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Strains run deep on hospital sector

A question mark looms large this year over whether hospitals and health systems will see sufficient recovery from 2022’s operating wounds to spare them from rating and outlook deterioration, rating agencies warn.

The not-for-profit hospital sector suffered bruising margin wounds last year as it confronted inflationary costs along with ongoing supply-chain issues, labor shortages and wage pressures. The latter was most acutely felt in the use of expensive agency nurses.

Lengthier hospital stays also dragged down margins eroding the late 2020 and 2021 recovery from COVID-19 blows.

November margins tracked by the advisory firm Kaufman Hall showed some signs there is light at the end of the tunnel later this year, despite headwinds, like inflation, a potential recession, investment losses after 2021 record gains that bolstered liquidity, and the future course of COVID-19.

Growing cyber threats amid high profile attacks like the ransomware one that hit CommonSpirit Health last year and the cost of preventative measures also adds to strains.

The question for analysts this year is whether incremental improvement supports a rating affirmation. “For some it might be enough, for other it might not be,” healthcare analyst Suzie Desai said during a S&P webinar accompanied with a report “A Long Road Ahead.”

“We believe many hospitals, though not all, will be in a tighter space” as cash is compressed “for credit quality given higher labor costs, inflationary expenses, and a mixed revenue outlook,” warned S&P Global Ratings, which moved its outlook to negative on the sector. “Unrestricted reserves and a generally low leveraged sector supported credit quality in 2022, however, without cash flow growth or investment rebound, the overall balance sheet could be less supportive of credit quality in 2023.”

Negative outlooks rose through the second half of last year and S&P expects that trend to persist, with more negative outlooks and downgrades this year “though there will continue to be affirmations for many of our credits that are well positioned at their rating, both financially and enterprise-wise,” S&P said.

Not all hospitals are faring poorly, especially in certain regions as well as children’s hospitals, and some will regain their operational footing this year while others won’t see notable improvement until 2024.

The question for analysts this year is whether incremental improvement supports a rating affirmation. “For some it might be enough, for other it might not be,” healthcare analyst Suzie Desai said during a S&P webinar last week that accompanied a report “A Long Road Ahead.”

While the emphasis remains on margins, a wider range of factor will influence rating decisions, such as planned strategies and investments.

Federal actions also stand to weigh on balance sheets, including sequestration that was restarted last year. The expected end later this year to the federal pandemic emergency brings with it a reduction in some reimbursement costs. The federal government extended the federal emergency through April and will provide 60 days’ notice before allowing it to expire.

Hospitals have a series of near-term strategies in play to cope, including labor management that focuses on reducing overtime pay and agency use, shutting down some services, diversifying services and markets, and monetizing assets.

Longer-term strategies are likely to involve data/technology for care delivery redesign and efficiencies, clinical developments, M&A and affiliations, and/or broader diversification, S&P said.

Consolidation picked up steam in 2022, according to Kaufman Hall’s latest analysis of healthcare transactions.

The not-for-profit and for-profit sector saw a total of 53 announced transactions involving $45 billion of revenue as many fell into the category of “mega mergers” that involve the smaller party having at least $1 billion of revenue.

“The high percentage of mega mergers and other significant transactions over the course of 2022 resulted in an historically high average smaller party size by annual revenue of $852 million, more than $200 million higher than last year’s historic high of $619 million,” noted the report, authored by Anu Singh, Kaufman Hall practice leaders of partnerships, mergers & acquisitions.

Four of the 17 announced transactions in the fourth quarter met the mega merger criteria.

“Despite challenging headwinds to transaction activity, Kaufman Hall experts believe that providers will continue to seek partnerships or transactions that provide the resources needed to pursue their post-pandemic strategies, including transforming care delivery and improving resiliency,” according to the report.

Fitch Ratings left a deteriorating outlook on the sector.

“Volumes have generally rebounded from early pandemic lows, but expense inflation remains pronounced, particularly for labor. Even as inflation is expected to attenuate eventually, labor expenses appear to have been reset at a permanently higher level. Remedying this will take all of 2023, and likely beyond,” Kevin Holloran, a senior director at Fitch Ratings, said in an outlook report accompanied by a webinar this week.  

“Volumes have generally rebounded from early pandemic lows, but expense inflation remains pronounced, particularly for labor. Even as inflation is expected to attenuate eventually, labor expenses appear to have been reset at a permanently higher level. Remedying this will take all of 2023, and likely beyond,” said Kevin Holloran, a senior director at Fitch Ratings

For providers that suffered significant operational losses in 2022, Fitch believes a break-even on a month-to-month basis should return sometime in 2023, with gradual improvement from there.

Others, that suffered only modest losses, may have returned to profitability or could this year. A select few health systems continue to enjoy strong operating margins.

“Fitch is not calling for downgrades across the entire sector, but does predict a period in which downgrades and negative outlooks outpace upgrades and positive outlooks,” Fitch said.

Given investment losses and ongoing operational struggles, rating agencies will be watching closely for bond covenant violations that could drive defaults and acceleration on some credits if investor waivers are not granted.

The labor shortage especially on the nursing front remains the most daunting challenge.

The sector has seen the pre-pandemic nursing shortage of about 500,000 nurses swell to 1 million to 2 million, according to statistics cited by Fitch.

“Multiple efforts to recruit and retain staffing, along with increasing throughput of nurses through nursing school and into the workforce, novel use of new technology and a reengineering of the hospital operating model will all need to be employed over the next year and well beyond,” Fitch said.

Moody’s Investors Service last month said its outlook remains negative.

“While operating cash flow will grow in 2023, the high expense environment, coupled with modest revenue gains, will limit the profit margin for the not-for-profit healthcare sector,” said Brad Spielman, a senior credit officer at Moody’s. “This level of operating cash flow production will likely prove insufficient over the long term to enable adequate reinvestment in facilities, maintain investment in programs, or support organizational growth — key considerations that drive our negative outlook.”

Hospital margins recorded a slight month-over-month gain in November due to a softening on the expense side and higher outpatient revenue, but fell far short of making up for months-long losses that will leave the sector in the red for the year, according to Kaufman Hall’s latest National Hospital Flash Report which draws data from 900 not-for-profit and for-profit hospitals compiled by Syntellis Performance Solutions. 

Hospital margin rose 12% from the previous month but overall for the year margins were at a negative 0.2%.  Shorter lengths of stay contributed to a 1% decrease in total expenses for November while labor expenses fell by 2%.

“Hospitals were fortunately relieved of some financial pressure in November amid a continued competition in the healthcare labor market, potentially due to a shift away from expensive contract labor,” said Erik Swanson, a senior vice president of data and analytics at Kaufman Hall.

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