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Rating Update:

MOODY'S AFFIRMS KETTERING HEALTH NETWORK'S (OH) A2 BOND RATING; OUTLOOK REVISED TO NEGATIVE FROM STABLE

26 Apr 2011

ACTION AFFECTS APPROXIMATELY $441 MILLION OF RATED DEBT OUTSTANDING

Montgomery (County of) OH
Health Care-Hospital
OH

Opinion

NEW YORK, Apr 26, 2011 -- Moody's Investors Service has affirmed Kettering Health Network's (KHN) A2 bond on approximately $441 million of bonds (listed at the end of this report) issued through Montgomery County, OH and Greene County, OH. The rating outlook is revised to negative from stable.

KHN is a health system comprising of seven hospitals located in the Dayton, OH area, including: (a) Kettering Medical Center, KHN's flagship tertiary referral hospital located in Kettering, OH; (b) Grandview Medical Center in Dayton, OH; (c) Southview Medical Center in Miami Township, OH; (d) Sycamore Medical Center in Miamisburg, OH; (e) Greene Memorial Hospital in Xenia, OH; (f) Kettering Behavioral Medicine Center in Miami Township; and (g) Fort Hamilton Hospital, located in Hamilton, OH and acquired by KHN in 2010. KHN plans to add an eighth hospital, the Indu and Raj Soin Medical Center, located in Beavercreek, OH, which currently is under construction and is expected to open in early 2012.

RATINGS RATIONALE

SUMMARY RATING RATIONALE: The outlook change to negative from stable at the A2 rating level factors our expectation that KHN will issue approximately $155 million of new money debt later in 2011. The bond sale by itself may not result in a downgrade, rather the negative outlook reflects a combination of (1) our expectation that Kettering will issue more debt (or use more cash than projected) to support the system's capital projects and (2) if Kettering does not meet management's cash flow projections in the near term then there likely would be pressure on the rating because KHN's debt coverage ratios would not be consistent with the A2 rating category.

STRENGTHS

*Large health system with sizeable market presence over a broad service area (KHN recorded $1.05 billion of operating revenue in audited fiscal year 2010)

*Track record of profitable operating results, although we note that operating margins have fluctuated in recent years; in fiscal year (FY) 2010 KHN recorded a 9.3% operating cash flow margin compared to 11.3% in FY 2009

*Good liquidity with 176 days cash on hand at audited fiscal year end (FYE) 2010

*While the City of Dayton is somewhat challenged demographically, KHN's facilities tend to be located in more favorable locations

CHALLENGES

*Material competition from market leader Premier Health Partners (PHP), which includes Aa3 rated Miami Valley Hospital

*Significant capital spending plans expected to continue through FY 2012, although spending projected to taper thereafter

*Somewhat modest adjusted debt coverage ratios are modest at the A2 rating level (98% cash-to-debt, 45% debt-to-total operating revenue, 4.6 times debt-to-cash flow, and 4.5 times peak debt service coverage); we note that KHN does not have additional new money debt plans through FYE 2015 beyond the expected debt issuance later in 2011

*Material variable rate demand bond (VRDB) debt and swap exposure; KHN's cash-to-demand debt measured 164% at FYE 2010

DETAILED CREDIT DISCUSSION

LEGAL SECURITY: The Obligated Group consists of the Kettering Medical Center (which includes Sycamore Medical Center, Kettering Behavioral Medicine Center, Kettering College of Medical Arts, and KHN Homecare), Dayton Osteopathic Hospital d/b/a Grandview Medical Center and Southview Medical Center, and Beavercreek Medical Center. All bonds are secured by a gross receipts pledge of the Obligated Group, a mortgage on the Beavercreek Medical Center and a negative mortgage pledge on the remaining obligated group entities.

