OREANDA-NEWS. Fitch Ratings has assigned an 'AA-' rating to the approximately $500 million California Health Facilities Financing Authority revenue bonds, Sutter Health, series 2016A.

In addition, Fitch has affirmed the 'AA-' on Sutter Health's (Sutter) outstanding debt, listed at the end of the press release.

The series 2016A bonds will be fixed rate and expected to price the week of Jan. 11. Bond proceeds will provide reimbursement for prior capital expenditures.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross revenue pledge of the obligated group.

KEY RATING DRIVERS

STRONG OPERATING PLATFORM: Sutter is a large system with a concentrated geographic presence in Northern California. Its physician alignment strategies, Epic implementation, and formation of a health plan should position the organization well as it focuses on transitioning from the fee for service model to total cost of care. Sutter is undergoing a consolidation of its operating units from five regions to two, which should be complete by 2017 and is expected to increase operational efficiency.

SIZABLE SYSTEM TRANSFORMATION INVESTMENTS: Sutter has significantly invested in support function consolidation, care management initiatives, and a health plan, which is expected to improve efficiency, lower its cost structure, and transform healthcare delivery across the system. Profitability was pressured in 2013; however, operating cash flow rebounded in 2014, which has been sustained through the nine months ended Sept. 30, 2015.

DELIBERATELY LOWER LIQUIDITY: Sutter has historically had a weaker liquidity position compared to Fitch's 'AA' category medians due to its long standing philosophy of deploying its free cash flow into capital investments and fully funding its pension plan, which otherwise would have increased days cash on hand. In addition, Sutter maintains a 100% fixed rate debt profile.

LARGE CAPITAL PLAN: Sutter has significantly invested in capital mainly driven by state seismic requirements in addition to the implementation of its common electronic medical record (Epic). Sutter has successfully constructed and opened nine new hospitals and the last major projects are the San Francisco facilities. Capital spending totals $4 billion from 2016-2019 with the majority funded through cash flow. Sutter generally issues additional debt for reimbursement financing such as this issuance.

INCREASED DEBT BURDEN: Although Sutter's debt burden has increased with this issuance, debt metrics are still in line with the 'AA' category medians and debt service coverage is solid. Sutter continually evaluates future debt needs and there could be another debt issuance in the next four years for reimbursement financing as the San Francisco project progresses.

RATING SENSITIVITIES

FINANCIAL FLEXIBILITY: Fitch believes Sutter Health has financial flexibility at its rating level due to its size and scale and views Sutter Health's strategic investments favorably, which should further differentiate the organization in the changing healthcare industry.

CREDIT PROFILE
Headquartered in Sacramento, California, Sutter is a large, integrated healthcare provider that was historically organized into five regions (since 2009) - Central Valley, East Bay, Peninsula Coastal, Sacramento Sierra, West Bay with each region having an aligned medical foundation and affiliated surgery centers. These five regions are being consolidated into two operating units, Sutter Health Bay Area and Sutter Health Valley Area, which should be completed by 2017 and is expected to streamline decision making, coordinate resources, and leverage economies of scale. Other services include home health and hospice, long-term care, and medical research and education. The obligated group accounted for 92% of total assets and 96% of total revenue of the consolidated entity in fiscal 2014 (Dec. 31 year end). Fitch's analysis is based on the consolidated entity. Sutter's total revenue in fiscal 2014 was $10.2 billion.

System Transformation Investments
The organization is preparing for anticipated changes to the delivery and financing of healthcare, where Sutter is expected to be accountable for patient clinical outcomes, service experience and overall cost of care. Fitch believes Sutter's operating platform with its geographic concentration, physician alignment and electronic medical record should position the organization well in the new environment. One example is Sutter's success under its Advanced Illness Management program, which has reduced hospital stays, emergency room visits, and time in the intensive care unit due to coordinated care management.

Sutter has made significant investments to fund several system initiatives targeting the organization's healthcare delivery models and business support functions. These one-time investments have largely been expended and are expected to integrate the organization's IT platforms (Epic installation at all facilities), reengineer healthcare delivery processes, lower the cost structure, increase efficiency and improve performance. The shared services consolidation has yielded $366 million of savings to date.

In addition, Sutter's health plan is in its infancy and coverage has been offered since 2014. There are gradual growth plans for this business line, which is expected to complement other partnerships with other insurers in various payment arrangements. Fitch views management's actions positively and believes these investments should allow the system to better coordinate and deliver care in the most cost effective setting, strengthen its competitive position, and prepare it to manage population health.

Rebound in Profitability
After a weak 2013 due to several large one-time items related to the system strategic investments, profitability rebounded in 2014 and has been sustained through the nine months ended Sept. 30, 2015. Operating and operating EBITDA margins were 3.6% and 10.1%, respectively, which were ahead of budget and the prior year period. This compares to 4% ($410 million operating income) and 10.5%, respectively in 2014 and negative 0.3% and 6.8%, respectively in 2013. Management indicated that the one-time items in the nine months ended Sept. 30, 2015 totaled $81 million compared to $186 million in 2014 and a budgeted $40 million for 2016.

