total revenue was more than $1 billion, which included approximately $22 million of unrestricted property tax revenues to support operations and $48 million of restricted property tax revenues for debt service payments on the GO bonds.
Sources of Information
In addition to the sources of information identified in Fitch's applicable criteria specified below, this action was informed by information from Lumesis.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG Considerations
The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.
Additional information is available on www.fitchratings.com
PALOMAR HOLDINGS, INC. 
