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Rating Update:

MOODY'S DOWNGRADES MEMORIAL HEALTH SYSTEM OF EAST TEXAS' LONG TERM BOND RATING TO Baa3 FROM Baa2; OUTLOOK REMAINS NEGATIVE AT THE LOWER RATING LEVEL

27 Jun 2011

RATING ACTION AFFECTS $112.8 MILLION OF RATED DEBT OUTSTANDING

Lufkin Health Facility Development Corporation, TX
Health Care-Hospital
TX

Opinion

NEW YORK, Jun 27, 2011 -- Moody's Investors Service has downgraded Memorial Health System of East Texas's (MHSET) bond rating to Baa3 from Baa2 on $112.8 million of outstanding bonds issued by the Lufkin Health Facilities Development Corporation (see RATED DEBT section at end of report). The outlook remains negative at the lower rating level.

SUMMARY RATING RATIONALE

The downgrade to Baa3 from Baa2 reflects the material decline in financial performance in fiscal year (FY) 2010 following a three-year trend of very modest operating performance. The trend of declining performance resulted in weak operating cash flow generation and softening of debt coverage ratios. Management has engaged consultants and is implementing initiatives to enhance revenue and reduce expenses, however the unfavorable trends continue in the first quarter of FY 2011 which is the driver to maintaining the negative outlook.

CHALLENGES

*Material decline in financial performance in FY 2010 with operating losses (-3.3% operating margin) and low cash flow (5.3% operating cash flow margin), following a three-year trend of modest financial performance with higher cash flow margins between 6.9% and 7.1% and operating margins between -0.6% and 0.4%

*Continued decline in financial performance through the first quarter of FY 2011 with increasing operating losses (-10.6% margin) and negative operating cash flow (-1.3% operating cash flow margin), however results are a modest improvement over the same period in the prior year when MHSET reported operating margin of -3.3% and operating cash flow margin of -12.1% (the interim results do not include an accrual for disproportionate share funding)

*Low cash flow in FY 2010 leading to a decline in debt ratios with FY 2010 Moody's adjusted maximum annual debt services (MADS) coverage of 2.2 times and adjusted debt-to-cash flow of 11.1 times

*New tower did not produce the expected increase in volume especially in the intensive care unit (ICU) largely due to the impact of the local economy; however expenses associated with the new tower have been realized

*Multi-year trend of declining inpatient volume continuing in the first quarter of FY 2011 with admissions down 3% over the prior year period; we note outpatient volumes show multi-year trend of good growth continuing in the first quarter of FY 2011

*Competition from a for-profit hospital located one mile from MHSET that includes a joint venture with 55 local physicians investors

*Slow economic recovery in the local community contributing to the continue elevated levels of uncompensated care and volume declines

STRENGTHS

*Leading market share of 60% in its primary service area (PSA) of Angelina County (based on 2009 data); market share growth in orthopedic and women's service lines and maintenance of lead market share for nearly all services in Lufkin

*Management's engagement of Community Hospital Corporation (CHC) to provide consulting services for revenue cycle, supply spend, benefits, strategic planning, productivity, IT planning, managed care contracting, and financial forecasting; CHC is assisting the MHSET board in determining its long-term strategic plan

*Expectation of revenue enhancements and expense savings totaling $12.6 million through the end of FY 2011 and an additional benefit of $21.3 million in FY 2012

*Stable liquidity position despite poor cash flow, with 87 days cash on hand and 56% cash-to-debt as of fiscal year end (FYE) 2010 aided by a $3.3 million Foundation grant for capital repurposed for operations

*All fixed rate debt structure and a frozen defined benefit pension plan alleviate some pressure on the balance sheet

*Conservative investment allocation with the majority of assets invested in cash and certificates of deposit and a small portion in fixed income; 100% is liquid on a monthly basis

*Support from a large foundation that has contributed approximately $5 million annually in each of the past seven years for capital needs

DETAILED CREDIT DISCUSSION

LEGAL SECURITY: Bonds are secured by a revenue pledge from the Obligated Group that includes Memorial Medical Center of East Texas (acute care hospital in Lufkin), Memorial Specialty Hospital (Lufkin) and Memorial Medical Center - Livingston and a mortgage on Memorial Medical Center of East Texas (acute care hospital in Lufkin). Memorial Medical Center - San Augustine is leased by MHS and is not a member of the Obligated Group. Covenants include debt service coverage of not less than 1.1 times (below which would require the hiring of a consultant, but in no event less than 1.0 times); liquidity of at least 70 days cash on hand and debt to capitalization of no more than 65%.