INTEREST RATE DERIVATIVES: KHN has five swaps in place, including three fixed payer swaps and two total return swaps. According to management, as of March 31, 2011 the total notional amount of the outstanding swaps was approximately $279.7 million and the total net termination value was a negative $31.2 million to KHN. Cash flow payments under hedging agreements are parity with bond payments, termination payments are not. According to management, as of April 15, 2011 KHN has posted approximately $520,000 of collateral. Management notes that KHN had five additional swaps (one fixed receiver, two constant maturity, and two total return swaps) that matured or were terminated recently.

DEBT STRUCTURE: KHN's total direct debt totaled approximately $475 million at FYE 2010, including $286 million of VRDB debt. The VRDB debt is supported by standby bond purchase agreements (SBPAs) from Dexia Credit Local ($273 million principal) and JPMorgan Chase Bank ($12.4 million). The Dexia SBPAs expire on January 17, 2015 and the JPMorgan Chase Bank SBPA expires on July 22, 2012. Management expects KHN will need to find a replacement liquidity provider when the Dexia SBPAs expire. Management expects to issue approximately $155 million of fixed rate debt later in 2011.

MARKET POSITION/COMPETITIVE STRATEGY: SIZEABLE MARKET SHARE OVER BROAD, COMPETITIVE SERVICE AREA

KHN captures the number two market position in the Dayton/Montgomery County area. According to KHN management, excluding out-migration, the KHN obligated group captured 42.6% market share in 2010 of Montgomery County, consistent with the 42.7% share in 2008 and 42.5% share in 2009. PHP, anchored by Aa3-rated Miami Valley Hospital, is the market leader, capturing a 57.4% share in 2010 (57.3% in 2008 and 57.5% in 2009). Both KHN and PHP offer a wide array of tertiary services.

The service area is somewhat challenged, particularly in the City of Dayton (general obligation limited tax rating of Aa2). According to US Census Bureau data, the City of Dayton is characterized by declining population trends and a median income level well below state and national averages. We note that many of KHN's facilities are located in suburban locations with higher income levels, including the Kettering, OH where KHN's flagship hospital is located and in Beavercreek, OH where the Soin Medical Center is scheduled to open in early 2012.

OPERATING PERFORMANCE: TRACK RECORD OF PROFITABLE OPERATIONS

KHN has a track record of recording favorable operating results, although we note with some variability in operating margins in recent years. In audited FY 2010 (December year end) KHN recorded adjusted operating income of $24.4 million (2.3% operating margin, adjusted to include capitalized interest as an operating expense and reclassify the portion of investment income included in operating revenue to non-operating) and operating cash flow of $97.2 million (9.3% operating cash flow margin). In audited FY 2009, KHN recorded adjusted operating income of $37.3 million (3.9% margin) and operating cash flow of $108 million (11.3% margin). The A2 median operating cash flow margin is 9.7%.

Management notes that the reduced profitability in FY 2010 is due in large part to non-recurring costs. For example, KHN recorded a $4.9 million charge in FY 2010 related to the acquisition of Fort Hamilton Hospital and an additional approximately $3 million charge at Greene Memorial Hospital for prior year items. Favorably, management reports that same-store outpatient growth has been strong, boosted in part by KHN's acquisition of six imaging centers. We note further that FY 2009 was a particularly strong year; over the last five years the system's operating cash flow margin has averaged 10.3%. To that end, management is projecting KHN's operating cash flow margin to range between 10.0% and 10.4% between FY 2011 and FY 2015. We expect that failure to improve cash flow over FY 2010 results would pressure KHN's rating, particularly given how leveraged the system will be after issuance of the Series 2011 bonds.

Management has identified a number of improvement efforts, focusing on cost controls and improved efficiencies. Fort Hamilton Hospital is of particular focus for management's turnaround efforts because the hospital had been struggling in the months leading up to the acquisition. Management expects Fort Hamilton will be operating at break even on a monthly basis by the end of 2011.

