Baylor Scott & White Health, TX

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1 CREDIT OPINION Baylor Scott & White Health, TX New Issue - Moody s assigns Aa3 to Baylor Scott & White Health s (TX) Ser and 2016A; outlook stable New Issue Summary Rating Rationale Contacts Lisa Martin Senior Vice President lisa.martin@moodys.com Lisa Goldstein Associate Managing Director lisa.goldstein@moodys.com Moody's Investors Service assigns an Aa3 to Baylor Scott & White Health's (TX)+ (BSWH) proposed $536 million of Series 2016 taxable bonds to be issued by Baylor Scott & White Holdings and to BSWH s proposed $382 million of Series 2016A tax-exempt bonds to be issued by Tarrant County Cultural Education Facilities Finance Corporation. The bonds are expected to have a final maturity in The outlook is stable. We are affirming the Aa3 and Aa3/P-1 ratings on approximately $1.5 billion of outstanding debt. The Aa3 is attributable to BSWH's position as the largest not-for-profit health system in Texas, geographic diversity, favorable demographics driving very good revenue growth, strong cashflow margins, and proven track record of executing integration and growth strategies. These strengths provide support for the increase in debt following the proposed financing. Challenges include high competition and no Certificate of Need regulations, a leveraged balance sheet, managing an aggressive growth strategy, and potential reduction in sizable Medicaid supplemental funds if the Texas Medicaid waiver program is not extended. The P-1 on BSWH s Windows debt reflects our estimation of the system s market access and ability to pay the purchase price of a mandatory tender when due at the end of the mandatory tender window. Credit Strengths Largest not-for-profit health system in Texas with $7.5 billion in revenue, including a large health plan and good geographic diversification of hospitals in the North and Central Texas regions Dominant market position in the Central Texas region with the only stand-alone children's hospital between Austin and Dallas Favorable demographics with strong population growth, driving a very good 8-9% annual revenue growth Strong 14% operating cashflow margins, demonstrating ability to quickly execute large integration and manage growth strategies Adequate liquidity with over 194 days cash on hand at December 31, 2015, of which close to 90% has monthly liquidity

2 Primarily defined contribution pension plans, providing predictability in funding requirements Credit Challenges Highly competitive markets served by large well-funded not-for-profit and for-profit providers and no Certificate of Need regulations Leveraged balance sheet with modest proforma 113% cash-to-debt and somewhat high operating leverage with 3.2 times proforma debt-to-cashflow Risk of reduction in or elimination of sizable Medicaid supplemental payments with the expiration of the Texas Medicaid waiver in September 2016 Increasing capital investments, some of which may be debt financed, for growth strategies and competitive positioning Rating Outlook The stable outlook reflects expected stable absolute cashflow levels to support the proposed incremental debt, sustained cashflow margins at or close to current levels, and an ability to largely offset possible reductions in Medicaid funding given the system s track record of executing operating improvement strategies. The outlook assumes maintenance of relative liquidity (days cash on hand) given cashflow that comfortably supports higher capital spending, and anticipates no material incremental debt beyond the proposed offering in the absence of cashflow growth. Factors that Could Lead to an Upgrade Meaningful deleveraging of balance sheet and operation Significant reduction in competition or increase in market share Sustained improvement in operating margins Factors that Could Lead to a Downgrade Material amount of incremental debt Multi-year decline in operating margins or inability to absorb significant decline in Medicaid funding Contraction in liquidity Dilution of key measures from acquisition or merger This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2

