Fitch Affirms Community Health Systems, Inc.'s IDR at 'B+'; Outlook Negative

Fitch Ratings has affirmed Community Health Systems, Inc.'s (CHS) Issuer Default Rating (IDR) at 'B+'. The ratings apply to $17 billion of debt at Sept. 30, 2014 and a full list of rating actions follows at the end of this press release. The Rating Outlook is Negative.

KEY RATING DRIVERS:

-- In 2014, CHS acquired rival hospital operator Health Management Associates (HMA) in a deal that added about $7 billion of debt to CHS's capital structure. Growth in EBITDA since the close of the transaction has been hampered by some operational issues at the HMA hospitals and ongoing government investigations and lawsuits. This has delayed the pace of deleveraging; Fitch estimates total debt-to-EBITDA of about 6.3x at the end of 2014.

-- The acquisition had a sound strategic basis because it enhanced the geographic scope of CHS's business while adding considerable scale. Fitch believes operational issues at the HMA hospitals were in part the result of HMA management distraction in the months leading up the acquisition, and expects CHS to make improvements in areas like physician recruitment, which should improve organic growth and expand margins at the HMA hospitals during 2015.

-- Prior to the acquisition and early during the integration process, CHS's very weak patient volume trends lagged industry peers and weighed on top-line growth and margins. However, over the last couple quarters, CHS has reported an improvement in volumes that mirrors the trend exhibited by the rest of the hospital industry.

-- CHS has been dealing with government investigations and lawsuits related to the issue of short-stay hospital admissions. CHS made progress in resolving the legal issues facing the legacy CHS hospitals during 2014, which did not involve financial fines significant enough to threaten financial flexibility or require major operational changes that would influence future revenue and EBITDA growth.

-- CHS's good liquidity profile, including solid and consistent free cash flow (FCF) generation, is an important factor supporting the credit profile. Fitch projects that the company will maintain a greater than 2% FCF margin, with FCF generation of at least $400 million annually. While FCF could support debt repayment, Fitch expects most deleveraging to result from EBITDA growth, with the company prioritizing acquisitions as a use of cash.

RATING SENSITIVITIES:

Maintenance of the 'B+' IDR considers CHS reducing total debt-to-EBITDA to below 6.0x during 2015 and maintaining a stable to improving FCF margin of greater than 2%. Fitch thinks that reducing leverage to this level is achievable based on its forecast for CHS's 2015 EBITDA, and assuming a small amount of debt paydown through required amortization of the bank term loans. A return to positive organic revenue growth starting in 2015 and maintenance of an operating EBITDA margin of at least 14% would also be supportive of the ratings.

A downgrade of the ratings could result from leverage sustained above 6.0x and a FCF margin below 2%, with a strained operating trend illustrated by negative organic topline growth, stagnant to declining EBITDA and profitability measures. Risks to the operating outlook that could result in a deterioration of the financial profile include the inability to achieve projected cost synergies and implement operational improvements at the HMA hospitals, lack of progress towards resolution of HMA's legal issues, and a reversal of the improving trends in patient volumes exhibited across the for-profit hospital industry during 2014. In particular, a return to negative growth in CHS's organic adjusted admissions during 2015 would be concerning.

IMPROVING HOSPITAL INDUSTRY OPERATING ENVIRONMENT, BUT SUSTAINABILITY IS UNCERTAIN:

The Fitch-rated group of for-profit hospital companies reported very strong growth in organic patient volumes in the third quarter of 2014 (3Q'14), with same hospital admissions up 0.7% and adjusted admissions up 3.5%. This is a sequential improvement from a good result in 2Q'14, and the first quarter of positive growth in inpatient admissions since 4Q'12. Economic improvement in many markets, growth in the insured population under the Affordable Care Act (ACA), and management initiatives to boost volumes are converging to support this improved performance.

Better organic growth is particularly notable since certain secular headwinds continue to work against the industry, particularly with respect to volumes of inpatient admissions. Short-stay admissions continue to decline with pressure from both Medicare and commercial health insurers, and rates of hospital readmissions have dropped across the industry. However, it is reasonable to assume that the influence of these factors is tapering since the industry has now been facing these pressures for several years.

Fitch believes the hospital industry may post another couple of quarters of above trend growth in volumes as the positive effects of the ACA gain a bit more momentum early in 2015. Results in 1Q'15 will also benefit from an easy comparison versus a weak 1Q'14, and seasonal flu activity. Positive organic growth in inpatient admissions is probably not sustainable over the longer term because of the types of secular headwinds mentioned above. However, Fitch thinks there is reason for optimism that the improved trend in outpatient volumes has legs, since operational initiatives to capture these volumes will have a sustaining influence.

