Fitch Revises HealthEast's (Minnesota) Outlook to Positive; Affirms Revenue Bonds at 'BB+'.

NEW YORK -- Fitch has affirmed the 'BB+' rating on the approximately $278 million revenue bonds issued on behalf of HealthEast and Controlled Affiliates (HealthEast). The Rating Outlook is revised to Positive from Stable.

Most of HealthEast's financial indicators are below Fitch's 'BBB' medians, however Fitch believes HealthEast's continued operating profitability, solid market position in a favorable market and planned quality initiative support the affirmation and positive outlook. Fitch believes HealthEast's qualitative factors offset its below average financial indicators and warrant the outlook revision to positive despite the projected temporary decline in liquidity and profitability due to the quality initiative investment.

Fiscal 2006's positive operating margin (1.3%) marks five straight fiscal years of operating profitability (average margin of 1.7%) for the system. However, operating profitability is expected to temporarily decline for the next three fiscal years, as HealthEast implements a significant quality and safety improvement program, the annual cost of which is expected to be approximately $8 million. Major components include the continued use of internal benchmarks and process improvements to increase profitability, improve patient safety, and reduce waste through measured outcomes. Management expects the program to yield stronger operating performance through increased recognition of quality care by patients, greater market share, improved employee and physician recruitment, and favorable rate negotiations.

The benefits of the quality initiative should help solidify HealthEast's market leadership position in the service area. HealthEast maintains a leading market position in St. Paul, MN, with a 38.9% market share in fiscal 2006, compared with 30.4% for its closest competitor, United Hospital (part of Allina Health System, rated 'A' by Fitch Ratings). Market share has remained relatively stable over the past four years for the dominant players in the market.

HealthEast's already light liquidity (70.2 days cash on hand at fiscal 2006) is expected to drop by approximately 15 days, below Fitch's 'BBB' median of 130.5 days cash on hand. HealthEast's low liquidity limits operating flexibility and management has stated that if needed, it would curtail spending on the quality initiative to achieve future financial targets and maintain operating profitability.

Additional credit concerns are HealthEast's high debt load relative to liquidity, exposure to governmental payors and future capital needs. HealthEast's balance sheet remains significantly leveraged, with a debt to capitalization of 73% at fiscal 2006. The Minneapolis-St. Paul metropolitan region is dominated by four major managed care companies accounting for 52.8% of HealthEast's revenues in fiscal 2006. Recent rate negotiations have been favorable, but the slim operating margins projected in the near term will depend on management's ability to continue securing favorable increases going forward. HealthEast's high average age of plant of 15.7 years at fiscal 2006 and low average capital expenditure as a percent of depreciation expense of 82.2% for the last five fiscal years are below Fitch's 'BBB' medians (9.6 years, 127.2%, respectively). However, these indicators do not reflect HealthEast's use of operating leases and does not incorporate the opening of the patient tower at the St. Joseph campus scheduled for December of 2008.

The Positive Rating Outlook reflects Fitch's confidence that management will maintain HealthEast's profitability at or above a 0.5% operating margin and that future liquidity levels will not drop below 55 days cash on hand. If HealthEast is able to meet these expectations over the next two fiscal years then an upgrade may be warranted. Following the successful implementation of this new three year strategic initiative, operating profitability is expected to return to historic levels and liquidity should grow.

Headquartered in St. Paul, Minnesota, HealthEast is a large health care system providing inpatient and outpatient care and rehabilitation services, as well as a variety of other ancillary services primarily through three acute-care hospitals, one long-term care hospital, two ambulatory surgery centers, and 11 primary care clinics. The three acute care hospitals operate 519 of 654 licensed beds. In fiscal 2006 HealthEast reported $682.8 million in operating revenue. HealthEast covenants to provide annual and quarterly disclosure to the nationally recognized municipal securities information repositories (NRMSIRs). Disclosure to the NRMSIRs has been timely and includes a balance sheet, income statement, cash flow statement and utilization statistics but no management discussion and analysis.

Outstanding debt:

--$204,590,000 million Saint Paul, MN Housing and Redevelopment Authority hospital revenue bonds, series 2005 (HealthEast Project);

--$48,327,000 Washington County Housing and Redevelopment Authority hospital facility revenue bonds (HealthEast Project), series 1998;

--$24,996,000 City of St. Paul, MN Housing and Redevelopment Authority hospital facility revenue bonds (HealthEast Project), series 1997.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, 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.