[November 13, 2012]

Fitch Rates Covenant Health's (TN) Series 2012A Bonds 'A'; Outlook Stable

Fitch Rates Covenant Health's (TN) Series 2012A Bonds 'A'; Outlook Stable

Fitch Ratings assigns a long-term rating of 'A' to approximately $117.240 million of series 2012A revenue bonds to be issued by the Health, Educational and Housing Facility Board of the County of Knox (HEHFB) on behalf of Covenant Health.

In addition, Fitch affirms its 'A' rating on the following outstanding debt issued through HEHFB:

-- $60,245,000 fixed rate revenue bonds series 1993

-- $140,630,248 capital appreciation bonds series 2002A

-- $14,320,000 current interest bonds series 2002A

-- $97,950,000 auction rate securities series 2002D

-- $60,660,848 capital appreciation bonds series 2006A

-- $125,000,000 direct bank loan series 2006B

-- $103,700,000 variable rate demand bonds series 2011A and 2011B*

-- $135,500,000 direct bank loan series 2011C

*(underlying rating; secured by Letters of Credit from Bank of America)

The Rating Outlook is Stable.

Covenant Health also plans to issue $37, 875,000 of series 2012B bonds, which will be a direct loan with First Tennessee Bank National Association. Fitch was not asked to rate these bonds.

The series 2012A bonds are expected to be issued as fixed-rate debt. Bond proceeds, together with the 2012B bonds, will be used to refund the series 2002A capital appreciation bonds (CABs) and 2002A current income bonds for debt service savings. Although the transaction is estimated to produce significant present value savings, the refunding of CABs results in additional debt service in 2012-2015 due to resulting interest payments. As a result, aggregate MADS is expected to increase to $39.1 million. The 2012A bonds are expected to price the week of November 12 via negotiation.

SECURITY

Debt payments are secured by a pledge of the gross receipts of the obligated group. There is also a springing mortgage on Fort Sanders Regional Medical Center and Parkwest Medical Center in the event of default.

KEY RATING DRIVERS

STRONG LIQUIDITY: Covenant's strong liquidity metrics continue to be one of its key credit strengths. At August 31, 2012, unrestricted cash and investments totalled $973.5 million equating to 355.2 days cash on hand, which is comfortably above 'A' category medians. Maintenance of its strong liquidity levels is necessary given its historically weak operating performance.

LEADING MARKET POSITION: Covenant continues to be a leading provider in its competitive service area with 42.4% market share, which has steadily increased over time through both organic growth and acquisitions. Covenant is the largest health system in Eastern Tennessee with seven hospitals.

MANAGEABLE CAPITAL NEEDS: Covenant has expanded its operating footprint through a series of acquisitions and solid capital spending that has averaged 144% of annual depreciation since fiscal 2009. Covenant's future capital needs are limited and management projects future capital spending to equal a manageable $40 - 50 million per year or approximately 60 - 70% of depreciation expense.

WEAK PROFITABILITY: Operating profitability continues to be weak with -1.3% operating margin though the eight-month interim period ended Aug. 31, 2012, compared to -1.0% the same prior year period. However, the fourth quarter is generally Covenant's best performing quarter, and management expects to end fiscal 2012 at a level similar to fiscal 2011 with a 0.2% operating margin. Additionally, Covenant is implementing strategies to enhance future profitability.

ABOVE AVERAGE DEBT BURDEN: Without an improvement in cash flow, Covenant is near its debt capacity with MADS equal to 3.4% of revenue compared to the 'A' category median of 2.8%. Debt service coverage was only 2.9x for the interim period compared to 3.4x in fiscal 2011, 2.9x in fiscal 2010, and the 'A' category median of 4.1x.

CREDIT PROFILE

The 'A' rating is supported by Covenant Health's (Covenant) strong liquidity and leading market share position sustained by its regional reach achieved through growing its network of hosptals and physician affiliations. Primary credit concerns include its historically weak operating profitability, relatively high debt burden, and competitive market.

Covenant's strong liquidity position remains one of its primary credit strengths. At Aug. 31, 2012, unrestricted cash and investments totalled $973.5 million, producing a very strong 355.2 days cash on hand relative to the 'A' category median of 191.0 days. Cushion ratio of 24.9x and cash to debt of 130.3% are both favorable to the respective 'A' category medians of 16.3x and 116.4%. As Covenant's liquidity is a major credit strength, maintaining a strong liquidity position is important to support its current rating.

