Scale sav­ings seen in Dig­nity-CHI merger, but debt is­sues loom

Modern Healthcare - - NEWS - By Dave Barkholz

Six months be­fore Dig­nity Health and Catholic Health Ini­tia­tives an­nounced they were in merger talks, the two hos­pi­tal gi­ants each dis­patched small work teams to probe whether a deal was de­sir­able.

What they found were com­ple­men­tary ge­o­graphic foot­prints, hefty debt bur­dens and sev­eral very suc­cess­ful mar­kets dragged down by a smat­ter­ing of chal­leng­ing ones.

Now they are on a due-dili­gence fast track to gauge by early 2017 whether they’d be stronger to­gether or bet­ter off apart.

Daniel Moris­sette, Dig­nity’s chief fi­nan­cial of­fi­cer since Fe­bru­ary, said on a call with an­a­lysts last week that CHI and Dig­nity share a com­mon Catholic her­itage that has cre­ated con­sis­tent di­a­logue be­tween the two sys­tems over the years. “We’ve al­ways had a cul­ture of part­ner­ships,” he said.

At first blush, Moody’s In­vestors Ser­vice sees a merger—if that’s where the talks lead—as “a net pos­i­tive.” So far, Dig­nity and CHI have said they are ex­plor­ing an “align­ment” and have de­clined to pub­licly de­fine the prospects be­yond that.

A merger would cre­ate the na­tion’s largest not-for-profit hos­pi­tal com­pany with com­bined an­nual rev­enue of $27.8 bil­lion and 142 hos­pi­tals. That’s big­ger than the cur­rent leader, St. Louis-based As­cen­sion, with its an­nual rev­enue of $20.5 bil­lion.

San Fran­cisco-based Dig­nity has lead­ing mar­ket-share po­si­tions in South­ern Cal­i­for­nia, the Bay Area, Ari­zona and Ne­vada. Its 39 hos­pi­tals are con­cen­trated in just those three states. More­over, it has been able to max­i­mize an­nual rev­enue of $12.6 bil­lion by of­fer­ing ev­ery con­ceiv­able ac­cess point for pa­tients through a large physi­cian prac­tice and joint ven­tures with for-profits in am­bu­la­tory surgery, ur­gent-care cen­ters and even mi­cro-hos­pi­tals—a model that pairs an emer- gency depart­ment with 10 to 20 beds.

CHI’s 103 hos­pi­tals are lo­cated where Dig­nity has none. The sys­tem, which posts an­nual rev­enue of about $15.2 bil­lion, has 11 big mul­ti­hos­pi­tal hubs. Based in Englewood, Colo., the com­pany’s fa­cil­i­ties are spread over 22 states, pro­vid­ing eco­nomic di­ver­sity that makes it less sus­cep­ti­ble to re­im­burse­ment pres­sures in a sin­gle state or re­gion that might or might not have ex­panded Med­i­caid, for in­stance.

But both sys­tems have high debt lev­els, and both have un­der­per­formed fi­nan­cially in the past year, ac­cord­ing to Fitch Rat­ings. In the case of CHI, that led Fitch to take the un­usu­ally harsh step on July 12 of down­grad­ing CHI’s debt three notches from A+ to BBB+ with a neg­a­tive out­look.

The same day Fitch down­graded CHI’s bonds, the sys­tem with­drew a nearly $1 bil­lion debt of­fer­ing an­nounced just days ear­lier.

The of­fer­ing was pre­dom­i­nantly in­tended to re­fi­nance more ex­pen­sive debt. Last week, CHI con­firmed to Mod­ern Health­care that it was

Com­bi­na­tion would cre­ate na­tion’s largest not-for-profit hos­pi­tal sys­tem. Above: St. Luke’s in Houston

with­drawn in light of the start of align­ment talks with Dig­nity.

Dig­nity and CHI ex­ec­u­tives de­clined to be in­ter­viewed for this story or com­ment be­yond the news re­lease they is­sued last week to an­nounce the non­bind­ing talks. Both sys­tems carry “el­e­vated” credit lev­els into a po­ten­tial mar­riage, Fitch an­a­lyst Olga Beck said.

CHI’s an­nual debt ser­vice, or in­ter­est paid on its bonds and bor­row­ing, is about $460 mil­lion on to­tal debt of $9 bil­lion. While down­grad­ing the com­pany in July, Fitch said its max­i­mum an­nual debt-ser­vice cov­er­age ra­tio (the ra­tio of cash avail­able to pay its debt obli­ga­tions) de­creased in the first nine months of 2016 to 1.3 times from 1.9 times in the com­pa­ra­ble pe­riod in 2015 while cash-to-debt de­creased to 66.9%.

Dig­nity’s over­all debt is lower at $5.25 bil­lion, but it, too, has hefty max­i­mum debt ser­vice to carry, $408 mil­lion an­nu­ally.

Beck said the good news is that both sys­tems have de­cent cash flow and in­ter­est pay­ments are man­age­able for sys­tems of their size and fi­nan­cial state. Even at BBB+, CHI’s debt rat­ing is in­vest­ment grade.

High debt lev­els can be wor­ri­some in an in­dus­try go­ing through mas­sive

changes in re­im­burse­ment from feefor-ser­vice to value-based pay­ments and con­stant de­mands for cap­i­tal to buy new IT sys­tems, up­grade clin­i­cal equip­ment and open pa­tient ac­cess points.

In­vestor-owned Com­mu­nity Health Sys­tems of Franklin, Tenn., for in­stance, is in crisis as it tries to re­duce a mas­sive $15 bil­lion debt load in the face of losses and those head­winds.

