OREANDA-NEWS. Fitch Ratings has downgraded the rating on the following revenue bonds issued on behalf of East Texas Medical Center Regional Health System (ETMC) to 'BBB-' from 'BBB':

--\\$35.8 million Wood County Central Hospital District hospital revenue bonds, series 2011;
--\\$255.6 million Tyler Health Facilities Development Corporation hospital revenue bonds, series 2007A.

The Rating Outlook remains Negative.

SECURITY

The bonds are secured by a pledge of gross revenues of the obligated group, a first mortgage lien on certain property and debt service reserve funds on the series 2007 and 2011 bonds.

KEY RATING DRIVERS

PERSISTENT WEAK PERFORMANCE: The downgrade reflects continued operational weakness since October 2013 when Fitch assigned the rating a Negative Outlook. The maintenance of the Negative Outlook reflects Fitch's view that operating challenges will persist. Weak profitability continues to be driven by reimbursement pressure from major commercial payors at ETMC's main Tyler hospital, and sizeable declines in volume. ETMC's performance has weakened year over year and through the nine-month interim period ended July 31, 2015, ETMC posted a negative 1.3% operating loss (\\$8.6 million) and a 7.2% operating EBITDA margin, down from a respective negative 0.6% and 9.1% in the prior year period.

EXPECTED FORWARD PRESSURE: The maintenance of the Negative Outlook reflects Fitch's concern that profitability will remain weak over the intermediate term, as a result of continued commercial payor pressures and persistent declines in inpatient volume at ETMC's rural hospitals. Additionally, ETMC's thin margins budgeted for 2016 rely on supplemental reimbursement programs, some of which are set to expire after 2016. Fitch views this as a concern.

DECLINING SHARE OF COMPETITIVE MARKET: ETMC maintains a leading though declining share within its nine-county primary service area, at 39.7% of total admissions, down from 41.2% year prior. Its position is pressured by Trinity Mother Frances ('BBB+'/Outlook Positive), whose market share is up to 37.3% in 2014 from 36.1%. While ETMC's decision to reduce its rural clinical footprint by four to eight communities will reduce its exposure to dilutive performance at those facilities, it may present future challenges in local referral patterns and any eventual move toward population health in the northeast/east Texas market.

LIQUIDITY LIGHT BUT IMPROVING: ETMC's liquidity has improved materially since 2012. ETMC had \\$297 million in unrestricted cash and investments as of July 31, 2015, up 36% since 2012 and equal to 129 days of cash on hand (DCOH) and 77% cash to debt. Cushion ratio remains weak at 6.8x, well below the 11.1x 'BBB' category median. Fitch expects that future capital investment will be muted from recently elevated levels through 2013. ETMC maintains a defined benefit pension plan that is 79% funded.

CONSERVATIVE BUT ELEVATED DEBT PROFILE: ETMC's debt profile is conservative, with all fixed-rate debt and limited derivative exposure, though the system is somewhat leveraged and coverage has been weak. Maximum annual debt service (MADS) as a percent of total revenue was high at 5.1% as of July 31, 2015. Coverage by operating EBITDA has been below the 'BBB' median for four years and weakened to 1.4x through the nine-month interim. Positively, no additional debt is planned.

RATING SENSITIVITIES

CASH FLOW IMPROVEMENT: An Outlook revision to Stable is possible if East Texas Medical Center is able to staunch its operating losses as projected and preserve its liquidity in 2016. However, Fitch notes that there are ongoing pressures on East Texas Medical Center's credit profile given the competitive and payor landscape and these issues could result in negative rating pressure within or beyond the outlook period depending on management's ability to manage the challenges.

CREDIT PROFILE

ETMC is an integrated health system servicing the east and northeastern regions of Texas. ETMC's network consists of a tertiary care and level-one trauma center in Tyler (Smith County); nine acute care hospitals (eventually reduced to seven by 2018); rehabilitation, specialty, and behavioral health practices; and 40 rural clinics covering a nine-county area centered on Smith County. The system had 848 staffed acute care beds as of Oct. 31, 2014. Total revenues were \\$855 million in fiscal 2014.

