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The not-for-profit (NFP) hospital sector credit ratings and fundamentals peaked in 2017. Over the last three years, hospitals saw accelerating revenue growth, reduced charity care and falling bad debt expense resulting from expanded health insurance access. These improvements led to stable, and in some cases improved, operating cash flow margins during a time of both regulatory implementation pain and robust political healthcare debate.
There are two secular trends in the hospital sector: NFP tax status and a booming +65-year-old population. NFP hospitals do not distribute profits, and therefore earnings accumulate into sizable cash and liquid investments, which boosts balance sheet strength. For-profit hospitals, on the other hand, distribute earnings and generally have weaker liquidity ratios and less balance sheet strength, which potentially makes them more susceptible to market disruptions. The relative balance sheet strength of the NPF hospitals is a positive secular trend. The growth of the +65-year-old population between now and 2030, however, is a negative secular trend. An aging population is good for hospital demand, but 65 is also the eligibility age for the government Medicare insurance program. This is important because Medicare reimbursement rates are typically the lowest among health insurers. The Centers for Medicare & Medicaid Service set payment policies, payment rates and quality of service provisions. For 2018, the relative value unit (RVU) adjustment is just 0.3%, which is below the 0.5% rate established under the Medicare Access & CHIP Reauthorization Act of 2015 (MACRA). The lower than expected conversion factor limits the pricing power of healthcare providers and places downward pressure on revenues where hospitals have Medicare as their dominant payer.
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While the major secular trend is the +65 year old boom, the major cyclical trends are legislative uncertainty and regulatory risk. The first cyclical risk is legislative action. Though legislative risk has not gone away, the likelihood of a full repeal of the Affordable Care Act is unlikely. For instance, the Congressional Budget Office estimates that the piecemeal repeal of the individual mandate, which takes place in 2019, will gradually increase the number of uninsured by 13 million in 2025. The Kaiser Family Foundation estimates the number of uninsured in the U.S. is about 28 million in 2016. The greater number of uninsured will likely increase hospitals’ charity care and bad debt expenses, which will erode operating cash flow margins. The second cyclical trend is regulatory risk. Under the Affordable Care Act, Medicaid payment to hospitals for indigent population care would decrease as more people gained access to health insurance. The data analyzed from 280 hospitals’ annual financial reports showed that as the insured rate increased both hospital charity care and bad debt expense fell, which may decrease Medicaid assistance. However, since these rules were delayed and implemented just last fall, over the next 18 months hospitals will have to deal with both rising numbers of uninsured patients and less assistance from Medicaid.
In all, these secular and cyclical trends are likely to converge, thereby reducing pricing power and accelerating expense growth for the hospital sector, which could culminate in significant margin compression. Moody’s rating service projects operating cash flow margins could decline 2% to 4% in 2018 alone. Hospital managers realize that greater patient volumes will not result in better operating cash flow margins because they lack pricing power. In response, NFP hospital managers are getting big. For example, Ascension Health will merge with Providence St. Joseph, and Kaiser Permanente recently bought Group Health. Smaller hospital systems are also getting bigger. Tower Health, in the exurbs of Philadelphia, raised debt and combined five smaller independent hospitals. The strategy behind “GET BIG” is expense management, but it is also comes with risks. Size can increase negotiating power with private health insurance companies to maintain fees. Size can scale pharmaceutical purchasing and reduce costs. And size could help attract specialists and slow wage and benefit cost. However, getting big involves integration risks, which could zap any benefits of the merger if executed poorly. Given the trends, we like hospital names that have experienced management teams, operating cash flow margins in the low teens or consistent margins in high single digits, a diversified insurance payer mix, and locations where the underlying operating markets show robust economic fundamentals.
Source: Credit Scope, Kaiser Family Foundation, Moody’s