Global Credit Research Rating Update 16 NOV 2007 Rating Update: McLaren Health Care Corporation, MI MOODY'S AFFIRMS MCLAREN HEALTH CARE CORPORATION'S (MI) A1 RATING; OUTLOOK REMAINS STABLE AFFIRMATION AFFECTS TOTAL OF $327 MILLION OF RATED DEBT OUTSTANDING Michigan State Hospital Finance Authority Health Care-Hospital MI Opinion NEW YORK, Nov 16, 2007 -- Moody's Investors Service has affirmed the A1 long-term rating assigned to McLaren Health Care Corporation's (McLaren) $327 million of rated debt issued through the Michigan State Hospital Finance Authority as listed at the conclusion of the report. The outlook remains stable. McLaren is an integrated healthcare delivery system that operates hospitals in six distinct markets in Michigan: 20,000-admission McLaren Regional Medical Center (MRMC) in Flint; 18,000-admission Bay Regional Medical Center (BRMC) in Bay City; 19,000-admission Ingham Regional Medical Center (IRMC) in Lansing; 6,000-admission Lapeer Regional Medical Center (LRMC) in Lapeer; 15,000-admission Mount Clemens Regional Medical Center (MCRMC) in Mount Clemens (McLaren became the sole corporate member of MCRMC effective January 1, 2007 and is included in McLaren's financial statements for nine months of fiscal year 2007); and 6,000-admission Pontiac Osteopathic Hospital (POH). McLaren became the sole corporate member of POH in 2007. POH is currently rated Ba1, and will be included in the system's financial statements starting in fiscal year (FY) 2008. LEGAL SECURITY: McLaren uses a designated affiliate structure, which we believe is a weaker structure than a joint and several obligation, given that significant assets and cash flows are outside of the obligated group. The bonds are a direct obligation of the McLaren obligated group, currently the only member of which is the McLaren Health Care Corporation parent. The parent holds approximately 13% of total McLaren system assets and generates minimal cash flows. MRMC, BRMC, LRMC, IRMC, the Lapeer Area Hospital Fund, and the McLaren Foundation are designated affiliates and members of the McLaren credit group. Currently, neither MCRMC nor POH are members of the McLaren credit group. Similarly, McLaren is not obligated on MCRMC's or POH's debt. INTEREST RATE DERIVATIVES: McLaren has two interest rate swaps in place. (1) In connection with the Series 2005A indexed put bonds, McLaren entered into a floating-to-fixed interest rate swap (equivalent to the outstanding principal of the bonds) with Citibank. Under the swap, which runs for the life of the bonds, McLaren pays a fixed rate of 3.355% and receives 65% of LIBOR plus 0.12%. (2) In connection with the Series 2005B indexed put bonds, McLaren entered into a floating-to-fixed interest rate swap (equivalent to the outstanding principal of the bonds) with Citibank. Under the swap, which runs for the life of the bonds, McLaren pays a fixed rate of 3.64% and receives 65% of LIBOR plus 0.12%. Because the bonds are tax exempt, the swaps are not a perfect hedge and McLaren may need to make additional floating rate payments to the extent that the tax-exempt variable rates on its bonds exceed the percentages of LIBOR. Given the terms of the swaps and McLaren's credit profile, we believe that the swap transactions do not detract from the rating. STRENGTHS *Sizeable and growing health system (approximately $1.5 billion of system operating revenues in FY 2007) with geographic expansion and diversification across six markets in lower Michigan *Track-record of good system-wide operating results, with operating cash flow diversified across regions and business lines. McLaren's operating performance rebounded well in FY 2007 (8.9% operating cash flow
