Fitch Rates Children's National Medical Center, Washington, D.C. 2005 Hospital Revs 'A-'.

NEW YORK -- Fitch assigns an underlying 'A-' rating to the $150 million District of Columbia hospital revenue bonds (Children's Hospital Obligated Group Issue), series 2005. The obligated group is composed of Children's Hospital and Children's Hospital Foundation (the foundation); however, Fitch has analyzed the consolidated system of Children's National Medical Center (CNMC). The series 2005 bonds will be issued as auction-rate securities with insurance expected to be provided by FSA, whose insurer financial strength is rated 'AAA' by Fitch. The Rating Outlook is Stable.

The series 2005 bonds are expected to sell the week of Oct. 24 through negotiation led by UBS Financial Services Inc. Bond proceeds will be used to complete the East Addition patient tower, expand and renovate the operating suites and ambulatory centers at the main hospital, upgrade information systems and medical equipment, reimburse the hospital for prior capital expenditures, fund a capitalized interest account and debt service reserve fund, and pay for costs of issuance.

The 'A-' rating reflects CNMC's strong reputation in pediatric medicine and research, fundraising capabilities and foundation support, dominant market position in pediatric services, close alignment with physicians, and improved operating performance in recent years. As a major, full-service pediatric teaching hospital, CNMC is nationally recognized for pediatric medicine and research. Annual funded research has shown solid growth over the years with CNMC ranking seventh in the nation for National Institute of Health (NIH) funding for Children's Hospitals in 2005. CNMC's strong reputation has allowed it to build communitywide support as demonstrated by the foundation's ability to fundraise over $300 million from 1998-2004. The foundation will embark later this year on a new major capital campaign to raise $500 million over the next seven years to fund specific programs and research, support the operations and capital needs of the hospital, and to build an endowment (the endowment size was $32.2 million as of June 30, 2005). Over the years, the foundation has provided operating support to CNMC with annual unrestricted contributions averaging $12.6 million over the past five years. Further support is provided to CNMC through federal grants and appropriations to fund a portion of the hospital's capital projects, which has averaged $7.2 million annually over the past four years.

As the only freestanding children's hospital in the Washington D.C. metropolitan area providing a full-spectrum of pediatric services, CNMC has a dominant 60.6% market share in the primary service area, which has grown from 55.5% in fiscal 2003. In the secondary service area, CNMC faces more competition from Inova Fairfax Hospital and Johns Hopkins Hospital (revenue bonds rated 'AA-' by Fitch); however, CNMC maintains a leading market share of 33.6% for the total service area. Market share and volume growth has been driven by CNMC's close alignment with its physicians, all of whom are employed by the hospital. Moreover, CNMC maintains a strong network of regional outpatient centers and affiliations with local community hospitals throughout the service area.

Profitability trends have been positive in recent years with CNMC posting a strong operating gain of $17.3 million (margin of 3.4%) in fiscal 2005, compared with a loss of $12.1 million (margin of negative 2.9%) in fiscal 2003, and a gain of $4.1 million (margin 0.9%) in fiscal 2004. Recent profitability has been aided by increased managed care rates, strong volume growth, stabilized labor costs, and reduced agency expense. Pro forma MADS coverage by EBITDA in fiscal 2005 was 4.5 times (x), compared with 2.3x in fiscal 2004.

Primary credit concerns include a volatile operating history, weak liquidity, exposure to governmental payors, and construction risk. Despite the recent improvement, historical operating profitability has been very volatile with losses incurred in four out of eight years from fiscal years 1998-2005, with operating margins ranging from negative 11.9% to positive 3.4% (Fitch notes that, in its analysis, the foundation's unrestricted contributions have been reclassified as operating revenue for all prior years). Limited cash flow generation has led to weak liquidity indicators. CNMC had $77.0 million of unrestricted cash and investments at fiscal 2005, which resulted in a low 63.3 days cash on hand. Factoring in the current debt issuance and reimbursement of $30 million with bond proceeds, CNMC's pro forma liquidity indicators would be 88.0 days cash on hand, 8.5x cushion, and cash to debt of 53.6% at fiscal 2005, which all compare unfavorably with Fitch's 'A' category medians. Despite having poor historical financial performance, CNMC has been able to invest in property, plant, and equipment at or exceeding depreciation expense over the past eight years due to the hospital's ability to fundraise and secure government grants and funding.

Typical of children's hospitals, CNMC has a high exposure to Medicaid payors as it composed 45.0% of net revenues in fiscal 2005, which makes the hospital vulnerable to potential changes in governmental reimbursement. However, Medicaid reimbursement to CNMC is spread over D.C., Maryland, and Virginia and has historically been favorable. Additional risks include the large size and scope of the current capital project, which exposes the hospital to potential cost overruns and delays. This risk is heightened by CNMC's low liquidity levels.

The Stable Rating Outlook reflects Fitch's expectation that CNMC's operating performance in fiscal 2005 will be sustained due to management's focus on improving managed care rates, strategy to capture growth in the service area, and controlling labor costs. Further supporting CNMC is its strong reputation and dominant market share in the PSA, and ability to fundraise. Fitch believes stronger profitability will translate into better cash flow generation and result in steadily improving liquidity over the medium term.

CNMC has entered into a forward starting swap option to synthetically swap the series 2005 bonds (notional amount of $150 million) from variable to fixed rate. Swap and termination payments are expected to be insured by FSA. More details will be provided in Fitch's upcoming new issue report.

Located in Washington, D.C., CNMC is a nationally recognized full-service tertiary and quaternary pediatric hospital with 279 licensed and 240 staffed beds. CNMC had total operating revenues of $505 million in fiscal 2005. With the series 2005 financing, CNMC will covenant to provide audited annual financial statements and quarterly disclosure to bondholders. Disclosure information will be disseminated through the NRMSIRs. Details of the items to be provided quarterly have not been disclosed in the current draft of the legal documents. Fitch believes good quarterly disclosure includes a balance sheet, income and cash flow statements, utilization statistics, and management discussion and analysis. Lack of any of the aforementioned items would be viewed negatively.

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