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Rating Update:

MOODY'S DOWNGRADES EL CAMINO HOSPITAL'S (CA) REVENUE BOND RATING TO A2 FROM A1; THE OUTLOOK IS STABLE AT THE NEW RATING LEVEL

15 Apr 2011

APPROXIMATELY $193 MILLION OF RATED REVENUE BONDS OUTSTANDING

El Camino Hospital, CA
Health Care-Hospital
CA

Opinion

NEW YORK, Apr 15, 2011 -- Moody's Investors Service has downgraded the underlying and long term revenue bond ratings on El Camino Hospital's $193 million of rated revenue bonds to A2 from A1. Bonds were issued by the Santa Clara County Financing Authority. The outlook is stable at the new rating level.

El Camino Hospital District's 2006 General Obligation bonds are rated Aa1 and are secured by the district's voter-approved unlimited property tax pledge. Bond holders of the general obligation bonds do not have any recourse to the hospital for payments under the bonds. Tax revenues and payments related to the general obligation bonds have been excluded from this analysis. A complete list of El Camino's debt is included at the end of this report.

SUMMARY RATING RATIONAL: The downgrade to A2 from A1 reflects the significant weakening of El Camino Hospital's balance sheet, the material deterioration of the hospital's operating performance in fiscal year (FY) 2010, and continued instability among senior management, as evidenced by the indicated departure of the CEO. Cash levels decreased primarily due to a substantial equity contribution to the replacement hospital project (in FY 2009) and the cash purchase of the Los Gatos hospital (in FY 2010). FY 2010 was operationally challenging due to: 1) the opening of the new replacement hospital; 2) the opening of the new Los Gatos hospital; and 3) a difficult operating environment which saw a shift in payer mix, an increase in bad debt expense, and a decrease in volumes at the Mountain View facility. The stable outlook at the A2 level reflects significant improvement in operating performance year-to-date, and the hospital's fundamental strengths as a large, wealthy community hospital with a strong clinical reputation and located in a demographically attractive service area.

CHALLENGES

*Instability among senior management; the long-serving CFO unexpectedly retired in early 2010, and the organization is currently being served by its second interim CFO; it was recently announced that the current CEO will depart in June of this year after serving with the organization for five years; the search for a new CEO is currently underway

*Dilution of balance sheet measures, with cash on hand dropping to 174 days at fiscal year end (FYE) 2010 from 376 days at FYE 2008 and cash to debt to dropping to 121% at FYE 2010 from 253% at FYE 2008

*Deterioration of operating performance, with operating margin dropping to 1.6% in FY 2010 from 10.3% in FY 2009, and operating cash flow margin dropping to 9.9% in FY 2010 from 16.1% in FY 2009; debt service coverage is weaker with Moody's adjusted maximum annual debt service (MADS) coverage dropping to 4.0 times in 2010, from 5.7 times in 2009; year-to-date, based on 8 month unaudited interim financial statements, operating results have significantly improved

*Softer volumes at the Mountain View facility with inpatient admissions dropping by 2% in FY 2010; bad debt expense increased by nearly 40% in 2010; overall, with the opening of the new facility and the addition of the Los Gatos campus, operating and management expense increased by 24% while revenues increased by just 16%

*Strong competition for high end services, including Stanford University nine miles to the north and Kaiser Permanente eleven miles to the south; El Camino Hospital Los Gatos competes with two nearby larger hospitals, one located less than two miles away

*High level of dependence on the Palo Alto Medical Foundation (PAMF), a large, multi-specialty physician group responsible for 50% of admissions and affiliated with Sutter Health System; PAMF captures a significant share of all outpatient services in Mountain View, including surgeries

*High cost of living in the area makes physician and nurse recruitment a challenge

STRENGTHS

*Leading market share (48%) in a very wealthy, desirable service area; community hospital with strong net patient revenues (nearly $600 million in fiscal year 2010) and a wide array of primary, secondary, and tertiary services; El Camino Hospital's Mountain View campus is the only inpatient facility within the district's boundaries

*Strong community support evidenced by the passage of a $148 million district bond measure by more than two-thirds of the population in 2003; approximately $9 million of property tax revenues is available annually to support capital investment and community health services (this is in excess of tax-backed debt service requirements)

*Conservative asset allocation with 86% of all investments allocated to cash and fixed income; monthly cash to putable debt is good at over 500%

*Completion of new replacement facility in Mountain View makes El Camino seismically compliant through 2030; construction was completed on time and on budget; new facility has 85% private rooms, and ample procedural space

*Acquisition of additional facility in Los Gatos gives the hospital better access to new markets, expands the hospital's market share of outpatient procedures, and diversifies the medical staff to include additional community physicians

DETAILED CREDIT DISCUSSION

LEGAL SECURITY: The bonds are a general obligation of El Camino Hospital and are backed by a security interest in El Camino's gross revenues. The Hospital has covenanted not to assume liens in excess of 25% of the value of all its property.

