Fitch Affirms Methodist Hospitals, IN’s Revs at ‘BBB’; Outlook Stable - July 22, 2016

Courtesy of Financial Buzz • July 22, 2016

Fitch Ratings has affirmed the ‘BBB’ rating on the following Indiana Finance Authority bonds, issued on behalf of The Methodist Hospitals (TMH):

–$45.2 million revenue refunding bonds, series 2014A.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a pledge of gross revenues and a debt service reserve fund.

KEY RATING DRIVERS

OPERATING PROFILE SUPPORTS THE ‘BBB’ RATING: The Methodist Hospitals’ (TMH) operating results and liquidity metrics are stable and consistent with the ‘BBB’ rating. Operating margin of 1.6% and operating EBITDA of 8.4% for fiscal 2015 (ended Dec. 31, 2015) are slightly above the 0.6% and 7.7%, respectively, for the category median. Similarly, days cash on hand (DCOH) of 185.7 compares favorably to the 161.5 median days. Fitch expects these metrics to weaken modestly in 2016, but remain adequate for the rating.

LIGHT DEBT BURDEN: TMH’s debt position is low as reflected in strong cash-to-debt of 221.6%, 2.1% maximum annual debt service (MADS) as a percent of revenue, and solid MADS coverage of 4.8x, all considerably stronger than the ‘BBB’ category medians. These metrics will strengthen further after 2016 when MADS decreases from $7 million to $6 million. TMH does not have current plans for additional debt at this time although longer-term capital plans may result in future financing needs.

PAYOR MIX LIMITS PROFITABILITY: TMH has an unfavorable payor mix with approximately 76% of gross revenues from government payors and consequent dependence on supplemental funding. Indiana’s Medicaid expansion waiver will likely mean reduced exposure to supplemental funding over time, partially offset by an increase in Medicaid revenue.

PENDING CAPITAL AND STRATEGIC NEEDS: With a high age of plant (17.2 years), TMH has pending capital needs and ambulatory/ physician growth strategies that it needs to fund to remain competitive. Due to its limited EBITDA generating capacity, TMH may either issue debt or partner with another hospital or health care system to address these needs. The system has already begun the first phase of its master facility plan with key projects at its Northlake campus.

RATING SENSITIVITIES

POSSIBLE AFFILIATION OR MERGER: The Methodist Hospitals’ (TMH) board has recently made the decision to explore the possibility of partnering with another provider and is beginning the due diligence process. The rating impact of any affiliation or merger will be determined once the partner and terms are available for Fitch’s review.

FUTURE CAPITAL PLANS: If a partner is not selected in the near future, TMH may continue to fund its capital expenditures with a combination of debt and equity. While TMH’s financial profile could absorb incremental debt, additional clarity on TMH’s capital and debt plans is needed to determine if it presents stress to the ‘BBB’ rating.

CREDIT PROFILE

Serving northwest Indiana, TMH operates a 302-bed acute care facility in Gary, IN (Northlake campus), a 313-bed acute care facility in Merrillville, IN (Southlake campus), and various other clinical entities. The two campuses are 14 miles apart. The primary service area for Northlake is Gary and northern Lake County communities, and the primary service areas for Southlake include Merrillville, Hobart, and Crown Point. Total revenues for 2015 were $335.5 million, excluding investment losses.

NEW STRATEGIC DIRECTION

TMH’s evaluation of how best to remain competitive in its service area has led it to assess whether it should remain an independent provider. In June, the board embarked on a process to evaluate if a potential partnership or merger will allow TMH to accelerate its strategic plans while meeting the local healthcare needs of its community. Management reported that there are a number of interested parties and a decision may be announced before the end of the year.

Fitch believes that a larger partner may provide additional resources and financial flexibility to address the capital and strategic needs of the system. While TMH maintains adequate profitability and balance sheet strength, it has limited cash flow available for reinvestment because of its challenging payor mix. TMH does, however, have debt capacity to finance part, or all, of its capital plan, depending on the final amounts.

