OREANDA-NEWS. Fitch Ratings has affirmed its rating of 'A+' on the following series of bonds issued by the Kentucky Economic Development Finance Authority for the benefit of Baptist Healthcare System (BHS).

--$140,000,000 series 2011;
--$159,365,000 series 2009A.

The Rating Outlook is revised to Negative from Stable.

SECURITY

The bonds are secured by a pledge of the gross revenues of the obligated group (OG). The BHS OG represented approximately 67% of system revenues and 83% of system assets in fiscal 2015 (year-end Aug. 31, unaudited).

KEY RATING DRIVERS

EXPECTED DECLINE IN PROFITABILITY AND LIQUIDITY: The revisions of the Outlook to Negative from Stable is based on the recent decline in operating profitability that is projected to continue in fiscal 2016 and a decline in liquidity as the system makes a number of strategic investments expected to produce returns in the 2017-2018 time frame. The projected decline is driven by the expenses associated with implementation of the EPIC electronic health record (EHR), investments in population health management strategies and also reflects a recent unfavorable shift in the payor mix and continued subsidy to the system's employed physician group.

PLANNED DECLINE IN LIQUIDITY: At Aug. 31, 2015, BHS's liquidity metrics were favorable to Fitch's 'A' category medians with cash and unrestricted investments of $1.16 billion, translating to 212.7 days cash on hand (DCOH), cash equal to 194% of debt and cushion ratio of 28.1x. However, several planned strategic investments are expected to results in a reduction in DCOH below Fitch's 'A' category median.

CAPITAL INVESTMENTS TO BE ACCRETIVE: The hospitals in the Louisville and Lexington markets, which constitute approximately 45% of system revenues, are faced with a competitive landscape. The major project underway to convert to all-private rooms and construct a new NICU and obstetrics unit at Baptist Health Lexington, expected to be completed in the early part of calendar 2016, is projected to be accretive to operations. Likewise, the major IT investment should produce returns by 2017-2018.

MANAGEABLE DEBT LEVEL: Coverage of the system's $41,672 maximum annual debt service (MADS) by EBITDA was a solid 4.6x in fiscal 2015 and MADS as a percent of revenues, at 1.9%, is light for the 'A' category. Potential debt issuance contemplated in the next 12 months was not incorporated into the rating and will be evaluated when details become available.

RATING SENSITIVITIES
NEED TO REALIZE RETURNS ON STRATEGIC INVESTMENTS: Fitch expects the Baptist Health System to return to profitability level more consistent with the 'A' rating category over the next two years. Failure to reverse the operating loss projected for fiscal 2016 could lead to negative rating action.

POTENTIAL DEBT ISSUANCE IN THE NEAR TERM: Fitch believes that given Baptist Health System's moderate leverage, there is a limited debt capacity for additional debt at the current rating level assuming operating profitability returns to a more robust level.

CREDIT PROFILE
BHS, headquartered in Louisville, is a large integrated healthcare system with 2015 revenues of approximately $2.14 billion. It is the largest health care system in Kentucky operating seven hospitals, five of which are currently in the OG. BHS has 1,745 beds in service, generated 74,466 acute admissions in fiscal 2015 and leads the state in number of admissions, births, outpatient visits and is only second in the number of open heart surgeries it performs.

It is expected that the Baptist Health Medical Group (BHMG), the 440 strong employed physician group, will be added to the OG in the near future. The two hospitals which were brought into the system in 2012 - Baptist Health Richmond and Baptist Health Madisonville may be brought into the OG at the time of the potential next debt issuance. Fitch reports on the performance of the consolidated system.

FLUCTUATING PROFITABILITY
Reversing a 2013 loss of $22 million, fiscal 2014 (year-end Aug. 31) ended with operating income of $53.5 million (2.6% operating margin), accomplished both with the help of Huron Consulting Group mostly focused on BHMC revenue cycle and process improvements, which included consolidating all the physician groups under one leadership and into a single entity, as well as work done by BHS internal groups. Operating profitability in fiscal 2015 (unaudited) was somewhat lower with income from operations reported at $30.9 million, better than budgeted $15.5 million, equal to operating margin of 1.4% and operating EBITDA margin of 7.4%, both below Fitch's 'A' category medians of 3.6% and 10.3%, respectively. The 2015 results were impacted by several factors, including (1) an unfavorable payor mix shift as the state employees insurance converted to Anthem from Humana in January 2015 and some patients previously covered by commercial insurance qualified for the state's expanded Medicaid, partially offset by fewer uninsured patients, with $20 lower margin ($30 million annual impact), and (2) $23 million of investment in IT (mostly Epic) and (3) $6 million into population health.

The Negative Outlook is driven by the projected decline in operating performance as the factors influencing lower profitability in 2015 carry forward to the immediate near term as BHS continues to invest in the conversion of their EHR to EPIC with a total 2014-2018 cost of over $250 million and invests in population health management infrastructure assisted by a contract with Evolent Health, a company providing integrated technology, tools and team to advance value-based care. The expected decline in profitability also includes the continued significant subsidy to BHMG; the BHMG loss also incorporates some of the expense associated with the EPIC implementation. BHS is in the final stages of completing the expansion at its Lexington facility, which had temporarily constricted capacity during the construction period. Completion is projected for spring 2016 and there are physician recruitment potentials which would be expected to increase volumes (not included in 2016 budget).

While Fitch recognizes the need for the strategic investments which will temporarily reduce profitability, it is expected that these will produce returns over the next two years. Failure to reverse the operating loss within that time frame would likely result in negative rating action.

PLANNED DECLINE IN LIQUIDITY
BHS's balance sheet was historically its main credit strength. The system reported $1.16 billion of cash and unrestricted investments at Aug. 31, 2015, but management projects that the 2016 fiscal year will end up to $251 million (IT, Baptist Health Lexington expansion and Baptist Health Paducah cancer center being the largest components). The decline is projected to temporarily decrease DCOH to below Fitch's 'A' category median of 205 DCOH.

ADEQUATE DEBT SERVICE COVERAGE AND MODEST DEBT BURDEN
The system coverage by EBITDA was a solid 4.6x in 2015 and MADS constituted a light 1.9% of revenues, favorable to the 'A' category medians of 4.2x and 2.8%. On July 1, 2015, BHS entered into variable rate private placements of the series 2009 bonds, which were previously rated by Fitch, with US Bank (2009B-1), BAML (2009B-2) and BB&T Bank (2009B-3 and 2009B-4). The private placement was not rated by Fitch. The commitment of the three banks is for a 10 year term at a rate based on a percent of LIBOR spread and the transaction eliminates put risk associated with letters of credit and resulted in savings of approximately $1 million annually.

Of the system's approximately $599 million of outstanding long-term indebtedness, 46% is variable rate and there are no swaps. The system's capital budget for 2016 is $251 million, equal to 194% of depreciation expense.

DISCLOSURE

The system covenants to disclose audited financial statements no later than 150 days after the fiscal year end and quarterly statements no later than 60 days after each quarterly end. Both audited and quarterly financial statements include management's discussion and analysis, income statement, balance sheet, cash flow statements and utilization statistics.