HealthEast and Controlled Affiliates' hospital facility revenue bonds affirmed 'BBB-'

Fitch Ratings has affirmed the unenhanced 'BBB-' long-term rating on HealthEast and Controlled Affiliates' hospital facility revenue bonds as part of its continuous surveillance effort, as follows:

Washington County Housing & Redevelopment Authority (MN)

-- $203 million, series 2005;
-- $48.5 million, series 1998.

St. Paul Housing & Redevelopment Authority (MN)

-- $20.1 million, series 1997A & 1997B.

The Rating Outlook is Stable.

RATING RATIONALE:

-- HealthEast & Controlled Affiliates' (HealthEast) leading market position in the St. Paul area and the high barriers to entry that exist within Minnesota combine to contribute to its sustained operating profitability;
-- Having completed all major phases of its campus renewal projects on-time and within budget, HealthEast has no plans for additional debt in the near future;
-- HealthEast's three core acute care facilities are highly modernized and well positioned for the future delivery of medicine.

KEY RATING DRIVERS:

-- Over the near term, improvement in HealthEast's operating performance is necessary to buffer its weak liquidity position and mitigate any deterioration in the credit rating;
-- The combined effects of health reform, which could have a mixed impact on HealthEast.

SECURITY:

The bonds are secured by a gross revenue pledge and are governed by a master trust indenture that contains various standard business and financial covenants. The Main facilities housing, St. John's Hospital, St. Joseph's Hospital, Woodwinds Hospital, and Bethesda Hospital are subject to a Mortgage.

CREDIT SUMMARY:

The 'BBB-' rating affirmation is centered on HealthEast's leading market position in the St. Paul area that continues to produce positive operating performance metrics. HealthEast is the market share leader in the east metro area of the Twin Cities market with a 39.1% inpatient share, outpacing its nearest competitor by nearly ten percentage points (29.5% for United Hospital, part of Allina Health System, revenue bonds rated 'A+' by Fitch).

HealthEast recently opened the replacement patient tower at its flagship facility, St. Joseph's Hospital in St. Paul; which combined with the modern Woodwinds campus (86-bed acute care hospital opened in 2000) and the St. John's campus form a solid operating platform. Further, HealthEast continues to make investments in its system-wide quality initiatives; principally its electronic health record, which continues to buoy operating performance via a more efficient and clinically aligned operating platform. In light of health reform initiatives that portend the necessity of such investments, HealthEast should be well positioned relative to others in the market upon implementation of reform directives.

As expected and as detailed in Fitch's rating action commentary dated Dec. 11, 2008, HealthEast experienced a decline in operating profitability due primarily to the increased annual costs associated with its significant investments in a comprehensive quality and safety initiative (anticipated to have annual costs of $12 million over the next two years) and the general weakness in the overall economy for most of 2009. Operating margins and operating EBIDTA margins declined to 0.6% and 4.6 %, respectively on total revenues of $827.3 million in fiscal 2009; slightly off from 0.9% and 4.8%, respectively in fiscal 2008.

The Rating Outlook remains Stable, with operating yields expected to improve upon full implementation HealthEast's quality and information technology investments. Over the near term, however, a return to operating profitability metrics more in-line with Fitch's 'BBB' medians is necessary to mitigate any downward pressure in the rating.

Management has budgeted that 2010 operating performance will exceed the recent two years and be more in-line with numbers generated in 2006 and 2007. The combined effects of the quality investment and the downturn in global markets have weakened HealthEast's balance sheet and leave little room for flexibility if operating metrics again fall short of expectations. Fitch expects that HealthEast's liquidity will not weaken any further and expects liquidity to strengthen over the medium term, once the projects are completed and as market conditions stabilize. The Rating Outlook incorporates no material increase in long-term indebtedness.

Major credit drivers include HealthEast's liquidity position, its debt levels, and the stability of its market. HealthEast's liquidity position continues to be light for the rating category and places limitations on its operating flexibility. Days cash on hand, cushion ratio, and cash-to-debt of 45.1 days, 4.5 times (x), and 35.3%, respectively, are all below Fitch's 'BBB' category medians. Fitch notes that all of HealthEast's debt is fixed-rate with no insurance exposure or any derivative products.

HealthEast's debt leverage is high as evidenced by debt-to-Operating EBIDTA of 7.2x, weaker than Fitch's category median of 5.2x. However, HealthEast's realization of some strategic initiatives that have grown revenues along with management's continued focus on maintaining operating profitability have lowered maximum annual debt service (MADS) as a percentage of revenues to 2.6% in fiscal year 2009 from 3.4% in fiscal year 2004. Further, the bed moratorium in the State of Minnesota creates a very high barrier for any competitors wishing to establish new acute care operations within HealthEast's primary market, mitigating any erosion of market share via competitor expansion.

HealthEast's management team members are very transparent and provide timely and candid responses to analysts' inquiries during credit reviews. HealthEast provides annual and quarterly disclosure via the MSRB's EMMA system and Digital Assurance Certification (DAC). Interim disclosure includes detailed financial statements, volume statistics, and payor mix information. The interim disclosure lacks a detailed management discussion and analysis section, which Fitch views as an industry best practice.

HealthEast operates 519 staffed beds at three acute care hospitals in downtown St. Paul (St. Joseph), Maplewood (St. Johns) and Woodbury (Woodwinds), as well as a 140-bed long term acute care hospital, and various outpatient imaging and surgery operations. The system also employs approximately 240 physicians practicing within its hospitals and throughout the community. At fiscal year-end 2009, HealthEast reported total operating revenue of $827.3 million.

An error was found in the rating on Fitch's web site for the bond listed below:

St. Paul Housing & Redevelopment Authority (MN) (HealthEast Project)

-- Hospital facility revenue bonds, series 2005.

The rating for the above bond was entered in Fitch's ratings database under the issuer St. Paul Housing & Redevelopment Authority. The bond is in fact issued by Washington County Housing & Redevelopment Authority. The issuer now appears correctly at 'www.fitchratings.com'.