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Fitch Downgrades Covenant Health, MA (dba Covenant Health System) Revs to 'A-'; Outlook NegativeFitch Ratings has downgraded to 'A-' from 'A' various series of bonds issued on behalf of the obligated group of Covenant Health (CH) by the Massachusetts Development Finance Agency, the Massachusetts Health & Educational Facilities Authority, and the New Hampshire Health & Education Facilities Authority. The Rating Outlook remains Negative.
SECURITY KEY RATING DRIVERS WEAKER PERFORMANCE PERSISTS: The downgrade reflects CH's very thin operating margins for the rating category. CH generated approximately breakeven operating margins over the last four audited years, including a negative 1.5% in fiscal 2015. Its operating EBITDA margin averaged a weak 5.6% over the same period, relative to a median of 10.3%, and maximum annual debt service (MADS) coverage averaged 2.6x relative to Fitch's 'A' category median of 4.2x. NEGATIVE OUTLOOK: The Negative Outlook reflects the continued weakness in CH's performance, although it has improved slightly in 1Q2016, the potential for a debt issuance to fund an information technology installation, and the execution risk on a number of initiatives that CH is undertaking to improve its performance. STRONG LIQUIDITY: Most of CH's unrestricted liquidity metrics are on the upper end of the 'A' category. The 'A-' rating is based largely on the strength of CH's unrestricted liquidity, which Fitch views as providing financial flexibility as CH addresses its operating challenges, even as the financial performance remains materially below 'A' category medians. MIXED MARKET POSITION: CH has some geographic and revenue diversity, operating in five states from Pennsylvania to Maine, while providing a full continuum of care ranging from acute care to long-term care services. However, CH operates in fairly competitive markets, especially its three acute care hospitals. Two are in Maine, which has not expanded Medicaid, and none of the three are the market share leader in their respective markets. RATING SENSITIVITIES IMPROVEMENT INITIATIVES UNDERWAY: Covenant Health System (CH) is implementing a number of revenue and expense initiatives aimed at improving performance. Successful execution of these initiatives is critical for CH to be able to maintain its current 'A-' rating and for future revision of the Outlook to Stable. POTENTIAL DEBT ISSUANCE: CH is in the process of implementing an Epic software installation that would likely require additional debt or the use of a sizable equity contribution. Negative rating pressure could also potentially result from the final funding structure for the project and CH's operational performance at that time. CH has little debt capacity, given the current level of its financial performance.
CREDIT PROFILE The obligated group made up only approximately 58% of total assets and 40% of total revenues of the system in fiscal 2015. Fitch's analysis continues to be based on the consolidated system, which had total revenue of $613.2 million in fiscal 2015.
Financial Performance CH is implementing a larger turnarond plan to improve operations, including initiatives around supply and revenue cycle. The effort is being assisted by the use of consultants. The results of these initiatives should further improve CH's financial results. In addition to the focus on operational improvement, CH is moving forward on a number of other system initiatives including enhancing its clinical relationships with other hospitals, which has helped CH recruit physicians in key service lines such as cardiology and orthopedics; creating an integrated physician network to broaden its physician alignment with both employed and community physicians; and centralizing other services and corporate functions for greater efficiencies. Fitch views these initiatives positively and as an appropriate response to changes in the healthcare environment. Fitch's concern is that implementation of the initiatives is occurring simultaneously while CH is also aiming to improve its financial performance. Further concern relates to an expected large IT implementation project expected to begin within the next year. Investments in new IT systems have proven to be strategically and economically accretive for health systems once fully operational, but there is a sizable capital cost and often near term stress on financial performance during implementation and rollout. CH management has stated that it would need to see operational improvement before it would move forward on issuing debt for the IT project. However, the Negative Outlook reflects concerns regarding the project and the need to improve performance.
Liquidity a Key Credit Strength CH's strong liquidity position provides some financial cushion at the current rating level, as CH works to improve operations, as well as could be used as a resource to reduce the need to issue debt to fund the IT project. CH has very little debt capacity, given its thin debt service coverage metrics, unless its operational performance improves. However, Fitch will consider the strong balance sheet in its analysis should the turnaround plan take longer than expected to show results.
Debt Profile In addition, CH's debt burden is relatively manageable for the rating level. MADS as a percentage of revenue of 2.9% at March 31, 2016 compares well to Fitch's 'A' category median of 2.8%. However, debt to EBITDA was elevated at 5.8x, relative to a median of 3x, reflecting the weaker operating performance. CH's EBITDA MADS coverage was 1.9x and its operating EBITDA coverage was 1.6x in the first quarter of 2016, both of which trailed category medians. The relatively manageable debt burden as reflected in MADS as a percentage of revenue is a key credit factor, indicating that even a modest improvement in performance should be able to bring the debt to EBITDA metric more in line with the category median and increase the level of CH's debt service coverage.
Continuing Disclosure Additional information is available at 'www.fitchratings.com'.
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