CHS's IMPROVED PATIENT VOLUME GROWTH MIRRORS INDUSTRY:

CHS reported positive organic growth in adjusted admissions of 2.7% in 4Q'14; this is the first quarter of positive growth in patient volumes for CHS since 4Q'12. In addition to posting a long period of declining organic volumes, the company consistently lagged its hospital industry peers. Fitch believes CHS's relative weak volume performance can be attributed to a combination of factors, including its geographic mix, with most hospitals located in rural or small suburban markets that were slower to recover after the economic recession, compounded by the overhang caused by governmental investigations and the related issue of regulatory and payor scrutiny of short-stay admissions.

The acquisition of HMA did not immediately improve the company's outlook for recovery in volume growth since that company faced many of the same issues as the legacy CHS hospitals. In addition, due to disruption caused by shareholder activism that ultimately culminated in the sale to CHS, HMA experienced a period of management distraction in the months leading up to the transaction.

CHS's recently improved volume trends are consistent with the rest of the for-profit hospital industry starting in 2Q'14. More time is needed to determine if the company is closing the performance gap relative to peers, or simply benefiting from the recently more favorable operating environment as discussed above. Fitch thinks certain factors support an expectation that CHS will be able to narrow the performance gap in 2015, including initiatives to expand higher growth service lines and improve physician recruitment results. Furthermore, headwinds related to declining short-stay admissions should continue to lessen since both CHS and HMA have been dealing with this issue for several years.

EXPECT DELEVERAGING PRIMARILY TRHOUGH GROWTH IN EBITDA HELPED BY HMA SYNERGIES:

CHS generates solid cash flow; Fitch projects cash from operations of $1.45 billion in 2014 and FCF of slightly more than $400 million. Despite the solid cash generation, CHS has applied little cash to debt reduction in 2014, and Fitch does not expect this to be a major use of cash in 2015-2016. Instead, Fitch thinks the company is more likely to use cash for acquisitions.

Fitch does think that EBITDA growth will be sufficient to reduce leverage to below 6.0x during 2015, versus the year end 2014 level of 6.3x. Sources of EBITDA growth include HMA integration cost synergies and the tailwind provided by the operational improvements and generally improving operating environment. The company reports that it will meet its year one cost synergies target of $125 million in 2014 and expects the benefit to increase to $275 million by the end of year two. Management does have experience integrating large acquisitions; the fact that the company met the cost synergy target following the acquisition of Triad Hospitals in 2007 provides support that the HMA synergy target is achievable.

PROGRESS IN RESOLUATION OF LEGAL ISSUES:

During 2014, CHS made significant progress towards the resolution of some of its ongoing legal issues and the associated financial obligations are manageable. With respect to the legacy CHS hospitals, the two most important inquiries have been resolved, with total settlement costs for fines to the federal and various state governments of $173 million (entirely expensed and cash payment of $98 million made as of Sept. 30, 2014). As part of one of the settlements, the company has entered into a five-year corporate integrity agreement with the federal government, which involves some minor incremental operating costs associated with staff training and the retention of outside organizations to monitor certain operating practices.

HMA is facing its own set of lawsuits and regulatory investigations related to the same issue of short-stay admissions practices. Before the acquisition, the federal government announced that it would intervene in several qui tam or whistleblower suits against the company. Historically, government intervention in qui tam proceedings has heightened the probability of an eventual fine against the company. At Sept. 30, 2014, CHS has recorded a $333 million reserve for potential financial payment associated with these cases. Based on the size of the financial settlement negotiated for the legacy CHS hospitals, Fitch thinks this reserve is likely adequate to cover the eventual penalty.

SOLID LIQUIDITY PROFILE:

CHS's liquidity profile is solid. Near-term debt maturities are manageable, with potential sources of debt repayment including cash on hand, capacity on the established revolving lines of credit and good access to the capital markets for refinancing purposes. At Sept. 30, 2014, sources of liquidity included cash on hand of $221 million, LTM free cash flow of $533 million and availability on the bank revolver and ABL facility of $957 million. The primary financial maintenance covenant in the debt agreements is a secured net leverage test. The company has an adequate operating cushion under this covenant, which requires secured net leverage of below 4.5x. Fitch estimates secured net leverage of 3.6x at Dec. 31, 2014. The leverage covenant steps down to 4.25x starting with the quarter ended Dec. 31, 2015.

