HOSPITAL RATING AGENCY UPDATE

Hospital Rating Agency Update:
Balance Sheets and Business Combinations Provide Buffer in Difficult Operating Environment

Continuing a theme from last year, 2017 saw operating margins deteriorate because of long-term industry trends on the revenue side and rapid expense increases. Furthermore, capital spending needs remain high but mainly for shorter-lived assets such as IT, outpatient clinics and ambulatory services. Fortunately, 2017 was a better year than 2016 from a non-operating income perspective, as investment returns were good and the strong economy helped bolster contributions for many nonprofit health care providers. Industry forces continue to favor larger providers, leading to acceleration in mergers and acquisitions (M&A) and affiliation activity. The combination of good non-operating income and consolidation improved the balance sheet of most hospitals and systems, particularly the large and highly rated ones. This balance sheet strength is always considered an extremely important credit attribute but especially in an environment where unpredictable but certain changes are coming.
Each of the credit rating agencies (CRAs) issue an annual report that summarizes past performance and provides a forecast for the upcoming year. With approximately 95% of the world market share for credit ratings, Fitch Ratings (Fitch), Moody’s Investor Service (Moody’s), and Standard & Poor’s (S&P) reports provide a wealth of information which systems and standalone hospitals can use to make meaningful comparisons to financial benchmarks and emerging trends.
Operating PerformanceAfter three years of robust revenue growth from the end of 2014 through 2016, 2017 saw the winding down of increases attributable to Medicaid expansion resulting from the Affordable Care Act (ACA). All three CRAs reported revenue growth slowing rather dramatically. Meanwhile, the economic recovery that started nearly 10 years ago has slowly driven up labor costs in many service sectors. Health care is acutely affected by labor costs, as the supply of workers with the necessary skills or experience is limited, and consumer demands place a premium on quality and availability. In addition, pharmaceutical costs increased at a rate faster than inflation for the second consecutive year.
Moody’s reported that the median expense growth rate slowed from 7.1% in 2016 to 5.7% in 2017, but the revenue growth rate was even slower, dropping from 6.1% to 4.6% over the same period. The CRAs all expect the negative operating factors to continue for the foreseeable future. In addition to the current expense challenges, demographic and consumer preference changes stand to dampen revenue growth for many years to come. Common themes among all three agencies include:

• Aging population and changing industry dynamics weaken payor mix. All three agencies noted that Medicaid expansion from 2015 through 2016 contributed to slight improvement in payor mix, as the proportion of self-pay declined. However, the population continues to age, leading to a conversion from commercial payors to Medicare. Both Medicare and commercial payors have pushed initiatives for value or risk-based payment plans, which if nothing else, create uncertainty of reimbursement. In addition, more employers are pushing their covered employees into high deductible plans, which can lead to a reversal of the decline in self-pay. Finally, “the current administration continues its efforts to chip away at key components [of the ACA]…including diminishing support of the exchanges and benefit reductions.”[1] This weakening support for the ACA also contributes to a rise in the uninsured rate, which contributes to higher bad debt expense and/or charity care.
• Weak volume growth. Outpatient volume growth continues to exceed inpatient, but overall demand was very weak in 2017. Moody’s notes that “median 1% growth in inpatient admissions marks the lowest rate of growth in three years, while outpatient growth slowed to 2.2%--down for the first time in five years.” [2]
• Slow transition from fee-for-service. Although movement has been slower than anticipated, a gradual shift from fee-for-service to at-risk sharing and value-based compensation models is changing the industry. The consensus view is that the change will favor large systems that can develop and maintain infrastructure to adapt to a population health environment.
• Competition from specialized and non-traditional entrants. In addition to the decline in inpatient and outpatient growth, Moody’s noted a decline in the growth of outpatient surgeries because of “an increasing supply of competing sites providing these more lucrative services.” All three agencies emphasized the competitive threat from alternative providers. S&P commented that “the industry is also experiencing an unparalleled rise in nontraditional competitors aiming to provide care that is more consumer friendly, higher quality, and lower cost.”
• Consolidation as a means to gain negotiating leverage and framework for population health. With the gradual shift from volume to value, the increased need for and opportunities to use technology, and the general uncertainty of future changes, more providers are seeking to affiliate with other players through a combination of horizontal and vertical integration, network collaboration and M&A. Networks will be important in gaining negotiating leverage from a revenue and expense perspective and enabling providers to have sufficient infrastructure to manage in an environment where population health and access are key aims.
• Management teams seek efficiency through varying strategies. As reimbursement mechanisms continue to change and margins get squeezed from both sides, it is imperative for organizations to adapt. Again, size offers an opportunity to achieve economies of scale, and the ability to afford stronger and deeper management teams. By focusing on expense efficiency and revenue cycle optimization, organizations can maintain acceptable cash flow.

