Fitch Affirms Cottage Health System's (CA) Rev Bonds AA-; Outlook Stable

Fitch Ratings has affirmed the 'AA-' rating on the following revenue bonds issued on behalf of Cottage Health System (Cottage):

--$280,230,000 California Statewide Communities Development Authority fixed-rate revenue bonds series 2010;

--$47,980,000 California Health Facilities Financing Authority fixed rate revenue bonds series 2003B.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a pledge of gross revenues of the obligated group. The obligated group accounted for 95% of total revenue and 80% of total assets of the consolidated entity in fiscal 2013 (Dec. 31 year end). Fitch's analysis is based on the consolidated entity.

KEY RATING DRIVERS

SOLID FINANCIAL PROFILE: Cottage's financial profile is solid with strong profitability, good debt service coverage and a rebound in liquidity after heavy capital spending. The majority of Cottage's financial metrics exceed Fitch's AA category medians.

DOMINANT MARKET POSITION: Fitch believes that Cottage's dominant market position is a key credit strength. As the only major provider of acute health care services in the Santa Barbara region, Cottage maintains a strong market position of over 80% in its primary service area.

MAJOR CAPITAL INVESTMENT UNDERWAY: Cottage is nearing the completion of its master facilities plan, which included a significant rebuilding of its Santa Barbara Cottage Hospital and the replacement of its Goleta Valley Hospital. The remaining spend totals approximately $246 million of which more than half will be funded by its related foundations. Cottage recently decided to invest in Epic, which will be an additional capital outlay mainly in 2015 and 2016.

RELATED FOUNDATIONS: Cottage is affiliated with four separately incorporated charitable foundations, Santa Barbara Cottage Foundation, Goleta Valley Cottage Hospital Foundation, Santa Ynez Valley Hospital Foundation, and Rehabilitation Hospital Foundation. The sole purpose of the foundations is to provide support to the respective hospitals and the foundations provided funding for $291 million of Cottage's $925 million master facilities plan.

RATING SENSITIVITIES

AFFILIATION WITH LARGE PHYSICIAN GROUP: Cottage has been in the process of further integrating with the largest multispecialty physician group in town, Sansum Clinic. The transaction is currently under review by the FTC and could close by the end of the year. Cottage may issue additional debt if the affiliation occurs. Fitch will evaluate the impact of this transaction on Cottage's rating when details are finalized.

CREDIT PROFILE

Cottage consists of Santa Barbara Cottage Hospital (SBCH; 450 licensed beds), Goleta Valley Cottage Hospital (GVCH; 122 licensed beds) and Santa Ynez Valley Cottage Hospital (11 licensed beds) all located in southern Santa Barbara County, California. Total revenue in 2013 was $697 million.

CREATING AN INTEGRATED DELIVERY SYSTEM

Cottage enjoys a dominant market position as the only major provider of acute health care services in the desirable and affluent Santa Barbara region with 88.2% market share in its primary service area. Cottage has had a close working relationship with Sansum Clinic, the large multispecialty physician group (160 physicians), in town and the two organizations have been working toward a closer alignment strategy over the last several years. The contemplated structure would result in the creation of a medical foundation and common governance and management. Fitch views this affiliation favorably as it better positions the organization to coordinate care and manage population health.

STRONG PROFITABILITY

Operating cash flow has been consistently strong due to good revenue growth from increased volume, favorable contracting, and continued cost management. Operating EBITDA margin was 17.1% in 2013 compared to 12.6% in 2012 and 11.4% in 2011. There was a significant increase in depreciation and interest expense in 2012 as the majority of its master facilities plan at SBCH came on line. Operating margin was 8.1% in 2013 compared to 3.3% in 2012 and 6.9% in 2011. Through the three months ended March 31, 2014, operating margin and operating EBITDA margin were 9.9% and 18.3%, respectively and performance is ahead of budget.

Fitch notes that Cottage's profitability is impacted by the timing of the California provider fee program. The various components of the program get approved at different times and the revenue from the fee lags the expense. Although Cottage is a net beneficiary from the program, the impact on the financials was negative $7 million in 2012 and positive $13 million in 2013. It is expected that 2014 will also exhibit a lag effect and portray a loss on the provider fee program.

REBOUND IN LIQUIDITY

Cottage's balance sheet has rebounded after spending on its master facilities plan and metrics are now back in line for a AA category credit. Unrestricted cash and investments at March 31, 2014 was $528.9 million and translated to 360.4 days cash on hand and 161.2% cash to debt compared to the AA category median of 254.3 and 173.6%. Liquidity growth has been driven by strong operating cash flow and good investment returns. Cottage is currently analyzing its investment policy and may make minor changes to its investment strategy as the organization is nearing the completion of its master facilities plan.

MAJOR CAPITAL SPENDING UNDERWAY

Cottage is nearing the end of its extensive master facilities plan, which has a total cost of $925 million and includes rebuilding SBCH ($811 million) and GVCH ($114 million) to modernize the facilities and meet seismic requirements.

The sources of funding include $325 million of series 2003 and 2010 bonds, $309 million from cash and cash flow and $291 million from the Foundations. Major elements of these projects include the construction of three 100-bed patient pavilions at SBCH and a replacement facility at GVCH. SBCH brought two new inpatient pavilions online in February 2012 and the third pavilion and an expanded emergency room is currently being constructed and is expected to be completed at the end of 2018 and open in early 2019. The remaining spend totals $246 million from 2014 - 2018 for the project. Other capital needs include routine capital expenditures that total $123 million from 2014 -2018 as well as its investment in Epic. The cost of Epic is yet to be finalized as Cottage is still in contract negotiations. Fitch views the investment in Epic favorably as Sansum Clinic is already on Epic and Cottage plans to offer the same platform to independent physicians. Capital spending is expected to impact liquidity; however, Fitch expects this to be temporary.

CONSERVATIVE DEBT PROFILE

Cottage has $328 million of total debt outstanding, which is 100% fixed rate. Cottage retained three fixed payer swaps after the refinancing of its variable rate debt to fixed rate debt in 2010. In addition, Cottage has one fixed receiver swap. The swaps have a notional amount of $227 million and no collateral is being posted at this time.

Cottage's debt burden is moderately high with MADS accounting for 3.2% of total revenue in 2013, but has declined from 3.9% in 2010. MADS is $22 million and debt service is level. Debt service coverage is solid due to strong profitability and debt service coverage by EBITDA was 6.4x in 2013 compared to 4x in 2012 and 5.3x through the three months ended March 31, 2014 and the AA category median of 5x.

DISCLOSURE

Cottage covenants to provide annual audits within 150 days of fiscal year end and quarterly disclosure within 75 days of quarter end for the first three quarters.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Nonprofit Hospitals and Health Systems Rating Criteria' (May 20, 2014).

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=746860

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=843317

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