Fitch Affirms Heartland Health (MO) at 'A+' & Removes Rating Watch Negative; Outlook Stable

CHICAGO--()--Fitch Ratings has affirmed and removed from Rating Watch Negative the 'A+' rating on approximately $119 million of bonds issued by the St. Joseph Industrial Development Authority (MO) and Missouri Health and Educational Facilities Authority on behalf of Heartland Health (Heartland). The rating affirmation affects the following bonds:

--$68,820,000 variable rate demand bonds (VRDB), series 2009A*;

--$50,000,000 fixed rate revenue bonds, series 2012.

*Underlying rating. The series 2009A VRDB bonds are supported by a letter of credit (LOC) from US Bank that expires in November 2019.

The Rating Outlook is Stable.

SECURITY

Debt payments are secured by a pledge of the gross revenues of the obligated group and a first mortgage on Heartland Regional Medical Center (HRMC, dba Mosaic Life Care), the sole member of the obligated group. As of June 30, 2012, HRMC satisfied the mortgage release provisions of the master trust indenture but has chosen to keep the mortgage in place at this time.

KEY RATING DRIVERS

REVIEW OF MISSOURI SUPPLEMENTAL FUNDING PROGRAMS COMPLETE: A review of Missouri's Federal Reimbursement Allowance (FRA), FRA and Medicaid disproportionate share (DSH) concluded that in prior years certain hospitals in the state were overcompensated. Based on analyses by third party accountants, Heartland incurred a $26 million reduction in patient revenue in fiscal 2016.

STRONG LIQUIDITY: Heartland's liquidity remains strong, with cash on hand of 327 days and cash-to-debt of 217% at fiscal year-end 2016.

CORE OPERATING MARGINS BELOW PEERS: Heartland's core operating margins are somewhat modest at the 'A+' rating category, as its operating EBITDA margin measured 8.7% in fiscal 2016 (not including the FRA adjustment).

GOOD DEBT COVERAGE: Heartland's debt coverage ratios remain favorable. Maximum annual debt service (MADS) coverage measured a strong 7.5x in fiscal 2016. Even if the FRA adjustment is included in fiscal 2016, MADS coverage still measured a good 5.5x.

STRONG MARKET POSITION: Heartland has a distinctly leading 80% inpatient market share in its multi-county primary service area (PSA). Heartland recently expanded into northern metro Kansas City, which has broadened its regional footprint.

RATING SENSITIVITIES

OPERATING STABILITY: Fitch believes Heartland Health can regain adequate operating margins despite lower disproportionate funding going forward. Fitch views Heartland Health's strong liquidity and moderate leverage position as sufficient mitigants to lower core operating profitability.

CREDIT PROFILE

Heartland Health is composed of: HRMC (dba Mosaic Life Care), a 352-operated bed hospital located in St. Joseph, Missouri; Heartland Long Term Acute Care Hospital; Northwest Medical Center, a 25-bed critical access hospital acquired in December 2014; Community Health Plan Insurance Company; Midwestern Health Management, Inc.; and HHS Properties, Inc. Total operating revenue in fiscal 2016 measured nearly $585 million (which includes the revenue suppression resulting from the FRA review). Heartland has been a Mayo Clinic Network member since 2012.

REVIEW OF MISSOURI SUPPLEMENTAL FUNDING PROGRAMS COMPLETE

A review of Missouri's provider tax program (known in the state as Federal Reimbursement Allowance) and Medicaid DSH concluded that in prior years certain hospitals in the state were overcompensated. Based on analyses by third party accountants, Heartland incurred a $26 million reduction in patient revenue in fiscal 2016 for prior year overpayments. Cash repayments to the state will be made over multiple years. The FRA adjustment resulted in a $46 million cash dilution. The FRA review also will result in Heartland receiving less net annual FRA reimbursement from the state, although the effect in fiscal 2017 and beyond will be modest compared to the one-time $26 million income statement adjustment fiscal 2016.

STRONG LIQUIDITY

Heartland's liquidity ratios remain strong. Cash on hand measured 327 days at fiscal year-end 2016 ('A' median is 216 days). Similarly, cash-to-debt at 217% and cushion ratio at 37% both measured well above 'A' medians (149% and 19%, respectively).

Given Heartland's absolute liquidity strength, its investment portfolio is not particularly aggressive. Fixed income and related investments account for approximately 45% of Heartland's portfolio (not including current cash) and equities accounting for the remaining 55% (weighted slightly towards international and global equities). Heartland does not have exposure to hedge funds or other illiquid alternative investments.

