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The Influential Big Three: Credit Rating Agency Forecasts

Who is the most influential “Big Three” in the U.S. today? 

No, it’s not LeBron James, Kevin Love and Kyrie Irving of the Cleveland Cavaliers. Although that trio is sure to make noise this coming season, the most influential Big Three is undoubtedly the three credit rating agencies (CRAs) that hold approximately 95% of the world market share for ratings: Moody’s Investor Service, Fitch Ratings and Standard & Poor’s (S&P).

These agencies issue annual reports that analyze past performance and provide forecasts for the upcoming year: Moody’s on hospitals; Fitch on hospitals and senior living; and S&P on hospitals and housing. These reports provide illuminating overviews that can help industry leaders adjust to current trends and prepare for future developments. 

Hospitals

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 CRAs 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. 

Senior Living

Fitch’s report “2014 Median Ratios for Nonprofit Continuing Care Retirement Communities (CCRCs)” cited continued improved performance, especially for those projects already rated within Fitch’s higher-rated categories. The strengthening of the sector was sparked by increased liquidity due to the growth of entrance fees, as the improving U.S. housing market has allowed providers to increase entrance fees for the first time since the recession. Similar to the hospital sector, CCRCs also benefited from strong investment returns, further strengthening the balance sheet metrics. For example, the days cash on hand median for investment grade CCRCs increased from 442 days last year to 476 days this year. Similarly, cash to debt increased from 65.6% to 75.1% the past year. 

Income statement metrics were largely stable. For investment grade credits, the median operating ratio deteriorated slightly from 96.9% to 97.3% year-over-year, while the net operating margin improved from 21.4% to 21.7%.  

Through the first eight months of the year, Fitch has not downgraded any CCRC credits and has upgraded five. Fitch expects this stability to remain as facility occupancies and the U.S. housing market continue to improve, offsetting a lagging overall economy and projected increased capital borrowing within the sector. This is the second consecutive year Fitch has placed a stable outlook on the sector. Longer term, the sector will benefit from the rapidly growing population of the senior market. 

Housing

In its report “Housing: A Slow Return to Normal,” S&P describes a housing sector that is steadily continuing its gradual recovery. After a harsh winter, the spring saw a surge in housing starts that leads S&P to expect 1 million starts in 2014, which is an improvement from recent years but still trails the annual average of 1.25 to 1.5 million units. S&P expects starts to return to the 1.5 million level in 2015. Multifamily units are accounting for an increasing portion of those starts as the younger generation continues to postpone purchasing homes due to several issues including stricter credit standards and high student loan payments.

S&P believes that the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, are crucial participants in the U.S. housing sector, noting that they hold 90% to 95% of mortgages. S&P acknowledges the existing proposals in congress to wind down the programs, but believes such legislation, even if agreed upon and passed, would be a multi-year process and as such the GSE’s prominence will continue in the near future. Overall, S&P cites the continued decline in delinquency levels, coupled with the ongoing increase in home prices, as it projects a stable outlook for the housing sector.

Overall, the Big Three forecast continued steady improvement for the senior living and housing sectors while the hospital sector faces a more challenging future as operating difficulties persist.

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