TMH needs to reinvest to remain competitive as it has a limited market share and faces significant competition from Community Health Care System and other providers in northwest Indiana. Part of its strategic objectives focuses on ambulatory expansion and growing its employed physician base. TMH is targeting a growth of approximately 10 employed physicians per year to replace retiring physicians and to align with physicians in the area, most of whom are split admitters. The number of employed physicians grew from 43 in fiscal 2015 to 55 currently employed providers.

In addition, TMH is opening its first two urgent care sites this year. The first opened in Crown Point (in Southlake’s primary service area) in June and the second location in Merrillville is expected to open before year end. With the shift to outpatient services and decreasing inpatient utilization, TMH’s ability to capture higher-margin ambulatory services in areas with more commercial payers is crucial to its future financial viability.

MASTER FACILITY CAPITAL PROJECTS

Capital spending in 2016 will be slightly elevated as TMH is completing the first two projects of its master facility plan: the $12 million renovation and expansion of the emergency room and intensive care unit at the Northlake campus. Capital spending will decrease from $30 million in 2016 (consuming most of the $34 million in annual EBITDA generated in 2015; 2016 EBITDA is expected to be less) to $20-$25 million for routine capital in 2017.

In addition, management is considering other expansion and renovation projects, including the renovation of all patient rooms and nurses stations at Northlake, a new medical office building for outpatient services in Northlake and a new patient tower at Southlake. These projects may cost as much as $80 million, but no decision has been made as to timeframe or plan of financing. TMH may fund and/or finance these projects on its own while preserving balance sheet strength, which is one of management’s goals.

CONSISTENT OPERATING RESULTS

Operating results have stabilized over the past couple of years at a level of approximately 8-8.5% operating EBITDA margin. Operating margin of -0.1% and operating EBITDA margin of 7% in the five months of fiscal 2016 (ended May 31) slightly trail the 0.4% and 7.8%, respectively, in the same period in 2015 due to higher expenses related to the claims and expenses for its self-insured employee health plan. Management will be implementing certain changes to control the self-insured expense in the new 2017 plan year. Even with a slower start in fiscal 2016, management expects to achieve an operating margin of 1% by year-end as the second half of the year is historically stronger than the first half. However, 2016 will be slightly weaker than 2015 as there were one-time revenues from cost report settlements that helped augment 2015 results.

Long-term pressure continues from TMH’s reliance on supplemental revenues, which are being pressured under health care reform. With Medicaid expansion partially offsetting reduced DSH payments, Fitch expects Medicaid reimbursement combined with Medicaid DSH payments to be neutral to slightly negative for TMH in the future. In 2015, TMH received $40.3 million in Medicaid DSH and net provider tax payments, but management expects this number to decrease to approximately $36 million in 2016.

TMH’s liquidity position remains a key credit strength. DCOH as of May 31, 2016 was 178.8 days, slightly below the 185.5 days for the comparable interim period in 2015. As of May 31, TMH had $152.7 million in unrestricted cash.

CONSERVATIVE DEBT PROFILE

TMH had $68.3 million in fixed rate long-term debt and capital lease obligations as of fiscal year end 2015. Leverage is low, with MADS as a percent of revenues at 2.1% in 2015 and year-to-date in 2016. Debt to EBITDA in fiscal 2015 was a low 2.1x, well below the ‘BBB’ category median of 3.9x. TMH’s defined benefit pension plan has been frozen since 2005 and is currently funded at a manageable 82% (on a GAAP basis) based on a $22.5 million pension liability.

CONTINUING DISCLOSURE

TMH covenants to disclose audited financial statements within 150 days of fiscal year end. Annual disclosure is posted to the Municipal Securities Rulemaking Board’s EMMA system. While TMH does not covenant to disclose quarterly statements, it does so voluntarily to bondholders via EMMA. Quarterly disclosure includes balance sheet, income statement, statement of cash flows, utilization, and management discussion and analysis.

Additional information is available at ‘www.fitchratings.com’.

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Nonprofit Hospitals and Health Systems Rating Criteria (pub. 09 Jun 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=866807

Additional Disclosures

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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1009305

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