margin) after recording modest performance in FY 2006 (6.6% operating cash flow margin) that was the result of a nurse strike at IRMC early in FY 2006 *Good cash flow generation and manageable capital spending plans should allow McLaren to build liquidity. At fiscal year end (FYE) 2007, the system had an adequate 169 days cash on hand and 117% cash-to-debt excluding POH *Management has demonstrated the ability to integrate successfully and improve financial performance of newly merged yet financially struggling hospitals into the system, including dramatic operating improvement at MCRMC in its first year as a McLaren subsidiary CHALLENGES *Certain key McLaren hospital markets are competitive; becoming the sole corporate member of MCRMC and POH introduces McLaren to the competitive metropolitan Detroit acute care hospital market *POH operates in competitive and demographically challenged Pontiac, MI and has recorded operating losses in recent years (-2.4% operating loss margin in unaudited FY 2007) *Including POH dilutes McLaren's key ratios somewhat *The McLaren system is heavily unionized, as approximately half of system employees are covered under collective bargaining units *Michigan economy is vulnerable and McLaren hospitals operate in many markets that are susceptible to the struggling auto industry RECENT DEVELOPMENTS/RESULTS Moody's views McLaren's broad market reach throughout lower Michigan favorably, although we note that certain key McLaren hospital markets are competitive and becoming the sole corporate member of MCRMC and POH introduces McLaren to the very competitive metropolitan Detroit healthcare market. With greater than 84,000 inpatient admissions and approximately $1.5 billion of operating revenue (inclusive of MCRMC and POH), McLaren is a very sizeable healthcare organization. McLaren's market presence is somewhat mitigated by the state's economic struggles, highlighted by the challenged auto industry, which particularly affects markets such as Flint and, to a lesser degree, Lansing. Also partially offsetting the strong and diverse geographic market reach are competitive factors in specific markets, as McLaren subsidiaries face sizeable competition in Lansing, Flint, Mount Clemens, and Pontiac. In Lansing, IRMC is the number two provider in a two hospital market behind A1-rated Sparrow Health System. The Flint market is split among three sizeable providers: MRMC; 25,000-admission Genesys Regional Medical Center (a member of Aa2-rated Ascension Health System); and Ba1-rated, 22,000- admission Hurley Medical Center, although we note that Hurley is a safety net hospital that captures a disproportionate share of Medicaid and self-pay volumes. In Macomb County north of Detroit, MCRMC's leading competition is Clinton Township-based St. Joseph's Medical Center (a member of Aa2-rated Trinity Health). In the crowded and challenged Pontiac market, POH competes with 19,000-admission St. Joseph Mercy Oakland (a member of Trinity Health) and B3-rated, 8,000-admission North Oakland Medical Center. Moody's views McLaren's track-record of good operating results favorably. In unaudited FY 2007 (excluding POH) McLaren recorded operating income of $41.2 million (3.1% operating margin, after reclassifying the portion of investment income included in operating revenue to non-operating revenue) and operating cash flow of $117.5 million (8.9% operating cash flow margin). These margins are in-line with fiscal years 2003 through 2005. In FY 2006, McLaren's operating performance was more modest, recording operating income of $21.0 million (1.9% margin) and operating cash flow of $72.4 million (6.6% margin). The softer performance in FY 2006 was due to a nurse strike at IRMC early in FY 2006. McLaren management estimates that the strike resulted in combined revenue losses and added expenses totaling approximately $12 million. The improved results in FY 2007 were due to the resolution of the nurse strike at IRMC, volume growth throughout the system, and more than $20 million of bottom line improvements at MCRMC, as McLaren implemented expense savings in areas such as supply costs, information technology, captive insurance, labor productivity, and improved union contracts.