3 Key Indicators Exhibit 1 Baylor Scott & White Health, TX Based on audits for Baylor Scott & White Health, fiscal years ended June 30 Fiscal year 2015 Pro Forma includes proposed Series 2016 financing Investment returns normalized at 6% prior to FY 2015 and 5% in FY 2015 and beyond Source: Moody's Investors Service Recent Developments Recent developments are incorporated into the Detailed Rating Consideration section. Detailed Rating Considerations Market Position: Good Market Diversification in Competitive Markets BSWH faces high competition in the North Texas region. While the Central Texas region has historically enjoyed a dominant market position, the system is making investments in selective markets in Texas over the next five years. BSWH benefits from high 7-8% population growth (over a five-year period) in many markets, but the absence of CON regulations attracts well-funded competitors including large not-for-profit and for-profit healthcare systems. Based on management-provided data for 2013, BSWH holds an approximate 21% total market share across the North Texas region. BSWH holds approximately 24% total market share across the Central Texas region. BSWH also faces significant competition from physician groups that own hospitals and surgery centers. A significant strategy for BSWH involves joint ventures, which allow alignment with physicians and organizations with clinical expertise in particular specialties but require the system to share income for these services. All of the system's ambulatory surgery centers (27) and eight short-stay surgical hospitals are part of a joint venture with USPI. Other joint ventures include rehabilitation services, free-standing emergency hospitals and imaging centers. BSWH has an aggressive growth strategy, which brings execution risks and significant cost but the system has a strong track record of evaluating opportunities and executing strategies while maintaining operating focus and balancing affordability with resources. The Scott and White Health Plan is growing membership in the North Texas region with plans to expand statewide. The system recently entered into two joint ventures with Tenet to operating five hospitals as the majority owner in the North Texas region. Notable capital and physician-related investments are expected statewide. Operating Performance, Balance Sheet, and Capital Plans: Strong Margins Support Incremental Debt BSWH produced strong margins in FY 2015, the first full year since the merger, demonstrating an ability to quickly and effectively execute integration strategies and improvement initiatives. The system s operating cashflow margin was a strong 14.7% in FY 2015, 3

4 returning to average 13-14% margins produced by Baylor Health Care System prior to the merger with Scott & White Healthcare. Strong results continue through six months of FY 2016 with a 14.4% operating cashflow margin, driven in part by strong 9% revenue growth. Performance benefited from operating improvements and synergy initiatives, increased volume, revenue cycle improvements and increased performance from joint ventures. (The audit reports noncontrolling interests related to joint ventures as a change in net assets; Moody's includes noncontrolling interests as a non-operating deduction, affecting debt-to-cashflow and debt service coverage ratios.) The system is targeting close to $600 million in total operating improvements and synergy benefits started in BSWH achieved approximately $240 million in improvements in FY 2015 and is targeting about $140 million in FY The largest initiatives involve centralization of and/or improvements in revenue cycle, supply costs including pharmaceutical costs, and retail pharmacy. The system re-negotiated and centralized managed care contracting early in the integration. The greatest near-term operating risk is the future of the Texas Medicaid waiver program that drives supplemental funding to BSWH. The waiver program expires in September 2016 and the system receives sizable payments from the program to support indigent care. Growth strategies and competition will result in increased capital spending to about times depreciation, which is still under operating cashflow projections. Capital spending is targeted at growing the system s presence in Texas, growing the health plan beyond the Central Texas market and increasing the number of physicians aligned through the Baylor Scott & White Quality Alliance. LIQUIDITY BSWH had close to $4 billion in unrestricted cash and investments at FYE 2015, equating to an adequate 218 days cash on hand. Investments declined to $3.7 billion (194 days) at December 31, 2015 primarily due to market losses. Investments are fairly liquid with almost 55% cash and fixed income securities. The system has manageable and predictable liquidity risks with minimal swap collateral and defined contribution pension plans. Debt Structure and Legal Covenants: Balance Sheet Leveraged The proposed issuance results in approximately $650 million of incremental debt, compared to FYE 2015, representing a 24% increase in debt. On a proforma basis, the system is leveraged with modest cash-to-debt of 113% and somewhat high 3.2 times debt-tocashflow. DEBT STRUCTURE Debt structure risks are manageable with diversified bank counterparties and facility expiration dates for bank agreements supporting variable rate debt. BSWH has ample headroom under covenants. MTI and bank agreement covenants include a debt service coverage ratio of at least 1.10 times (measured quarterly under bank agreements); if less than 1.10 times, a consultant will be hired. An event of default occurs if, under the MTI, the debt service coverage ratio for two consecutive fiscal years is less than 1.00 times. Bank agreements also include a days cash on hand covenant of 75 days or greater. The Aa3/P-1 rating on the 2011B and 2013B bonds reflects the system's ability to access the market or liquidate assets should the bonds fail to be remarketed and the structure that allows a lengthy period of time to get funds to meet the mandatory tender. DEBT-RELATED DERIVATIVES BSWH's combined swap program includes $952 million of fixed payer swaps and $81 million of fixed receiver swaps including two forward starting swaps. Counterparty risk is diversified among five counterparties. The system's collateral posting requirements are modest for the size of the program ($25 million at February 29, 2016), resulting in minimal liquidity pressure. Collateral thresholds are high for most swaps. PENSIONS AND OPEB BSWH's pension plan is largely defined contribution. Management and Governance The majority of the senior leadership positions of BSWH are held by executives with a long track record of executing integration and growth strategies, while maintaining strong margins as evidenced by the consolidation of Baylor Health Care System and Scott & White Healthcare in BSWH has control and substantial reserved powers over the system's affiliates, which supports tight 4