Dig­nity and CHI have had their own op­er­at­ing chal­lenges. For its fis­cal 2016, ended June 30, Dig­nity posted an op­er­at­ing loss of $63.4 mil­lion on $12.6 bil­lion in rev­enue.

In the nine months ended March 31, CHI posted a net loss of $568.1 mil­lion. Its prob­lems have been ex­ac­er­bated by about $100 mil­lion of losses on a health plan busi­ness that CHI built over the past five years and is now try­ing to un­wind to stanch the losses.

Each sys­tem has spe­cific mar­kets that are be­dev­il­ing them. For CHI, it’s Houston and Louisville, Ky., where the meld- ing of dis­parate hos­pi­tals to cre­ate Ken­tuck­yOne has been a slog that claimed the jobs of three se­nior ex­ec­u­tives this sum­mer.

In Houston, the in­te­gra­tion of six­hos­pi­tal St. Luke’s Health, ac­quired in 2013, has gone slowly.

Dig­nity has chal­leng­ing mar­kets as well.

In an earn­ings call last week, Dig­nity se­nior fi­nan­cial ex­ec­u­tives said the sys­tem is putting re­sources into turn­ing around op­er­a­tions in South­ern Cal­i­for­nia, where fierce com­pe­ti­tion, com­mer­cial payer pres­sures and Medi­care growth has made for “a com­pli­cated mar­ket.” Dig­nity re­cently brought in a new ad­min­is­tra­tor to over­see the re­gion, the ex­ec­u­tives re­vealed.

Dig­nity also is work­ing with physi­cians to im­prove per­for­mance in the Bay Area. The sys­tem has a hos­pi­tal in Santa Cruz, one in Red­wood City and two in San Fran­cisco that have strug­gled be­cause of a chal­leng­ing payer mix.

Moody’s health­care an­a­lyst Brad Spiel­man said he’s op­ti­mistic the two com­pa­nies can tackle those is­sues bet­ter to­gether than sep­a­rately.

Dig­nity has used joint ven­tures ef­fec­tively to ex­pand its foot­print and con­tin­uum of care in its mar­kets, Spiel­man said. Those are skills that can be ap­plied across CHI, which he noted has far more healthy mar­kets than poorly per­form­ing ones.

Dig­nity, for ex­am­ple, has opened more than two dozen am­bu­la­tory surgery cen­ters in joint ven­tures with United Sur­gi­cal Part­ners In­ter­na­tional, shar­ing the cap­i­tal risk and profits for the fa­cil­i­ties. USPI is now ma­jor­i­ty­owned by Tenet Health­care Corp., an in­vestor-owned hos­pi­tal chain based in Dal­las.

Dig­nity is also a joint-ven­ture part­ner with Tenet and As­cen­sion in three-hos­pi­tal Caron­delet Health Net­work in Tuc­son, Ariz. Its other joint ven­tures in­clude part­ner­ships with pri­vate eq­uity-backed GoHealth Ur­gent Care and Emerus, a for-profit devel­oper of mi­cro-hos­pi­tals. Dig­nity also has launched a pre­ci­sion medicine ini­tia­tive with CHI and owns Op­tum360, a rev­enue-cy­cle-man­age­ment com­pany in part­ner­ship with Unit­edHealth Group sub­sidiary Op­tum.

CHI, mean­while, has a long track record of suc­cess­fully in­te­grat­ing re­gional hos­pi­tal sys­tems into its fold, Spiel­man said. The vol­ume is di­ver­si­fied, with no one mar­ket rep­re­sent­ing more than 16% of to­tal com­pany rev­enue. CHI’s big­gest mar­ket, the Pa­cific North­west, is pro­duc­ing some of the sys­tem’s best re­sults.

In its July re­port, Fitch said the Pa­cific North­west op­er­a­tions pro­duced a 9.2% EBITDA op­er­at­ing mar­gin in 2016. But even that mar­ket is un­der pres­sure. The re­gion’s op­er­at­ing EBITDA mar­gin was 10.6% a year ago but has fallen due to higher la­bor and sup­ply ex­penses as well as tight­en­ing re­im­burse­ment.

The Fitch re­port noted that CHI is work­ing on an im­prove­ment plan that, if suc­cess­ful, should yield “a sus­tain­able EBITDA of above 7% within the next 12 months” sys­temwide. But in Ken­tucky, CHI’s per­for­mance im­prove­ment ef­forts have “met with tepid re­sults,” the re­port noted.

“CHI is con­tin­u­ing to ad­dress the short­falls in the Ken­tucky mar­ket by de­vel­op­ing stronger part­ner­ships with the Univer­sity of Louisville, sta­bi­liz­ing op­er­a­tions, build­ing out the Ken­tuck­yOne med­i­cal group and fur­ther de­vel­op­ing its clin­i­cally in­te­grated net­work,” the re­port said.

In Texas, CHI has seen some op­er­at­ing im­prove­ment, es­pe­cially on la­bor pro­duc­tiv­ity, ac­cord­ing to the Fitch re­port. But man­age­ment is still “grap­pling with weak out­pa­tient vol­ume and higher Medi­care us­age.”

The teams wrestling over whether to join forces will fo­cus on big-pic­ture is­sues—such as whether larger scale would pro­duce costs sav­ings, bet­ter care and a stronger credit struc­ture—so they can reach a con­clu­sion by early 2017. “Our tim­ing is ag­gres­sive,” Dig­nity’s Moris­sette said.

Catholic Health Ini­tia­tives and Dig­nity Health have no over­lap­ping states where they op­er­ate hos­pi­tals

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