Rating Agencies Update: Overall Outlook Improves, Gains Concentrated at the Top

Finally, we have some winners. After years of gloom over stagnant volume growth amid uncertainty over the Affordable Care Act (ACA) and challenging economic forces, the outlook is brighter for many health care providers. The consensus theme of the three largest credit rating agencies (CRAs) is that the rich got richer, while weaker providers continue to struggle adapting to technological and market dynamics.

Each of the CRAs issue an annual report that summarizes past performance and provides a forecast for the upcoming year. With approximately 95% of the world market share for credit ratings, Fitch Ratings (Fitch), Moody’s Investor Service (Moody’s), and Standard & Poor’s (S&P) reports provide a wealth of information which systems and standalone hospitals can use to make meaningful comparisons to financial benchmarks and emerging trends.

Profitability Improvements

One of the key trends noted by the CRAs was the improvement in operating margins for the largest providers realized through a combination of good revenue growth and continued expense controls. Overriding themes are a bifurcated industry with a surge in revenue—largely resulting from Medicaid expansion—combined with efficiency improvements by highly rated providers, while lower rated organizations exhibit stagnant revenue growth.

  • Moody’s reported a 5.2% median annual revenue growth rate, reversing a two-year trend in which expense growth outpaced revenue growth. According to Moody’s, increasing patient volumes contributed to the revenue increase. Moody’s attributed the volume expansion to myriad factors including growth in admissions, outpatient visits and surgeries. Particularly noteworthy was Moody’s observation that outpatient revenues exceeded inpatient revenues for the first time ever. This volume growth is important because the reduction of some limited time revenue enhancements (e.g., meaningful use) and the continued reimbursement challenges imposed as a result of sequestration threaten profitability.
  • All three CRAs note that health care providers are effectively checking expense growth with increased operating efficiencies from value-based purchasing and supply chain management. In addition, further consolidation and affiliations are helping achieve economies of scale that facilitate expense control. Cost containment is also aided by the long-term shift of health care delivery to lower cost outpatient settings. It would be beneficial to the industry to examine continued slowing of expense growth in order to validate the policies and procedures that hospitals adopted over the past few years.
  • Almost two years after the first open enrollment period of the ACA and multiple legal challenges, the extension of health care benefits to millions of citizens has had a positive impact on the financial health of hospitals. First, as expected, the extension of health care benefits coupled with improving economic prospects has contributed to improvements in volume and, therefore, revenues. Second, since hospitals treat any patient who enters their facility regardless of their ability to pay, Medicaid expansion reduces the amount of uncompensated care. To date, 29 states and the District of Columbia have accepted the Medicaid expansion. S&P cited a two-to-one upgrade to downgrade ratio in expansion states versus a slightly less than one-to-one upgrade to downgrade ratio in non-expansion states. The CRAs did express concern regarding the long-term impact facing the industry given expectations of adverse changes in reimbursement rates and possible increases in bad debt expenses resulting from the prevalence of co-pays and high deductible health plans (HDHPs). However, Fitch did state a belief that more states will opt-in to Medicaid expansion in some fashion, noting that the recent Supreme Court decision to uphold federal subsidies provides clarity regarding the long-term viability of the ACA.

Overall, the combined impact of increased revenue growth rates and greater cost controls yielded improved profitability. According to Fitch, the median operating margins for 2014 and 2013 were 3.0% and 2.2%, respectively. Operating EBITDA margins demonstrated similar results.

Improved Liquidity

The overall strength in operating cash flow margins—especially among the largest providers—combined with sound investment returns and relatively light capital spending, contributed to the trend of improving balance sheets. Moody’s noted median cash to debt increased to 151.2% compared to 135% in 2013. Further, the median days’ cash on hand for S&P-rated hospitals increased to 214, which is 41% higher than the same metric in 2009 and 8.3% higher than in 2013.

According to Fitch and Moody’s, capital spending as a percentage of depreciation declined, contributing to an increase in the average age of physical plant. The reduction in capital expenditures generally has a positive impact on liquidity. Given the changes in health care delivery from capital extensive inpatient settings to clinic-based care, this observation is not indicative of an emerging concern at this point. However, existing physical plants require significant ongoing capital commitments in the form of preventative maintenance in order to keep routine upkeep issues from becoming major concerns. While the aging of physical plants has been gradual, it will be important for hospitals to monitor their capital spend to ensure there is not a build-up of deferred maintenance, which could quickly erode the recent increase in liquidity.