BALANCE SHEET POSITION: LEVERAGED BALANCE SHEET AND CAPITAL SPENDING WILL DEPRESS LIQUIDITY RATIOS

Due to cash flow generation, use of bond proceeds to fund capital, and investment returns KHN's absolute unrestricted cash and investments increased to $467 million at audited FYE 2010 from $419 million at audited FYE 2009. As a result, cash-to-debt improved to a still modest 98% at FYE 2010 from 86% at FYE 2009 (A2 median is 132%). Due to a rising expense base in FY 2010 (including the Fort Hamilton Hospital acquisition), however, cash on hand decreased very modestly at FYE 2010 to a good 176 days from 177 days at FYE 2009 (A2 median is 169 days). According to management, at audited FYE 2010 KHN's unrestricted cash and investments were allocated among approximately 56% cash and fixed income and 44% equities, and approximately 99.5% of KHN's unrestricted cash and investments could be liquidated within one month.

At FYE 2010 approximately 59% of KHN's debt was in VRDB mode. The system's cash-to-demand debt measured 164% at FYE 2010.

KHN's Moody's adjusted debt ratios are somewhat modest at the A2 rating level. Based on KHN's audited FY 2010 results, adjusted debt-to-cash flow measures 4.6 times (A2 median is 3.2 times), adjusted maximum annual debt service (MADS) coverage measures 4.5 times (A2 median is 5.0 times), and debt-to-total operating revenue measures a somewhat high 45% (A2 median is 34%). These ratios do not factor KHN's expected issuance of approximately $155 million of debt later in 2011.

We note that KHN's significant capital spending continues through FY 2011 ($228 million) and into FY 2012 ($105 million) before tapering off thereafter. As a result, absent material improvement in cash flow generation, the system's balance sheet will be stressed, either in the form of additional debt or a material decline in unrestricted cash and investments. Based on management prepared projections (which factor the issuance of $155 million of new debt later in 2011), KHN's cash on hand is expected to reach a low point of 166 days at FYE 2012 and the system's cash-to-debt is expected to reach a nadir of 79%.

KHN is in the midst of a series significant capital spending efforts. Approximately $500 million of total capital spending is projected between FY 2011 and FY 2015 (translating to a capital spending ratio of 1.5 times); well over half of the capital is expected in FY 2011 and FY 2012. Highlighted projects include the construction of the Soin Medical Center (which is expected to open in early 2012), adding approximately 50 beds at Grandview Medical Center, information technology (including the installation of an electronic medical record system), and improvements to Fort Hamilton Hospital. Beyond the expected $155 million debt issuance later in 2011, KHN management does not have new money debt plans through FYE 2015.

Outlook

The outlook change to negative from stable at the A2 rating level factors our expectation that KHN will issue approximately $155 million of new money debt later in 2011. The bond sale by itself may not result in a downgrade, rather the negative outlook reflects a combination of (1) our expectation that Kettering will issue more debt (or use more cash than projected) to support the system's capital projects and (2) if Kettering does not meet management's cash flow projections in the near term then there likely would be pressure on the rating because KHN's debt coverage ratios would not be consistent with the A2 rating category.

What could change the rating--UP

Sustained elevated cash flow generation leading to materially improved debt coverage ratios; material market share capture

What could change the rating--DOWN

Failure to meet cash flow projections in FY 2011 and FY 2012 resulting in inability to improve debt coverage ratios; greater than expected weakening of liquidity ratios; greater than expected increase in debt without commensurate increase in cash flow and liquidity

KEY INDICATORS

Assumptions & Adjustments:

-Based on Kettering Health Network consolidated financial statements

-First number reflects audited FY 2009 for the year ended December 31, 2009

-Second number reflects audited FY 2010 for the year ended December 31, 2010

-Ratios do not factor expected debt issuance later in 2011

-Interest expense "grossed up" to included capitalized interest

-Investment returns reclassified as non-operating and normalized at 6%

*Inpatient admissions: 44,032; 47,856

*Total operating revenues: $954 million; $1.05 billion

*Moody's-adjusted net revenues available for debt service: $130.8 million; $124.0 million

