[September 24, 2014]

Fitch Rates Tenet's Senior Unsecured Notes 'B-/RR5' & Affirms IDR at 'B'; Stable Outlook

Fitch Ratings has assigned a 'B-/RR5' rating to Tenet Healthcare Corp.'s (Tenet) $500 million senior unsecured notes due 2019. Proceeds will be used to refinance existing debt, fund recent acquisitions and for general corporate purposes. Fitch has also affirmed Tenet's existing ratings, including the 'B' Issuer Default Rating (IDR). The Rating Outlook is Stable.

A full list of rating actions follows at the end of this press release. The ratings apply to approximately $11.6 billion of debt as of June 30, 2014.

KEY RATING DRIVERS

--The Q4'13 acquisition of Vanguard Health Systems (VHS) left Tenet with one of the most highly leveraged balance sheets in the for-profit hospital industry. The all-cash transaction added approximately $4.3 billion of debt to the balance sheet. Fitch projects total-debt-to-EBITDA of 5.8x at the end of 2014, about a full turn of EBITDA above the 4.7x level prior to the acquisition.

--Opportunities to reduce leverage through debt repayment are limited since Tenet generates negative FCF. Persistently negative FCF is partly the result of the company's industry lagging profitability; operating EBITDA margins had been exhibiting an improving trend, but the integration of the lower margin VHS business set back progress in this area.

--Fitch viewed the purchase of VHS as strategically sound. It enhanced the geographic scope of Tenet's portfolio of acute-care hospitals and added operational diversification through VHS' health plan business. The strategic rationale for consolidation in the hospital industry is encouraged by reforms favoring larger, integrated systems of care delivery, including the Affordable Care Act (ACA).

--Hospital industry management teams are contending with a very dynamic operating environment due to the implementation of the ACA, the evolution of payment schemes, and other regulatory reforms influencing organic operating trends. On top of these issues, Tenet's business profile currently involves the integration VHS, which was the first major acquisition made by the company in recent history, as well as managing a large schedule of in progress and recently completed capital expansion projects.

--The most important near-term drivers of improvement in the operating profile include Tenet's recent investment in building its outpatient services capacity, the completion of some of the large capital projects during 2014, and growth of the Conifer Health Solutions business. All of these initiatives should contribute to sustainable growth in EBITDA and higher operating margins, but each involves some execution risk.

VHS Acquisition Strategically Sound But Stresses Balance Sheet

Tenet's fourth-quarter 2013 acquisition of VHS was entirely debt financed, resulting in pro forma leverage of 5.8x and interest coverage of 2.5x. Funding for the transaction, as well as share repurchases during 2013, added $4.6 billion of debt to the capital structure, including $1.8 billion of secured notes and $2.8 billion of unsecured notes.

On a stand-alone basis, the financial profiles of both Tenet and VHS were fairly weak relative to the industry peer group. Both companies had high leverage, generated weakly positive or negative FCF, and had industry-lagging EBITDA margins. Weak profitability was partly a business mix issue; Tenet's outpatient operations were historically lacking, and VHS's health plans pulled down overall profitability. In addition to weak profitability, cash generation was strained by high-cost debt and aggressive capital spending.

Fitch thinks the additional scale and broader geographic footprint resulting from the acquisition will aid the recent progress that both companies were making in addressing headwinds to their financial profiles. Synergies are a time-proven component of return on investment in hospital acquisitions, and the strategic rationale for consolidation in the industry is further encouraged by reforms favoring larger, integrated systems of care delivery, including the Affordable Care Act (ACA).

Tenet expects to achieve $60 million to $110 million of EBITDA growth due to realization of cost synergies in 2014, and $100-$200 million of benefit over the entire integration process. Fitch believes this is a reasonable number based on the size of the business and the relatively lower operating margins of VHS. According to Tenet's management, the primary source of synergies stems from VHS's decentralized cost management and payor contracting practices, which limited the company's financial benefits of scale.

Despite the reasonable basis supporting the expectation of synergies, Fitch notes that Tenet does not have a track record of successfully integrating hospital acquisitions; most of the company's recent purchases have been of small outpatient assets. Tenet is now nine months into the integration process, and it appears to be proceeding smoothly, with no major surprises or hiccups. On the company's Q2'14 earnings calls, management increased the 2014 synergy target by $10 million. The company has achieved an important milestone in the process, completing contract negotiations with most of the major national health insurance carriers, including Aetna, Cigna, UnitedHealth and Humana, to include the VHS hospitals.

Hospital Industry Operating Trend Improving

The for-profit hospital industry has been experiencing weak organic growth in patient volumes, particularly of inpatient admissions, since the trough of the 2007-2009 recession. A high unemployment rate and growth in the consumer share of healthcare spending led to the deferral of elective medical procedures and higher volumes of Medicaid and uninsured patients (which are less profitable than those with commercial health insurance). Acute care hospitals have also been contending with heightened payor scrutiny of relatively expensive hospital admissions as technological advancements enable the shift of increasingly complex medical procedures to outpatient settings.

