OREANDA-NEWS. Fitch Ratings has assigned an 'A+' rating to the approximately $237,875,000 Massachusetts Development Finance Agency, revenue bonds, Lahey Health System Obligated Group Issue, series F (2015).

In addition, Fitch has affirmed the 'A+' rating on the following debt issues:

--$48,691,000 Massachusetts Health & Educational Facilities Authority (MA) (Lahey Clinic Medical Center Issue) revenue bonds series D;
--$115,960,000 Massachusetts Health & Educational Facilities Authority (MA) (Lahey Clinic Medical Center) hospital revenue bonds series C.

The Rating Outlook is Stable.

The series 2015 bond proceeds will be used to refund the outstanding series C and D bonds and provide $105 million of new money for capital expenditures. The bonds will be fixed rate and are expected to price the week of Oct. 5th.

SECURITY

Gross revenue pledge of the Lahey obligated group. In May 2012, Lahey Clinic Foundation merged with Northeast Health System (Northeast) and the Lahey Health System (Lahey) was formed. In July 2014, Winchester Hospital and its affiliates (Winchester; rated 'A-', Outlook Stable) joined Lahey. Currently, the three entities are separately obligated on their respective debt. The Lahey obligated group accounted for 61% of total assets and 67% of total revenue of the consolidated system in fiscal 2014 (Sept. 30 year end). Fitch's analysis is based on the consolidated system.

KEY RATING DRIVERS

INTEGRATED AND GROWING DELIVERY SYSTEM: Lahey's business model has historically fostered strong physician alignment with physician clinic and hospital operations under a single unified board and management structure that facilitates the coordination of care. Over the last three years, Lahey has grown to include two community hospital systems - Northeast and Winchester. Lahey has been very successful in leveraging the strength of the system and providing care in the most appropriate cost setting.

VERY COMPETITIVE MARKET: The market is highly competitive and has resulted in low managed care rate increases. The market is currently dominated by one player (Partners HealthCare, rated 'AA'; Outlook Stable) and further consolidation activity is expected. Lahey continues to pursue merger/affiliation discussions. Lahey's volume growth has been very strong, especially at its community hospitals, and the rate of growth is higher than the overall service area. In addition, over 70% of Lahey's revenue is from outpatient services already.

WEAK OPERATING PERFORMANCE: Lahey had a difficult fiscal 2015, which is expected to end with a negative 1.4% operating margin and 4.4% operating EBITDA margin due mainly to the costs associated with its Epic implementation as well as lower volume than expected given the severe snowstorms in winter 2015. In addition, expense reductions were purposely delayed due to the Epic implementation.

GOOD LIQUIDITY: Liquidity metrics are solid and even with the expected additional debt, cash to pro forma debt is in line for the rating category. Unrestricted cash and investments at June 30, 2015 was $847 million, which translated to 168.9 days cash on hand and 138.6% pro forma cash to debt compared to the 'A' category medians of 205.3 and 143.7%, respectively.

CAPITAL NEEDS: The series 2015 bonds ($105 million new money) will fund the construction of a new emergency room and the build out of new space for General Internal Medicine at Lahey Hospital and Medical Center. Pro forma debt metrics are still fairly moderate and there is a slight reduction in aggregate maximum annual debt service (MADS) due to the restructuring of outstanding debt. Debt service coverage is low for the rating level and was 2.9x through the nine months ended June 30, 2015 compared to 3.5x in fiscal 2014.

RATING SENSITIVITIES
IMPROVED OPERATING PERFORMANCE: Improved operating performance is necessary to maintain the current rating level given the weaker financial ratios relative to the 'A' category medians. The failure to meet projected targets would likely result in downward rating pressure.

CONSOLIDATION ACTIVITY: Lahey has ongoing affiliation and merger discussions and Fitch will monitor future consolidation activity and the impact on Lahey's financial profile.

CREDIT PROFILE
The system includes Lahey Hospital and Medical Center (tertiary and quaternary facility in Burlington, MA), Lahey Clinic (physician clinic with over 700 employed physicians), Beverly Hospital in Beverly, MA, Addison Gilbert Hospital in Gloucester, MA, senior living and behavioral health entities, and Winchester Hospital in Winchester, MA. The organization has population health management initiatives under various contracting strategies including an alternative quality contract with Blue Cross. Total annualized revenue for fiscal 2015 is $1.9 billion. The numbers referenced in this report are for the consolidated system (historical pro forma combined).

Although the majority of Lahey's financial ratios lag the category medians, the rating is affirmed due to Lahey's unique operating platform, which will position the organization well in a value based reimbursement environment. The addition of the community hospitals has been accretive and Fitch views Lahey's business strategy favorably. Fitch does not expect all of Lahey's ratios to be in line with category medians given their business model and operating environment, however, it is necessary for Lahey to meet its projected operating targets, which indicate steady improvement through fiscal 2017 and a return to operating EBITDA margins around 8%.