*Total debt outstanding: $486 million; $475 million

*Maximum annual debt service (MADS): $27.4 million; $27.4 million

*MADS Coverage with reported investment income: 4.28 times; 4.03 times

*Moody's-adjusted MADS Coverage with normalized investment income: 4.77 times; 4.52 times

*Debt-to-cash flow: 4.40 times; 4.56 times

*Days cash on hand: 177 days; 176 days

*Cash-to-debt: 86%; 98%

*Operating margin: 3.9%; 2.3%

*Operating cash flow margin: 11.3%; 9.3%

RATED DEBT (debt outstanding as of December 31, 2010)

Issued through Montgomery County, OH:

-Series 2008A VRDB Revenue Bonds ($93.6 million outstanding), insured by Assured Guaranty, SBPA from Dexia Credit Local (SBPA expires January 17, 2015), rated Aa3/VMIG 1, A2 underlying rating

-Series 2008B VRDB Revenue Bonds ($94.2 million outstanding), insured by Assured Guaranty, SBPA from Dexia Credit Local (SBPA expires January 17, 2015), rated Aa3/VMIG 1, A2 underlying rating

-Series 2006A VRDB Revenue Bonds ($85.3 million outstanding), insured by Assured Guaranty, SBPA from Dexia Credit Local (SBPA expires January 17, 2015), rated Aa3/VMIG 1, A2 underlying rating

-Series 1996 Fixed Rate Revenue Bonds ($58.7 million outstanding), insured by MBIA, A2 unenhanced rating

Issued through Greene County, OH:

-Series 2009 Fixed Rate Revenue Bonds ($98.0 million outstanding), rated A2

CONTACTS

Obligor: Russ Wetherell, Chief Financial Officer, (937) 395-8816

Underwriters: Gerry Knorr, Bank of America Merrill Lynch, (212) 449-0613; Basilio Paneque, Bank of America Merrill Lynch, (305) 442-6275

Financial advisor: Andy Majka, Kaufman Hall & Associates, (847) 441-8780

The last rating action with respect to KHN was on October 14, 2009, when an A2 municipal scale rating was assigned and affirmed and the outlook remained stable. That rating was subsequently recalibrated to A2 on May 7, 2010.

The principal methodology used in this rating was Not-for-Profit Hospitals and Health Systems published in January 2008.

REGULATORY DISCLOSURES

Information sources used to prepare the credit rating are the following: parties involved in the ratings, parties not involved in the ratings, public information, confidential and proprietary Moody's Investors Service information, and confidential and proprietary Moody's Analytics information.

Moody's Investors Service considers the quality of information available on the credit satisfactory for the purposes of maintaining a credit rating.

Moody's adopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources Moody's considers to be reliable including, when appropriate, independent third-party sources. However, Moody's is not an auditor and cannot in every instance independently verify or validate information received in the rating process.

Please see ratings tab on the issuer/entity page on Moodys.com for the last rating action and the rating history.

The date on which some Credit Ratings were first released goes back to a time before Moody's Investors Service's Credit Ratings were fully digitized and accurate data may not be available. Consequently, Moody's Investors Service provides a date that it believes is the most reliable and accurate based on the information that is available to it. Please see the ratings disclosure page on our website www.moodys.com for further information.

Please see the Credit Policy page on Moodys.com for the methodologies used in determining ratings, further information on the meaning of each rating category and the definition of default and recovery.

Analysts

Mark Pascaris
Analyst
Public Finance Group
Moody's Investors Service

Beth I. Wexler
Backup Analyst
Public Finance Group
Moody's Investors Service

Contacts

Journalists: (212) 553-0376
Research Clients: (212) 553-1653


Moody's Investors Service
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New York, NY 10007
USA

MOODY'S AFFIRMS KETTERING HEALTH NETWORK'S (OH) A2 BOND RATING; OUTLOOK REVISED TO NEGATIVE FROM STABLE
No Related Data.
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