FITCH UPGRADES APPALACHIAN REGIONAL HEALTHCARE (KENTUCKY) TO 'BB'; OUTLOOK STABLE

2/23/2012


Fitch Ratings-New York-23 February 2012: In the course of its ongoing surveillance efforts, Fitch upgrades to 'BB' from 'BB-' the following bond issued on behalf of Appalachian Regional Healthcare (ARH):

--$61,545,000 Kentucky Economic Development Finance Authority refunding and improvement revenue bonds (Appalachian Regional Healthcare, Inc.) series 1997

The Rating Outlook is Stable.

SECURITY
Bonds are secured by a pledge of gross revenues of the system, which is weak for the rating level.

KEY RATING DRIVERS:

IMPROVED FINANCIAL PROFILE:

The upgrade is based on an improved financial profile that is more in line with the 'BB' rating level, driven by three audited years (fiscal year-end Jun. 30) of positive operating margins, which has been maintained through the six month interim period ended Dec. 31, 2011. The improved cash flow has led to a material growth in ARH's liquidity, with liquidity very solid for the rating level.

PRO FORMA MADS COVERAGE ADEQUATE:
Fitch expects ARH to borrow approximately $68 million over the next few years (approximately $14 million in fiscal 2012) that will fund capital projects and address critical capital needs across ARH's system. A pro forma analysis of the maximum annual debt service (MADS) shows coverage at an adequate 1.5 times (x) in the six month fiscal 2012 interim period.

PHYSICIAN RECRUITMENT IMPROVING:
ARH has grown its active medical staff by about 10% over the last 18 months, and a focused campaign to recruit physicians with connections to the region is beginning to show results with two general surgeons, an oncologist, and an obstetrician with ties to the area expected to join the medical staff in the near term. ARH is also growing its clinical relationship with the University of Kentucky in the areas of cardiology and oncology, which should further help in physician coverage of acute service lines and overall physician recruitment.

CREDIT CONCERNS REMAIN:
ARH's weak service area demographics and its high levels of Medicaid (24% of gross revenues), self pay, bad debt, and charity care continue to present a challenging operating environment.

CREDIT PROFILE
After an operating loss in fiscal 2008, ARH has posted three consecutive years of positive operating margins. ARH finished fiscal 2011 with a 2.2% operating margin ($12.6 million in operating income) and a 7.2% operating EBTIDA margin. Results in fiscal 2011 were helped by a few one-time revenue items, the largest approximately $5.5 million in meaningful use funds. However, six month fiscal 2012 results show a 0.7% operating margin and a 5.2% operating EBITDA, similar to results from the same period in fiscal 2011. ARH management reports that the system enters its busy season in the first quarter of the calendar year, and early indications are that volumes are holding. ARH has managed expenses well and is under budget for both supplies and pharmaceuticals through the six month interim period. ARH is budgeting for a positive operating margin in fiscal 2012, which Fitch believes ARH will achieve.

Positive operations have contributed to strong liquidity growth over the last fiscal three years, as ARH added more than $100 million of unrestricted liquidity to the balance sheet. As of December 31, 2011, ARH had $145.3 million of unrestricted cash and investments (excluding a $2.3 million draw on a line of credit and $11.4 million held as collateral for worker's compensation insurance), which equated to 107.7 days cash on hand, a 6.1x pro forma cushion ratio, and 173.5% cash to debt, all very solid for the rating level. Cash to debt drops to 95.8% on a pro forma basis factoring in the expected new debt, but remains strong for the rating level. In fiscal 2012, ARH purchased the assets of Mary Breckinridge Hospital, a critical access hospital located near Hazard. The purchase had little effect on ARH's liquidity and overall should be a credit neutral to ARH's financial profile.

Growth in liquidity has been aided by the stretching of payables and deferred capital spending. Days in current liabilities stood at a very high 113.9 days at Dec. 31, 2011, much higher than the 92.3 days at year end fiscal 2009, including a $12 million rise in accounts payable from fiscal 2010 to fiscal 2011. In addition, ARH has preserved liquidity by deferring capital expenditures. Capital spending has averaged a thin 47% of depreciation over the last four years and raises concerns about ARH's competitive ability. Average age of plant has increased to 13.3 in fiscal 2011 from 10.5 in fiscal 2008. Additional stress on liquidity comes from the pension liability. ARH's pension is approximately 70% funded. The pension liability as of Dec. 31, 2011 was $65 million, and ARH is expected to make payments of $18 million in 2011 and $20 million in 2012. While these are credit concerns, Fitch believes that these concerns are manageable at the higher 'BB' rating level and that liquidity will remain stable over the near term.

Fitch view positively that ARH is addressing its deferred capital spending. ARH plans to spend approximately $70 million mostly at Whitesburg, Hazard, and Beckley. The projects will include a new tower at Whitesburg, a new emergency room at Hazard, and renovations to patient rooms at Beckley. The projects will provide critical capital updates to components of the ARH system that are dated. Fitch expects ARH to finance approximately $68 million of the capital projects through a combination of United States Department of Agriculture (USDA) loans ($40 million) and bank loans with a USDA guarantee ($20 million), with the remaining portion ($6.8 million) still to be determined but likely to be a bank loan. Pro forma MADS remains manageable increasing to $23.8 million from $20.4 million and is helped by the favorable financing terms of the USDA loans which are expected to have a 40 year amortization and a 3.75% interest rate. Construction for all the projects will occur during the next two years with completion expected by fiscal year 2014. Additionally, even with the reduced capital spend, ARH was able to invest in information technology and attest to Stage 1 meaningful use.

ARH has maintained a solid market position in its service areas, but utilization trends are essentially flat except for emergency room (ER) visits. Renovations to Hazard's ER should continue to strengthen ER visits. Approximately 60% of ARH's admissions come through its ER, so it is an important source of volumes. Physician recruitment and retention continue to be challenges for the system. But active staff has grown 10% in the last 18 months and ARH's program to recruit physicians with ties to the region is beginning to show benefit. Successful execution of this strategy as well a focus on growing oncology and cardiology through expanding its clinical relationship with the University of Kentucky will be critical in ARH sustaining current levels of operations.

ARH service area remains challenging. Unemployment rates in the system's Kentucky service are higher than state and national averages and Median household income is below state averages.

Economic statistics are similar for the system's West Virginia market, though not as severe. Sixty percent of ARH's revenue mix comes from a combination of Medicare and Medicaid and 10% of the revenues are self pay, further highlighting the area's challenges.

The Stable Outlook reflects Fitch's belief that ARH's will maintain positive operating margins over the next few years which will led to further financial stability at the current rating level.

Appalachian Regional Healthcare (ARH) is a not-for-profit health system serving 350,000 residents across Eastern Kentucky and Southern West Virginia.

Operating ten hospitals, multi-specialty physician practices, home health agencies, homecare stores and retail pharmacies, ARH is the largest provider of care and single largest employer in southeastern Kentucky and the third largest private employer in southern West Virginia. Total operating revenue in fiscal 2011 was $578.8 million. ARH covenants to disclose only annual financial information and utilization statistics to bondholders. ARH provides timely disclosure including quarterly disclosure of income statements, balance sheets, and utilization statistics to bondholders on its secure web site.

Additional information is availableat'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-SupportedRatingCriteria'(June20,2011);--'Nonprofit Hospitals and Health Systems Rating Criteria' (Aug.12,2011).

Applicable Criteria and Related Research:
Revenue-SupportedRatingCriteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=637130NonprofitHospitalsandHealthSystemsRatingCriteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=648836
 
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