Despite a competitive service area, Covenant's market share continued to strengthen. Market share in its primary and secondary service areas has steadily increased over the years with 42.4% inpatient market share in fiscal 2011, up from 31.2% in 2007. The market has been consolidating and the remaining main competitors are Tennova (subsidiary of HMA, rated 'BB-' ), which purchased the Mercy Health Partners (formerly part of Catholic Health Partners) facilities at the end of 2011, University Health System (rated 'BBB+'), and Blount Memorial Hospital. Management stated that the entrance of a for-profit provider in the market has not impacted Covenant to date. Covenant's comprehensive geographic coverage combined with its physician employment strategies is expected to solidify Covenant's market position.

Covenant has expanded its operating footprint through the acquisition of Roane Medical Center (Roane) in 2008 and Morristown-Hamblen Health System in 2010. Additionally, Covenant has replaced or significantly renovated most of its facilities in the past decade and has already made substantial investments in information technology and clinical technology. As a result, capital spending is projected to be modest in the near to medium term at approximately $40 - 50 million per year (approximately 60-70% of depreciation).

Covenant's operating performance has historically been weak for the rating category. Operating margin softened in fiscal 2011 to 0.2% from 0.6% in fiscal 2010 and remains significantly below the 'A' category median of 2.8%, but is notably higher than -2.3% in 2008. Through the eight-month interim period ended Aug. 31, 2012, operating margin was -1.3%, compared to -1.0% in the same period the prior year. The fourth quarter is typically Covenant's most profitable period, as evidenced by improved results from third to fourth quarter of 2011, and management expects fiscal 2012 to end close to fiscal 2011 results. Additional operational improvements are underway, and include productivity enhancement, case management, and consolidation of non-clinical systems. Management expects the various operational initiatives to reduce expenses by approximately $1 million in 2013.

Leverage metrics are weak as reflected by debt to EBITDA of 6.6x and debt to capitalization of 46.6% for the interim period when compared to the respective 'A' category medians of 3.4x and 40.7%. Further, historical coverage of pro-forma MADS by EBITDA in 2011 and through the eight month interim period is light at 3.4x and 2.9x, respectively. Without an improvement in cash flow, Fitch believes Covenant's debt capacity is limited at the current rating. No new debt is anticipated in the near term.

Total outstanding debt at Aug. 31, 2012 was $747.1 million. The 2012 issuance will consist of $117.2 million of fixed rate bonds and a $37.9 million indexed floating rate direct loan from First Tennessee Bank National Association, which will increase floating rate exposure slightly from 63% to 68%. Management has a deliberate balance sheet management strategy to offset risks associated with its variable rate exposure in its debt profile by allocating a portion of its investments into a short term portfolio in high quality fixed income securities. The asset allocation strategy is expected to result in a return of the short term portfolio in excess of its total variable rate interest cost.

Covenant's put risk is manageable with $103.1 million subject to short-term put in the form of variable rate demand bonds (VRDBs) supported by Letters of Credit (LOCs). The LOCs on the series 2011A&B VRDBs expire on March 24, 2014 and have a term out provision of five years. While the 2006B and 2011C direct bank loans face medium-term renewal risk, the series 2012B direct loan will be issued with a term extending to its final maturity date. Covenant is not party to any swap agreements.

The Stable Outlook reflects Fitch's expectation that Covenant will continue to maintain its leading market position and strong liquidity. Profitability should improve due to the organization's strategic growth initiatives and focus on cost control. A deterioration in balance sheet strength or material weakening of operating performance could place downward pressure on the rating.

Covenant consists of seven hospitals with 1,705 licensed beds located throughout 16 counties that make up the Knoxville metropolitan service area, and several other health care related organizations. Covenant had total operating revenues of $1.1 billion in 2011. Through a continuing disclosure agreement Covenant agrees to provide annual audited and quarterly financial statements to the MSRB's EMMA system.

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.

In addition to the sources of information identified in Fitch's Rating Criteria, this action was additionally informed by information from Citigroup.

Applicable Criteria and Related Research:

--'Revenue Supported Rating Criteria' (June 12, 2012);

--'Non-Profit Hospital and Health System Rating Criteria' (July 23, 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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