OREANDA-NEWS. Fitch Ratings has downgraded Catholic Health Initiatives' (CHI) Long-Term Rating on approximately $6 billion of outstanding debt by various issuers to 'BBB+' from 'A+'. Fitch has also downgraded the Short-Term Rating on $978 million of debt additionally supported by CHI's self-liquidity to 'F2' from 'F1+'.

The Rating Outlook is Negative.

SECURITY

Unsecured general obligation of the CHI Credit Group.

KEY RATING DRIVERS

WEAK FINANCIAL PROFILE: The downgrade to 'BBB+' and maintenance of the Negative Outlook is driven by a financial profile that is no longer consistent with an 'A' category rating as well as Fitch's heightened concerns as the system struggles to rein in the losses throughout a substantial part of its operations. CHI needs to realize the synergies of its recent acquisitions to generate organic growth in its new and existing markets.

ELEVATED DEBT METRICS: With the decrease in liquidity and weak cash flow generation, the weight of CHI's elevated debt load becomes more amplified in 2016. Maximum annual debt service (MADS) coverage decreased in the nine months of 2016 to 1.3x from 1.9x in the comparable period in 2015 while cash-to-debt decreased to a low 66.9%. (Fitch includes all long-term, commercial paper and short-term lines in MADS and debt outstanding.)

LEAN LIQUIDITY OFFERS DIMINISHED CUSHION: The deterioration in CHI's unrestricted cash and investments in 2015 and through the nine months of 2016 provides a weaker financial cushion to support operating volatility at CHI. Unrestricted funds of $6.05 billion at March 31 2016 equates to a light 140 days cash on hand, which should improve by year-end with the completed real estate sale of 43 properties that generated approximately $527.3 million in net cash proceeds by fiscal year-end.

DIVERSE REVENUE AND OPERATING PLATFORM: With no market representing greater than 16% of total revenue, operations in 18 states, and multiple clinically integrated networks, CHI has broad and geographically diverse operations to help offset losses in any one particular region. Fitch views this diversity as a key credit strength.

SUFFICIENT LIQUIDITY TO SUPPORT SHORT-TERM RATING: CHI has sufficient liquidity in the form of highly liquid unrestricted cash and investments and dedicated lines of credit to support the 'F2' Short-Term rating. As of April 30, 2016, CHI's ratio of eligible cash and investments to self-liquidity obligations exceeded Fitch's criteria threshold of 1.25x.

RATING SENSITIVITIES

PROFITABILITY IMPROVEMENT: CHI will need to execute on its performance improvement plan to reverse the current operating trend and improve profitability and liquidity to maintain the current 'BBB+' rating. Fitch believes that if the system's strategies are successful, it should be able to deliver a sustainable EBITDA of above 7% (as calculated by Fitch) within the next 12 months. Failure to improve operating performance to levels more consistent with 'BBB+' category peers and/ or a further deterioration in balance sheet metrics will result in a downgrade.

CREDIT PROFILE

CHI is one of the largest not-for-profit integrated healthcare delivery systems in the U. S. The system sponsors 11 markets in 18 states, consisting of 103 acute care hospitals (30 of which are designated as critical access hospitals); numerous long-term care, assisted living and residential facilities; two community health service organizations; and two nursing colleges. The consolidated system generated over $15 billion in total operating revenues in the fiscal year ended June 30, 2015.

WEAK FINANCIAL PROFILE

The Negative Outlook reflects continued challenges in turning around core operating performance despite a multi-year effort to return the system to profitability. CHI has been heavily affected by losses in certain market-based organizations (MBOs) and the health plan QualChoice Health, Inc. (formerly known as Prominence Health). In the nine-months of 2016, operating and operating EBITDA margins were -4.3% and 3.0%, respectively, significantly below the 'A' category medians of 3.6% and 10.3%. (Fitch excludes non-cash gains on business combinations and includes expenses related to restructuring and impairment in its calculations. Donations and changes in equity of unconsolidated organizations ($66.7 million) are classified as non-operating revenue and are therefore excluded from the operating margin).

Fitch expects that CHI may need two to three years to fully implement its financial turnaround plan as it is working on multiple initiatives concurrently. Aside from the losses at QualChoice (CHI is exploring strategic options that could result in the sale or partnership of the plan), CHI is attempting to address increased supply and overhead expenses, rationalizing clinical staff labor expense, weaker volume trends in some markets, unfavorable shifts in payer mix with increasing self-pay deductibles, tightening reimbursement, and increased competition from strong regional providers. Management reports that there has been progress in several areas in the latter half of fiscal 2016, particularly in revenue cycle and labor initiatives.

While CHI's revenue diversity is a credit strength and insulates the system from losses in any one market, it cannot cushion against deficits occurring in several large markets simultaneously, which has been CHI's recent experience. The difficulties in Nebraska (approximately 13% of the system's 2015 revenues) following a contract dispute with Blue Cross Blue Shield that resulted in a very weak 2.7% operating EBITDA margin for that market in 2015 were mostly resolved by fiscal 2016, but the challenges in Kentucky (15% of revenues) and Texas (12% of revenues) have proved more difficult to resolve. The high performing Pacific Northwest market (16% of revenues) has declined modestly in 2016 to a 9.2% operating EBITDA margin from a solid 10.6% operating EBITDA margin in 2015 due to higher labor and supply expenses that outpaced revenue from volume shortfalls and tight reimbursement.

