Fitch Affirms Cottage Health System (CA) Revs at 'AA-'; Outlook Stable

Fitch Ratings has affirmed its 'AA-' rating on the following revenue bonds issued on behalf of Cottage Health System (CHS), California:

--$288.9 million CSCDA (California Statewide Communities Development Authority (CA)) fixed rate revenue bonds, series 2010;

--$50.7 million CHFFA (California Health Facilities Financing Authority (CA)) fixed rate revenue bonds, series 2003B.

The Rating Outlook is Stable.

SECURITY

The bonds are secured by a pledge of gross revenues of the obligated group.

KEY RATING DRIVERS

STRONG PROFITABILITY: For fiscal year (FY) 2011, CHS posted strong operating and operating EBITDA margins of 6.7% and 11.1%, respectively, which exceeded Fitch's 'AA' category medians for the fourth year in a row. Through the six-month interim period ending June 30, 2012, CHS reported respective margins of 3.9% and 12%. The drop in the operating margin is due to rising depreciation and interest expense related to the February 2012 opening of CHS's two new patient pavilions.

DOMINANT MARKET POSITION: Fitch believes that CHS's market position is a key credit strength. As the only major provider of acute health care services in the Santa Barbara region, CHS enjoys approximately a 94% market share in its primary service area.

ADEQUATE LIQUIDITY: Balance sheet metrics exhibit very good liquidity relative to expenses as unrestricted cash and investments at June 30, 2012 equated to 232.3 days cash on hand compared to Fitch's 'AA' median of 241.1 days. However, CHS's cash-to-debt position is a weak 103.2%, when compared to Fitch's 'AA' median of 169.4% reflecting the impact of the corporation's heavy capital spending.

HEAVY CAPITAL SPENDING TO MODERATE: With the opening of CHS's two new patient pavilions on its Santa Barabara campus and significant progress on its replacement facility in Goleta Valley, capital spending is expected to gradually ebb after 2013. CHS's four-year $174.7 million capital budget (2012-2015) will be funded from operating cash flow. Given CHS's history of robust cash flow generation, Fitch believes this capital spending rate should have minimal impact on liquidity.

CREDIT PROFILE

CHS consists of the 511-licensed bed Santa Barbara Cottage Hospital and two smaller acute-care hospitals with 132 licensed beds, all located in southern Santa Barbara County, California. Total revenues in 2011 were $600.5 million.

Strong Profitability

Historically, profitability has been consistently ahead of Fitch's 'AA' category medians and are key to CHS's financial success as it approaches the last three years of its major campus repositioning plan. Averaging a 10% operating margin in each of the last four years, CHS's robust profitability has been among the highest in Fitch's healthcare portfolio. The softer six-month interim operating margin of 3.9%, however, was impacted by sharply higher depreciation and interest expense related to the opening of CHS's two new patient pavilions. Nevertheless, CHS's interim operating EBITDA margin of 12% is in line with historical results and exceeds Fitch's 'AA' median of 10.6%. Fitch believes that CHS will need to maintain its strong profitability and cash flow generation to help fund its ongoing and sizable capital projects over the next three years without eroding liquidity.

CHS's track record of strong financial results reflects, in part, its dominant market position where CHS remains the only major provider of acute health care services in the Santa Barbara region, capturing approximately a 94% market share in the primary service area. Further, CHS operates in the highly desirable and affluent greater Santa Barbara area.

Adequate Liquidity

Fitch believes CHS's balance sheet provides adequate liquidity for the current rating and expects CHS to maintain this liquidity level as it continues to fund its ongoing and sizable capital projects from operating cash flow over the next three years. As of June 30, 2012, CHS had $232.3 million in unrestricted cash and investments, equating to a very good 232.3 days cash on hand, a good 16.5x cushion ratio and an adequate cash-to-debt position of 103.2%.

Capital Spending To Moderate

Fitch's main credit concern is CHS's extensive capital plan, which totals $925 million and will rebuild Santa Barbara Cottage Hospital (SBCH; $811 million) and Goleta Valley Cottage Hospital (GVCH; $110 million) to modernize the facilities and meet seismic requirements. To date, CHS has spent almost $534 million on its SBCH strategic projects and approximately $63 million on its GVCH projects, which were funded primarily by bond proceeds, operating cash flows and contributions from the SBCH Foundation.

Major elements of these projects entail construction of three 100-bed patient pavilions on CHS's Santa Barbara campus. In February 2012, SBCH brought online and moved various service line operations into the two new inpatient pavilions. Preparation for construction of the third pavilion is underway with demolition of buildings that will be replaced by the pavilion. Completion of the third pavilion is expected to be in 2018. CHS has budgeted $284 million in capital spending on its remaining SBCH projects through 2019.

CHS's capital needs (2012-2019) total $543 million, including Facilities Master Plan (FMP) projects, special projects, and routine maintenance. As CHS is relying on hospital reserves, operating cash flow and Foundations' support to funds its ongoing capital plan, Fitch believes that CHS's proven track record of strong cash flow generation should provide sufficient funding needs without materially impacting liquidity.

Strategic Planning

As CHS approaches completion of its multi-year FMP, management and the Board are in the midst of formulating a new strategic plan intended to ready the organization for a post healthcare reform era. High among these strategies are development and growth of clinical centers of excellence and the development of a clinically-integrated organization.

Over the last few years, CHS has had affiliation discussions with both the Sansum Clinic (a 150-physician multi-specialty clinic) and the Cancer Center of Santa Barbara. Fitch views these discussions positively believing that CHS, along with other providers in the area, will ultimately need to further develop a highly-aligned and clinically-integrated healthcare delivery platform. This, Fitch believes, should ensure financial viability in an operating environment driven by a strong focus on quality outcomes and pressured by lower reimbursement.

Debt Profile

CHS's debt burden is above-average with maximum annual debt service (MADS) composing a high 3.4% of 2011 revenues, which compares unfavorably to Fitch's 'AA' median of 2.5%. However, MADS coverage by operating EBITDA was an adequate 3.3x compared to Fitch's 'AA' median of 4.2x.

Total debt is $323.5 million, which is in fixed-rate mode. CHS has several swaps with a notional par of $248.5 million, which had a negative $39 million mark-to-market at June 30, 2012 and required no collateral posting at that time.

Stable Outlook

The Stable Rating Outlook reflects Fitch's belief that CHS will maintain its strong cash flow generation to fund its remaining capital projects without materially impacting its liquidity position.

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:

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

--'Nonprofit Hospitals and Health Systems Rating Criteria', dated 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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