INTEREST RATE DERIVATIVES: Two floating-to-fixed rate long-dated swaps are outstanding (notional amounts of $63.3 million). These swaps previously were creating a synthetic hedge on the Series 2005 and 2005A variable rate demand bonds. These bonds were refinanced with fixed rate debt in 2009. There is no collateral posting requirement for either series of debt. The current mark-to-market is a negative value of $5.7 million at December 31, 2010. MHSET will look to terminate the swaps when the termination costs are more palatable.

RECENT DEVELOPMENTS/RESULTS

The downgrade to Baa3 from Baa2 reflects MHSET's material decline in financial performance in FY 2010 and through the first quarter of FY 2011, following a three-year trend of modest financial performance. In audited FY 2010, MHSET recorded an operating loss of $9.1 million (-3.3% margin including $3.3 million of grant money repurposed for operations) and operating cash flow of $14.4 million (5.3% operating) compared to performance in FY 2009 with operating income of $972 thousand (0.4% margin) and operating cash flow of $18.6 million (6.9% margin).

Through the first unaudited quarter of FY 2011 ending March 31, 2011, MHSET continued the unfavorable financial performance recording an operating loss of $6.8 million (-10.6% margin) and negative operating cash flow of $870 thousand (-1.3% margin). These results are slightly improved when compared to the same period FY 2010, when the System recorded a operating loss of $8.0 million (-12.1% margin) and negative operating cash flow of $2.2 million (-3.3% margin). The interim results do not include an accrual for disproportionate share funding that has been received annually and is included in the audited results.

Management attributes the decline in FY 2010, and continuing in FY 2011, to the rise in interest expense associated with having 100% fixed rate debt, the increase in expenses associated with the new tower without the expected increase in volume, and losses from the employed physician group who are still building practices and referral patterns. Declines in inpatient volume (2.6%), inpatient surgeries (5.0%), and newborn admissions (5.3%) contributed to flat revenue growth of 1.9% over FY 2009 that could not keep pace with the expense growth of 3.6%. Furthermore, MHSET also continues to see high levels of uncompensated care and deferral of care due to the slow economic recovery.

To curb the financial decline, MHSET engaged Community Hospital Corporation (CHC) to provide consulting services on revenue cycle, supply spend, benefits, strategic planning, productivity, IT planning, managed care contracting, and financial forecasting. With the help of CHC, management has identified $12.6 million of benefits that should be realized between April and December 2011 including: (1) improved reimbursement from the largest managed care provider starting in August 2011; (2) improved supply cost from joining a new group purchasing organization through CHC; (3) labor cost savings through improved productivity standards; and (4) projected revenue growth from Medicare rebasing in Livingston, qualifying for disproportionate share at the Lufkin Medical Center, and upper limit payments at the San Augustine critical access hospital. Furthermore, management expects an additional annual benefit of $21.3 million from these initiatives in FY 2012. CHC is also assisting the board in developing its long-term strategic plan which may include partnerships with other organizations.

Through the first quarter 2011, expenses are down 7%, a strong improvement over the same period in FY 2010 and the historical double digit expense growth MHSET has experienced in years past. The maintenance of the Baa3 rating will depend on the degree of the financial improvement and its sustainability. Likewise, failure to show some stabilization in financial performance will pressure the rating.

In addition to the material decline in performance in FY 2010 and through the first quarter of FY 2011, the modest performance since FY 2007 is a credit concern. MHSET recorded an operating loss in fiscal year 2007 and 2008 and operating cash flow margin of 7.0% and 7.1% respectively. This trend in performance is below the Moody's 2009 Baa3 median operating margin of 0.7% and median operating cash flow margin of 7.3%.

As a result of the decline in operating performance in FY 2010, Moody's-adjusted debt measures also declined with debt-to-cash flow moving to 11.1 times from 6.2 times in FY 2009 and MADS coverage declining to 2.2 times from 2.7 times in FY 2009. Moody's 2009 Baa3 median debt-to-cash flow is 5.5 times and MADS coverage is 2.4 times.

Despite the operating loss in FY 2010 unrestricted cash and investments grew by 6% to $63.6 million or 87 days cash on hand as of FYE 2010 (December 31, 2010) from $60.2 million or 87 days cash on hand at FYE 2009. Cash-to-debt measured 56% at FYE 2010 as compared to 53% at FYE 2009. This steady cash position is due to proceeds from the last installment of $3.3 million in grant money from the T.L.L Temple Foundation. This Foundation pledged $44.5 million to fund capital projects from 2003 to 2010. MHSET also enjoys support from the Kurth Trust in the form of investment income; the contribution is expected to increase due to the viability of new investments. The System invests its unrestricted cash conservatively in 100% cash and fixed income and 100% is liquid on a monthly basis.