INTEREST RATE DERIVATIVES: In conjunction with the original issuance of the 2007 bonds, El Camino Hospital entered into three LIBOR-based, fixed payer swaps equal to the full amount of the bonds ($150 million). Two of the swaps were unwound in 2009 at a cost of approximately $8 million. The remaining swap (in the amount of approximately $50 million) now serves to hedge interest rate risk on the Series 2009A bonds. The current mark to market on the swap is negative $4.2 million (as of February 28). Compared to traditional fixed rate bonds, the swap exposes El Camino to certain additional risks, namely: counterparty risk, tax risk, and basis risk.

RECENT RESULTS/DEVELOPMENTS

FY 2010 was a pivotal year for El Camino which saw both the opening of its new $480 million replacement facility in Mountain View, California, and the opening of a second facility in Los Gatos, approximately 12 miles away. El Camino broke ground on the replacement of its flagship hospital in the summer of 2006 on property located adjacent to its original hospital. The project was funded with $148 million of tax-backed general obligation bonds, $200 million of revenue bonds (consisting of the Series 2008 bonds, and the Series 2009 bonds), and approximately $130 million from cashflow and cash reserves. The new facility is SB 1953 seismically compliant, provides El Camino with additional procedural capacity, and increases capacity in its emergency department. Patients were transferred to the replacement hospital on November 15, 2009, and FY 2010 results include approximately seven months of operations at the new facility. The former facility, which originally had been scheduled for eventual demolition, is available for outpatient care through 2013.

The second significant undertaking in FY 2010 involved what we view as a fundamental modification of the District's core operating strategy. The District purchased a second hospital and for the first time began providing clinical services outside the district's boundaries. The acquired hospital formerly operated as Community Hospital Los Gatos and most recently was operated by Tenet. While the community of Los Gatos mirrors Mountain View's attractive demographics, the Los Gatos facility competes with two larger neighboring hospitals: 429-licensed bed Good Samaritan hospital owned by for-profit HCA and located 1.5 miles away; and 353-bed O'Conner Hospital owned by Daughters of Charity Health System and located approximately five miles away. The Los Gatos facility is approximately twelve miles from the Mountain View facility.

El Camino purchased the 143-licensed bed facility in March 2009 for $54 million. Following Tenet's announced closure of the Los Gatos facility in 2008, admissions at the hospital declined significantly. Closure of the hospital was completed on April 10th, 2009 El Camino kept the facility closed for approximately three months in order to evaluate the equipment, train staff, and install its own systems and procedures. The hospital reopened as El Camino Hospital Los Gatos in July 2009. Approximately twelve months of operations of the Los Gatos facility are included in the FY 2010 financial statements, including the ramp up of patient volumes.

We see both risks and advantages in El Camino's acquisition strategy. The new Los Gatos facility arguably complements El Camino's clinical offerings, diversifies El Camino's medical staff to include more community physicians, and gives El Camino a stronger presence in the South Bay region which it has targeted for growth. Risks related to the new facility include dilution of organizational focus, the potential for significant unexpected capital requirements, potential conflicts related to owning a hospital outside of the district, and the incursion of increased competition regionally. In its first year of operations the Los Gatos facility exceeded financial expectations, and on a standalone basis produced positive net operating income.

Nevertheless, El Camino as a whole experienced a significant deterioration in operating performance in FY 2010. Prior to 2010, operating performance at El Camino had been exceptionally strong, with the hospital producing an exceptional average operating margin of 9.5% over the previous four years, and an average operating cashflow margin of 16% over the same time frame. In 2010 results declined significantly. Operating income for the system dropped to just $9.7 million (1.6% margin) in FY 2010 from a very robust $53.2 million (10.3% margin) in 2009 and operating cashflow dropped to $58.9 million (9.9% margin) from $82.8 million (16.1% margin). If a number of onetime items are excluded from the 2010 results, including extraordinary Medicare recoveries and payer settlements totaling $23.2 million, and adjustments to reserves for workers compensation totaling $8.3 million, results drop even more significantly, with the system achieving an operating margin of -4.1%, and an operating cashflow margin of 4.7%.

While management expected some softening of performance resulting from start up costs at both of the new facilities, and other expenses relating to the replacement hospital, operating performance declined much more significantly than had been expected. There are number of factors that contributed to the weaker performance, including: growth of expenses (24.2%) that far exceed growth in revenues (15.6%); a 2% drop of inpatient volumes at the Mountain View facility; and a weakening economy within the systems' primary service area resulting in nearly 40% growth in bad debt expense.

The hospital engaged Wellspring and has undertaken significant measures to improve operating performance, including a reduction in force, revenue cycle improvements, supply chain improvements, improved productivity, and detailed cost controls. Year-to-date, per unaudited, eight-month, interim financial statements, operating results have improved significantly, with the operating margin improving to 4.7% for the period compared to a loss of 6% for the same period the previous year, and with the operating cash flow margin improving 13.7%, versus 2.2% the prior year. Management expects operating cash flow to show significant improvement over the previous year in the FY 2011 audited financial statements, and for the organization to return to its previous levels of profitability by 2012.

