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Fitch Upgrades Central Washington Health (WA) Rev Bonds to 'A-' & Assigns 'A-' IDR; Outlook Stable.

Austin: Fitch Ratings has assigned an 'A-' Issuer Default Rating (IDR) to Central Washington Health Services Association dba Central Washington Hospital (CWH). Fitch has also upgraded approximately $113.4 million of Washington Health Care Facilities Authority series 2015 and 2009 revenue bonds issued on behalf of CWH to 'A-' from 'BBB+'. The rating incorporates Fitch's 'Rating Criteria for U.S. Not-for-Profit Hospitals and Health Systems', dated Jan. 9, 2018.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross revenue pledge and mortgage pledge of the obligated group (OG), which only consists of CWH. CWH is part of Confluence Health (CH) and accounted for 68.7% of CH's total assets and 49.1% of CH's total revenue in fiscal 2017 (Dec. 31 year-end). Fitch's analysis is based largely on consolidated results, but the OG results are reviewed as well. Figures quoted in this press release are for the consolidated entity, Confluence Health, unless otherwise noted. The outstanding series 2009 bonds have a debt service reserve fund.

ANALYTICAL CONCLUSION

The 'A-' IDR and revenue bond upgrade to 'A-' from 'BBB+' is based on CH's strong consolidated financial profile under Fitch's new criteria, which places heightened emphasis on liquidity and leverage metrics. CH's liquidity and low leverage are the key rating drivers. It maintains better than 125% cash to adjusted debt in Fitch's rating casem and its net adjusted EBITDA debt to adjusted EBITDA remains below zero through the cycle. CH's balance sheet has grown from $95.7 million in fiscal 2013 to a high of $186 million in fiscal 2017 while continuing to make strategic investments.

KEY RATING DRIVERS

Revenue Defensibility: 'bbb'; Leader in a Stable Market

CH's revenue defensibility is midrange, reflecting its strong market share, low percentage of gross revenues from Medicaid and self-pay and a demographically stable service area.

Operating Risk: 'a'; Weak Margins; Low Routine Capital Needs

Operating risk is midrange. CH's operating EBITDA margin results in a weak operating cost flexibility assessment under Fitch's criteria but has produced a stronger balance sheet since the CH affiliation was executed. A continued focus on optimization and execution brought stability through the Epic installation, and capital needs are flexible as a result of the relatively new plant.

Financial Profile: 'a'; Strong Financial Profile Maintained Through the Cycle

Fitch's forward look shows CH's financial metrics consistent with its 'a' assessment with cash to adjusted debt after recovery from the economic stress at 134% in the fourth year and a negative net adjusted debt to adjusted EBITDA through the forward cycle.

Asymmetric Additional Risk Considerations

There are no asymmetric risk factors identified with CWH's IDR and revenue bond rating.

RATING SENSITIVITIES

CONTINUED OPERATIONAL EXECUTION: There is limited downward pressure on CWH's rating. The rating would likely come under pressure if operations begin to significantly deteriorate or if unrestricted liquidity unexpectedly declines and begins to pressure key leverage metrics that support the rating. Given this upgrade, additional upward rating potential is limited over the outlook period.

CREDIT PROFILE

CWH, Wenatchee Valley Medical Group (WVMG), and Wenatchee Valley Hospital (WVH) entered into a Master Affiliation Agreement on Jan. 1, 2013 and formed CH. CH is the sole corporate member of CWH and WVH. The hospitals contract with WVMG for physician services under a professional services agreement. WVMG's goals are further aligned with CH through a co-management agreement that includes an annual incentive payment related to contributions to the overall success of CH, quality, patient satisfaction, and financial measures. The master affiliation agreement has an initial termination date of Dec. 31, 2017, which automatically renews for two additional terms of five years each, unless otherwise terminated. Fitch does not expect the affiliation to terminate given the benefits achieved to date and the continued integration efforts underway.

CH includes the 198 bed CWH (176 acute and 22 skilled nursing beds), 20-bed WVH (11 acute and nine acute rehab beds), and 12 outpatient sites. WVMG includes approximately 270 physicians. CWH is located in Wenatchee, Washington, approximately 150 miles east of Seattle and 170 miles west of Spokane. In fiscal 2017, CWH had approximately $342 million of total revenue and CH had approximately $697 million of total revenue. CH, WVH, and WVMG are not obligated to pay debt service on CWH's outstanding bonds.

CWH's strong operating performance following the affiliation reflects the coordination of resource allocation, which is integral to the hospital's success. Management has been focused on optimizing the capacity of the system, eliminating duplication of services, implementing lean methodology and a common EMR. Ongoing performance improvement initiatives include outpatient productivity, charge capture, product standardization, contract consolidation, expansion of 340b drug purchasing program, and labor productivity.

Revenue Defensibility

Revenue source characteristics are midrange as Medicaid and self-pay accounted for 18.4% and 1.7% of CH's gross payor mix in fiscal 2017, respectively. Concentration of governmental payors is noted to be a high 68.2% of the gross payor mix in fiscal 2017. Despite challenges associated with a high governmental payor mix, CH continues to focus on cost containment balanced with additional opportunities for revenue growth in its region. The system is working to grow its primary care footprint and build strong relationships with non-Confluence providers, which should continue to strengthen volumes.