Fitch has taken the following rating actions:

Community Health Systems, Inc.:

--IDR affirmed at 'B+'.

CHS/Community Health Systems, Inc.:

--IDR affirmed at 'B+',

--Senior secured credit facility downgraded to 'BB/RR2' from 'BB+/RR1';

--Senior secured notes downgraded to 'BB/RR2' from 'BB+/RR1';

--Senior unsecured notes upgrade to 'B+/RR4' from 'B/RR5';

The Rating Outlook is Negative.

The 'BB/RR2' rating for CHS's secured debt (which includes the bank term loans, revolver and senior secured notes) reflects Fitch's expectations for 82% recovery under a hypothetical bankruptcy scenario. The 'B+/RR4' rating on CHS's $6.2 billion senior unsecured notes rating reflects Fitch's expectations for principal recovery of 48%.

The Recovery Ratings (RR) reflect Fitch's expectation that the enterprise value (EV) of CHS will be maximized in a restructuring scenario (going concern), rather than a liquidation. In estimating its going concern EV for CHS, Fitch assumes a 30% discount to LTM EBITDA of $2.7 billion for CHS, resulting in a post-default cash flow estimate of $1.9 billion (calculated pro forma for HMA's contribution to EBITDA). The magnitude of the discount to current cash flow is fairly substantial in this instance, given that the company is well removed from potential default, as reflected in the 'B+' IDR.

Fitch's post-default cash flow estimate for companies in the hospital sector mainly considers the structure of the industry. Hospital providers are highly exposed to potential cuts in Medicare and Medicaid payments since these companies can be considered price takers with respect to the 30%-40% of revenues derived from patients with government-sponsored health insurance. Furthermore, cuts in government payment rates or unfavorable changes in the reimbursement environment (i.e. higher scrutiny of short-stay hospital admissions), will invariably influence payments from commercial health insurers, augmenting the impact on cash flow. Fitch then applies a 7.0x multiple to CHS's post-default EBITDA estimate of $1.9 billion, resulting in a going concern EV of $13.1 billion. The 7.0x multiple is based on observation of both recent transactions/takeout and public market multiples in the healthcare industry.

Fitch applies a waterfall analysis to the going concern EV based on the relative claims of the debt in the capital structure. Fitch estimates going concern EV of $11.8 billion, net of a standard assumption of 10% for administrative claims. At Sept. 30, 2014, about 60% of consolidated total asset value resides in the guarantor group, which is used as an estimate for collateral value, with Fitch assuming that 60% of the going concern EV, or $7.1 billion, is recovered by first-lien secured holders, leaving $4.7 billion of non-collateral value to be distributed to unsecured claimants. Based on $10.8 billion of total secured claims (which includes the bank term loans, revolver and senior secured notes), the resulting first-lien secured deficiency claim of $3.7 billion is added to $6.2 billion of senior unsecured claims, resulting in $9.9 billion of total unsecured claims.

The changes to the debt issue ratings are due to Fitch's bespoke analysis of the secured debt collateral value. Rather than assuming that total asset value is first assigned to recovery of the secured debt, including the credit facility and senior secured notes, a revised approach assumes full recovery for the secured lenders only up to the secured debt collateral value of $7.1 billion, with the residual secured claims recovering on a pro rata basis with the unsecured claims.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'For-Profit Hospital Insights: Fitch's Annual Review of Bad Debt Accounting Policies and Practices' (Jan. 6, 2015);

--'Hospitals Credit Diagnosis: Favorable Factors Converge to Support Organic Growth' (Jan. 5, 2015);

--'2015 Outlook: U.S. Healthcare' (Dec. 4, 2014);

--'High-Yield Healthcare Checkup' (April 4, 2014);

--'Corporate Rating Methodology' (May 28, 2014).

Applicable Criteria and Related Research:

For-Profit Hospital Insights (Fitch's Annual Review of Bad Debt Accounting Policies and Practices)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=845870

Hospitals Credit Diagnosis (Favorable Factors Converge to Support Organic Growth)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=845469

2015 Outlook: U.S. Healthcare (The Value Debate Intensifies While Aggressive M&A Continues)

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=824368

High-Yield Healthcare Checkup: Comprehensive Analysis of High-Yield U.S. Healthcare Companies

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=736356

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=978916

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