Non-Operating Income and Cash FlowPartially offsetting the difficult operating environment, investment returns were generally excellent in 2017 and many providers enjoyed above average charitable contributions. Consequently, overall earnings before interest, depreciation and amortization (EBIDA) margins were barely lower, despite the sharp decline in operating margin. The CRAs have observed a gradual reduction in debt burden in recent years, and the interest rate environment remained favorable throughout 2017. As a result, debt service coverage (DSC) was relatively unchanged from 2016 to 2017; although, some lower rated categories did see a decline. Median maximum annual debt service (MADS) coverage remained at 3.9x in 2017 for the S&P portfolio of health care organizations. It remains to be seen if non-operating income can continue to make up for operating challenges, but we can assume the U.S. equity markets will slow down.
Liquidity and Capital SpendingThe strength of non-operating income helped to offset declines in operating margin, resulting in another year of improved balance sheets. Fitch states that liquidity metrics, “by any traditional ratio are at an all-time high point in the sector.”[3] The CRAs also noted that the sector has experienced a long-term trend of moderating leverage resulting in improved debt/capitalization ratios. Capital spending remained above depreciation expense for the third year in a row, but average age of plant declined in many rating categories. For the most part, hospitals are shunning large replacement or expansion projects. However, capital expenditure remains strongest for the highest rated organizations, who “continue to try to lock in their business advantages—highlighted by continued spending on information technology, ambulatory care and population health infrastructure.”[4] 
Trends and ExpectationsThe following themes were common to all median reports:

• There are few signs that the expense pressures will abate in the near term, revenue growth will remain slower and operating margins will be challenged.
• The sector outlook is generally negative, but rating changes have been limited. Despite the headwinds facing the industry, ratings downgrades only slightly outpaced upgrades and the vast majority of ratings for all three CRAs remained stable. One reason for the ratings stability is that some highly rated systems acquired lower rated and struggling providers, thus there was a reduction in the number of low investment grade and non-investment grade organizations.
• Hospital management and boards must strive to control expenses, find growth opportunities, respond to threats from a variety of competitors and maximize competitive advantages. The skill, experience and creativity of health care management teams will be increasingly important to the overall success of an organization. Therefore, the CRAs, as well as creditors and investors, will be increasingly interested in regular interviews with management teams.

As we mentioned last year, S&P, Moody’s, and Fitch all signaled that 2015 was likely to be as good as it gets for the hospital sector. Revenue growth in 2016 was better than expected, but extremely fast expense increases squeezed margins. The following year, 2017, was indeed a very challenging year from an operational perspective, as margins were compressed even further. On the other hand, many hospitals used the recent “fat years” to shore up their balance sheets. Today, liquidity and debt/cap ratios are at all-time strengths, while debt service coverage is within the range experienced since 2008. The significant buildup in liquidity over the last 10 years helps provide a margin of safety, as operating margins continue to compress.

As the expense pressure and anemic revenue growth will likely not abate in the near-term, hospitals must continue to focus on efficiency, while investing prudently in capital projects that enhance the patient experience and/or improve the availability and use of technology. The management teams that can adapt to the change from volume to value and embrace the goal of population health will be poised to succeed in the future.
 
Ritchie Dickey is a vice president with Lancaster Pollard in Atlanta. He may be reached at rdickey@lancasterpollard.com.


[1] “U.S. Not-For-Profit Acute Health Care Ratios: Sector is Buffeted by Disruption, Yet 2017 median Trends Remain Unchanged from Last Yea” (S&P Global Ratings, www.spgglobal.com/ratingsdirect)

[2] “Medians-Operating pressures persist as growth in expenses exceeds revenue” (Moody’s Investor Service”)

[3] “2018 Median Ratios for Nonprofit Hospitals and Healthcare Systems” (FitchRatings, www.fitchratings.com)

[4] “U.S. Not-For-Profit Health Care System Median Financial Ratios -- 2017 vs. 2016” (S&P Global Ratings, www.spglobal.com/ratingsdirect)