Moody's Investors Service has downgraded Sisters of Mercy Health System's (Sisters of Mercy) long-term and underlying bond ratings to Aa3 from Aa2. The downgrade factors in Sisters of Mercy's material decline in unrestricted liquidity in fiscal year (FY) 2008 and recent track record of modest operating performance (for a Aa-rated credit) including significant challenges in two of the system's three Arkansas markets and at the health plan, and incorporates our expectation that Sisters of Mercy will issue up to $302 million of new money bonds in the coming weeks. The system also is expecting to refund approximately $378 million of Series 2001A,B,&C auction rate bonds, perhaps early in calendar year 2009. The expected issuance of new money and refunding bonds is expected to be a mix of fixed rate and variable rate. The variable rate portion of the issuance is expected to be supported by multiple standby bond purchase agreements. The timing and ultimate size of the issue will depend on market conditions and is expected to provide approximately $110 million of reimbursement for prior capital spending. This action affects approximately $500 million of rated bonds as listed at the conclusion of this report, including $110 million of Series 2008A,B,&C variable rate demand obligation (VRDO) revenue bonds that are supported by a standby bond purchase agreement (SBPA) from Bank of America.
The outlook is stable at the lower rating level.
LEGAL SECURITY: The bonds are general unsecured obligations of Sisters of Mercy under a restricted affiliate structure, which we view as not as secure for bondholders as a joint and several obligation. The master indenture does not contain any limitations or tests for the issuance of additional indebtedness.
INTEREST RATE DERIVATIVES: Sisters of Mercy has ten variable-to-fixed interest rate swap agreements (all with Bear Stearns Capital Markets, guaranteed by JP Morgan Chase & Co.), one constant maturity swap (CMS, with Bear Stearns Capital Markets, guaranteed by JP Morgan Chase & Co.), and two fixed-to-variable interest rate swaps (with Merrill Lynch). The fixed payer swaps have a total notional amount of approximately $360 million. The fixed receiver swaps have a total notional amount of $100 million. The CMS swap has a notional amount of $125 million. As of September 30, 2008 the total net termination value of the swaps was negative $14.7 million. Sisters of Mercy plans to keep all the swaps in place.
STRENGTHS
*Large multi-state integrated healthcare system that recorded nearly $3.8 billion of total operating revenue in FY 2008 (the system includes a sizeable health plan and more than 1,000 employed physicians)
*Sisters of Mercy's hospitals are diversified among many markets in four states
*Low debt load, which results in good debt ratios (1.7 times debt-to-cash flow, 5.2 times peak debt service coverage, and 14% debt-to-total operating revenue); while the expected issuance of up to $302 million of new money debt will stress debt-to-cash flow somewhat, the plan of finance (including the expected refunding) is expected to generate significant peak debt service savings
*Demonstrated willingness and ability of management to take aggressive steps to freeze most discretionary capital spending plans in light of recent market challenges and the system's significant decline in unrestricted liquidity
CHALLENGES
*Material decline in unrestricted liquidity in FY 2008 resulting in a decline in cash on hand to a modest 90 days at fiscal year end (FYE) 2008 from 131 days at FYE 2007; the system has plans to change its investment strategy and invest up to 40% of cash and investments in generally less liquid securities (e.g., real estate, private equity, commodities, and other alternative investments); this would be accomplished over a multi-year period of time as opportunities are identified
*Factoring in the planned issuance of up to $302 million of new debt later in calendar 2008, pro forma cash-to-debt measures a modest 117% (including $110 million of reimbursement for prior capital expenditures), which is below the
Aa3 median of 163%; management projects the entire $302 million will be drawn down within 18 months of issuance; we note that a significant portion of Sisters of Mercy's future capital spending plans will be funded from construction bond funds (which Moody's does not include as unrestricted cash) that otherwise would have been funded out of cash flow or a decline in existing unrestricted liquidity
*High dependence on two states (Missouri and Oklahoma) for operating revenue and operating cash flow; two of the three strategic service units (SSU), St.
Louis and Oklahoma, operate in highly competitive markets; we note that the presence in Missouri is diversified into two geographically diverse markets
*Modest operating margins for a Aa-rated health system (7.5% operating cash flow margin in FY 2008), although operating cash flow generation has been stable
*Significant operating challenges in two of the three Arkansas markets and at the health plan in recent years
*Underfunded defined benefit pension plan (77% funded ratio at FYE 2008), although we note that Sisters of Mercy's defined benefit pension is a church plan and is not subject to ERISA funding guidelines
MARKET POSITION/COMPETITIVE STRATEGY: BROAD MARKET COVERAGE AMONG MULTIPLE MARKETS IN FOUR STATES
Sisters of Mercy is a large integrated healthcare system. The system operates:
(a) 18 acute care hospitals and two heart hospitals in seven SSUs in four states (Missouri, Oklahoma, Arkansas, and Kansas), encompassing both urban and rural markets; (b) a sizeable health plan with more than 225,000 commercial members and more than 20,000 Medicare HMO members; and (c) employs more than 1,000 physicians. We note that the two Missouri SSUs (Springfield and St.
