Fitch Affirms WakeMed Health System’s (NC) Revs at ‘AA-‘; Outlook Revised to Negative

The following is from Fitch Ratings on June 11:

Fitch Ratings has affirmed the 'AA-' rating on the following bonds issued by the North Carolina Medical Care Commission on behalf of WakeMed Health System (WakeMed):

--$283,250,000 health care facilities revenue refunding bonds series 2012A;

--$75,000,000 health system revenue bonds series 2009B;

--$66,815,000 health system revenue bonds series 2009C.

The rating for the series 2009B and 2009C bonds is an underlying rating.

The Rating Outlook is revised to Negative from Stable.

Security

Fixed-rate bonds are secured by an interest in pledged assets and variable-rate bonds are secured by a direct-pay letter of credit from Wells Fargo Bank.

KEY RATING DRIVERS:

NEGATIVE OPERATING PERFORMANCE: The Negative Outlook reflects WakeMed's operating losses over the last year and a half, with WakeMed posting a negative 1.4 percent operating margin ($14.4 million operating loss) in fiscal 2013 (Sept. 30 year end), and a negative 1.9 percent operating margin ($9.4 million operating loss) through the first six months of fiscal 2014. Fitch's decision not to downgrade at this time incorporates the positive impact of a new CEO, brought in on an interim basis in the current fiscal year and installed permanently last week, and the operating losses driven, in part, by one-time strategic investments in IT and health care reform initiatives.

CARDIAC VOLUME DISRUPTION: A Department of Justice (DOJ) investigation begun in 2012 into cardiology admissions at WakeMed led to a disruption of volume and the departure of some cardiologists; cardiology historically has been one of WakeMed's strongest service lines. WakeMed settled with the DOJ for $8 million and signed a five-year corporate integrity agreement (CIA) in December 2012. WakeMed has worked to rebuild its cardiac volumes. After cardiology volumes fell by 34 percent from fiscal 2011 to 2103, seven-month fiscal 2014 interim figures show a slight increase in volumes year over year.

KEY STRATEGIC INVESTMENTS: WakeMed is making an $82.2 million investment in EPIC, with the implementation costs absorbed in 2013 and 2014 and has made a $27 million investment, also in fiscal 2013 and 2014, to establish an Accountable Care Organization (ACO). Both of these initiatives, and a new $90 million hospital in the northern service area, are being funded out of cash flow. Fitch believes that all of these are strategically important and will yield economic benefits in the years to come.

GOOD LIQUIDITY FOR RATING LEVEL: At March 31, WakeMed had $531.3 million in unrestricted cash and investments, which equated to 206.8 days cash on hand, a 20.1x cushion ratio, and 115.2 percent cash-to- debt. Unrestricted cash and investments have fallen since year-end fiscal 2012, when it was at $617.4 million. The drop in liquidity is due largely to the strain of weaker operations and continued capital and strategic investments, but it remains adequate for the rating level.

STRONG MARKET POSITION: WakeMed's leading 46 percent inpatient market share (2013 data) in the economically solid Wake County (where approximately 70 percent of WakeMed's patients originate) is a key credit strength. Both the city of Raleigh and Wake County GOs are rated 'AAA' by Fitch, supported by population growth, good wealth indicators, and a diverse economic base. There are formidable competitors in the service area: Duke University Health System (revenue bonds rated 'AA'), UNC Health System, and Rex Hospital (revenue bonds rated 'AA-').

RATING SENSITIVITIES

CONTINUED POSITIVE TRAJECTORY: Over the next two years, WakeMed needs to continue on its trajectory toward a positive operating margin. Fitch notes positively that the operating losses have narrowed year over year and volumes year to date have stabilized. Fitch expects 2015 to be a stronger year as the benefits from the strategic investments begin to be realized. A return to 2013 operating losses would lead to a downgrade.

CREDIT PROFILE

Headquartered in Raleigh, NC, WakeMed is an integrated health system with two acute care hospitals, a 98-bed rehab hospital, and other related entities primarily serving Wake County and surrounding areas. In fiscal 2013, WakeMed had total revenues of approximately $1 billion.

EARLY POSITIVE INDICATORS

After a difficult year in fiscal 2013, WakeMed has begun to show signs of stabilization and improvement. The six-month fiscal 2014 operating margin was a negative 1.9 percent, much improved over the negative 2.8 percent operating margin in the six-month fiscal 2013 interim period. WakeMed reports the losses narrowing further through April 2014. Strong expenses management helped drive the improvement with personnel costs down 4 percent and total expenses down 2 percent, year over year. Patient volumes seem to be stabilizing, especially cardiology volumes. Further, after posting negative margins in both cardiovascular services and medical and surgery services in 2013, WakeMed has returned those to positive margins in the six-month interim period.

