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:
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.” 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.”
Trends and ExpectationsThe following themes were common to all median reports:
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 email@example.com.
 “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)
 “Medians-Operating pressures persist as growth in expenses exceeds revenue” (Moody’s Investor Service”)
 “2018 Median Ratios for Nonprofit Hospitals and Healthcare Systems” (FitchRatings, www.fitchratings.com)
 “U.S. Not-For-Profit Health Care System Median Financial Ratios -- 2017 vs. 2016” (S&P Global Ratings, www.spglobal.com/ratingsdirect)