Louis) alone accounted for a sizable 83% of system operating cash flow in FY 2008.
Springfield, MO is Sisters of Mercy's largest SSU (based on percent of operating revenue). In the Springfield SSU, Sisters of Mercy's St. John's Health System captures approximately 40% market share of a broad multi-county service area, just ahead of its major competitor's share, A2-rated CoxHealth.
The Springfield SSU has generated increasing operating income and operating cash flows for Sisters of Mercy in recent years.
Sisters of Mercy's next two largest SSUs - St. Louis and Oklahoma - also operate in very competitive markets and are not the leading providers. In St.
Louis, Sisters of Mercy's St. John's Mercy Health Care captures 13% market share, behind market leaders BJC Health System (rated Aa2) and SSM Health Care System. The Oklahoma SSU includes two markets, Oklahoma City and Ardmore. In competitive Oklahoma City, Sisters of Mercy's Mercy Health System of Oklahoma captures 9% market share behind market leaders Integris Health (rated Aa3) and for-profit HCA. In smaller Ardmore, Sisters of Mercy captures a leading 58% market share. Sisters of Mercy has recorded increasing profitability in St.
Louis despite the high level of competition (12.4% operating cash flow margin in FY 2008). While still quite profitable, the Oklahoma market's profitability declined in FY 2008 (12.3% operating cash flow margin in FY 2008 compared to 15.1% margin in FY 2007).
OPERATING PERFORMANCE: MODEST OPERATING MARGINS FOR A Aa-RATED HEALTH SYSTEM, ALTHOUGH OPERATING CASH FLOW GENERATION IS STABLE
While system margins remain weak compared to peers, Sisters of Mercy's absolute operating cash flow generation has increased moderately in recent years and provides predictable debt coverage. In unaudited FY 2008, Sisters of Mercy recorded operating income of $36.8 million (1.0% operating margin) and operating cash flow of $281.8 million (7.5% operating cash flow margin).
Operating results are adjusted to: (a) reclassify the portion of investment income/loss included in operating revenue to non-operating revenue ($4.0 million loss in FY 2008); (b) "gross up" interest expense to included capitalized interest ($15.5 million in FY 2008); and (c) interest expense on Series 2001 bonds reclassified from non-operating interest income offset to operating expense ($6.7 million in FY 2008). In FY 2007, Sisters of Mercy recorded operating cash flow of $277.2 million (7.6% margin). Between fiscal years 2005 and 2008, the system's operating margins were very stable, as the operating cash flow margin ranged from 7.5% to 7.6%.
The system operating cash flow margin remained flat despite the aforementioned good profitability at the Springfield, St. Louis, and Oklahoma SSUs. The system continued to face operating challenges at the Hot Springs, AR and Rogers, AR SSUs and the health plan. Hot Springs struggles with a challenging payor mix as Medicare and Medicaid represent a combined 65% of gross revenues for the SSU. Hot Springs also is challenged by a high length of stay. Rogers operating performance has been modest for years, and was particularly challenged by a number of factors in FY 2008, including: (a) a material increase in the number of employed physicians that led to an increase in physician losses to $15 million in FY 2008 from $5 million in FY 2007; (b) in early calendar year 2008, Sisters of Mercy opened a new hospital in the Rogers market and concurrently implemented a new electronic health information system, the combination of which resulted in significant operating challenges.
Improving performance in the Hot Springs and Rogers markets is a key focus for Sisters of Mercy. Specific initiatives include: (a) the CEOs of the more profitable SSUs throughout the System are working with the CEOs of Hot Springs and Rogers to implement operating efficiencies; (b) implementing a statewide managed care contracting plan with price increases; (c) revenue coding and charge capture improvements; and (d) a number of significant cost savings efforts, including staff reductions at both Hot Springs (163 full time
equivalents) and Rogers (205 FTEs), improved management of overtime expenses, and consolidating regional business offices.
Profitability at Mercy Health Plans, the managed care line of business, decreased from an operating profit of $24.9 million in FY 2005 (4.4% margin) to an operating loss of $4.1 million in FY 2008 (-0.7% margin, which was only modestly better than the -1.0% margin in FY 2007). Management attributes the loss of profitability at the health plans to mis-priced products (namely the Medicare risk plan and the PPO in the St. Louis market). Sisters of Mercy is experiencing significant improvement for the health plan in FY 2009, projecting net income of $7.2 million, before taxes, for calendar 2008.
Due to a low debt load, the system's debt ratios are strong despite the system's modest operating margins. Based on unaudited FY 2008 results adjusted debt-to-cash flow measures a favorably low 1.7 times and maximum annual debt service (MADS) coverage measures an adequate 5.2 times. Despite the expected issuance of up to $302 million of new debt later in 2008, the upcoming financings are expected to include significant MADS savings as the new debt service amortization schedule will smooth out debt service over 33 years. Pro forma adjusted MADS coverage measures a very good 7.3 times.