CORE OPERATING MARGINS BELOW PEERS

Heartland's core operating margins are somewhat modest at the 'A+' rating category. In fiscal 2016, Heartland's operating margin measured 2.5% and operating EBITDA margin measured 8.7% (not including the FRA revenue adjustment), below the 'A' medians of 3.8% and 10.3%, respectively. In fiscal 2015, Heartland's operating margin measured 2.8% and operating EBITDA margin 9.6% (not including a $24 million loss on the partial settlement of the defined benefit pension plan). Including the FRA adjustment dilutes Heartland's fiscal 2016 results considerably, however, as the operating margin and operating EBITDA margin would measure -1.9% and 4.6%, respectively.

Heartland's fiscal 2016 core operating EBITDA margin compressed in fiscal 2016 due in part to comparatively high expense growth in areas such as supplies (8.5%) and employee benefits (11.9%) and a 1.9% drop in inpatient admissions. Partly offsetting these challenges in fiscal 2016, Heartland benefited from outpatient volume gains, notably observation stays (up 20.5%; total hospital stays including admissions and observations increased 3.3%) and outpatient surgeries (up 7.7%).

Looking forward, Heartland management has budgeted a 2.5% operating margin for fiscal 2017, which is consistent with "core" results recorded in fiscal 2015 and fiscal 2016. Heartland's key ongoing operating improvement initiatives include increased outpatient volumes (particularly from the north Kansas City metro expansion), supply cost savings (in part through its MPact Health collaboration with Mercy Health and University of Missouri Healthcare), and improved staff flexing and reduction of staff turnover and agency use.

GOOD DEBT COVERAGE

Heartland's debt coverage ratios remain sound, in part because the system's debt load is relatively modest, as MADS as a percent of total revenue measured 2.2% in fiscal 2016 ('A' median is 2.7%). MADS coverage from EBITDA measured a strong 7.5x in fiscal 2016 ('A' median is 4.5x). Even if the FRA adjustment is included in fiscal 2016 results, MADS coverage still measured a good 5.5x. Similarly, debt-to-EBITDA in fiscal 2016 measured 2.3x (not including the FRA adjustment) and 3.1x (including the adjustment) (the 'A' median is 2.9x).

Heartland's debt structure is weighted toward variable rate (70% of total debt at fiscal year-end 2016). Heartland has two swaps in place, a floating-to-fixed rate swap ($57 million notional) and a basis swap ($45 million notional). Wells Fargo is the counterparty on both swaps. The swaps had a negative termination value of $9.8 million to Heartland at fiscal year-end 2016.

Heartland is in the process of terminating its defined benefit pension plan. During fiscal 2015, the defined benefit plan purchased annuities to terminate a portion of the plan. As part of this process, Heartland's projected benefit obligation (PBO) decreased from $124 million at fiscal year-end 2015 to $72 million at fiscal year-end 2016, and the underfunded status of the plan decreased from $9.2 million to $4.3 million. Heartland recorded a $24 million loss on the partial settlement of the defined benefit plan in fiscal 2015. Management expects to finalize the termination of the plan in calendar year 2017.

STRONG MARKET POSITION

Heartland has a distinctly leading 80% inpatient market share in its PSA. The PSA covers Andrew and Buchanan counties in Missouri and Doniphan County in Kansas, plus portions of other counties in the surrounding area. HRMC is the only hospital between Kansas City and Omaha, NE that provides tertiary services. Heartland recently expanded into northern metro Kansas City, which has broadened its regional footprint, although this strategy also exposes the system to new outpatient competition.

A driving factor contributing to Heartland's north Kansas City expansion strategy is the rapid population growth expected in that part of the market, which the system hopes will counterbalance expected stagnant population trends in the PSA.

MANAGEABLE CAPITAL SPENDING

Heartland's capital spending plans are manageable. The system has $75 million of capital plans between fiscal 2017 and fiscal 2018, which should translate to a capital expenditures-to-depreciation expense of approximately 120% ('A' median is 125%).

Disclosure

Heartland agrees to provide annual and quarterly disclosure to bondholders and the Municipal Securities Rulemaking Board's EMMA system. Quarterly disclosure includes a balance sheet and income statement and calculation of days cash on hand, debt-to-capitalization, and historical MADS coverage.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/site/re/750012

U.S. Nonprofit Hospitals and Health Systems Rating Criteria (pub. 09 Jun 2015)

https://www.fitchratings.com/site/re/866807

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1014828

Solicitation Status

https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1014828

Endorsement Policy

https://www.fitchratings.com/regulatory

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Contacts

Fitch Ratings
Primary Analyst
Mark Pascaris
Director
+1-312-368-3135
Fitch Ratings, Inc.
70 West Madison St.
Chicago, IL 60602
or
Secondary Analyst
Dmitry Feofilaktov
Associate Director
+1-212-908-0345
or
Committee Chairperson
James LeBuhn
Senior Director
+1-312-368-2059
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com