S&P’s Outlook For U.S. Not-For-Profit Acute Health Care: A Long Road Ahead

As an industry, nonprofit health care has an outsized impact on tax exemption jurisprudence.  Competitive economic pressures lead to rules impacting partnerships with for profit entities, compensation planning, and public benefit, to name a few.  And those rules usually apply beyond the nonprofit hospital setting.  It may be an exaggeration to claim that when nonprofit health care sneezes, the entire sector catches the flu, but there is no doubt that industry trends in nonprofit health care greatly impact tax exemption jurisprudence. 

So Standard & Poors recently published report on the economic outlook regarding nonprofit acute care hospitals is helpful and timely.  The pictures above are from the report.  After the fold I quote liberally from the report.

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Here are a few excerpts:

Good demand, but revenue trends may be mixed.  Revenue has been rising compared with 2020’s low and there appears to be generally good demand for health care services due in part to virus surges, particularly at the start of 2022, and patients feeling more comfortable returning to receive care. However, for some credits revenue has been constrained by an inability to staff beds and operating rooms due to labor shortages, throughput issues stemming from difficulty discharging patients to lower care settings, and in certain parts of the country continued reluctance to seek health care. In addition, a continued shift in treatment patterns has resulted in more virtual and ambulatory care that is reimbursed at lower rates and third-party insurance companies have generally been reluctant to reopen contracts or consider additional rate increases for acute care providers, in some cases denying payments per our discussion with management teams. We expect management’s ability to secure meaningful rate increases from insurance companies to remain difficult as their employer customers are concerned about keeping their own benefit costs low. Revenues are further constrained by government payers which often account for 50% or more of revenues. Finally, the reduction in COVID-19 relief funds and resumption of sequestration have left big holes in many budgets and will further unveil some of the underlying operating challenges for certain providers. The upcoming winter will be a test of how COVID-19 related illnesses and other respiratory illnesses will be managed along other health care needs. With all of this, the pace of revenue and volume recovery has emerged with many elements of unpredictability that contribute to difficulties in forecasting performance.

Extraordinary government support is coming to an end.  With COVID-19 stimulus funds and other related reimbursement coming to an end, and more governmental and external scrutiny on providers, we don’t expect additional material support to providers despite ongoing pressures. We view requests for one-time support from FEMA and potentially state American Rescue Plan Act funds as providing short-term relief but won’t offset the broader structural mismatch of revenues and expenses.

Broader strategies to generate financial improvement will be critical to maintain rating stability.  While management teams address labor challenges, organizations are also identifying other ways to generate cash flow improvement including personnel cuts in non-clinical areas, revenue cycle opportunities often using external resources, throughput improvements and length of stay reductions, and renegotiated supply and payer contracts–although the latter has not yielded significant benefits for most. Other strategic efforts include closure of service lines and facilities, revenue diversification, strategic investments into higher margin businesses such as specialty pharmacy business, lab services and other related business services, as well as longer-term care delivery model redesigns using technology and data to lower costs of care. With a higher number of covenant defaults, many organizations are relying on consultants to both serve as a cure under bond documents for a rate covenant violation, and to help accelerate improvement initiatives and provide a clearer lens on industry standards. While we have always viewed management teams as an important credit factor, we have seen heightened executive turnover since the start of the pandemic, creating some challenges with developing and implementing strategic and financial improvement plans.

Balance sheets will remain critical for credit stability given expected uneven operating performance over the next year.  The significant improvement in reserves during 2020 and 2021 have helped support credit quality despite declines in the investment markets through 2022 as reserves are generally still consistent with 2019 levels. Unrestricted reserves are still providing some, albeit more limited cushion during this period of operating volatility. In the year ahead we may see the following:

• • There could be erosion of this cushion depending on investment market performance, prolonged inflationary pressure, effects from a possible recession, and cash flow and capital expenditure trends. While there was ample debt issuance during the pandemic associated with historically low interest rates, some of the borrowing replenished balance sheet reserves and in general did not materially impact leverage, especially given the continued rise in capitalization driven by the benefit of stimulus funds and market returns.
  • Investment market returns could help improve balance sheet flexibility over time; however, we do not expect material improvement in unrestricted reserves over the next year due to likely weaker cash flow and potentially pent-up capital spending needs after two years of relatively thin spending by many organizations coupled with higher construction costs due to inflation.
  • Capital needs persist given the capital-intensive nature of the sector, competition, and the fact that many strategic growth initiatives have a capital requirement; however, addressing these needs will be especially challenging given a focus on preserving unrestricted reserves in the current environment. A renewed focus on fundraising or issuing debt to support capital needs could be options, although higher interest rates for the latter could make that more difficult.

A recession could make things worse.  Our chief U.S. economist has indicated a recession is likely in 2023 (see “Business Cycle Barometer: Worsening Near-Term Growth Prospects,” published Oct. 24, 2022, on RatingsDirect), which could complicate efforts by hospitals to improve financial performance. On the one hand, a recession could improve labor conditions, but we also recognize that other factors such as bad debt, volume shifts due to higher deductible plans, and payer mix changes could negatively influence volumes and revenue for many providers, although these latter indicators generally lag and will depend on the extent and duration of any recession if it happens. Further, investment markets could continue to move sideways, potentially resulting in more pressure to credit quality as reduced cash flow, likely slower fundraising, and capital demands slow unrestricted reserve growth.

On balance, legislative and administrative actions likely to be less favorable to providers.  There are no signature pieces of health care legislation that we believe will materially affect providers over the next year. That said, in that it is a highly regulated sector and with heightened focus on health care costs and operating policies, we expect continued debate at the federal and state level, although providers will likely have less upside in the near term.

• • We continue to monitor such areas as the 340b program revenue as that has become an increasingly meaningful portion of revenue and earnings; the impact of sequestration; and Medicare PAYGO payment cuts. While Medicare provided better rate increases this year, they don’t offset the higher expenses. Price transparency has also become an increasing area of discussion, particularly as affordability remains a focus and governments support an increasing portion of the health care costs.
  • The continued scrutiny of mergers and acquisitions by federal and state regulators could afford fewer options for struggling providers. While many of the recently announced transactions are more strategic in nature, we believe broader efficiency opportunities will rise in importance given the current operating climate. Separately, some health care systems may try to divest of certain facilities to better focus resources, but with sector challenges, some of those divestitures could be slower.
  • The end of the public health emergency may lower the number of individuals covered by Medicaid, partially offset by a few states that recently expanded or will expand Medicaid. However, if those individuals do not re-enroll for health insurance on the individual exchanges, or the plans they enroll in have higher deductibles, hospitals could see less demand for services as well as higher bad debt and charity care expense that will incrementally pressure finances.
  • One bright spot has been the additional funding support from enhanced state supplemental funding programs in states such as Kentucky and Florida and the continued adoption of Medicaid expansion in certain states.