BALANCE SHEET POSITION: MATERIAL CASH DECLINE IN FY 2008
Sisters of Mercy's absolute unrestricted cash and investments decreased significantly in FY 2008. The system's absolute unrestricted cash decreased to
$864 million at FYE 2008 from $1,220 million at FYE 2007. As a result, cash on hand declined materially to a very modest 90 days at FYE 2008 from 131 days at FYE 2007. Due to Sisters of Mercy's moderate debt load, however, cash-to-debt measured a good 162% at FYE 2008 despite the decline in cash.
Factoring in the planned issuance of $302 million of new money bonds later in 2008, which is expected to include approximately $110 million of reimbursement for prior capital expenditures, pro forma cash on hand and cash-to-debt measure modest 101 days and 117%, respectively (pro forma cash-to-variable rate demand obligation debt measures a good 210%). These ratios are modest compared to the Aa3 medians of 234 days cash on hand and 163% cash-to-debt.
Management projects the entire $302 million will be drawn down within 18 months of issuance. We note that a significant portion of Sisters of Mercy's future capital spending plans will be funded from construction bond funds (which Moody's does not include as unrestricted cash) that otherwise would have been funded out of cash flow or a decline in existing unrestricted liquidity. We note that total cash and investments (including restricted and unrestricted funds) was down a further approximately $42 million between FYE
2008 and August 31, 2008. Given market performance since August, we expect Sisters of Mercy's liquidity to be down further.
Sisters of Mercy has approximately $1.7 billion of capital spending plans in FY 2009 through FY 2013. We note that management has implemented a freeze on most discretionary capital spending, indicating management discipline and control. Implementation of information systems is a significant component of the system's capital efforts.
OUTLOOK:
The stable outlook at the lower rating level reflects our belief that Sisters of Mercy will continue to generate stable operating cash flow, with expectation of improved results beyond FY 2009 as the system realizes the benefits of various capital investments and operating improvements. We expect liquidity to rebuild after FYE 2009.
What could change the rating--UP
Sustained materially improved operating margins; maintenance of good debt ratios; materially improved liquidity
What could change the rating--DOWN
Decline in operating margins leading to weaker debt ratios; continued weakening of liquidity ratios; increase in debt beyond upcoming expected debt issuance without commensurate increase in cash flow and liquidity
KEY INDICATORS
Assumptions & Adjustments:
-Based on Sisters of Mercy Health System, Inc. and Subsidiaries consolidated financial statements
-First number reflects audited FY 2007 for the year ended June 30, 2007
-Second number reflects unaudited FY 2008 for the year ended June 30, 2008
-Ratios do not include expected issuance of up to $302 million of new money debt later in 2008 or expected refunding of Series 2001A,B,&C auction rate bonds
-Interest expense "grossed up" to included capitalized interest ($15.5 million in FY 2008), and interest expense on Series 2001 bonds reclassified from non-operating interest income offset to operating expense ($6.7 million in FY
2008)
-Investment returns reclassified to non-operating revenue and normalized at 6%
*Inpatient admissions: 147,234; 147,222
*Total operating revenues: $3.64 billion; $3.75 billion
*Moody's-adjusted net revenues available for debt service: $359 million; $342 million
*Total debt outstanding: $526 million; $534 million
*Maximum annual debt service (MADS): $65.3 million; $65.3 million
*MADS Coverage with reported investment income: 5.60 times; 5.06 times
*Moody's-adjusted MADS Coverage with normalized investment income: 5.50 times;
5.25 times
*Debt-to-cash flow: 1.59 times; 1.69 times
*Days cash on hand: 131 days; 90 days
*Cash-to-debt: 232%; 162%
*Operating margin: 1.1%; 1.0%
*Operating cash flow margin: 7.6%; 7.5%
RATED DEBT (debt outstanding as of June 30, 2008)
Issued through Arkansas Development Finance Authority:
-Series 1993A Fixed Rate Health Facilities Revenue Refunding Bonds ($9 million outstanding), rated Aa3
Issued through Louisiana Public Facilities Authority:
-Series 1993A Fixed Rate Health Facilities Revenue Refunding Bonds ($3 million outstanding), rated Aa3
Issued through Health and Educational Facilities Authority of the State of
Missouri:
-Series 2001A Auction Rate Health Facilities Revenue Bonds ($126 million outstanding), insured by Ambac (currently rated Aa3 on review for possible downgrade), Aa3 unenhanced rating
-Series 2001B Auction Rate Health Facilities Revenue Bonds ($126 million outstanding), insured by Ambac (currently rated Aa3 on review for possible downgrade), Aa3 unenhanced rating
-Series 2001C Auction Rate Health Facilities Revenue Bonds ($126 million outstanding), insured by Ambac (currently rated Aa3 on review for possible downgrade), Aa3 unenhanced rating
-Series 2008A,B,&C VRDO Health Facilities Revenue Bonds ($110 million outstanding), supported by a standby bond purchase agreement from Bank of America, rated Aa3/VMIG1