In addition to the poor operating performance, there was also a significant weakening of El Camino's balance sheet. Due primarily to poor operating cashflow, the purchase of the Los Gatos facility, an equity contribution to the Mountain View facility, and an increase in working capital, unrestricted cash and investments declined by nearly 36% from FYE 2008 to FYE 2010. Due to the significant increase in the system's expense base over the same time period, liquidity at the system has fallen significantly, with cash on hand dropping to 175 days at FYE 2010, from a very healthy 376 days at FYE 2008. Year-to-date, per unaudited financial statements ended February 28, 2011, liquidity has somewhat improved, with cash on hand measuring 184 days.

Debt measures have also weakened over the last two years. Cash to debt measured 121% at FYE 2010, compared with 166% at FYE 2009 and 253% at FYE 2008. Moody's adjusted maximum annual debt service (MADS) coverage measured 4.0 in 2010, compared with 5.6 in 2009. Debt to cashflow climbed to 3.3 in 2010, from 2.2 in 2009. El Camino's revenue bond debt structure is fairly conservative, with 77% of its debt held as fixed rate bonds, and with the hospital's exposure to derivatives restricted to a $50 million notional fixed payer swap. The hospital's investment allocation policy is also conservative, with 86% of the system's unrestricted cash and investments allocated to cash and fixed income securities. El Camino's ratio of monthly liquidity to putable debt is good at over 500%.

Significantly, El Camino is currently experiencing instability within its senior management team. El Camino's CFO of nearly 30 years unexpectedly retired in early 2010. More recently, the organization announced the departure of its current CEO, who will depart in June of this year after serving with the organization for five years. El Camino had been conducting a search for a new CFO, but is now prioritizing its search for a new CEO. For the last year, El Camino has been served by an interim CFO. This individual has completed his contract, and a new interim CFO was appointed last month, who expects to serve until the permanent CFO position is filled hopefully by the end of the year. El Camino hopes to have a new full time CEO in place by the time the current CEO departs in June.

Outlook

The stable outlook reflects our belief that operations will show significant improvement in audited FY 2011, and that the organization will be able to take advantage of its fundamentally strong market position to return to overall stability.

WHAT COULD MAKE THE RATING GO UP

Significant and sustained improvement in operating performance and balance sheet measures; stabilized senior management

WHAT COULD MAKE THE RATING GO DOWN

Failure to improve operating performance, balance sheet measures, and debt service coverage; significant additional capital outlays resulting in an increase in debt or a decrease in liquidity

KEY INDICATORS

Assumptions & Adjustments:

-Based on financial statements for El Camino Hospital District

-First number reflects audit year ended June 30, 2009

-Second number reflects audit year ended June 30, 2010

-Third number reflects unaudited eight month interim results ended February 28, 2011, annualized

-Investment returns normalized at 6%; provision for bad debts reclassified as operating expense; property tax revenue available for operations reclassified as operating revenue; property tax revenue used for GO bond interest expense and for capital expenditures excluded from non operating revenues; GO bond interest expense excluded from other non operating expenses; certain items excluded from board-designated funds and treated as restricted investments

*Inpatient admissions: 20,676; 22,886; 23,202

*Total operating revenues: $515 million; $595 million; $653 million

*Moody's-adjusted net revenue available for debt service: $102 million; $72 million; $107 million

*Total debt outstanding: $218 million; $215 million; $215 million

*Maximum annual debt service (MADS): $17.9 million; $17.9 million; $17.9 million

*MADS Coverage with reported investment income: 5.0 times; 4.6 times; 5.5 times

*Moody's-adjusted MADS Coverage with normalized investment income: 5.7 times; 4.0 times; 6.0 times

*Debt-to-cash flow: 2.2 times; 3.3 times; 2.2 times

*Days cash on hand: 306 days; 174 days; 184 days

*Cash-to-debt: 166%; 121%; 137%

*Operating margin: 10.3%; 1.6%; 4.7%

*Operating cash flow margin: 16.1%; 9.9%; 13.7%

RATED DEBT

General Obligations Bonds (excluded from the Revenue Bond credit analysis)

-Series 2006 General Obligation Bonds ($146 million outstanding), rated Aa1

Revenue Bonds

-Series 2008 Fixed Rate Revenue Bonds ($143 million outstanding), rated A2

-Series 2009A Variable Rate Demand Revenue Bonds ($50 million outstanding); supported by joint default including a letter of credit from Wells Fargo Bank N.A. (expires 4/6/2012); rated Aa1/VMIG1; A2 underlying rating

CONTACTS

Obligor: El Camino Hospital; Ned Borgstrom, interim CFO, (650) 940-7073

Underwriter: Rae Boylan, Managing Director, RBC Capital Markets: (212) 618-5642

PRINCIPAL METHODOLOGY USED

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, and confidential and proprietary Moody's Investors Service 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.

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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

Brad E. Spielman
Analyst
Public Finance Group
Moody's Investors Service

Deepa Patel
Backup Analyst
Public Finance Group
Moody's Investors Service

Contacts

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


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MOODY'S DOWNGRADES EL CAMINO HOSPITAL'S (CA) REVENUE BOND RATING TO A2 FROM A1; THE OUTLOOK IS STABLE AT THE NEW RATING LEVEL
No Related Data.
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