Fitch Rates Children's Hospital of Orange County — CA — Bonds 'A+'

Business Wire, Sept 13, 2004

SAN FRANCISCO -- Fitch Ratings has assigned an underlying 'A+' rating to the $85 million California Health Facilities Financing Authority (Children's Hospital of Orange County) insured revenue bonds, series 2004A and 2004B. In addition, Fitch assigns an underlying 'A+' rating to the approximately $33 million of outstanding bonds, listed below. The Rating Outlook is Stable. Bond proceeds will be used to add 30 intensive care beds to existing shelled space, purchase adjacent land rights, construct a new parking structure, and pay costs of issuance. The bonds will be issued as insured auction rate securities and are scheduled to price Oct. 13 via negotiation by Morgan Stanley. The bonds are anticipated to be swapped to fixed rate.

The rating is based on Children's Hospital of Orange County's (CHOC) leading and growing market share, improved financial performance, solid liquidity, manageable debt burden, and limited seismic-related costs. CHOC, together with another affiliate, CHOC at Mission, maintains a dominant pediatric market share of 56% in its primary service area, well above its nearest competitor with only 9%. CHOC's market share has increased significantly from 50% in 2001 due to management's business development focus and the closure of pediatric beds by some of CHOC's competitors. CHOC's current management team has led an impressive financial turnaround since 1997. Operating performance of CHOC and affiliates has improved dramatically, ranging from a $5.4 million operating loss, or negative 3.5% operating margin, in 1998 to an unaudited $12.1 million gain, or 3.7% operating margin, in 2004. Better payer arrangements, stronger relationships with physician groups, and market share and volume growth are attributed to the improvement. Fitch believes CHOC will continue to produce solid margins given its projected volume growth and licensed bed additions. However, Fitch also believes 2004 margins will be difficult to sustain due to rising interest, depreciation, and labor costs, and notes operations could be stressed further depending on the uncertain future of Medi-Cal reimbursement levels. Liquidity for CHOC and affiliates is good with 140 days cash on hand at June 30, 2004 and is expected to improve to an even more solid 173 days after receipt of the net proceeds from a building sale that closes in October. Pro forma cash to debt at June 30, 2004 was a healthy 116%, and maximum annual debt service coverage was a strong 3.9 times. Fitch also notes CHOC has minimal state-mandated seismic requirements, projected at $2.4 million (through 2030), which is viewed favorably.

Primary concerns include a high proportion of state government reimbursement and a sizable capital plan with the potential for additional debt issuance. State reimbursement, including Medi-Cal, CalOPTIMA, and California Children's Services (CCS), constituted 26% of CHOC's net patient revenues in fiscal 2004, exposing the hospital to changes in state funding of the Medi-Cal and CCS programs. However, reimbursement risk is offset somewhat by the diversification of state-funding approaches among the three programs. In addition, while Medi-Cal funding levels remain uncertain over the medium term, CHOC is expected to receive an increase in Medi-Cal reimbursement for inpatient care in 2005. CCS, a state program managed by the Department of Health Services that covers medical services for children with certain physical limitations and chronic health conditions, is currently funded through 2008.

Another concern is the inherent risk related to CHOC's significant master plan, which involves the construction of a new approximately $160 million inpatient tower expected to commence construction in 2008. Funding sources include fundraising, additional debt, and cash flow from operations. The amount of additional debt has not yet been determined and will depend upon CHOC's five-year comprehensive major gift campaign and the California Children's Hospital Bond Initiative (November 2004 ballot), from which CHOC could receive $75 million. Fitch believes the comprehensive major gift campaign target is achievable and will evaluate the impact of additional debt, if any, on the rating at the time of issuance.

CHOC consists of a 202 staffed bed pediatric hospital and other affiliates located in Orange County, California and had total revenue of $326 million in fiscal 2004. CHOC covenants to provide annual and quarterly disclosure to the trustee, which will disseminate the information to bondholders upon request. CHOC also plans to covenant to provide annual and quarterly disclosure to the bond insurer and rating agencies.

Outstanding Debt:

--$23,800,000 California Health Facilities Financing Authority revenue bonds, series 1991; MBIA insured.

--$9,400,000 California Health Facilities Financing Authority revenue bonds, series 1994; MBIA insured.