Fitch Rates Covenant Health (TN) Revs 'A'; Outlook Stable

Fitch Ratings has assigned an 'A' rating to approximately $187.6 million of series 2016A hospital revenue bonds expected to be issued by The Health, Educational and Housing Facility Board of the County of Knox (TN) on behalf of Covenant Health (Covenant).

Proceeds from the series 2016A bonds will be used to refund Covenant's series 2002D auction rate securities and series 2006A capital appreciation bonds, and finance the construction of expansions, improvements and renovations to several of Covenant's regional hospitals. The series 2016A bonds will be issued as long-term fixed rate obligations and are expected to sell via negotiated sale the week of Oct. 31.

In addition, Fitch has affirmed the 'A' long-term rating on the following revenue bonds issued by the board on behalf of Covenant:

--$87.8 million auction rate securities series 2002D;

--$44.7 million capital appreciation bonds series 2006A;

--$125 million variable rate direct bank loan series 2006B;

--$50.2 million variable rate direct bank loan series 2011A;

--$50.2 million variable rate direct bank loan series 2011B;

--$135.5 million variable rate direct bank loan series 2011C;

--$107.6 million fixed rate bonds series 2012A.

The Rating Outlook is Stable.

SECURITY

Debt payments are secured by a pledge of the gross receipts of the obligated group. There is also a springing mortgage on Fort Sanders Regional Medical Center and Parkwest Medical Center in the event of default. It is important to note, however, that the springing mortgage is a provision of the insured bonds, series 2002D and 2006B. Once the 2002D bonds are refinanced, this lien will only be effective as long as the 2006B bonds are outstanding. Covenant is currently seeking both the insurer's consent and bank consent (if needed) to remove the springing mortgage provision from the series 2006B bonds.

KEY RATING DRIVERS

STRONG LIQUIDITY: Covenant's strong liquidity metrics continue to be one of its key credit strengths. At June 30, 2016, unrestricted cash and investments totaled $1.2 billion, generating liquidity ratios well in excess of 'A' category medians.

IMPROVING PROFITABILITY: Despite operating challenges, profitability has been on an improving trend, with operating margin increasing to 3.2% in fiscal 2015, from 2.9% in 2014 and 1.3% in 2013. This improvement can be attributed both to growth in net patient revenues, in addition to cost control initiatives. Fitch expects that Covenant will maintain positive operations over the long term.

STABLE MARKET LEADERSHIP: Despite operating in a competitive service area, Covenant continues to be a leading provider with market share above 55% in its primary service area.

REGIONAL EXPANSION: Covenant completed two acquisitions in early 2014; Cumberland Medical Center and Claiborne County Hospital. With nine hospitals, Covenant is the largest health system in eastern Tennessee and its growing network should continue to support its market position.

NEW CAPITAL PROJECTS: The series 2016A issuance will net $120 million in new money debt, the proceeds of which Covenant will use for renovation and expansion projects at several of its regional hospitals. Fitch believes these projects and associated costs are manageable and will effectively address capacity issues at these facilities.

WEAKENED PRO FORMA DEBT BURDEN: Pro forma debt-to-capitalization of 40.9% and maximum annual debt service (MADS) coverage of 2.4x at June 30, 2016 compare unfavorably against 'A' category medians. However, Fitch notes positively that the 2016A transaction will reduce Covenant's variable rate debt exposure to 53% of its total debt from 77% currently. Improvements in profitability and liquidity metrics offset concerns about the increased debt burden.

RATING SENSITIVITIES

SUSTAINED OPERATING IMPROVEMENTS: Fitch expects Covenant Health to continue producing positive operating and financial results. Continued revenue growth, improvement of operating profitability and moderation of Covenant's pro forma debt burden could give the rating upward momentum.

CAPITAL IMPROVEMENTS: Fitch expects Covenant to complete its planned new capital projects on time and on budget. Significant deviations in timeline or cost of the projects, or an unanticipated need for regulatory approval could negatively impact the rating.

CREDIT PROFILE

Covenant Health consists of nine hospitals with 1,928 licensed beds located throughout 23 counties that make up the Knoxville metropolitan service area, and several other healthcare related organizations.