CH benefits from a strong market position with inpatient market share of approximately 85% in its primary service area that consists of Chelan and Douglas counties. CH also continues to grow market share in the secondary service area of Grant and Okanogan counties by growing its footprint through ambulatory sites, reducing outmigration, and increasing regional relationships. The largest competitor in the PSA is Lake Chelan Community hospital with a market share of 3.91%, and the largest competitor in the SSA is Samaritan Healthcare with 28.91% market share. Services that patients primarily leave the area for are transplants, burns, children's specialty care and very high end neurosurgery services that are not provided by CH.

CH generates approximately nearly all its patient admissions from the four Washington counties of Chelan, Douglas, Grant, and Okanogan. The primary service area counties of Chelan and Douglas have shown good population growth of 4.1% and 6.9%, respectively, from five years ago, which is above the nation's level of 3.7%. Conversely, median household income and unemployment levels are slightly weaker than national levels at $51,845 and 4.9% in 2016 for Chelan County and $53,758 and 5.7% in Douglas County.

Operating Risk

CH has averaged 6.7% operating EBITDA margins over the last four fiscal years, though CWH's margins are much stronger having averaged 12.3% operating EBITDA over the same period. Management continues to focus on promoting "Lean" ideas at the employee level, which has helped to produce consistent margins at CH and very strong margins at CWH. Management's hands-on approach was also key to the successful Epic hopsital implementation in 2017, which replaced Cerner, Paragon and other subsidiary systems. The IT install was on time and under budget.

Effective March 2, 2018, CWH was designated a Rural Sole Community Hospital, which allowed it to be excluded from 340B cuts that were implemented by the Centers for Medicare & Medicaid Services on Jan. 1, 2018. The designation is expected to allow CH to avoid approximately $6 million in reduced reimbursement for outpatient drugs, which could have had a material impact on CH's margins. Despite a lower than average operating margin of 5.9% in fiscal 2017 results, which was expected due to one-time operating costs related to the Epic implementation, fiscal 2018 is expected to be a stronger operational year due to better cost containment on Epic and performance on capitated risk contracts. Fitch expects CH to maintain operating margins at or slightly above 6% going forward.

Epic was CWH's only major capital investment after the May 1, 2011 opening of a new five-story 176-bed patient tower ($122 million). As a result of the relatively new plant, routine capital spending needs are relatively low despite CH's slightly elevated average age of plant of 12.0 years. Capital expenditures over the past five years have been healthy averaging 132% of depreciation. Total fiscal 2018 capital expenditures of approximately $30 million for CH include a $7.1 million lab consolidation project and spending over the next five years is expected be around $30 million with a continued focus on strategic investments to enhance and expand primary care, case management, behavioral and population health and technology. Also, given the recent strong volume growth, management may consider additional bed capacity over the next three to five years after finishing work that is currently being undertaken to utilize CH's spaces efficiently.

Financial Profile

In fiscal 2017, CH had only $1.76 million of operating lease expense, which translates to a debt equivalent of $8.8 million (based on 5x lease expense). CH's total adjusted debt at fiscal year-end 2017 was approximately $148.7 million and unrestricted cash and investments was $186.1 million resulting in a net adjusted debt position (debt plus operating leases plus underfunded defined benefit pension plan below 80% minus unrestricted cash/investments) at year-end 2017 of negative $44.7 million.

Fitch's base and rating case show CH with a strong financial profile. Overall leverage position is greatly improved as cash to adjusted debt has strengthened to 130% as of fiscal 2017 from 88% in fiscal 2013 and net debt to adjusted EBITDA to -1 from 0.4. The FAST base case assumes that CH's margins rebound slightly in 2018 after a weaker than average year in 2017 due to Epic. Capital expenditures are projected at around $30 million per year for the next five years with a focus on strategic spending.

The rating case applied to CH over the five year period shows stability at the 'A' rating category. Based on Fitch's FAST scenario analysis, CH's capital related ratios should improve through the cycle due to margin recovery, a modest deferral of capital spending and continued debt amortization. CH's investment portfolio is relatively conservative, as reflected in the loss of 4.6% in the worst return year. Through the stressed rating case (which assumes a mild recession in years one and two followed by a recovery in year three and then stability), Fitch expects cash to adjusted debt to improve over 130% and net adjusted debt to adjusted EBITDA to remain negative.

Asymmetric Additional Risk Considerations

There are no asymmetric risk factors identified with CWH's IDR and revenue bond rating. CWH's debt profile is 100% fixed rate with no swaps and the total amount of debt outstanding is $113.4 million. CWH guarantees the $25 million Epic lease and MADS with the Epic lease is $12.7 million compared to $8.3 million on CWH bonded debt only. CWH's debt service coverage calculation on the $8.3 million in 2017 was 5.01x and CH's debt service coverage was 3.5x in fiscal 2017.
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