Volume growth has been very strong especially at the medical foundations and outpatient setting. In addition, bad debt expense has significantly reduced due to the benefits from Medicaid expansion. Adjusted discharges were up 1.9% through the nine months ended Sept. 30, 2015 over the same prior year period compared to an 11.2% increase in outpatient surgeries and 10.5% growth in outpatient RVUs.

Similar to many California hospitals, Sutter has been a net beneficiary under the California provider fee program, receiving a net benefit of $94 million in 2012, $122 million in 2013, and $109 million in 2014. Although the current provider fee program is in place through December 2016, the recording of the net benefit varies with the timing of the approval of various components of the program. Sutter is now expecting the net benefit in 2015 to total $112 million compared to $140 million that was expected during Fitch's last rating review in September 2015. The benefit of the current provider fee program is expected to run through 2019. Through the nine months ended Sept. 30, 2015, the net benefit from the provider fee program was $90 million.

Deliberately Lower Liquidity
At Sept. 30, 2015, Sutter had $4.1 billion of unrestricted cash and investments, which translated to 151.4 days cash on hand and 110.8% cash to debt compared to Fitch's 'AA' medians of 289.4 and 201.7%, respectively. Sutter's liquidity metrics have historically been low when compared to Fitch's 'AA' category medians, due to its philosophy in deploying cash to a fully funded pension plan as well as into capital investments. Despite Sutter's sizeable capital plan, liquidity is still projected to grow due to solid cash flow.

Large Capital Plan
Sutter has spent a considerable amount of capital due to state mandated seismic requirements with all major hospital replacements complete in each region except for San Francisco. After a 10-year negotiation with the city, Sutter has started the construction of two new hospital buildings in San Francisco that includes a 274-bed (up to 304) hospital at Van Ness and Geary (former Cathedral Hill) and a 120-bed hospital on the St. Luke's campus with a total project cost of $2.565 billion. The San Francisco facilities are approximately 30% complete and are tracking favorable to budget. The facilities are expected to open in the second quarter of 2019 and the Van Ness and Geary location will replace the current CPMC Pacific and California campuses.

Future projected capital spending totals $4 billion from 2016-2019. In addition to seismic requirements, other spending includes discretionary projects, ambulatory clinics, routine, and information technology. Management stated that capital spending will be scaled back if cash flow is not sufficient to fund the capital plan.

Capital Structure
Total pro forma debt outstanding after this issuance is approximately $4.1 billion. Sutter's debt profile is very conservative and is 100% fixed rate. The only uncommitted capital in its current capital structure is $300 million of series 2013A-C taxable bonds, which are structured with mandatory tender dates in August 2016, 2018, and 2020 of $100 million each. Fitch used pro forma MADS of $251.6 million, which was provided by the underwriter and assumes the mandatory tender bonds are rolled at the mandatory tender dates. Fitch believes Sutter has good market access and solid liquidity to handle the mandatory tenders.

The debt burden has increased but is still manageable with MADS accounting for 2.5% of 2014 revenue. Sutter's debt service coverage calculation includes unrealized gains/losses on investments. MADS coverage per Fitch's calculation (excluding unrealized gains/losses on investments) was 4.6x through the nine months ended Sept. 30, 2015, compared to 5.2x in 2014, and 3.1x in 2013 and the 'AA' category median of 5.7x. Sutter's calculation resulted in debt service coverage (for the obligated group) of 4.6x in 2014.

Disclosure

Sutter covenants to provide annual disclosure within 180 days of fiscal year end. Sutter will provide quarterly disclosure within 75 days of quarter end for the first three quarters at the request of a bondholder. Annual and quarterly disclosure has been available on Municipal Rule Making Board's EMMA system.

Fitch has affirmed the following Sutter Health bonds at 'AA-':

--$189,165,000 California Health Facilities Financing Authority (CA) revenue bonds, series 2015A;
--$95,840,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2003A&B;
--$68,600,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2004C&D;
--$47,430,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2005B&C;
--$756,410,000 California Health Facilities Financing Authority (CA) revenue bonds, series 2007A;
--$200,535,000 California Health Facilities Financing Authority (CA) revenue bonds, series 2008A;
--$252,675,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2008B;
--$47,325,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2008C;
--$275,000,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2011A;
--$475,000,000 California Health Facilities Financing Authority (CA) revenue bonds, series 2011B;
--$36,535,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2011C;
--$310,300,000 California Health Facilities Financing Authority (CA) revenue bonds, series 2011D;
--$118,510,000 California Statewide Communities Development Authority (CA) revenue bonds, series 2012A;
--$450,000,000 California Health Facilities Financing Authority (CA) revenue bonds, series 2013A;
--$100,000,000 Sutter Health taxable bonds, series 2013A;
--$100,000,000 Sutter Health taxable bonds, series 2013B;
--$100,000,000 Sutter Health taxable bonds, series 2013C.