During this period, Tenet's organic operating trends have mostly mirrored the broader industry. Like other operators with an urban and suburban market focus, Tenet has fared somewhat better than rural market operators in this challenging environment, although the group has not been entirely resilient to headwinds to organic growth. Facing a stiff comparison to a strong result in 2012 and weak growth in lower acuity service lines, Tenet's organic patient volume growth in 2013 was softer than in recent periods, with same hospital adjusted admissions dropping 1.1%. This wea volume metric somewhat underperformed the peer group; same hospital adjusted admissions across the Fitch-rated group of for-profit hospital providers dropped 0.7% on average in 2013.

Operating trends were similarly weak in Q1'14, then improved drastically in Q2'14, with most companies reporting better organic volume growth, an improved payor mix with lower volumes of insured patients, and a higher acuity case mix, which is supportive of pricing growth and profitability. Tenet reported organic volume growth of 4.7% and 4% on a pro forma basis if VHS had been owned in both periods. This is the company's best performance on volumes in recent history and well out performed the industry despite the generally strong performance across the peer group.

Drivers of the improved trend include economic improvement in most geographies, the effects of the insurance expansion elements of the ACA, as well as an ongoing skew toward a more acute (sicker) patient population. Fitch thinks that management initiatives to create growth in more profitable areas, including targeted expansion in outpatient services and more acute service lines, were also a factor. While these results are encouraging, it is difficult to determine if the improved trend will be sustainable since the secular headwinds to growth mentioned above remain intact, including general pressure on payment rates and actions by patients and payors to limit relatively expensive hospital care in less acute situations.

Weak FCF Profile

Tenet's liquidity profile is adequate aside from persistently negative FCF (equals cash from operations less capital expenditures and dividends). At June 30, 2014, liquidity was provided by $406 million of cash on hand and $994 million of availability on the $1 billion capacity bank revolver. Following the redemption of the $474 million 9.25% unsecured notes maturing in February 2015 with proceeds of a 5% notes issuance in July 2014, near-term debt maturities are minimal. Redemption of the 2015 notes also eliminates the potential for the springing maturity of the credit facility to fourth-quarter 2014.

Tenet's limited financial flexibility, most particularly its negative FCF profile, has been the major issue constraining the company's ratings over the past several years. The rate of cash burn had been incrementally improving due to expanding operating margins and the refinancing of high-cost debt, but progress reversed somewhat in 2013. In the LTM ended June 30, 2014, Tenet produced FCF of negative $250 million. Negative FCF was partly the result of the VHS acquisition, which contributed to higher cash outflows for acquisition-related expenses, capital expenditures and interest expense beginning in fourth-quarter 2013, as well as delay in the receipt of certain supplemental Medicaid payments.

Fitch expects Tenet's cash generation to improve in the second half of the year and for the company to generate positive but thin FCF in 2014, with a FCF margin below 1%. The refinancing of certain high cost debt will help cash generation in the second half, and the company expects to receive the delayed Medicaid payment in Q4'14. A high level of capital expenditures, as well as spending required to ramp up some newly opened capital projects, will continue to be a headwind.

VHS is committed to capital investments in some of its recently acquired markets. However, the funding of these projects will support growth in EBITDA over the longer term. Some of the in-progress projects, including a heart hospital in Detroit, MI and a general acute care hospital in New Braunfels, TX, opened earlier in 2014. Fitch projects annual run rate capital expenditures of about $1 billion in 2014 through early 2015 to support this schedule of projects before the level of spending moderates starting in mid-2015.

Prior to the acquisition of VHS, Tenet had been showing decent improvement in profitability, which had historically lagged the industry because of operational issues dating from the past decade. From 2008 to the LTM ended Sept. 30, 2013, Tenet's operating EBITDA margin expanded about 450 bps to 13.3% from 8.8%. The integration of VHS did result in an immediate drop in margins since the operating EBITDA margin of that company prior to the acquisition was around 10%, with both the health plan business and the acute care operations posting industry-lagging margins. In addition, Tenet is facing secular threats to profitability like the rest of the hospital industry, manifesting in weak organic growth in patient volumes and pressure on Medicare and Medicaid payment rates.

Despite the challenging operating environment and set back related to the VHS integration, Fitch thinks Tenet's business profile includes several opportunities to boost profitability and generate sustainable growth in EBITDA. One area in which the company has already made significant progress is expanding its outpatient business. Starting in 2010, Tenet invested significantly in this area through both de novo construction of outpatient facilities and acquisitions. During 2013, Tenet's results were significantly helped by stronger performance in the outpatient portfolio, with outpatient visits up 2.9% and outpatient revenue per visit up 3.3%. The company attributes $72 million of 2013 EBITDA to investments in outpatient capacity of $264 million since 2010. Outpatient services made up about 35% of revenue in 2013, up from about 30% in 2008. This progress demonstrates that Tenet is closing the gap in this area relative to its industry peers; in comparison, HCA generates about 40% of revenue from outpatient services.

