Fitch Rates Lexington Medical Center’s (SC) Series 2016 Bonds ‘A+’

Fitch Ratings has assigned an ‘A+’ rating to approximately $171 million in series 2016 bonds to be issued by the Lexington County Health Services District, Inc. (the District) on behalf of Lexington Medical Center (LMC).

In addition, Fitch has downgraded the rating to ‘A+’ from ‘AA-‘ on the following bonds issued by the District:

–$49.4 million fixed rate bonds series 2011;

–$172.8 million fixed rate bonds series 2007.

The Rating Outlook is Stable.

The series 2016 bonds are expected to be issued as fixed rate debt. The bonds will finance certain capital expansions at LMC, pay a portion of the interest accruing on the series 2016 bonds during the construction and provide for costs of issuance. The bonds are scheduled to sell via negotiated sale on the week of Aug. 8, 2016.

SECURITY

Debt payments are secured by a pledge of the gross receipts of the obligated group, which operates LMC and LexMed, a skilled nursing facility.

KEY RATING DRIVERS

INCREASED DEBT BURDEN: The downgrade to ‘A+’ reflects LMC’s elevated risk profile associated with a higher leverage position and a large pension liability. The increased balance sheet risk reduces financial flexibility for LMC in the medium term while operating in a competitive market. Pro forma cushion and cash to debt ratios decline to 21.1x and 139.6%, respectively, from 29.3x and 249.7%, making these metrics consistent with an ‘A’ category rating.

SIZABLE CAPITAL PLANS: LMC has begun construction on a $400 million project to expand its campus with the addition of a new patient tower and parking garage. The new tower will provide additional beds, neonatal ICU space and expanded operating room capacity, all of which are needed to accommodate capacity constraints due to high volume growth at LMC. Management may issue additional debt or use operating cash flow to fund the second half of its capital plans.

CONSISTENTLY STRONG OPERATING RESULTS: The District has a proven record of solid operating EBITDA margins (15.7% in fiscal 2015)) that has enabled it to build its unrestricted cash and investments in recent years. Days cash on hand (DCOH) was favorably robust at 276.8 days in fiscal 2015 (ended Sept. 30, 2015) and 258.1 days on March 31, 2016.

UTILIZATION GROWTH: Despite a highly competitive market, LMC continues to experience strong medical and surgical volume growth as a result of successful expansion strategies supported by a highly integrated physician platform and ambulatory network.

RATING SENSITIVITIES

STABILITY DURING CONSTRUCTION: The ‘A+’ rating incorporates the full impact of the $400 million capital expansion project planned through 2019. At the ‘A+’ rating, Lexington Medical Center is well positioned to absorb any inherent project risks. Over the longer term, moderation in leverage metrics while maintaining historical profitability could result in positive rating action.

CREDIT PROFILE

Located in West Columbia, South Carolina, the District includes Lexington Medical Center, which currently consists of a 428-operated bed acute care facility, six outpatient facilities providing urgent and primary care services, five medical office parks and a large employed physician network. The District also includes the Lexington Medical Center Extended Care (LexMed), a 388-bed skilled nursing facility. The District is a governmental entity but does not have any taxing authority nor does it receive any tax support. Fitch’s analysis is based on the District, which had operating revenues of $894.9 million in fiscal 2015.

STRATEGIC GROWTH

LMC operates in a relatively challenging market with significant competition, mostly from Palmetto Health (rated ‘BBB+’; Outlook Stable) but also from Providence Hospitals (acquired in 2016 by LifePoint Health). Due to Palmetto Health’s market presence in Richland County, LMC has historically focused its operations in its primary service area of Lexington County, where it holds the leading 56.6% market share. However, LMC has been capturing a modest increase in volume originating from its secondary service area of Richland County in recent years, where it holds an 11.5% market share.

Despite the competitive environment, LMC’s profitability has come from successfully integrating a large employed physician network that has generated increased referrals and revenues for the medical center. LMC has a long history of employing physicians and the losses per physician are low. The 301 employed physicians are mostly loyal to LMC’s culture and are a key driver of the strong utilization growth at the hospital.

LMC has also benefited from robust growth in cardiology and oncology (both programs are affiliated with Duke Health) and high surgical volume. Consequently, the Medicare case mix index (CMI) has continued to increase and was 1.87 through the first half of 2016.

LMC’s utilization growth has led to capacity constraints at the hospital and in its operating rooms. The volume demand can be taxing on the medical staff, which management is addressing by continuing its recruiting efforts in certain clinical lines. LMC’s track record of volume growth and consequent increases in revenue offsets the concern that this is a single-site medical center with limited geographic diversification.