5 integration and centralization of operations. BSWH's budgets and financial plans are very well detailed and appropriately conservative. The system typically underspends its capital budget. Quarterly disclosure is very good. BSWH recently announced the transition of the system s CEO to senior advisor to the Chairman of the Board effective February We expect an orderly transition given the length of time to recruit a new executive, transition plan, and the depth of the senior team. Legal Security The bonds are secured by the Obligated Affiliates. Obligated Affiliates include Baylor Scott & White Holdings, Baylor Health Care System, Baylor University Medical Center, Baylor All Saints Medical Center, Baylor Regional Medical Center at Grapevine, Baylor Medical Center at Waxahachie, Baylor Regional Medical Center at Plano, Scott & White Memorial Hospital, Scott & White Healthcare, Scott & White Clinic, Scott & White Hospital-Round Rock, Scott & White Continuing Care Hospital, and Hillcrest Baptist Medical Center. Effective on the closing date of the bonds, the following entities will be added as Obligated Affiliates: (1) Baylor Medical Centers at Garland and McKinney, (2) Scott & White Hospital College Station and (3) Baylor Scott & White Health. The bonds are secured by a security interest in account receivable and receipts. In the event that the Series 2010 bonds are no longer outstanding, the grant of security interest above will no longer be in effect and the bonds will be an unsecured general obligation of the Obligated Affiliates. There are no limitations on the issuance of debt and no limitations on the disposition of assets in the MTI. Use of Proceeds Proceeds from the Series 2016 and Series 2016A bonds will be used to provide funds for capital projects and strategic initiatives and possibly to refund the Scott and White Healthcare Series 2010 bonds. Obligor Profile BSWH is the largest not-for-profit healthcare system in Texas with 47 hospitals in northern and central Texas, over 6,000 affiliated physicians, the large Scott & White Health Plan with approximately 220,000 members and the Baylor Scott & White Quality Alliance with approximately 280,000 members. Methodology The principal methodology used in this rating was Not-For-Profit Healthcare Rating Methodology published in November An additional methodology used in this rating was Rating Methodology for Municipal Bonds and Commercial Paper Supported by a Borrower s Self-Liquidity published in January Please see the Ratings Methodologies page on for a copy of these methodologies. Ratings Exhibit 2 BAYLOR SCOTT & WHITE HEALTH, TX Issue Rating Taxable Revenue Bonds, Series 2016 Rating Type Sale Amount Expected Sale Date Rating Description Hospital Revenue Bonds, Series 2016A Rating Type Sale Amount Expected Sale Date Rating Description Aa3 Underlying LT $535,895,000 04/04/2016 Revenue: Other Aa3 Underlying LT $381,870,000 04/04/2016 Revenue: Other Source: Moody's Investors Service 5

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