Officially signed into law three-and-a-half years ago, the Affordable Care Act (ACA) continues to keep the health care sector in the spotlight. As the market has slowly accepted that the ACA is likely here to stay, the conversation has shifted from appeal attempts to how the law impacts the financial landscape of hospitals.
The hospital median reports recently released by the three largest Credit Rating Agencies (CRAs), Moody's Investor Service, Fitch Ratings and Standard & Poor's (S&P), provide ample opportunity to do just that.
Although the hospital market remains mostly stable, the trend is negative as downgrades exceeded upgrades across the board. Most of the negative pressure involves profitability metrics as all three CRAs cited a decline in income statement strength throughout the sector. Both highly rated and non-investment grade hospitals felt the pain as Fitch observed a decline in operating profitability across all rating categories for the first time in six years.
The income statement pressure is twofold as both revenue and expense trends have been negative. On the revenue side, the 3.9% growth cited by Moody’s is an all-time low. Many reasons for the revenue pressure have been citied; softness in volumes, especially the more profitable in-patient services, are most commonly cited. Specifically, inpatient admissions were down 1.3% according to Moody’s. Increased exposure to Medicaid at the expense of commercial payers also hurt revenue growth. Lastly, the sun-setting of some one-time or nonrecurring revenue enhancements, such as meaningful use payments and the Medicare rural wage settlement, have also hindered revenue growth.
Although the year-over-year expense rate growth slowed, expense growth exceeded revenue growth for the period reviewed. Considering the financial pressures hospitals have been under the past few years, hospitals are struggling to find additional expense cuts and much of the low-hanging fruit has already been picked. Increased personnel costs related to implementation of ACA provisions, training for electronic health records (EHR) and the eventual transition to ICD-10 have all provided additional expense pressure. The result is a net operating margin of 9.0%, another all-time low according to Moody’s.
The negativity of the profitability metrics has been partially offset by the strengthening of the liquidity metrics, which have provided a much needed cushion for hospitals. The median cash and investments balance increased in 2013 to 11% according to Moody’s (growth was in the single digits in the several years prior). Other positives included stable leverage metrics, a slight increase in days in accounts receivables, and improved cash-to-debt ratios. A strong stock market, aggressive revenue cycle management and decreased capital expenditures have contributed to this improvement.
The rating agencies have also touched on topics to monitor moving forward that could potentially impact the hospital sector. For example, will more states participate in the Medicaid expansion? The general consensus is that Medicaid expansions help the bottom line of hospitals, so the positive impact of the individual mandate may mitigate some of the slowdown in revenue growth, although likely not realized until 2015.
Another issue to monitor is how the increase in popularity of high deductible health care plans will impact hospital operations. According to a Kaiser Family Foundation survey, the number of employees enrolled in high deductible plans has increased five-fold from 4% in 2006 to 20% in 2013. First, these plans may mean consumers wait longer to seek care by delaying procedures. Once consumers make their way to hospitals, high deductible plans mean hospitals will incur an increased burden of collecting deductibles. This could compress admissions as hospitals become more selective and inflate bad debt as some of the deductibles will need to be written off. High deductible plans could also highlight pricing transparency as patients become more price sensitive and shop services across different hospitals.
The impact of robust mergers and acquisitions within the hospital sector driven by health care reform is also something to monitor. Often times, the rich will get richer as hospitals with larger revenues and greater admissions tend to have higher ratings. An example of this impact is the fact that Fitch’s median rating in its portfolio has increased from “A-” to “A” despite the pressure previously discussed, mostly as a result of upgrades due to a higher rated hospital absorbing a lower rated hospital.
What does all this mean for the hospital sector moving forward? The general consensus is that the overall outlook on the sector is poor. Fitch has a negative outlook on the sector, predicting that a more difficult operating environment is likely to persist. As such, Fitch expects downgrades to exceed upgrades, especially for lower-rated hospitals due to further narrowing in operating profitability. Similarly, Moody’s expects continued financial weakening due to volume declines in a predominately fee-for-service environment, reinforcing their negative outlook on the nonprofit hospital sector. Lastly, S&P expects a continued weakening of income statement metrics for the next two years, with volume trends playing a greater role in deteriorating margins. S&P also states the growing dependence on non-operating income is concerning because of its short-term nature and the expectation is that operating margins will continue to compress this year and beyond.