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TMCNet:  Fitch Affirms Cone Health (NC) at 'AA '& Affirms S-T Rtg at 'F1+'; Outlook to Negative

[January 24, 2014]

Fitch Affirms Cone Health (NC) at 'AA '& Affirms S-T Rtg at 'F1+'; Outlook to Negative

NEW YORK --(Business Wire)--

Fitch Ratings has affirmed at 'AA' the following bonds issued by the North Carolina Medial Care Commissions on behalf of Cone Health.

--$60,170,000 hospital revenue refunding bonds, series 2011A;

--$47,980,000 hospital revenue bonds, series 2011B;

--$47,500,000 hospital revenue bonds, series 2004A;

--$85,200,000 hospital revenue bonds, series 2001A and B.

Additionally, Fitch has affirmed the 'F1+' rating on the outstanding variable rate debt issued by the North Carolina Medical Care Commission on behalf of Cone Health.

--$47,500,000 hospital revenue bonds, series 2004A;

--$47,980,000 hospital revenue bonds, series 2011B.

The Rating Outlook has been revised to Negative.

SECURITY

Unsecured general obligations of the Cone Health obligated group, which includes Alamance Regional Medical Center (ARMC) following the November 2013 debt issuance. The obligated group represents approximately 86% of the system's revenues and 94% of system assets with ARMC. Fitch reports on the consolidated system. ARMC was included for five months of fiscal 2013.

KEY RATING DRIVERS

DECLINE IN OPERATING RESULTS: The Outlook revision to Negative reflects the sharp decline in Cone Health's (Cone) operating profitability that began in fiscal 2012 and worsened in fiscal 2013 (year ended Sept. 30; unaudited, but in substantially final form) Due to a number of one-time items, Cone expects to end fiscal 2013 (unaudited) with an operating loss of $49.5 million (negative 4.3% operating margin), a weak 2.6% operating EBITDA margin and net loss of $23.3 million.

IMPROVED PROFITABILITY IN 2014: The first quarter of fiscal 2014 ended Dec. 31, 2013; however, has shown a significant improvement over the prior year period with operating gain of $5.4 million. The system has budgeted to produce a slim, but positive operating gain in fiscal 2014 and is implementing a long range plan that is intended to actually exceed the budget.

DOMINANT MARKET POSITION: The system's market position is supported by a broad placement of inpatient and outpatient service locations, enhanced by the addition of ARMC, which should reduce outmigration to Durham and Chapel Hill. The system's position is also supported by a large, loyal referral base of employed and voluntary medical staff. An additional positive is the October 2012 affiliation with Carolinas Health System (CHS). Fitch views the strong North Carolina certificate of need program as a further mitigant to competitive risk.

MODERATE LEVERAGE: Debt service coverage declined in fiscal 2013 to 2.1x maximum annual debt service (MADS), but the system has very moderate leverage with MADS representing 2.3% of revenues and debt to capitalization of only 26%. Cone has now completed its large capital improvement plan with no plans for additional issuance in the near to intermediate term and has manageable ongoing capital needs. Coverage of MADS improved to a much stronger 5.2x through the first quarter of 2014.

ADEQUATE LIQUIDITY: Cone maintains solid liquidity, which helps to mitigate its weakened operating performance. DCOH was reported at 260.8 days through the end of the first quarter of 2014, and the system has 170.1% cash to debt on a consolidated basis including ARMC. The cushion ratio was better than 30x even in fiscal 2013 and was most recently at 33.7x.

RATING SENSITIVITIES

MARKED IMPROVEMENT EXPECTED: Fitch believes the deterioration in profitability is due to one-time items and does not reflect a fundamental change in operations. As such, Fitch expects Cone to outperform its conservative 2014 budget (operating EBITDA near 8%), as evidenced by strong first quarter results. However, failure to generate profitability margins and debt service coverage consistent with historical levels would likely produce negative rating pressure.

CREDIT PROFILE

Cone Health is a nonprofit, integrated healthcare system headquartered in Greensboro, North Carolina, operating four acute care and two specialty hospitals, with total revenues of $1.1 billion in the fiscal year ending Sept. 30, 2013. ARMC was merged into the obligated group effective May 1, 2013 and is included in the consolidated system results for five months of fiscal 2013. Cone Health entered into a 10-year management agreement with Carolinas Health System, a large healthcare system operating more than three dozen hospitals in North and South Carolina. The top five key Cone Health leadership individuals are now CHS employees. The benefits of the affiliation are estimated at approximately $20 million on an annual basis and the affiliation is viewed as a credit positive.

FINANCIAL PERFORMANCE REBOUNDING

Cone Health's financial performance declined in fiscal 2012, and significantly worsened in fiscal 2013, which ended with an operating loss of $49.5 million (-4.3%) and a very weak operating EBITDA margin of 2.6%, far below the budgeted operating gain of $27.6 million. The 2013 results contrasted sharply with the system's history of solid respective operating and operaing EBITDA margins of approximately 4% and 10% in the 2009 - 2011 period. The main drivers behind the poor 2013 results included major issues with outsourced physician billing, increased labor expenses related to the implementation of its EPIC electronic health record, expenses related to the ARMC merger, as well as investment in Triad Health Network (THN) -- its clinical integrated network.