As important, a significant amount of the costs for two key initiatives, EPIC implementation and the establishment of an ACO, are largely behind WakeMed. WakeMed is also entering year two of its CIA and reports that the first year review went well. Longer term, a new CEO is in place after the former CEO resigned in October 2013. The new CEO has 25 years of experience in health care and retired from the Navy to take on the position at WakeMed. He started as interim CEO very late in 2013 and was offered the position permanently last week.

In spite of his short tenure, he has already had a positive impact on the organization. One of his first initiatives was to standardize efficiency efforts across the organization. WakeMed had a number of initiatives in place and is already one of the lower cost providers in the region, but the effort was not coordinated systemwide. A new system has been adopted and is being rolled out across the system. The orthopedics department was one of the first to implement it, and early results are positive, with reduced length of stay and lower costs per procedure.

Fitch believes all these factors will continue to drive the positive year-over-year trajectory in operating results. However, a significant amount of execution and improvement remains for WakeMed to return to its pre-2013 levels of performance. A failure to continue to improve upon the current levels of performance or a continued decline in liquidity would pressure the rating.

Capital and Strategic Initiatives

The three major strategic initiatives currently underway at WakeMed are the EPIC implementation, the ACO start up, and the building of WakeMed North. WakeMed has successively gone live with EPIC in physician practices and is moving forward to implement it at all its hospitals, which should happen by February 2015. The implementation costs of $82.2 million include spending on staff training and additional FTEs for implementation, which has had an impact on WakeMed's operating performance.

Similarly, the establishment of an ACO has also affected WakeMed's operating margins. The vast majority of the $27 million in expenses is for contracted services, which run through the P&L, even though none of the expected gain has yet to be realized. WakeMed decided to use a third party vendor with expertise in establishing and managing ACOs partly to reduce the start-up implementation time. WakeMed was able to submit its ACO application to The Centers for Medicare and Medicaid (CMS) in July 2013 and approval by CMS was given in December 2013, with 31,000 Medicare lives attributed to WakeMed. WakeMed is currently focusing on other strategies to grow its number of attributed lives.

The third large initiative is the building of WakeMed North, which will be located in the northern service area and focus on women's services. The hospital is expected to open in May 2015, at a cost of $90 million. WakeMed had built a Healthplex in that area with outpatient services in order to establish a presence in the area. Based on the success of the Healthplex, WakeMed moved forward on building a hospital on the same campus. WakeMed anticipates that the new hospital will be cash flow positive by year three of operations.

As WakeMed moves through these major projects, which are all being funded out of cash flow, Fitch expects their negative impact on operations and liquidity to ease. Moving forward, Fitch expects capital spending and capital needs at WakeMed to remain strong, especially given the competitive landscape, but Fitch expects this capital spending to be at more sustainable levels.

Debt Profile

WakeMed's debt load is relatively manageable. Maximum annual debt service (MADS) as a percentage of revenue was 2.6 percent at March 31, which is at the 'AA' category median. Debt-to-EBITDA has historically been above the median and, given the weaker operating performance over the last year and a half, stood at an elevated 4.4x in the six-month fiscal 2014 interim period, relative to the 'AA' category median of 2.9x.

Overall MADS coverage has remained good; after dipping to a low 3.4x at year-end fiscal 2013, it improved to 4x in the six-month interim period. Fitch expects debt coverage to continue to improve for the rest of the fiscal year and end closer to WakeMed's four- year audited average of 4.6x. Fitch's 'AA' category median is 5x.

WakeMed's long-term debt is currently 67 percent fixed rate and 33 percent variable rate. The variable rate is supported by letters of credit (LOC) from Wells Fargo (rated 'AA-/F1+' by Fitch). The LOCs are set to expire in 2014, but renewal of the LOCs is not a concern given WakeMed's access to the capital markets and its solid liquidity position, with approximately 4x unrestricted cash and investments relative to the variable-rate debt.

DISCLOSURE

WakeMed provides annual and quarterly disclosure to EMMA.

In addition, Fitch has withdrawn its ratings for the following WakeMed Health & Hospitals (NC) bond due to prerefunding activity:

-- North Carolina Medical Care Commission (NC) (WakeMed Project) health system revenue bonds series 2009A (all maturities).

Additional information is available at 'fitchratings.com'.

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