SUSTAINED OPERATING PRESSURE; EXITING RURAL HOSPITAL OPERATING AGREEMENTS

The downgrade to 'BBB-' reflects continued operating pressures in 2015. Profitability has deteriorated from the prior year through the nine months ended July 31, 2015, showed a negative 1.3% operating margin and 7.2% operating EBITDA margin, both below July 31, 2014 performance and the respective 'BBB' category medians (0.6%, 7.7%). Pressure persists despite a sizeable staff reduction, other expense reductions, and exiting out of several rural hospital operating lease agreements at its Clarksville, Crockett, Gilmer, and Mt Vernon locations. Admissions are down on a same-store basis by 2% year on year (net discontinued operations); though marginally up at the more profitable Tyler hospital. ETMC is projecting a negative 1% operating margin for fiscal 2015.

In 2014, ETMC made the strategic decision to exit its operating lease agreements at a number of its rural locations. ETMC booked \\$37.3 million in loss on impairment and discontinued operations, which Fitch excluded from ETMC's operating performance in 2014. ETMC terminated its operations at Clarksville, Gilmer, and Mt Vernon in 2014 and Crockett in 2015. Transition plans are underway for the exit at the Fairfield and Trinity locations, impairments for which were recognized in 2014. No further impairments are expected, nor are further operating lease agreement terminations contemplated.

Inpatient volume trends at the eight existing rural hospital locations show a 31.4% decline in admissions from 2009 to projected 2015 compared to the Tyler facility which had a 0.7% decline over the same time period.

ETMC FILES SUIT AGAINST INSURERS

Fitch remains concerned regarding the payor landscape in ETMC's market, which has presented significant challenges in prior years and has recently become more acute. ETMC filed a lawsuit in Texas state district court in Smith County on June 2, 2015 against Blue Cross Blue Shield of Texas (Blue Cross), Aetna, and Cigna, alleging that the insurers violated state law by unreasonably denying ETMC's Tyler hospital an opportunity to join their preferred networks. ETMC Tyler has never been part of Blue Cross nor Aetna's preferred provider networks and was excluded from Cigna's in 2013. The lawsuit seeks damages from the defendants for breach of duties and interference with prospective business relations and economic advantage. Management reports that the lawsuit received approval to move to the discovery phase on Aug. 19, 2015. Arguments are expected in 2016. Fitch believes that a negotiated resolution would likely be a credit positive, though resolution is not expected within the one-to-two year outlook timeframe.

2016 PROJECTIONS REFLECTS DEPENDENCE ON SUPPLEMENTAL FUNDING

The current fiscal 2016 projection reflects continued inpatient volume declines through ETMC's rural clinical network and marginal increases in surgical volumes and outpatient services at Tyler. ETMC is projecting more substantial improvements at its emergency departments of 2%. ETMC is budgeting for a 3.1% increase (\\$26 million) in operating revenue year over year and a 0.2% operating margin. Approximately 50% of the year over year projected improvement is from supplemental payments, which Fitch views as concerning and not sustainable as the timing and amount have been somewhat variable in recent years.

ETMC's reliance on government payors (62% of gross payor mix in 2014) as well as supplemental reimbursement remains a key rating concern. ETMC expects to receive \\$43.7 million in Medicare/Medicaid DSH and UPL supplemental payments in fiscal 2016, up from the \\$35.4 million expected for fiscal 2015 and \\$40.8 million received in fiscal 2014. The longer term future of these supplemental payments is uncertain beyond 2016, when the current DSRIP/UC program expires.

ETMC has also benefited from meaningful use funds with the receipt of \\$21.7 million in fiscal 2013, \\$17.5 million in fiscal 2014. There were no meaningful use funds in fiscal 2015 and \\$6.1 million is expected for fiscal 2016.

CONTINUING DISCLOSURE

ETMC covenants to provide bondholders with annual audited financial information to the Municipal Securities Rulemaking Board's EMMA system within 150 days of fiscal year end and quarterly financial statements within 45 days of fiscal quarter end.