MHSET's100% fixed rate debt structure and frozen defined benefit pension plan alleviate pressure on the balance sheet. Management is waiting for more favorable interest rates before terminating the two floating to fixed rate swaps and a higher discount rate before closing out the pension plan. Management continues to fund the pension plan at the pension expense. Cash-to-comprehensive debt (including long and short-term debt and pension and least liability) is 52%.

Capital spending for FY 2011 is budgeted at $6.6 million, well below depreciation expense, however MHSET's average age is 10.5 years, only slightly above the national average of 10 years. Management expects to fund $5.5 million of the capital spending through cash flow and the additional $1.1 million from bond money. The budget includes $3.9 million for information technology systems. MHSET has installed a new electronic medical record system and expects to achieve meaningful use and receive Federal funds in 2013.

We view MHSET's lead market share of 60% in its PSA and flagship hospital location as the largest provider in a 90-mile radius as credit positives. The flagship faces competition from CHS owned 146-bed Woodland Heights Hospital one mile away in Lufkin. MHSET's Lufkin Medical Center has seen market share growth in orthopedic and women's service lines and has maintained lead market share in nearly all service lines. The closest large tertiary provider is 454-bed East Texas Medical Center, 90 miles away in Tyler, TX. Despite the limited competition for services, MHSET's PSA has experienced slow recovery from the economic recession and high gas prices this spring limited how far residents would travel for healthcare services.

We note that the CEO has announced his retirement next spring. Succession planning began a year ago; it is anticipated that the current Senior Vice President of Operations/Chief Operations Officer will assume the role of CEO.

Outlook

The negative outlook at the lower rating level reflects our concern that financial performance in the first quarter of FY 2011 does not indicate improved performance over FY 2010. Without improvement, MHSET will struggle to generate adequate operating margins to improve debt ratios and rebuild liquidity. Maintenance of the Baa3 rating will depend on the success of managements initiatives, the degree of the improvement and its sustainability.

WHAT COULD MAKE THE RATING GO UP

Unlikely given the negative outlook, however, an upgrade would be a function of material improvement in operating performance that is sustainable; improved debt ratios; rebuilding of liquidity ratios; sustained volume growth leading to stronger operating revenue growth and market share gain

WHAT COULD MAKE THE RATING GO DOWN

Inability to show stabilized financial performance toward the end of FY 2011 leading to further stressed debt ratios; material decline in volumes leading to loss of market share; decline in liquidity; additional debt without commensurate increase in cash flow and liquidity

KEY INDICATORS

Assumptions & Adjustments:

-Based on financial statements for Memorial Health System of East Texas (d/b/a Memorial Medical Center of East Texas) and Affiliates

-First number reflects audit year ended December 31, 2009

-Second number reflects audit year ended December 31, 2010

-Investment returns normalized at 6% unless otherwise noted

*Inpatient admissions: 13,012; 12,670

*Total operating revenues: $267.1 million; $272.1 million

*Moody's-adjusted net revenue available for debt service: $22.2 million; $18.4 million

*Total debt outstanding: $113.7 million; $113.6 million

*Maximum annual debt service (MADS): $8.3 million; $8.3 million

*MADS Coverage with reported investment income: 2.33 times; 1.86 times

*Moody's-adjusted MADS Coverage with normalized investment income: 2.67 times; 2.21 times

*Debt-to-cash flow: 6.15 times; 11.08 times

*Days cash on hand: 97.1 days; 87.4 days

*Cash-to-debt: 53.0%; 56.0%

*Operating margin: 0.4%; -3.3%

*Operating cash flow margin: 6.9%; 5.3%

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

Series 2007: $41.2 million, fixed rate

Series 2009: $71.6 million, fixed rate

CONTACTS

Obligor: Kristi Gay, Chief Financial Officer, (936) 631-6702

Underwriter: Jordan Melick, Raymond James & Associates, (214) 967-7608

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

Jennifer Ewing
Analyst
Public Finance Group
Moody's Investors Service

Lisa Goldstein
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 MEMORIAL HEALTH SYSTEM OF EAST TEXAS' LONG TERM BOND RATING TO Baa3 FROM Baa2; OUTLOOK REMAINS NEGATIVE AT THE LOWER RATING LEVEL
No Related Data.
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