Fitch Affirms Banner Health Rev Bonds at 'AA-'; Outlook Stable

The following is from Fitch Ratings on July 28:

Fitch Ratings has affirmed the 'AA-' rating on Banner Health, AZ's (Banner) outstanding debt, which is listed at the end of the press release.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a gross revenue pledge of the obligated group. The obligated group accounted for 76 percent of total revenue and 94 percent of total assets of the consolidated entity in fiscal 2014 (Dec. 31 year end). Fitch's analysis is based on the consolidated entity.

KEY RATING DRIVERS

STRATEGIC BENEFITS OF UAHN ACQUISTION: The affirmation at 'AA-' reflects Fitch's belief that the strategic benefits of the University of Arizona Health Network (UAHN) acquisition outweigh the near-term impacts of the cost of the transaction ($733 million) and the weak financial performance of UAHN on Banner's financial profile. Banner has a long track record of integrating acquired assets and improving financial performance.

EXPANDED GEOGRAPHIC FOOTPRINT: Historically, Banner's operations have been primarily concentrated in the Phoenix, AZ metropolitan area. The acquisition of UAHN expands Banner's presence into the Tucson metropolitan market and has turned Banner into a statewide network with 82 percent of Arizona's population having access to Banner providers.

EXISTING STRONG FINANCIAL PROFILE: Banner's current financial profile is very strong with solid balance sheet metrics, very good profitability, and manageable debt burden. While the UAHN acquisition is dilutive to Banner's financial profile, pro forma metrics are expected to remain in line with Fitch's AA category medians.

ELEVATED CAPITAL SPENDING: Banner has consistently invested in its plant, and the UAHN acquisition includes a $500 million capital commitment in the Tucson facilities. In addition, there may be other capital projects that would be driven by market/volume growth demands. Fitch believes that additional debt capacity after a planned fall 2015 financing will be dependent on Banner's ability to generate improved cash flow at UAHN and maintain debt metrics in line for the rating level.

PARTICIPATION IN RISK BASED CONTRACTS: Banner has been proactive in the move to risk based contracts. The Banner Health Network (BHN) was created to enter into various risk based reimbursement contracting including a Pioneer ACO and senior risk plans. Revenue from risk based contracts through BHN accounted for approximately 9 percent of Banner's net patient service revenue in 2014. There should be further growth in this area with the acquisition of UAHN's health plans and its strong presence in a Medicaid plan.

RATING SENSITIVITIES

SUCCESSFUL INTEGRATION OF UAHN: Although Fitch views the UAHN transaction favorably and believes that management will successfully integrate the two systems, there is less flexibility at the current rating level now for negative variance relative to its plan. A significant deterioration in financial performance, although not expected, could lead to negative rating pressure.

EXPECTED FINANCING: This rating action incorporates the short term financing that Banner utilized to finance the UAHN acquisition, which is expected to be partially refinanced in fall 2015 ($400-500 million) and the remainder to be paid down from cash.

CREDIT PROFILE

Banner Health is a large, integrated health care provider headquartered in Phoenix, AZ with operations in seven states that include 27 hospitals, over 1,000 employed physicians (Banner Medical Group), outpatient and post-acute facilities and insurance products. In 2014, Banner generated $5.4 billion in total revenue. The majority of Banner's operations are located in the Phoenix metropolitan area which accounted for over 60 percent of total revenue in 2014. In fiscal 2014 (June 30 year end), UAHN generated $1.4 billion of total revenues, had $963.5 million of total assets and $363.3 million of debt outstanding.

UAHN Transaction

As of Feb. 28, Banner acquired two medical centers in Tucson, the faculty practice plan of University of Arizona Colleges of Medicine, and three health plans. Banner and the University of Arizona, Colleges of Medicine have a 30-year Academic Affiliation Agreement in place with two 15-year terms. Banner already had a relationship with the Colleges of Medicine as Good Samaritan Medical Center was the teaching facility for the University of Arizona College of Medicine - Phoenix. The acquisition has solidified Banner's role in academic medicine and leveraging the academic brand in Phoenix/ Tucson is a component of the strategy. Banner has created a new division, Banner - University Medicine and all the entities have been rebranded and include Banner - University Medical Center - Phoenix (BUMCP; fka Good Samaritan Medical Center) and Banner - University Medical Center - Tucson (BUMCT; fka University of Arizona Medical Center - University Campus).

The total cost of the transaction was $733 million, which included $300 million for the establishment of an Academic Enhancement Fund (AEF) and $433 million to defease UAHN's debt and purchase a ground lease. In addition, Banner made a $500 million capital commitment to the Tucson facilities. The AEF is at the University of Arizona and is an endowment to support clinical and translational research, in addition to providing operating support for the academic enterprise. Banner funded the acquisition primarily through a $694 million draw on a bank loan, which is expected to be converted to permanent financing ($400-500 million debt) in October/ November 2015 with the remainder to be paid down from cash.

Fitch believes the opportunities related to the acquisition include a broader geographic network, greater scale and efficiency, and creating an academic brand. However, UAHN's financial performance has recently been challenged by a difficult electronic medical record implementation and loss of supplemental funding from the state for indigent care. In 2014, UAHN posted a negative 4.3 percent operating margin, which deteriorated further in year to date 2015. Other challenges include its market position with the Tucson market split fairly evenly between four players. UAHN's reputation in the market included being difficult to access. The physical plant needs investment, which should be resolved with a planned new patient tower, operating rooms and entrance to BUMCT that should be completed by 2019.

