[February 11, 2013]

Fitch Rates Scott & White Healthcare's (TX) Hospital Revs Ser 2013A 'AA-'; Outlook Stable

Fitch Ratings assigns a long-term rating of 'AA-' to approximately $177.6 million of series 2013A revenue bonds to be issued by Tarrant County Cultural Education Facilities Finance Corporation, TX (the corporation) on behalf of Scott & White Healthcare (S&W).

In addition, Fitch affirms its 'AA-' rating on the outstanding debt:

--$341.2 million series 2010

--$85.8 million series 2008-1

--$94.4 million series 2008-2

--$154.4 million series 2008A

The Rating Outlook is Stable.

The series 2013A bonds are expected to sell as fixed-rate tax-exempt bonds and proceeds will be used to refund a portion of the Hillcrest Baptist FHA insured debt, which was not rated by Fitch, and fund approximately $60 million of new money for the construction of a new 46-bed hospital. The series 2013A will not have a debt service reserve fund. The remaining funds for the refunding of the Hillcrest Baptist debt will be provided through a tax-exempt, variable series 2013B, issued as a private bank placement, which is not rated by Fitch. The bonds are expected to price the week of Feb. 18, 2013. Scott & White also anticipates issuing $94.4 million of series 2013C variable-rate private placement bonds, which will not be rated by Fitch, and whose funds will be used to refund Scott & White's existing series 2008A-2 bonds currently outstanding in the same amount.

SECURITY

The bonds are secured by a pledge of gross revenues of the members of the obligated group, which accounted for 69% of revenues and 87% of total assets of the consolidated S&W system in fiscal 2012. The S&W Health Plan and Hillcrest Baptist Medical Center are not in the obligated group but are consolidated into the S&W financial statements. Hillcrest Baptist will join the obligated group with the series 2013A transaction. Assuming the transaction, the obligated group would constitute 98% of system assets and 80% of system revenues. Fitch reports on the performance of the consolidated S&W system.

KEY RATING DRIVERS

PROPOSED MERGER WITH BAYLOR HEALTH SYSTEM: Pursuant to a Dec. 1, 2012 letter of intent, S&W is planning to merge with the Dallas-based, financially strong Baylor Health System (Baylor, not rated by Fitch), combining forces to create the largest not-for-profit healthcare system in Texas. The merger, once consummated, would be viewed as a strong credit positive by Fitch. Benefits include providing a large base for population health management initiatives, the ability to share clinical expertise, and derive savings based on the large scale of the new organization. Initially, the two organizations will remain solely obligated on their respective debt. While Fitch views the merger as a positive credit factor, the current rating does not incorporate the effect of the merger on S&W's rating.

SIGNIFICANT MARKET PRESENCE AND INTEGRATED PLATFORM: S&W's market presence and high degree of integration in a large, demographically favorable service area is a fundamental positive credit factor and positions the system favorably in the health care reform environment. S&W operates 12 hospitals (three are minority owned or managed), the largest employed multi-specialty physician group in Texas, 80 regional clinics, and a large health plan with 225,000 enrollees.

MISSED 2012 BUDGET: Operating income of $65 million in fiscal 2012 (year-end Aug. 31), equal to operating margin of 3.2%, fell short of the budgeted $100 million target. The most significant reason for the sub-optimal result was related to revenue cycle issues. Management has instituted a number of new processes to address this issue and expects to derive $25 million of additional cash flow from the revenues cycle improvements and is budgeting $107 million operating income for fiscal 2013.

WEAK LIQUIDITY: Days cash on hand (DCOH) have been relatively stable, hovering at approximately 120 days for the last several years as S&W continued to make significant investments in its facilities and physician network, with capital expenditures averaging 186% of depreciation over the last four years. DCOH at 121.8 days and cash to pro-forma debt equal to 57% are significantly below the 'AA' category medians of 241.1 DCOH and 169.4%, respectively. Unrestricted cash is projected to increase by 50% over the next several years, resulting in improvement in cash to debt, but DCOH will likely remain close to the current level given the projected growth of the system.

ELEVATED DEBT LOAD: S&W's pro-forma debt load, which includes the proposed refunding of the Hillcrest Baptist debt and $60 million of new money, is elevated compared to the category medians, but is reflective of the investment in the system's integrated network, which will be nearing end over the next two to three years. System EBITDA maximum annual debt service (MADS) coverage of pro-forma debt was 2.9x in fiscal 2012 and MADS represented 3.1% of revenues. The proposed 2013 transaction will decreased MADS and will add onlyapproximately $30 million to long-term debt.

RATING SENSITIVITY

RETURN TO STRONGER PROFITABILITY: Return to stronger operating performance is viewed as necessary in generating sufficient cash-flow to support the completion of S&W's capital plan.

CREDIT PROFILE

PROPOSED MERGER WITH BAYLOR HEALTH SYSTEM

Following an extended period of negotiations, S&W and Baylor signed a letter of intent to formally merge on Dec. 14, 2012, with a definitive agreement expected by April 30, 2013. The merged organization would be renamed Baylor Scott & White Health and, with combined revenues of $7.7 billion, 42 hospitals, 350 patient care facilities and 34,000 employees, would be one of the largest, non-religiously sponsored U.S. health care systems.