Observations and Expectations

All three of the CRAs pointed to the following common themes which contribute to a positive outlook for 2015 and into 2016.

  • Further expansion of covered persons through governmental payors—even in states that have not yet opted into the Medicaid expansion—and other programs
  • All three CRAs observed that risk or value based reimbursement programs have been slow to take hold, but the expectation is that these will accelerate in the next three months. The most efficient providers—who also tend to be the highest rated—stand to benefit most from this trend.
  • Continued efficiency initiatives through increasing use of technology and further consolidation/affiliation, especially where larger systems acquire weaker providers that lack the scale to keep up with the pace of change
  • Volume growth as the economy improves and as patients elect to have deferred procedures

While some of the trends above benefit all providers, it seems that the financial and operating divergence—where the strongest providers improve while the weaker ones struggle—will continue.

The Credit Gap

Despite meaningful improvements in profitability and liquidity across the industry as a whole, lower rated credits continue to lag behind their higher rated peers. The changes observed in the health care industry do not create a “rising tide” scenario. Rather, the emerging trends suggest hospitals may need to “advance to survive” or risk falling further behind their peers.

The most obvious difference of the credit gap falls with operating margins. While operating margins for the ‘A’ and ‘AA’ rating categories improved, Fitch noted that the operating profitability fell in the ‘BBB’ rating category. This observation is a continuation of a trend which started in 2011 and accelerated during 2014 with 11 high performing ‘BBB+’ upgrades out of the ‘BBB’ rating category. Larger organizations have benefited from a diversified revenue base which reduces market risk and strengthens negotiating power with other market participants like payors and suppliers. S&P echoed Fitch’s observations, citing the advantages of large hospitals as key differentiators when compared to smaller providers.

In contrast to recent years, the three credit rating agencies presented optimistic reports in 2015. With strong revenue growth—especially in the higher rating categories—and continued cost containment, rated hospitals generally performed well in 2014. The CRAs point to greater clarity with respect to the ACA, an improved economy and industry trends (consolidation and technology, specifically) as reasons for positive momentum to continue. The sanguine reports are tempered by concerns over reimbursement risk and the observation that the improved medians are not uniform, with the strongest improvements concentrated near the top of the rating scales.

About The Authors

Kyle W. Hemminger
Vice President
2110-A Boca Raton Dr.
Ste. 205
Austin, TX 78747
(512) 327-7400

Kyle W. Hemminger

Vice President

Kyle W. Hemminger is a vice president with Lancaster Pollard, a financial services firm based in Columbus, Ohio, that specializes in providing capital funding to the senior living and health care sectors. He works out of the firm’s Austin office, which covers Texas and Louisiana. In addition to underwriting tax-exempt bond offerings, Lancaster Pollard provides organizations with a complete range of funding alternatives through its HUD-FHA/GNMA/FNMA/USDA-approved mortgage lender subsidiary. It can also provide bridge-to-agency lending, private equity, balance sheet lending and investing, and M&A services. Mr. Hemminger is the primary point of contact for western Texas clients and is responsible for all underwriting and closing process details.

Since joining the firm in 2011, Mr. Hemminger has focused his efforts on the analysis of health care, long-term care and senior living, providing support to organizations on a wide range of bond transactions and mortgage loans for rehabilitation, new construction and refinancings totaling more than $500 million. He has a thorough understanding of financing structures via conventional bond funding as well as HUD-FHA, Fannie Mae and USDA programs.

Mr. Hemminger has a master’s degree in business administration from The Ohio State University in Columbus. He earned his bachelor’s degree in economics from the United States Military Academy at West Point. Mr. Hemminger is a veteran of the Iraq War where he served as a cavalry officer. He holds general securities representative licenses (Series 7, Series 63 and Series 79).

Ritchie Dickey

Ritchie Dickey

Ritchie Dickey, CFA, is a vice president with Lancaster Pollard in Atlanta. He specializes in hospital, senior living and housing finance structures and has completed over $617 million in closed transactions.


Subscribe to The Capital Issue Newsletter
Receive regular email issues with timely insights on financing hospitals, senior living and housing as well as nonprofit investment consulting and financial governance.