Sutter Health is building a 304-bed hospital at Cathedral Hill in San Francisco, part of a $5 billion capital plan over the next five years.

SAN FRANCISCO - Sutter Health, a major nonprofit healthcare system in Northern California, could see its Moody's Investors Service rating slip into the single-A category after two years of poor operating performance.

The credit rating agency late Tuesday revised its outlook on Sutter Health's Aa3 revenue bond rating to negative from stable.

"The negative outlook reflects certain challenges that the organization is currently facing, including poor performance in fiscal year 2013 that was well below a budget that was already modest, a capital plan of $5 billion over the next five years, and the possibility of additional debt," Moody's analysts said in a report.

The action affects $3.7 billion of rated revenue bonds issued for the healthcare system by entities that include the California Statewide Communities Development Authority, the California Health Facilities Financing Authority, and Sutter Health itself.

Moody's said it could downgrade the rating if Sutter Health fails to demonstrate significant operating improvement in 2014 or if its balance measures or debt measures weaken.

Sutter Health is headquartered in Sacramento. It has over $9 billion of operating revenues, 24 acute care facilities in five distinct service areas, and more than 2,500 physicians contracting with foundations — all of which Moody's views as strengths. The agency also noted that Sutter Health maintains a conservative asset-liability policy, with all fixed-rate debt, and that its holdings of unrestricted cash and investments have improved in recent years.

However, revenue growth in the last few years has been modest, and the system maintains a fairly high leverage position, with debt measures that are stressed for the Moody's rating category. Sutter's cash to debt measured 115% in fiscal year 2013 — below the Moody's Aa3 median of 177%.

The system is moving forward with major projects in San Francisco, and expects to continue high levels of capital spending totaling $5 billion over the next five years. The health system's $2 billion construction plans in San Francisco include building a 304-bed hospital at Cathedral Hill, a 120-bed hospital at its St. Luke's Campus, and three new medical office buildings these campuses. Sutter Health also has construction projects planned in Sacramento, Oakland, Santa Rosa, and San Carlos.

"To meet this level of spending, it is likely that cash reserves will drop, or debt will increase, or both," analysts said. "This could further weaken balance sheet measures."

Sutter Health must also deal with challenges the entire healthcare market in California faces, which include unfunded operating mandates such as minimum nurse staffing levels, high managed care penetration, high construction costs, seismic retrofit requirements, and low state reimbursement for the California Medical Assistance Program.

Among tax-exempt healthcare issuers, Sutter Health has consistently been one of the top 20 most active obligors.

During the month of May, the system was the 15th most active healthcare obligor, with 19 trades, according to a Barclays report on municipal healthcare, released monthly. In March, it was the number one most active obligor with 53 trades.

Standard & Poor's and Fitch Ratings both rate the health system at AA-minus, with stable outlooks.

With the healthcare industry facing certain challenges, and growing concern among investors about the potential for downgrades, analysts at Barclays analyzed the effects of rating changes on a select group of healthcare bonds.

The group consisted of larger hospital issuers with at least $1 billion of bonds outstanding, including Sutter Health.

They found that such changes typically do not have a significant effect on the yield differential between a particular hospital bond and its benchmark index.

"Thus, we think that investors may be able to benefit from the excess yield of a credit facing a potential downgrade with limited potential downside, as long as downgrades are within a rating category," said the report, authored by Thomas Weyl, Ming Zhang, and Sarah Xue.

The report was published on June 20, before the Moody's action on Sutter Health. Barclays said Wednesday it did not have anything to add specifically relating to Sutter Health.

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