Fitch Rates Children's Hospital of Orange County Series 2011A Bonds 'A'; Affirms Outstanding Debt

Fitch Ratings has assigned an 'A' rating to the approximately $105.27 million California Health Facilities Financing Authority Revenue Bonds [Children's Hospital of Orange County (CHOC)] Series 2011A.

In addition, Fitch has affirmed the 'A' rating on CHOC's outstanding debt:
--$139,565,000 California Health Facilities Financing Authority rev bonds ser 2009A;
--$50,000,000 California Health Facilities Financing Authority var-rate rev bonds ser 2009B; underlying rating;
--$50,000,000 California Health Facilities Financing Authority var-rate rev bonds ser 2009C; underlying rating;
--$27,800,000 California Health Facilities Financing Authority var-rate rev bonds ser 2009D; underlying rating;
The series 2009B-D bonds are variable rate demand bonds (VRDBs) supported by a letter of credit (LOC) from US Bank.

The Rating Outlook is Stable.

The series 2011A bonds are expected to be fixed rate and will fund capital needs. The series 2011A bonds are expected to price the week of Oct. 24th via negotiation.

KEY RATING DRIVERS:
--Major Building Project Progressing: Children's Hospital of Orange County (CHOC) is in the process of constructing a new seven story tower that will cost a total of $558 million and is 77% complete as of Aug. 31, 2011. The building is on schedule to be completed in October 2012 and open in April 2013.
--Improved Financial Flexibility: CHOC's financial performance greatly improved in fiscal 2011 due to the receipt of funds from the provider fee; however, these funds are still temporary and a long-term solution to inadequate Medi-Cal funding will need to be addressed.
--More Debt Than Anticipated: At the time of Fitch's last review, CHOC was only projecting an additional debt issuance of approximately $45 million versus the $105 million currently being issued. The main difference is the use of provider fee funds to build the balance sheet versus spending the funds on construction costs.
--Strong Market Position: CHOC is the only dedicated pediatric provider within Orange County except for one Tenet facility that maintains approximately 25 pediatric beds. CHOC continues to grow its service area beyond Orange County through partnerships with adult hospitals and increased outpatient facilities.
--High Exposure to Governmental Funding: Not unlike other children's hospitals, CHOC is vulnerable to changes in Medi-Cal funding with 59% of gross revenues from Medi-Cal payors in fiscal 2011.

SECURITY:
Gross revenue pledge of the obligated group.

CREDIT PROFILE:

Organization
CHOC is a 238 staffed-bed pediatric hospital located in Orange County, CA. Fitch's analysis is based on the consolidated entity, Children's Healthcare of California and Affiliates, which includes CHOC Children's at Mission Hospital, CHOC Children's Foundation, and other related entities.

Major Building Project
CHOC is in the midst of completing its master facility plan, which incorporates the construction of a new seven story tower and remodeling of the existing hospital tower. Fitch views the project favorably as it gives CHOC its own facility and is sized for future growth.

The new tower will have capacity for 142 additional beds (including shelled space) and a new emergency department, surgical and recovery suites, imaging and diagnostic services, laboratory and other ancillary services. CHOC is located adjacent to St. Joseph Hospital of Orange (part of St. Joseph Health System; rated 'AA-' by Fitch) and has historically utilized their space for these services under a shared services agreement. The agreement will terminate on March 31, 2013. The seismically compliant new tower is expected to be completed by October 2012 and open in April 2013 after a transitional planning and licensure period.

CHOC has been able to capitalize on the availability of outside funding sources for a portion of the cost of the project. Given the various funding sources, the amounts have fluctuated over the last few years, but are now final with $280.2 million from debt (series 2004, 2009, and 2011 bonds), $136.8 million from Proposition 3 and 61 funds, $106.5 million from cash flow, and $34.3 million from fundraising. The amount remaining to be spent includes $162.7 million from bond proceeds (series 2009 and 2011), $81.7 million from cash flow, $34.3 million from fundraising, and $7.8 million from Proposition funds.

CHOC was a beneficiary of Proposition 3 and 61 funds, which were voter approved ballot initiatives that authorized the issuance of state general obligation bonds for children's hospital construction. Additionally, CHOC launched a $125 million capital campaign in support of its Master Campus Plan. As of June 30, 2011, CHOC will have recorded $95.8 million in contributions, of which $28.2 million has been designated toward the project. CHOC also recently received two large gifts: an unrestricted $30.6 million estate gift and a restricted $10 million gift from Hyundai.

