Dignity, CHI would gain scale in merger, but debt issues loom

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 emergency 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 multi-hospital 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 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 fee-for-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 melding 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 six-hospital 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 majority-owned 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.