CAPITAL EXPANSIONS

To address the capacity constraints and accommodate future growth, LMC has embarked on a large capital project of more than $400 million that includes the construction of a new 10-story patient tower and additional ancillary facilities (parking and medical office building). The plan is to add approximately 200 new beds (including critical care), observation beds, labor and recovery rooms, private neonatal ICU spaces, eight new operating rooms and two endoscopy suites.

The series 2016 bonds will provide approximately $190 million for the project fund. LMC may pursue an incremental financing in 2017 for the final half of the project, but it may decide to fund it with cash flow and investments instead. The decision will be made based on the District’s financial profile at the time. Whether financed with debt or funded with equity and cash flow, Fitch believes that the District has flexibility at the ‘A+’ rating to complete its capital plans without additional rating pressure.

Fitch expects minimal disruption from the construction as the project is contained on the north side of the existing tower. Therefore, Fitch believes that LMC will continue to generate strong EBITDA in 2016 and 2017, although most likely not at the higher fiscal 2015 level.

Operating Profile

The District generated strong profitability in 2015 through a combination of revenue growth, tight expense control, and a further decrease in self-pay volume. Self-pay decreased from 10.8% of gross revenues in 2013 to 7.2% in 2015, which management believes is related to a shift that occurred with the opening of Palmetto Parkridge but also overall economic improvement in the area. Operating EBITDA margin declined through the six-months of fiscal 2016 and was restated to 10.7% after a one-time adjustment for a $17 million revenue reduction combined with legal expenses related to a False Claims Act settlement that was paid to the Department of Justice in July. Prior to the adjustment, operating EBITDA margin was calculated at 14.4%, slightly lower than 18.6% in the same period of 2015, but still significantly above the median for the ‘AA’ rating category.

In addition to the campus expansion and the investments in its physician network, LMC is also planning to migrate its ambulatory sites to EPIC Ambulatory EHR and Practice Management Solutions. The revenue cycle component will go live in April 2017 and the full system is expected to be implemented by July 2017. The $45 million implementation is part of the 2017 capital budget. Although Fitch views the implementation favorably, the EPIC installation at the medical center in 2013 resulted in one-time costs that suppressed the operating margins in that fiscal year. Similarly, there may be additional one-time expenses in 2017 related to this implementation. Ultimately, however, the conversion will introduce a single integrated medical record and one patient portal for LMC, which is an important objective given LMC’s large ambulatory component.

Fitch expects the District’s liquidity position to remain a credit strength even if it decreases slightly with the upcoming elevated capital and strategic investments. Days cash on hand at March 31, 2016 measured 258.1 days from 268.8 days for the six-month period in 2015. Cash is expected to decrease by approximately 7.5 days with the $17 million settlement payment in July with the Department of Justice. LMC maintains no wrong-doing but has entered into a Corporate Integrity Agreement related to this matter.

DEBT PROFILE

The District has a conservative debt profile with all fixed rate debt and no swaps outstanding. Debt metrics remain strong even with the increase in pro forma maximum annual debt service (MADS) to $27.6 million. Pro forma MADS coverage of 5.3x and MADS as a percent of revenues of 3.2% are slightly weaker than the ‘AA-‘ median of 5.7x and 2.4%, respectively. Based on the 2016 interim statements shared with Fitch, we expect that EBITDA in 2016 will be moderately lower than in fiscal 2015. Consequently, coverage may decrease in 2016, but is still expected to compare favorably to the 4.2x median for the ‘A’ rating category.

Elevated leverage is also reflected in a very high pro forma debt-to-cap of 60.3%. The sharp increase for this metric is partly due to the incremental debt, but also due to a large pension liability that is the result of a new accounting guideline. The District participates in multi-employer defined benefit plans with the South Carolina State Retirement Plan and the South Carolina Police Officers Retirement System that are currently underfunded. Beginning with the fiscal 2015 audit, the District adopted GASB 68 that resulted in a large net pension liability based on the District’s proportionate contributions into the plans. The net pension liability totaled $569 million as of fiscal year end 2015, representing an increase from $503.2 million in 2014.

DISCLOSURE

The District covenants to provide annual and quarterly disclosure to bondholders through the Municipal Securities Rulemaking Board’s EMMA system with quarterly statements no later than 60 days after the end of each fiscal quarter and annual statements no later than 135 days after the end of the fiscal year. Disclosure has been timely and complete.

Additional information is available at ‘www.fitchratings.com‘.

Applicable Criteria

Revenue-Supported Rating Criteria (pub. 16 Jun 2014)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=750012

U.S. Nonprofit Hospitals and Health Systems Rating Criteria (pub. 09 Jun 2015)

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=866807

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