The obligated group includes the Covenant Health parent corporation, Fort Sanders Regional Medical Center, Parkwest Medical Center, Methodist Hospital Center of Oak Ridge, LeConte Medical Center, Fort Loudon Medical Center, The Thompson Cancer Survival Center, and Covenant Home Care. As of fiscal year-end Dec. 31, 2015, the obligated group represented 76% of total operating revenues and 86% of total assets. Fitch reviews the consolidated system's results, which generated total operating revenues of $1.2 billion in fiscal 2015.

EXCELLENT LIQUIDITY

Covenant's strong liquidity position remains one of its primary credit strengths. At June 30, 2016, unrestricted cash and investments totaled $1.2 billion, up over $20 million from fiscal year end 2015. Liquidity metrics are very strong with 384 days cash on hand, 27.7x cushion ratio, and 149.2% pro forma cash to debt, all of which compare favorably to the 'A' category medians of 215.5 days, 19.4x and 148.6%. As the organization relies on its robust balance sheet to offset risks related to operating variability and increasing debt burden, maintenance of a strong liquidity position is essential.

STABLE MARKET LEADERSHIP

Despite operating in a competitive service area, Covenant's market share has shown incremental improvement over the past three years. Including Cumberland and Claiborne, market share in the primary service area was 55.7% in 2014, up from 54.1% in 2013. Market share in the combined primary and secondary service areas has also improved to 39.6% in 2014 from 38.3% the year prior. Fitch expects Covenant's comprehensive geographic coverage combined with its physician employment strategies and favorable status with regional health insurers to continue to support Covenant's leading market position.

IMPROVING PROFITABILITY

Profitability has been on an improving trend over the last three years, with operating margins increasing to 3.2% in fiscal 2015, from 2.9% in 2014 and 1.3% in 2013. Through the six-month interim period ended June 30, 2016, operating margin was -0.6% compared to -0.7% in the same prior year period. This performance is in line with historical performance, in that the second half of the year is typically Covenant's most profitable period. A number of adjustments will be made at year-end, as in prior years, and management expects to end fiscal 2016 with another positive operating margin.

Fitch notes favorably that this trend of profitability has been achieved against the backdrop of operating challenges, specifically pertaining to nursing staff. In fiscal 2015, Covenant experienced 21.2% turnover, 13.1% vacancy rate and $3.9 million agency expense, related to its nursing staff. This trend continued in the first six months of fiscal 2016, with a 21.5% turnover and 15.0% vacancy rate in its nursing staff and recognition of $4.2 million in agency expenses. Salaries and benefits represented 48.3% of total system revenues in fiscal 2015.

In response, Covenant has implemented more active recruiting and retention strategies, including partnerships with area schools and use of social media to identify qualified candidates. Management also introduced cost reduction initiatives, which Fitch believes will allow Covenant to maintain positive operations over the long term.

DEBT PROFILE

Following the series 2016A transaction, Covenant will have $815 million in pro forma long-term debt outstanding. The series 2016A bonds will add $120 million in net new money debt, the proceeds of which will be used to fund renovation and expansion projects at several of Covenant's hospitals. The addition of the new money debt will cause pro forma MADS to increase to $44 million from $42 million currently.

The balance of the proceeds from the series 2016A bonds will be used to refund the series 2006A capital appreciation bonds and, combined with a direct bank loan Covenant expects to obtain from First Tennessee Bank, its series 2002D auction rate securities. The net result of this debt restructuring will be to reduce Covenant's variable rate debt exposure to 53% of its total debt from 77% currently, in addition to realizing net present value savings of approximately $30 million on the series 2006A refunding. Fitch views this debt restructuring positively.

Pro forma leverage metrics remain weak for the category at 40.9% pro forma debt-to-capitalization and 3.6% pro forma MADS to total revenues as of June 30, 2016, relative to Fitch's 'A'-rated category medians of 36.0% and 2.7%, respectively. Pro forma MADS coverage of 2.4x as of the six-month interim also compares unfavorably to 'A' category medians. Improvements in profitability and liquidity metrics offset concerns about the increased debt burden.

Covenant has one fixed payor swap acquired from Cumberland. The swap has an outstanding notional amount of $35.8 million and terminates in 2017.

DISCLOSURE

Covenant discloses annual financial statements within 120 days and quarter unaudited financial statements within 60 days through the MSRB 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

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