Pursuant to the proposed governance structure, both organizations will be controlled by a new not-for-profit holding company with a 14-member board, with equal board representation by both organizations. The current chair of the Baylor board of trustees will serve as the chairman of the board of the new holding company and will be succeeded in two years by the chairman of the S&W board. Baylor's CEO, Joe Allison, will be the CEO of the combined entity and Dr. Robert Pryor, the current S&W CEO, will serve as the COO. Fitch views the proposed merger as a significant credit positive based on the considerable geographic footprint of the two systems, whose service areas do not overlap, combined with the leverage of the S&W Health Plan. The merger should provide a solid platform for engaging in population health management, a key feature needed to succeed in the health care reform environment.

DISAPPOINTING FISCAL 2012

System revenues increased by a healthy 6.7% in 2012 based on solid volumes, including a robust 5.3% increase in discharges. However, S&W failed to meet its fiscal 2012 operating income target of $100 million, ending the year with operating income of $65 million, equal to a 3.2% operating margin. Management reports the main reason behind the disappointing result was issues related to the revenue cycle in mid-year, including difficulties with aging of receivables due to an intermediary changing its billing platform. Steps taken to remedy the situation included aggressively engaging the LEAN methodology to improve the revenue cycle processes, and the expectation is that the revenue cycle improvements will generate an additional $25 million of revenues in the current fiscal year.

Positive developments last year included significant improvement in the Health Plan performance, which had $2.8 million of positive operating income, reversing a $23.1 million operating loss in the prior year. The Health Plan accounted for 30% of system revenues last year and is a key component of the S&W vertically integrated system. Hillcrest Baptist, likewise, has seen a turnaround in financial results, generating $7.5 million of income from operations (a 3.4% operating margin), producing consistent improvement in operations since being acquired in 2009. For the first quarter of fiscal 2013 ended Nov. 30, 2012 (the interim period), the system reported operating income of $12.8 million (2.5% operating margin), an improvement over prior year's $9.7 million (2% operating margin). Management is budgeting operating income of $107 million for the current fiscal year, which should be attainable as the revenue cycle improvements take hold and based on the continued strong volumes reported for the first quarter. During 2012 S&W added 72 physicians and advance practice providers, resulting in the first quarter exceeding budgeted discharges and close to a 10% increase in physician visits.

NEARING END OF CURRENT CAPITAL CYCLE

Capital projects funded with the proceeds of the series 2010 bonds include the addition of 26 beds to the highly utilized Round Rock Hospital, which was completed in the spring of 2012, and a new 146-bed hospital in College Station. Construction of the College Station Hospital is ahead of schedule and opening is slated for August 2013. The system is planning to break ground in August for the construction of its Surgical Sciences Building with an estimated cost of $100 million, partially funded from the series 2010 bond proceeds. Approximately $60 million of the new money from the 2013A transaction will be used toward the $100 million cost of a new 180,000 square foot 46-bed hospital in Marble Falls, with construction beginning this spring. The remaining cost of the facility will be funded from combination of cash flow and philanthropy. A 64,000 square foot MOB is being constructed by a third party adjacent to the new hospital (will be operated under an operating lease).

The system is implementing the installation of the EPIC IT platform, involving the considerable expense of nearly $160 million. The decision to move to the new IT platform was driven by the need to support the substantial system clinic operations, for which the EPIC system is better suited than the prior platform. Fitch views the return to a stronger operating performance as necessary in generating sufficient cash-flow to support both the completion of the construction projects as well as the IT implementation, in order to maintain the current rating, in the absence of the benefits from the proposed merger.

NEED TO STRENGTHEN BALANCE SHEET

The consolidation of the Health Plan into system financials in 2010 had a negative effect on S&W's liquidity metrics, and significant investment in plant, partially funded from operating cash-flow, has limited liquidity growth. The system's $628.1 million of unrestricted cash and investment at Nov. 30, 2012 translates to 121.9 DCOH, 56.8% cash to pro-forma debt, and cushion ratio of 9.9x, all unfavorable to the 'AA' medians. Fitch views the low liquidity as the main credit weakness. While cash to debt is projected to improve over time, DCOH, given the projected system growth, are not likely to increase materially over the near term.

Coverage of pro-forma MADS ($63.4 million) by EBITDA was 2.9x in fiscal 2012, as compared to the 'AA' category median of 4.0x. MADS as a percent of revenues was manageable at 3.1%, compared to 2.5% for the 'AA' rating median. Somewhat offsetting the below-category debt metrics is the relatively conservative debt composition with 62% of long-term debt in fixed-rate mode post issuance. The system has a number of swaps with notional par of $566.3 million, with a negative mark-to-market of $130.8 million as of Jan.31, 2013. No collateral is being posted and the system has a letter of credit in the amount of $65 million covering the $58.3 million posting requirement under one of the swaps.

S&W operates 12 hospitals (three are minority owned or managed) with 1,308 licensed beds, the S&W Clinic and the Scott and White Health Plan. The system generated $2 billion in revenues in fiscal 2012. S&W covenants to provide quarterly and audited fiscal year-end financial statements via the Municipal Securities Rulemaking Board's EMMA system. Quarterly disclosure has been excellent and has consisted of a balance sheet, income statement, cash flow statement, and management discussion and analysis.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

Applicable Criteria and Related Research:

--'Nonprofit Hospitals and Health Systems Rating Criteria', dated July 23, 2012

--'Revenue-Supported Rating Criteria', dated June 12, 2012

Applicable Criteria and Related Research:

Revenue-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=681015

Nonprofit Hospitals and Health Systems Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=683418

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