RATING SENSITIVITIES

Maintenance of the 'B' Issuer Default Rating (IDR) will require an expectation of total debt to EBITDA dropping to below 5.5x during 2015. Tolerance for normalized leverage of up to 5.5x at the 'B' IDR assumes improvement in cash generation, with FCF margins expanding to 1.0-1.5% in 2015-2016. Tenet's operating profile is improving and includes several potential drivers for better cash generation, including the stabilization of organic operating trends in the company's largest hospital markets, growth in the higher margin outpatient services and Conifer Health Solution business, the realization of financial synergies through the integration of VHS, and the successful ramp up of several recently opened and in-progress capital expansion projects.

The Stable Rating Outlook reflects Fitch's belief that the 5.5x leverage target is achievable through EBITDA expansion driven by organic growth in the business, as opposed to the application of cash to debt reduction. Given Tenet's strained FCF, opportunities to pay down debt are limited. If the company chooses to fund share repurchases or additional acquisition opportunities with debt and delay deleveraging, it could result in a downgrade of the ratings.

A positive rating action is unlikely over the next one-to-two years given Tenet's constrained FCF and weak margins. Furthermore, the 'B' IDR incorporates the expectation for generally improving operations in the hospital industry due to the ACA and economic improvement in the near term.

DEBT ISSUE RATINGS

Fitch has affirmed Tenet's ratings as follows:

--IDR at 'B';

--Senior secured credit facility and senior secured notes at 'BB/RR1';

--Senior unsecured notes at 'B-/RR5'.

The Recovery Ratings are based on a financial distress scenario which assumes that value for Tenet's creditors will be maximized as a going concern (rather than a liquidation scenario). Fitch estimates a post-default EBITDA for Tenet of $1.15 billion, which is a 40% haircut to Fitch's forecasted EBITDA 2014 of $1.9 billion considering the contribution of VHS. Fitch's post-default cash flow estimate for companies in the hospital sector considers the structure of the industry, including relatively stable and non-cyclical cash flows, a high level of exposure to cuts in government payor reimbursement that makes up 30-40% of revenues, offset by the consideration that hospital care is a critical public service.

Fitch then applies a 7.0x multiple to post-default EBITDA, resulting in a post-default enterprise value (EV) of $7.7 billion for Tenet. The multiple is based on observation of both recent transactions/takeout and public market multiples in the healthcare industry. Fitch significantly haircuts the transaction/takeout multiple assigned to healthcare providers since transactions in this part of the healthcare industry tend to command lower multiples. The 7.0x multiple also considers recent trends in the public equity market multiples for healthcare providers.

Fitch applies a waterfall analysis to the post-default EV based on the relative claims of the debt in the capital structure. Administrative claims are assumed to consume 10% of post-default EV. Fitch assumes that Tenet would draw $500 million or 50% of the available capacity on the $1 billion revolver in a bankruptcy scenario, and includes that amount in the claims waterfall. The revolver is collateralized by patient accounts receivable, and Fitch assumes a reduction in the borrowing base in a distressed scenario, limiting the amount Tenet can draw on the facility.

The 'BB/RR1' rating for Tenet's secured debt, which includes the bank credit facility and the senior secured notes, reflects Fitch's expectation of 100% recovery under a bankruptcy scenario. The 'B-/RR5' rating on the unsecured notes reflects Fitch's expectations of recovery of 23% of outstanding principal, under the conservative assumption that none of the $500 million in notes proceeds are used to refinance outstanding debt.

The bank facility is assumed to be fully recovered before the secured notes. The bank facility is secured by a first priority lien on the patient accounts receivable of all of the borrower's wholly owned hospital subsidiaries, while the secured notes are secured by the capital stock of the operating subsidiaries, making the notes structurally subordinate to the bank facility with respect to the accounts receivable collateral.

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

Applicable Criteria and Related Research:

--'Hospitals Credit Diagnosis' (June 30, 2014);

--'High-Yield Healthcare Checkup' (April 4, 2014);

--'2014 Outlook: U.S. Healthcare' (Nov. 25, 2013);

--'For Profit Hospital Insights: Fitch's Annual Review of Bad Debt Accounting Policies and Practices' (Oct. 24, 2013);

--'Margin Preservation Strategies: Different Angles (U.S. Hospitals and Health Insurers)' (Oct. 1, 2013);

--'The Affordable Care Act and Healthcare Providers: Assessing the Potential Impact' (May 1, 2013);

--'Corporate Rating Methodology' (May 28, 2014).

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=881554

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