Based on unaudited FY 2007 results (excluding POH), debt-to-cash flow improved to a manageable 3.6 times from 3.9 times in FY 2006 and maximum annual debt service (MADS) coverage strengthened to a good 5.2 times from 3.9 times. Factoring in POH dilutes McLaren's debt measures somewhat, as combined debt-to-cash flow increases to 3.8 times in FY 2007 and MADS coverage measures a still adequate 4.6 times (based on FY 2007 results). Similarly, POH dilutes McLaren's liquidity measures somewhat. Excluding POH, McLaren's cash on hand and cash-to-debt at FYE 2007 measured 169 days and 117%, respectively, which lag the A1 medians of 200 days and 144% somewhat. Consolidating POH, the system's FYE 2007 cash on hand and cash-to-debt weaken modestly to 156 days and 108%, respectively. McLaren became the sole corporate member of POH for two primary reasons. First - similar to MCRMC but on a smaller scale - McLaren management identified approximately $9-$10 million of net income improvements that can be implemented at POH immediately, such as supply cost, captive insurance and information technology costs savings, productivity improvements, and a reduction in the average length of stay. POH has recorded operating losses in recent years (-2.4% operating loss margin in unaudited FY 2007). Second, POH will serve as the southern anchor of McLaren's planned service area. McLaren acquired approximately 95 acres in Clarkston, northwest of Pontiac in Oakland County. Eventually, McLaren management hopes to build a hospital on this site, although due to the state's certificate of need laws and other regulatory concerns the construction of the new hospital may take years to develop. Prior to building a new hospital, McLaren is involved in constructing a number of joint venture facilities at the Clarkston site, including medical office buildings (the first of which will be completed in early 2009), an imaging center, a cancer center, and outpatient surgery center. Physicians will own most of the facilities at the site, with the exception of the acute care hospital. Outlook The stable outlook reflects our belief that McLaren will maintain operating performance at least in-line with FY 2007. Given management's demonstrated ability to absorb and improve challenged credits into system operations quickly, we believe MCRMC's operating results will continue to strengthen and management will implement material improvements at POH. We expect McLaren to strengthen its liquidity position in the coming years in advance of the system's plan to construct a new hospital in Clarkston. What could change the rating -- UP Material operating improvement at POH and continued successful integration of MCRMC leading to improved system-wide operating performance resulting in marked gains in liquidity and debt ratios; continued samestore volume gains throughout the system What could change the rating -- DOWN Material operating disruption leading to weaker debt and liquidity ratios; material market share loss in one or more key markets; increase in debt without commensurate increase in cash flow generation KEY INDICATORS Assumptions & Adjustments: -Based on McLaren Health Care Corporation and Subsidiaries consolidated financial report -First number reflects audited FY 2006 for the year ended September 30, 2006 (excluding MCRMC and POH) -Second number reflects pro forma on unaudited FY 2007 for the year ended September 30, 2007 (to include MCRMC and POH) -Investment returns reclassified to non-operating revenue and smoothed at 6% *Inpatient admissions: 62,324; 84,000
*Total operating revenues: $1.1 billion; $1.5 billion *Moody's-adjusted net revenues available for debt service: $101 million; $159 million *Total debt outstanding: $355 million; $534 million *Maximum annual debt service (MADS): $25.9 million; $34.2 million *MADS Coverage with reported investment income: 3.22 times; 4.05 times *Moody's-adjusted MADS Coverage with normalized investment income: 3.90 times; 4.64 times *Debt-to-cash flow: 3.89 times; 3.84 times *Days cash on hand: 161 days; 156 days *Cash-to-debt: 130%; 108% *Operating margin: 1.9%; 2.6% *Operating cash flow margin: 6.6%; 8.5% RATED DEBT Issued through Michigan State Hospital Finance Authority (debt outstanding as of September 30, 2006): -Series 1998A Hospital Revenue Bonds ($75.0 million outstanding), rated A1 -Series 2005A&B Indexed Put Bonds ($173.1 million outstanding), rated A1 -Series 2005C Hospital Revenue Bonds ($80.0 million outstanding); rated A1 CONTACTS: Obligor: Dennis Krzeminski, Senior Vice President, McLaren Health Care Corporation, (810) 342-1170; Jan Rizzo, Corporate Controller, McLaren Health Care, (810) 342-2091 Analysts Mark Pascaris Analyst Public Finance Group Moody's Investors Service Kay Sifferman Backup Analyst Public Finance Group Moody's Investors Service Contacts Journalists: (212) 553-0376 Research Clients: (212) 553-1653 Copyright 2007, Moody's Investors Service, Inc. and/or its licensors including Moody's Assurance Company, Inc. (together, "MOODY'S"). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE
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