OREANDA-NEWS. Fitch Ratings has affirmed the 'A-' rating on $228.6 million of bonds issued by the Kentucky Economic Development Finance Authority and the City of Ashland (KY) on behalf of King's Daughters Medical Center (KDMC).

The Rating Outlook is Negative.

SECURITY

Bond payments are secured by a pledge of the gross receipts of the obligated group and a mortgage interest in certain property including the acute care hospital.

KEY RATING DRIVERS

REBOUNDING PROFITABILITY: The rating affirmation reflects KDMC's improving operating profitability with operating EBITDA margin increasing from 3% in fiscal 2014 to 6.7% in fiscal 2015 and 8.5% in the six month interim period ending March 31, 2016 (the interim period).

WEAKENED LIQUIDITY: The Negative Outlook reflects the continued decrease in liquidity metrics with unrestricted cash and investments decreasing 10% since fiscal 2014 through March 31, 2016. The decrease is primarily due to swap collateral posting requirements. Unrestricted liquidity had previously been projected to increase.

IMPROVING COVERAGE: Reflective of the rebounding operating profitability, MADS coverage by operating EBITDA increased from 0.9x in fiscal 2014 to 2.0x in fiscal 2015 and 2.6x in the interim period.

DECLINING UTILIZATION: Inpatient and outpatient utilization decreased between fiscal 2011 and fiscal 2015, resulting in both an erosion of operating revenue and market share. Volumes appear to be stabilizing in the interim period with increased outpatient volumes.

RATING SENSITIVITIES

IMPROVED FINANCIAL PROFILE: Fitch expects that King's Daughters Medical Center's operating profitability will continue to improve to levels sufficient to produce coverage consistent with the rating category and that unrestricted liquidity metrics will improve due to the improved cash flows and low capital spending levels. Failure to improve profitability or liquidity metrics will result in negative rating pressure.

STABILIZED VOLUMES AND REVENUE: Additionally, Fitch expects that volumes and patient revenue will stabilize going forward. Continued deterioration in patient volumes and net patient revenues could result in negative rating pressure.

CREDIT PROFILE

KDMC operates a 465-staffed bed regional tertiary referral center located in Ashland, KY, approximately 120 miles east of Lexington, KY and 120 miles south of Columbus, OH. Additional operations include KDMC Ohio (a 10 licensed bed hospital that opened February 2013), six urgent care centers, a long-term and short-term care facility, an ambulance transport company, an integrated physicians group, a research foundation and a philanthropic foundation. Total operating revenue decreased 7.7% since fiscal 2013 to $448.3 million in fiscal 2015.

KDMC and the U. S. Department of Justice (DOJ) entered into a final settlement agreement in May 2014. The DOJ initiated an investigation of KDMC in 2011 for alleged violations of the False Claims Act related to KDMC's levels of cardiac stent and catheter procedures between 2006 and 2011. The government contended that the number of procedures was high, indicating that unnecessary procedures were performed. KDMC denied the DOJ's allegations. While no civil or criminal charges were ever filed against KDMC, KDMC entered into a settlement agreement with the DOJ to end the investigation. Under the terms of the agreement, KDMC paid a $40.9 million settlement to the DOJ and signed a corporate integrity agreement but did not admit to any wrongdoing.

REBOUNDING PROFITABILITY

The rating affirmation reflects KDMC's improving operating profitability. Profitability has incrementally improved since deteriorating in fiscal 2013. Operating EBITDA margins averaged 10.2% between fiscal years 2010 and 2012 but declined to a weak 3.1% in fiscal 2013. Management implemented an operating improvement plan in late fiscal 2013.

After a slow start, profitability stabilized in fiscal 2014 with operating EBITDA equal to 3% (excluding $3.9 million of non-recurring severance and restructuring expenses), slightly below management's budgeted target of 3.3%. Operating EBITDA margin improved in fiscal 2015 and the interim period, increasing to 6.7% and 8.5%, respectively. However, operating EBITDA margin remains light relative to Fitch's 'A' category median of 10.3%.