CHI is continuing to address the shortfalls in the Kentucky market by developing stronger partnerships with the University of Louisville, stabilizing operations, building out the KentuckyOne medical group and further developing its clinically integrated network. The strategies met with tepid results in 2016, although there has been improvement in revenue cycle and expense control. CHI has similarly been working on several initiatives at its Texas market and has seen improvement, particularly in labor productivity. However, operational efficiencies, physician alignment and integrating the CHI facilities and services in the Texas MBOs are still key focus areas for management as Texas is grappling with weak outpatient volume and higher Medicare usage. Fitch notes that CHI's smaller markets are generating stronger margins.

MBO REPOSITIONING AND INTEGRATION

CHI is comprised of 32 MBOs that are further organized into larger regions. Fitch believes CHI's strategy to focus and position its MBOs to build sufficient size and scale in order to develop and/or participate in value-based reimbursement and population management programs is appropriate. In prior years, CHI focused on mergers, acquisitions and divestitures to expand its geographic reach and map out the MBOs. Now, management's focus is on defining what market relevance means in an era of delivery transformation.

Defining market relevance, building a network of choice, aligning physician groups, and creating the correct number and locations for access points, is specific to each market. CHI's inherent execution risk comes from finding the right balance between demonstrating strong regional leadership and flexibility in implementing local strategies, while leveraging the system's overall size and scale for efficiencies and expertise at the national/system level. There is a small margin of error, as there is often significant competition from strong regional providers in the different markets. Nevertheless, if correctly executed, Fitch believes that CHI has the infrastructure needed to benefit from investments made to date and can make meaningful progress towards thriving under the changing revenue and reimbursement models prompted by healthcare reform.

DIMINISHED LIQUIDITY

At March 31, 2016, CHI had total unrestricted cash and investments of $6.05 billion which is down from $6.88 billion and $7.01 billion at FYE 2015 and FYE 2014, respectively. DCOH of 140.3 days at March 31, 2016 is materially weaker than 175 days at FYE 2015 and 198 days at FYE 2014, representing the combined impact of weakened cash flows, unrealized losses on the investment portfolio, elevated capital expenditures, and expense base growth. CHI's 10.9x cushion and 66.9% cash to debt ratios at March 31 2016 are well below the respective 'A' category medians of 18.5x and 143.7%.

Liquidity should receive a boost of approximately 12 days cash from the real estate sale of 43 properties that generated approximately $527.3 million in net cash proceeds by July 1. The properties are leased back to CHI for a net annual expense of over $30 million, net of real estate taxes and other expenses. CHI is considering a smaller additional sale of real estate assets in 2017 as it moves towards a goal of owned vs. lease ratio of 65%. Management is projecting DCOH of 165 days by Dec. 31, 2016, which Fitch believes will prove difficult to achieve unless operations improve significantly before December.

SHORT-TERM RATING

The downgrade to the 'F2' Short-Term Rating is correlated with the downgrade of the Long-Term Rating to 'BBB+'. The 'F2' rating is supported by the adequacy of CHI's highly liquid resources, which are available to fund any un-remarketed puts on the following: $96.7 million in weekly VRDBs, $250 million line of credit, and up to $881 million in CP ($741 million drawn as of March 31). CHI has directed dealers to tranche maturities so that no more than $200 million matures within any five-day period.

At April 31, 2016, CHI had approximately $2.4 billion of highly liquid, unrestricted cash and fixed income securities, and dedicated working capital lines available. CHI has total funding sources available to meet the tender exposure in excess of Fitch's 'F2' threshold of 1.25x. Fitch has received a written internal procedures letter from the organization, which outlines internal policies to meet any funding requirements.

DEBT PROFILE

As of April 2016, CHI had $9 billion in total outstanding debt, which includes $741 million in commercial paper and $907 million in non-Capital Obligation Debt (COD). Approximately 65% of the COD debt is fixed and the remainder is in a variety of floating rate products (weekly VRDBs, FRNs, and commercial paper).

With the weakened profitability ratios, MADS coverage was very low at 1.3x for nine months ending March 31. Fitch uses MADS of $554.3 million, which incorporates a smoothing of the bullet maturity structure and includes all debt, including short-term lines and commercial paper. CHI does not have to calculate quarterly debt service coverage nor is it obligated to include short term debt in its COD calculations. MADS on just the long-term debt is $460.7 million, which would result in MADS coverage of 1.5x for the nine-month interims in 2016 as compared to 2.2x for the same 2015 period.

CHI's swap portfolio represented an aggregate notional amount of $1.7 billion as of March 31, 2016, with $276 million of collateral posted against a total swap liability of $382.5 million.