GROWING OPERATING FOOTPRINT
Lahey's history of being founded by a physician and operating as an integrated unit (physicians and hospital) has fostered cost effective care that has only strengthened with the added capacity and capabilities of its community hospital division. There is strong coordination between the various units and keeping primary and secondary care in the community setting while creating capacity for higher acuity cases at the tertiary facility, Lahey Hospital and Medical Center. There is also a cross referral relationship depending on the patient's origin that may result in a referral from a Lahey primary care physician to a community hospital specialist. Volume growth through the nine months ended June 30, 2015 compared to the same prior year period was 1.13% at Lahey Hospital and Medical Center, 4.15% at Beverly and Addison Gilbert Hospitals and 5% at Winchester Hospital compared to 1.1% for Lahey's service area.

The growing system now has post-acute and behavioral health resources as well as experience under various shared risk contracts. Lahey is one of the lowest cost providers in the area and it has consistently been highly ranked amongst academic medical center peers related to quality and cost.

Lahey's primary service area is defined as the eastern half of Middlesex County and the majority of Essex County (78% of discharges) and the system had the leading market share of 31.6% in 2013 (most recent data available) compared to Partners (North Shore Medical Center, Massachusetts General, Brigham and Women's) with 26.2%.

WEAK OPERATING PERFORMANCE
Lahey's operating performance was very weak through the nine months ended June 30, 2015, mainly due to the costs associated with the Epic implementation as well as lower than expected volume due to the heavy snowstorms in winter 2015. The weather had a larger impact on Lahey than other providers in the service area due to the high percentage of Lahey's revenue from outpatient services (74%).

Through the nine months ended June 30, 2015, Lahey had negative 1.8% operating margin compared to 2.8% in fiscal 2014, 3.1% in fiscal 2013 and 2.3% in fiscal 2012. Lahey projects to end the year with a negative 1.4% operating margin.

Fitch notes that Lahey had a very successful Epic implementation with Lahey Hospital and Medical Center and the affiliated physician practices live in March 2015 and Northeast in August 2015 (which was accelerated by several months). The organization did not experience any revenue cycle issues during the implementation. However, this was at a cost and in addition to the capital expenditures, there were significant training and operating expenses related to the implementation as well as lower productivity as clinicians were learning the new system. Additional expenses are expected in fiscal 2017 as Winchester will go live in early 2017.

Management also purposely delayed executing expense reduction initiatives because of the Epic implementation and cost reductions implemented in July 2015 will mainly be realized in fiscal 2016. Performance improvement initiatives total $74.3 million and include $44.6 million from labor, $22.4 million in revenue enhancements and $7.3 million from supply chain savings. The projected fiscal 2016 operating margin is 1% and operating EBITDA margin of 7.4%. It is expected that Lahey will return to around an 8% operating EBITDA margin by fiscal 2017 otherwise negative rating pressure is likely.

CAPITAL SPENDING
Lahey recently spent $162 million on its Epic project and the next major project is the new emergency room at Lahey Hospital and Medical Center at a total cost of $85 million. Capital spending out of cash flow is manageable at $99 million in fiscal 2016 and $101 million in fiscal 2017, which is a little over 1x depreciation expense.

GOOD LIQUIDITY
Lahey's balance sheet metrics are solid with 168.9 days cash on hand and 138.6% cash to pro forma debt at June 30, 2015. Liquidity should remain stable as Lahey is debt financing its emergency room project and projected capital spending is manageable. The associated capital campaign for the emergency room project (raised $41 million to date of the $85 million campaign) should keep balance metrics stable as pledges are received. Lahey recently hired a new development officer with a focus on increasing overall fundraising.

CONSERVATIVE DEBT PROFILE
Total outstanding debt for the system was $512 million as of Sept. 30, 2014 and includes $276.7 million of Lahey obligated group debt, $113.6 million related to Northeast and $105.1 million related to Winchester, and $16.8 million of capital leases and note payables. Management is in the process of consolidating the debt under one obligated group. The system debt profile is approximately 78% fixed rate and 22% variable rate. There are several fixed payer swaps related to Northeast's and Winchester's debt.

Lahey obligated group's debt is front loaded due to a bank loan with a short amortization that was issued to fund Epic. With the proposed restructuring of outstanding debt and new money, maximum aggregate debt service declines to $44.8 million from $47 million (for the system).

Debt metrics are still moderate with MADS accounting for 2.5% of total revenue through the nine months ended June 30, 2015, compared to the 'A' category median of 2.8%. However, debt service coverage is light at 2.9x through the nine months ended June 30, 2015 due to weak operating performance compared to 3.5x in fiscal 2014, 4.3x in fiscal 2013 and the 'A' category median of 4.2x. Bond covenant debt service coverage calculation for the Lahey obligated group was 3.1x in fiscal 2014 and 3.7x fiscal 2013.

DISCLOSURE
Lahey provides annual and quarterly disclosure (for the first three quarters) to EMMA.