Additional unbudgeted expenses included an increase in pension charges of $5.5 million, higher than budgeted consulting and legal expenses related to the ARMC merger, CHS affiliation and EPIC installation, and $3.5 million of severance costs associated with reduction of approximately 150 FTE positions. Cone Health replaced the professional billing vendor in August 2013 with Alleviant (a Navigant subsidiary), but experienced poor collection performance throughout the year and incurred a significant write-off at year end.

The rating affirmation at 'AA' is supported by Fitch's expectation that the steps taken by leadership to return the organization to a more stable operating platform will demonstrate measurable results in fiscal 2014. A five-year long range financial plan has been formulated with the aim of generating operating EBITDA margins of close to or better than 10%, only slightly lower than Fitch's 'AA' median of 11.8%. The plan initiatives include a cost reduction plan of $30 million and $28 million in revenue cycle improvements. The long-range plan includes a further reduction of 100 FTE's in the current fiscal year.

Results for the first quarter of fiscal 2014 appear to support the beginning of the turnaround. The consolidated system reported operating income of $5.4 million, which translated to operating margin of 1.6% and operating EBITDA margin of 8.6%.

DOMINANT MARKET POSITION

Cone Health commands a dominant market share in Guilford, Rockingham and Alamance counties ranging between 60 - 70%. The merger with ARMC has the potential of reducing the outmigration of patients in ARMC's market to the tertiary providers in Durham and Chapel Hill. The system has a highly integrated clinical network, Triad Health Network, with 844 physicians; of whom approximately 40% are employed and over a third in primary care. Triad qualified as an ACO and is one of the largest ACO's in the CMS's Shared savings program with 40,000 Medicare lives. The ACO covers an additional 26,000 lives of Cone Health employees and other payor relationships.

MODERATE LEVERAGE

Cone also maintains manageable debt levels, with MADS representing a low 2.3% of revenues and debt to capitalization of only 26%. Debt service coverage declined in fiscal 2013 to 2.1x MADS, but coverage of actual debt service as per Cone Health's Master Trust Indenture was a much better 6.2x in fiscal 2013. Coverage of MADS improved considerably to a much stronger 5.2x through the first quarter of 2014. Cone has now completed its large capital improvement plan with no plans for additional issuance in the near to intermediate term and has manageable ongoing capital needs with 2014 capital plan equal to 115% of depreciation expense.

In November 2013 Cone Health issued its Series 2013 bonds in the amount of $130.2 million through the North Carolina Medical Care Commission as a direct placement debt with BMO Harris Investments Corp and Bank of America N.A. The bonds were used to retire the $42.9 million under the system's line of credit, fund a construction account with $60 million for use on two projects at ARMC - doubling of the ED capacity and construction of a cancer center (both now close to being completed), and to fund an escrow to repay the Alamance Extended Care Series 2007 bonds. The bonds have annual principal payments starting in fiscal year 2014 through 2024 with an $88.8 million bullet due in 2024, which the system plans to refinance prior to its maturity. The bonds are fixed rate obligations through 2024 with an average interest rate of 2.815%. Fitch's coverage calculation includes the bullet as per its stated amortization between 2024 - 2045.

Cone's debt structure currently has approximately 40% of its debt in fixed-rate mode and several bank commitments have been renegotiated with extended renewal dates. The risk associated with the $88.8 million bullet in 2024, as well other put, interest rate, and bank renewal risk is adequately offset by strong liquidity position with 261 days cash on hand and the system leadership's demonstrated ability to effectively manage its debt and swap portfolio.

The affirmation of the 'F1+' short-term rating is based on the availability of highly liquid securities to cover potential maximum liquidity demands presented by Cone Health's outstanding series 2004A weekly variable rate demand bonds (VRDBs) and the series 2011B bonds in the window mode. Cone Health meets Fitch's criteria for assigning short-term ratings based on internal liquidity, requiring coverage of unremarketed puts of the maximum tender exposure of the self-liquidity supported debt by a minimum of 1.25x based on Cone Health's cash and highly liquid investments.

Cone Health has liquidation procedures in place detailing the process by which internal funds would be liquidated to meet the tender obligations. The 'F1+' rating for the 2011B bonds takes into account Cone Health's sufficient unrestricted liquidity in addition to market access at its rating level relative to the series 2011B bonds in the window mode, which provides more flexibility to fund an unremarketed tender (180 days beyond 30 day remarketing period).

DISCLOSURE

Cone Health covenants to provide annual disclosure no later than 120 days after each fiscal year end and quarterly disclosure no later than 60 days after each quarter end to the Municipal Securities Rulemaking Board's EMMA system.

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

Applicable Criteria and Related Research:

--'Criteria for Assigning Short-Term Ratings Based on Internal Liquidity'(June 13, 2013);

--'Nonprofit Hospitals and Health Systems Rating Criteria' (May 20, 2013);

--'Rating U.S. Municipal Short-Term Debt' (Nov. 27, 2012).

Applicable Criteria and Related Research:

Nonprofit Hospitals and Health Systems Rating Criteria - Effective Aug. 12, 2011 to July 23, 2012

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=648836

Rating U.S. Municipal Short-Term Debt - Effective Dec. 23, 2010 to Dec. 8, 2011

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=592885

Rating U.S. Public Finance Short-Term Debt

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724680

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=816980

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON (News - Alert) THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.


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