KDMC's core operations have significantly improved as highlighted by excluding DOJ-related expenses and consulting engagement fees. Excluding DOJ-related expenses and consulting engagement fees, operating EBITDA margin equaled 4% in fiscal 2014 and increased to 8.7% in fiscal 2015 and 10.7% in the interim period. The consulting engagement is expected to cease in fiscal 2016 and the DOJ-related expenses are expected to materially decrease in fiscal 2018.

WEAKENED LIQUIDITY

The continued Negative Outlook reflects the unexpected continued decline in unrestricted cash and investments. Liquidity metrics continued to decrease since fiscal 2014 when liquidity metrics were materially impacted by KDMC's $40.9 million settlement payment to the DOJ. Unrestricted cash and investments decreased $22 million (10.5%) since fiscal 2014 to $188.5 million at March 31, 2016 despite modest capital spending and improving cash flow. The decrease is due to a $15.2 million swap collateral posting requirement and unrealized investment losses. With 158.7 days cash on hand, 12.2x cushion ratio and 81.1% cash to debt, liquidity metrics are weak relative to Fitch's 'A' category medians of 205.3, 18.5x and 143.7%.

Fitch expected that liquidity to strengthen due to the combination of improving profitability and low capital spending. Unrestricted cash and investments was projected to increase to $257.3 million by fiscal year-end 2017. Additionally, ongoing malpractice allegations related to the DOJ investigation may negatively impact liquidity.

IMPROVING COVERAGE

After materially compressing in fiscal 2013, with MADS coverage by EBITDA declining to 1.6x, coverage metrics have improved with the rebounding profitability. MADS coverage by EBITDA slightly improved to 1.7x in fiscal 2014 before increasing to 2.9x in fiscal 2015 and to 3.4x in the interim period. Excluding the DOJ and consulting expenses, MADS coverage by EBITDA would have improved to 2.0x in fiscal 2014, 3.4x in fiscal 2015 and 4.1x in the interim period. KDMC's debt burden is moderate with MADS equal to 3.4% of operating revenue in fiscal 2015. However, continued declines in operating revenue could increase the system's debt burden and negatively impact coverage ratios.

DECLINING UTILIZATION AND MARKET SHARE

Inpatient and outpatient utilization has materially decreased. Inpatient admissions and surgeries decreased 10% per year between fiscal 2013 and fiscal 2015 while outpatient surgeries decreased 8% per year. The decreasing utilization reflects a combination of the negative impact of the DOJ investigation and reputational damage in the community resulting from a reduction in force implemented in fiscal 2013 in addition to national utilization trends and the effects of high deductible health plans. Volumes appear to be stabilizing in the interim period.

Reflecting the declining utilization, KDMC's operating revenue decreased an average of 7% per year since fiscal 2012. Additionally, the system's leading market share in its primary service area decreased each year since fiscal 2010, declining from 39.5% in fiscal 2010 to 33.9% in fiscal 2014 (the most recent year for which data is available). However, management believes that KDMC's market share has stabilized and increased subsequent to the DOJ settlement. The service area remains challenging and is characterized by flat to declining population levels and low median household income levels relative to both state and national averages.

DEBT PROFILE

KDMC had $232 million of total debt outstanding at March 31, 2016. Outstanding bonds are comprised of 48% underlying fixed rate bonds and 52% underlying variable rate bonds. KDMC is counterparty to three fixed payor swaps with a total notional amount of $56.2 million effectively converting 25% of KDMC's bonds to synthetic fixed rates. The system had $15.2 million of collateral posted related to the swaps at March 31, 2016.

DISCLOSURE

KDMC covenants to provide annual disclosure within 150 days of the end of each fiscal year and quarterly disclosure within 45 days of the end of each quarter. Disclosure is provided through the Municipal Securities Rulemaking Board's EMMA website.