[October 22, 2014]

Fitch Upgrades Sky Lakes Medical Center (OR) Revs to 'A-'; Outlook Stable

Fitch Ratings has upgraded to 'A-' from 'BBB+' the rating on the following revenue bonds issued by Klamath Falls Intercommunity Hospital Authority on behalf of Sky Lakes Medical Center, OR (SLMC; formerly known as Merle West Medical Center):

--$16,160,000 series 2012 fixed rate bonds;

--$36,895,000 series 2006 fixed rate bonds.

The series 2006 bonds are insured by Assured Guaranty, which Fitch does not rate.

The Rating Outlook is Stable.

SECURITY

Debt payments are secured by a pledge of the gross revenues of the obligated group, a mortgage, and a debt service reserve fund.

KEY RATING DRIVERS

CONTINUED BALANCE SHEET GROWTH DRIVES UPGRADE: Supported by five years of strong profitability and cash flows, SLMC's unrestricted cash and investment grew over five times to $108.6 million at Aug. 31, 2014 from $21.2 million at fiscal year ended (FYE) Sept. 30, 2009. As a result, key liquidity metrics (229 days cash on hand, 22.8x cushion ratio, and 176% cash to debt) well exceed the 'A' category medians.

SOLID PROFITABILITY: Strong financial results reflect management's continued success in turnaround initiatives begun in fiscal 2009. Operating margin has been maintained at a robust level, and ranged from 5% to 8.5% over the last four fiscal years compared to the 'A' median of 2.5%. Similarly, operating EBITDA margin ranged from 11.9% to 15.8% compared to the median of 9.5%.

STRONG DEBT SERVICE COVERAGE: Debt metrics compare favorably against the 'A' medians, with coverage of maximum annual debt service (MADS) exceeding 5x over the last four years compared to Fitch's 'A' median of 3.8x.

LIMITED COMPETITION: SLMC is the only acute care provider within 75 miles and has sole community provider status. While independent, SLMC collaborates with a number of healthcare providers in the state and benefits from various relationships.

SMALL REVENUE BASE: As evidenced during the economic downturn, Fitch believes SLMC's relatively small revenue base exposes the organization to more operating volatility.

RATING SENSITIVITIES

CONTINUED STABILITY EXPECTED: Fitch expects SLMC to sustain strong financial metrics. The sharp improvement in balance sheet liquidity provides a strong financial cushion as the organization navigates challenges related to healthcare reform and its planned IT conversion in 2015. While not expected, inability to maintain metrics consistent with the 'A-' rating could pressure the rating.

CREDIT PROFILE

Located in Klamath Falls, OR, Sky Lakes Medical Center operates a 100-staffed bed general acute care community hospital and several clinics. SLMC generated total operating revenues of $176.9 million in fiscal 2013. The obligated group consists of Sky Lakes Medical Center and Sky Lakes Medical Center Foundation, which accounted for 99.8% of fiscal 2013 operating revenue. Fitch reviewed the financial performance of the consolidated system.

Excellent Balance Sheet

The rating upgrade to 'A-' from 'BBB+' reflects the sharp improvement in SLMC liquidity position which provides a healthy cushion against unexpected volatility even at the higher rating. At Aug. 31, 2014, unrestricted cash and investments totaled $108.6 million, which represents 30.6% growth year-over-year. Liquidity metrics of 229 days cash on hand, 22.8x cushion ratio, and 175.6% cash to debt comfortably exceeded the respective 'A' category medians of 199 days, 17x, and 131.2%.

Fitch views SLMC's capital plans as manageable, which are expected to be funded through operations. Of the $12.4 million budgeted for fiscal 2015 (109% of depreciation), approximately $5.9 million is budgeted forEPIC installation (anticipated August 2015).

Robust Profitability

SLMC ended fiscal 2013 with robust profitability metrics, albeit weaker than the prior year. Due to decreased volumes, lower meaningful use fund receipts, and heightened depreciation and labor expense, operating and operating EBITDA margins were 5% and 11.9% compared to 8.5% and 15.4% in fiscal 2012, but still significantly stronger than Fitch's 'A' medians of 2.5% and 9.5%. Profitability recovered through the 11 months ended Aug. 31, 2014, with operating and operating EBITDA margins of 8.6% and 15.1%. The improvements year to date are largely attributable to additional benefits from 340B program participation, higher meaningful use funds, and sound expense management.

Maintenance of strong profitability continues to reflect management's success to date in implementing performance improvement measures focusing on tight expense control, enhanced productivity, and revenue cycle management. Due to some heightened expenses related to IT implementation, operating income is budgeted at $8.3 million (4% operating margin) for fiscal 2015. Management has historically been conservative in its budgeting process and Fitch expects SLMC to achieve, if not exceed, this target. The expected IT conversion presents some revenue cycle risk in 2015, but SLMC's improved balance sheet liquidity helps mitigate some of the potential implementation risk.

Small Revenue Base

Fitch's primary credit concern continues to be SLMC's relatively small revenue base, which is inherently more susceptible to variability in operations and regulatory changes. The organization's sensitivity to operational challenges was evidenced in the 2008-2009 economic downturn, when total operating revenue declined 12.9% driven primarily by softening inpatient volume after opening a replacement facility. However, SLMC has successfully rebounded since then, returning to profitability and rebuilding its cash reserves. Fitch believes SLMC's significantly improved liquidity and modest leverage provides stability at the 'A-' rating. Additionally, SLMC participates in a group purchasing organization and a population health alliance, and benefits from the collective scale and expertise of other providers in the state.

Sole Community Provider

SLMC is a Medicare designated sole-community provider, serving a 10,000 square mile area including parts of Southern Oregon and Northern California, covering a population of approximately 80,000. Despite unfavorable economic characteristics and lack of population growth in the service area, SLMC enjoys a dominant position with virtually no competition, as the nearest hospital offering comparable services is located 75 miles away. Outmigration to Portland (250 miles north) and Medford (75 miles east) is mainly for tertiary care services SLMC does not provide.

Strong Debt Service Coverage

Debt service including capital leases produces a MADS of $4.8 million, which is decreased from $5.5 million at the time of Fitch's last review. Overall debt burden is moderate with 2.7% MADS as a percentage of revenue and 31.8% debt to capitalization in fiscal 2013, compared to the respective 'A' medians of 3.1% and 36.3x. MADS coverage by EBITDA was a very strong 5.7x in 2013 and 7.2x through the interim period, compared to the median of 3.8x.

Debt Profile

SLMC's debt portfolio consists of two series of fixed rate bonds and capital leases, totaling $61.9 million at Aug. 31, 2014. SLMC does not have any swaps outstanding.

DISCLOSURE

SLMC discloses annual financial statements within 150 days and quarterly unaudited financial statements within 45 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=904094

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