Strong Market Position
One of CHOC's main credit strengths is its strong market position. Market share was 69.6% for 2009, which has increased from 55.9% in 2003. Fitch believes CHOC's market position should further improve due to the continued growth of its regional partnerships with adult providers and successful physician recruitment. CHOC recently signed a transfer agreement with St. Jude Medical Center (part of St. Joseph Health System) to provide their pediatric services.

Discharges were down in fiscal 2011 after a 6% increase in fiscal 2010 mainly driven by a drop in NICU volume from the reduction in the birth rate. Management is projecting volume to improve in fiscal 2012.

CHOC has created a Medical Foundation that will be effective on or about Nov. 1, 2011 as a division of the hospital. Currently, Pediatric Subspecialty Faculty (PSF), a multi-specialty physician group, accounts for 69% of CHOC's admissions. PSF has 155 physicians in 19 pediatric subspecialties and is expected to become part of the Medical Foundation, which should further enhance physician alignment.

Provider Fee
California enacted a hospital provider fee program to draw down additional federal funds for Medi-Cal services. The 2010 provider fee (for the period April 2009 to December 2010) was approved and the net benefit to CHOC was $47.1 million, which was received in fiscal 2011. A 2011 provider fee (for January 2011 to June 2011) was subsequently established but is awaiting CMS approval. CHOC has already received a net benefit of $13.6 million from the 2011 provider fee, however the revenue and expense associated with the fee has not been booked.

The governor has signed a bill relating to a 30 month extension of the program (2012 provider fee) for the period July 2011 to December 2013, which is also awaiting CMS approval. Management expects this to be approved and is estimated to generate a net benefit of $103.7 million.

Although Fitch views the benefit from the provider fee favorably, these funds are still temporary and a long term solution to inadequate Medi-Cal funding will need to be addressed.

As a children's hospital, CHOC is highly exposed to changes in Medi-Cal funding, which comprises 59% of gross revenues. Approximately 40% of the overall payor mix is from the California Children's Services program and the state is expecting to change the reimbursement model for this program to control costs.

Financial Performance
Fiscal 2011's performance was very strong due to the receipt of the 2010 provider fee and an estate gift of $30.6 million. Operating margin was 12.4% compared to 2.2% the prior year. Without the provider fee, an estate gift, and one time litigation costs of $18.8 million, operating margin would have been 2.3%.

Liquidity has improved with $332.4 million of unrestricted cash and investments (266.8 days cash on hand and 90.5% pro forma cash to debt) for fiscal 2011 compared to 185 days and 56.1% pro forma cash to debt at fiscal year end 2010 and the 'A' category median ratios of 194.1 and 113.8%, respectively.

Due to management's decision to issue a greater amount of additional debt versus utilizing provider fee receipts to fund a portion of the construction costs, it is expected that CHOC's balance sheet will further improve as the 2012 provider fee funds are received. Fitch expects these funds to be retained on the balance sheet, which will provide a cushion against its high debt burden.

MADS coverage by EBITDA has historically been light at just under 2x and does not incorporate interest expense that is capitalized until fiscal 2014. Excluding provider fee revenue, management projects MADS coverage to be 3.1 times (x) in fiscal 2014.

Fitch believes fiscal 2013 and 2014 will be critical years for CHOC as management executes the opening of the new facility. Operating performance is expected to be pressured in fiscal 2013 due to one time transition costs of $12 million and in fiscal 2014 due to increased depreciation and interest expense.

Stable Outlook
The Stable Outlook reflects Fitch's expectation that CHOC will have a successful transition to the new facility on time and within budget. Fitch expects CHOC's balance sheet to further improve, which will be critical given the execution risk associated with the new facility and potential changes to Medi-Cal reimbursement.

Debt Profile
Total proforma debt is $372.635 million and is 66% fixed rate and 34% variable rate. CHOC has additional exposure to risks related to its outstanding VRDBs (remarketing, renewal and put risk) and swap portfolio. As of June 30, 2011, CHOC is posting $20.7 million of collateral related to its swaps.

CHOC's $128 million of VRDBs are supported by a LOC from US Bank and the expiration date was extended to Dec. 21, 2015. Under the LOC agreement, if there is a draw on the LOC, the term-out period is three years.

Additional information is available at 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-Supported Rating Criteria' (June 20, 2011);
--'Nonprofit Hospitals and Health Systems Rating Criteria' (Aug. 12, 2011).

For information on Build America Bonds, visit www.fitchratings.com/BABs

Applicable Criteria and Related Research:
Revenue-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=637130
Nonprofit Hospitals and Health Systems Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=648836

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