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

Fitch Ratings has affirmed the 'A' rating on the following revenue bonds issued by the Health, Educational and Housing Facility Board of the County of Knox on behalf of Covenant Health (Covenant):

-- $21,250,000 fixed rate revenue bonds series 1993;

-- $94,200,000 auction rate securities series 2002D;

-- $67,332,674 capital appreciation bonds series 2006A;

-- $125,000,000 variable rate direct bank loan series 2006B;

-- $50,870,000 variable rate direct bank loan series 2011A;

-- $50,870,000 variable rate direct bank loan series 2011B;

-- $135,500,000 variable rate direct bank loan series 2011C;

-- $107,555,000 fixed rate bonds series 2012A.

The Rating Outlook is Stable.

Covenant also has outstanding $37,875,000 in series 2012B and $38,665,750 in series 2014A bonds, both of which are variable rate direct bank loans and not rated by Fitch.

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.

KEY RATING DRIVERS

STRONG LIQUIDITY: Covenant's strong liquidity metrics continue to be one of its key credit strengths. At June 30, 2014, unrestricted cash and investments totaled $1.1 billion, generating liquidity ratios well in excess of 'A' category medians. Maintenance of its strong liquidity position is necessary given historically low profitability.

WEAK BUT CONSISTENT PROFITABILITY: Profitability continues to be weak, with operating margin ranging from 0% to 1.3% in the last four fiscal years. However, overall metrics have been stable and have generated enough cash flow to fund capital expenditures and support liquidity growth. Management continues to implement strategies to enhance future profitability.

STABLE MARKET LEADERSHIP: Despite operating in a competitive service area, Covenant continues to be a leading provider with market share consistently above 54% in its primary service area.

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

MANAGEABLE CAPITAL NEEDS: Covenant's future capital needs are limited and management projects future capital spending to equal a manageable $50 million- $60 million per year or approximately 70% - 85% of depreciation expense.

MODERATING DEBT BURDEN: Debt metrics compare unfavorably against 'A' category medians, due to a relatively high debt burden and weak cash flows. However, debt burden has improved over the last three years and coverage of maximum annual debt service (MADS) has been stable at around 3x.

RATING SENSITIVITIES

STABILITY EXPECTED: Fitch expects Covenant to continue producing stable operating and financial results as the organization continues to integrate Cumberland and Claiborne into the system. Fitch believes Covenant's strong liquidity position provides some cushion against potential operating variability at the current rating, and that its growing revenue base will further moderate its debt burden in the near term.

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 health care related organizations. The obligated group includes five hospitals, which represented 82% of total operating revenues and 87% of total assets in the fiscal year ended (FYE) Dec. 31, 2013. Fitch reviews the system's consolidated results, which generated total operating revenues of $1.1 billion in 2013.

In fiscal 2014, Covenant acquired two regional hospitals. The six-month interim results include five months of Cumberland results and three months of Claiborne results.

Excellent Liquidity

Covenant's strong liquidity position remains one of its primary credit strengths. At June 30, 2014, unrestricted cash and investments totaled $1.1 billion, up over $125 million from one year prior. Liquidity metrics are very strong with 384 days cash on hand, 26.6x cushion ratio, and 150.6% cash to debt, relative to the 'A' category median of 199 days, 17x and 131.2%. As the organization relies on its robust balance sheet to offset risks related to relatively weak cash flows, maintenance of strong liquidity position is essential.

Continued Regional Expansion

Covenant continued to expand its operating footprint through the acquisition of two regional hospitals. Cumberland Medical Center is a 189 licensed-bed facility in the western part of Covenant's service area. Claiborne County Hospital and Nursing Home operates 85 acute care beds and 100 skilled nursing beds, and is located in the northern part of Covenant's service area. Management indicated that integration processes are underway and that neither hospital facilities will require major capital investments. Fitch views the regional growth as consistent with the organization's goals of geographic diversification and believes its growing network well positions the organization to manage the changing healthcare environment.

Stable Market Leadership

Despite a competitive service area, Covenant's market share remains very stable. Including Cumberland and Claiborne, market share in the primary service area was stable at around 54% for the last three years. Market share in the primary and secondary service areas combined is also stable at around 38.5% over the same period. Fitch expects Covenant's comprehensive geographic coverage combined with its physician employment strategies to continue supporting Covenant's market position.

Fitch notes the overall market has been consolidating, and the remaining main competitors are Tennova and University Health System. Tennova has undergone several ownership/leadership changes in recent years and is now owned by a for-profit system. Management indicated that the entrance of a for-profit provider in the market has not negatively impacted Covenant to date.

Weak Profitability

Covenant's operating performance has historically been weak for the rating category, although improved in 2013 due in part to receipt of meaningful use funds. Operating margin was 1.3% in fiscal 2013 and about breakeven in 2012, which is consistent with prior years. Through the six-month interim period ended June 30, 2014, operating margin was -1.6%, compared to -1.7% in the same prior year period. Management notes that the second half of the year is typically Covenant's most profitable period, and a number of adjustments will be made at year-end as in prior years. Management expects to end fiscal 2014 at near-breakeven operating margin. While unfavorable against category medians, Fitch recognizes that this approach has worked well historically and has produced operational and financial stability as well as robust liquidity growth for Covenant.

DEBT PROFILE

At June 30, 2014, Covenant had $746.4 million in long-term debt outstanding, which includes $38.7 million in series 2014A bonds issued to refinance Cumberland's outstanding debt. The 2014A bonds added approximately $2.5 million-$3 million to annual debt service. A high portion of outstanding debt accrues interest at a floating rate (74%) but does not face immediate put risk as all floating rate debt is either in auction rate mode or directly placed with a bank. Additionally, Management has a deliberate balance sheet management strategy to offset risks associated with its variable rate exposure in its debt profile by allocating a portion of its investments into a short term portfolio in high quality fixed income securities. The asset allocation strategy is designed to result in a return of the bond portfolio in excess of its total variable rate interest cost.

Leverage metrics are weak reflecting a high debt burden, as evidenced by 3.9% maximum annual debt service (MADS) as a percentage of revenues in 2013 compared to the median of 3.1%. MADS coverage averaged 3x over the last three fiscal years, lagging the median of 3.8x, but exhibiting stability. Given the increased revenue base and no additional debt anticipated in the near term, Fitch expects Covenant to continue growing into its sizable debt burden.

Covenant has outstanding one fixed payor swap acquired from Cumberland. The swap has an outstanding notional amount of $38.7 million and terminates in 2017. No collateral is currently posted.

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 and Related Research:

--'Revenue-Supported Rating Criteria', June 16, 2014;

--'U.S. Nonprofit Hospitals and Health Systems Rating Criteria', May 30, 2014.

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

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

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=913134

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