Management is committed to achieving synergies in a short timeframe and $100 million from shared service savings is expected by 2018. The integration plans include reducing overhead costs, converting UAHN to Banner's Cerner IT platform, expanding payer relationships in the Tucson market, improving revenue cycle, supply chain and productivity, and reducing length of stay and increasing throughput. There is also significant opportunity related to market share growth.

Fitch believes that the main mitigating factor to the challenges related to the turnaround/integration of UAHN is the strength of the management team, which has a solid track record in delivering results according to plan due to its performance based culture.

Participation in Risk Based Contracts

As part of its overall strategic plan, Banner has been very proactive in readying the organization for payment reform, coordinated delivery of care, and population health management. With the acquisition of UAHN, 82 percent of the State of Arizona's population has access to a Banner provider. Banner created BHN to enter into various full risk and shared risk contracts and the full risk contracts are all Medicare Advantage plans. There was a turnaround in performance in 2014 as expected and further growth and experience in this area will be accelerated with the addition of UAHN's health plans, which has a solid presence in Medicaid products.

Solid Financial Profile

Banner's overall financial profile continues to be solid with a 4.9 percent operating margin ($263 million operating income) in 2014 compared to 5 percent operating margin in 2013 and the 'AA' category median of 3.9 percent. Through the three months ended March 31, operating margin was still solid at 5.4 percent but only included one month of UAHN performance. The projected 2015 performance is a 2.5 percent operating margin, which Fitch believes is conservative and likely to be exceeded.

Liquidity metrics have dropped with the UAHN acquisition with 270 days cash on hand and 132 percent cash to debt at March 31, compared to 298 days cash on hand and 155 percent cash to debt at fiscal year end 2014. Management projects a decline in days cash on hand due to the larger expense base and use of equity to fund a portion of the acquisition, however, cash to debt is expected to be around 150 percent after the permanent financing in the fall of 2015.

Elevated Capital Spending

Banner has consistently invested in its facilities and its clinical IT system. 21 of Banner's 27 hospitals have achieved HIMSS stage 7 designation compared to a total of 204 hospitals nationwide. Capital spending is projected to total $339 million in 2016, $361 million in 2017, and $378 million in 2018 and is in line with historical spending, but could increase depending on the success of Banner - University Medicine and if market share and volume growth necessitates additional capital.

Current major capital projects include a new emergency room at BUMCP and a new patient tower at BUMCT. The project at BUMCP includes a new and expanded emergency room, a 40 bed observation unit, and four additional operating rooms at a cost of $180 million that should be complete by mid-2017. The project at BUMCT includes an 11 story patient tower with 300 private rooms, new operating rooms, and new lobby and entrance at a cost of $438 million that should be complete by early 2019.

Debt Profile

Banner's total outstanding debt at March 31, (including bank debt used to acquire UAHN) was $3.2 billion. Management projects total debt to decline to $3 billion after the refinancing of the bank debt with permanent financing in fall 2015 due to the expected equity contribution. Including its swaps, Banner's debt profile is 100 percent fixed rate and management is still evaluating the final debt structure for the fall 2015 financing. The current long term debt profile is 63 percent underlying fixed rate, 7 percent direct purchase - variable rate, 14 percent variable rate demand bonds, and 16 percent indexed floaters. Current MADS is $166 million and debt service coverage is solid at 4.7x in 2014 and 4.8x in 2013 and projected performance (including fall 2015 debt issuance and UAHN performance), debt service coverage is expected to remain in line with historical results.

Banner recently novated its fixed payer swaps and increased the number of counterparties, and spread the collateral threshold among six counterparties from four and reduced the amount of collateral posting required. Banner is currently posting approximately $60 million in collateral compared to $190 million prior to the novation.

Disclosure

Banner covenants to provide audits within 150 days of fiscal year end and quarterly disclosure within 60 days of quarter end for the first three quarters. Banner's financial reporting is excellent. Disclosure is timely and complete. Interim financial statements are presented in an audit format and include a management discussion and analysis. Furthermore, Banner hosts quarterly investor calls.

For more information see Fitch's last press release on Banner Health dated Sept. 12, 2014.

Outstanding Banner debt rated by Fitch as of Dec. 31, 2014:

--$200,600,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2014A;

--$67,840,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2012B (taxable);

--$179,090,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2012A;

--$67,905,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008H (LOC: Northern Trust Company (The)) & bank bonds;

--$86,900,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008G (LOC: Wells Fargo Bank, N.A.) & bank bonds;

--$92,090,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008F (LOC: JPMorgan Chase Bank, N.A.) & bank bonds;

--$112,310,000 Arizona Health Facilities Authority (AZ) (Banner Health) variable-rate demand revenue bonds series 2008E (LOC: Bank of America, N.A.) & bank bonds;

--$754,195,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2008D;

--$209,675,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2008A;

--$400,000,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2007B;

--$135,350,000 Arizona Health Facilities Authority (AZ) (Banner Health) revenue bonds series 2007A.

Additional information is available at 'fitchratings.com'.

Applicable Criteria

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

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

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

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

Additional Disclosures

Dodd-Frank Rating Information Disclosure Form

https://fitchratings.com/creditdesk/press_releases/content/ ridf_frame.cfm?pr_id=988638

Solicitation Status

https://fitchratings.com/gws/en/disclosure/ solicitation?pr_id=988638

Endorsement Policy

https://fitchratings.com/jsp/creditdesk/ PolicyRegulation.faces?context=2&detail=31

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