Issue 9--April 15, 2020

The continued spread of COVID-19 cases in the U.S., more uncertain capital market conditions, and the specter of a prolonged recession have all contributed to the growing negative ratings sentiment for corporate health care ratings. S&P Global Ratings has taken 29 COVID-19 related negative rating actions thus far, though only eight were downgrades, with the balance being negative outlook revisions and CreditWatch negative listings. However, as the effects of the pandemic continue, we expect to see more subsectors affected and the potential effects to be more severe and longer term, leading to more downgrades and negative outlook revisions. Our ratings outlook for the rated health care industry in corporates was already negative coming into 2019, with 23.9% (48 out of 201, or close to one out of every four) companies with a negative outlook or on CreditWatch with negative implications, up from 15.6% in 2018 (28 out of 179). With the ongoing pandemic, the portion of corporate rated health care credits has risen to 33%. Meanwhile, the industry continues to face pricing pressure, technological and payor disruption, legislative scrutiny around ever-growing health care spending, and increasing merger and acquisition (M&A) risk. All this against a backdrop of the U.S. Presidential election, where health care spending is a top election issue, means that health care industry ratings were likely going to further deteriorate in 2020. (see "Industry Top Trends 2020: Healthcare," published Nov. 19. 2019).

The COVID-19 pandemic accelerates this downward slide in ratings. Health care, given the mostly nondiscretionary nature of its products and services, has faced fewer repercussions than other industries (such as retail and travel) from an operating performance and ratings perspective. Still, the environment remains fluid and uncertain. While the majority of our rating actions have been negative outlook revisions and negative CreditWatch placements, and have been largely concentrated in a number of subsectors, there will likely be more downgrades and more subsectors impacted.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession. See our macroeconomic and credit updates here:

www.spglobal.com/ratings.

As the situation evolves, we will update our assumptions and estimates accordingly.

Health Care Heat Map: The 25 Subsectors

We have divided health care into 25 subsectors and highlighted which we believe are more exposed to deteriorating credit quality, focusing on five major concerns: a drop in patient/procedure volume, a major operational disruption, exposure to supply chain disruption, inability to access capital markets, and, longer term, exposure to a prolonged economic downturn. We characterized each subsector by the level of discretion (that is, the ability to be delayed), acuity (higher levels means more unlikely to be delayed), and cost structure (the ability control costs in downturn).

High level of risk: Near-term impact, potential liquidity concerns

Example: Dental, physical therapy  Social distancing mandates, discretionary procedures, typically low acuity, and highly leveraged balance sheets across the board: subsectors in this category are the most vulnerable to the COVID-19 pandemic in terms of creditworthiness. Also, in many instances, companies in this category may not have sufficient liquidity to weather a prolonged period of very low revenues. Furthermore, for many companies there is no pent-up demand or only limited backlog. For example, dental cleaning appointments that are cancelled are not going to be made up and patients will just wait for the next cleaning. Patients do not necessarily double up on physical therapy to make up for missed sessions. Business volume may return quickly post-pandemic, but lost revenues and cash flows are not recaptured, and lower-rated, highly leveraged companies may not be able to afford to lose the business.

For staffing companies and physician groups, reliance on patient and procedure volume at hospitals and outpatient surgical facilities leaves earnings at significant risk. Patient volumes and discretionary surgical procedures have declined as hospitals conserve resources for potential COVID-19 cases and patients defer discretionary procedures. Business will return, as procedures are delayed, not cancelled, and certain procedures can only be delayed for so long. The degree of the negative impact will depend on a physician group's mix of specialties. For example, anesthesiology groups will see a larger impact.

Some staffing companies (particularly nursing) may benefit from the increased demand during the outbreak, but others will see a decline in demand as non-COVID-19 related procedure and patient volumes drop. The cost structure are likely not as flexible, as the staffing companies will need to keep doctors and nurses on payroll. Also, the disruption from the pandemic comes at a time when the staffing companies--Envision Healthcare Corp., Team Health Holdings Inc., and MEDNAX Inc. included--have had to deal with a payor, UnitedHealth Group Inc., aggressively cutting reimbursement rates to the staffing companies. These recent significant cuts have reduced staffing companies' capacity to deal with increased potential uncertainties.

Moderate/High level of risk

Example: Hospitals, orthopedic devices / CMOs  Subsectors in this category are also challenged by a drop in procedure and patient volume, but not to the extent of the high category. This is primarily because procedures are postponed, not cancelled, and we expect volumes to return relatively quickly. For example, the national postponement of discretionary, nonessential procedures in order to ration personal protective equipment (PPE), staffing, and facility capacity for the surge of COVID-19 patients has resulted in a large decline in overall patient volume to hospitals. Fear of going to hospitals, including emergency rooms, contributes to the declines. While there has been a steep decline in a short time, we expect some recovery because certain procedures, such as cardiology and oncology, cannot be delayed for too long. In addition, hospitals are significant beneficiaries of the CARES Act, which should support liquidity over the near term. While a small portion of the delayed business may not return because of newly unemployed people losing their health insurance or people seeking other alternatives, we expect the large majority of the delayed procedures to return as pent up demand.

The drop in non-urgent surgical procedures, such hip and knee replacements, has led to delayed demand of medical devices and products, especially for the orthopedic implant manufacturers and their contract manufacturing companies (CMOs). The drop in demand will hurt the CMOs more than the medical equipment companies, given potential slowing orders for an industry that has high fixed costs and was already under pricing pressure from the large medical device companies. The slowdown in orders will be gradual, and dependent on each company's client and product mix, but as the pandemic extends, the decline in orders could be steep.

We believe this group of companies will ultimately return to their pre-COVID-19 level of business, though it's likely to take some time. Hence, the greatest near-term challenge is liquidity.

Moderate level of risk

Example: Medical devices, laboratories  More discretionary, lower-acuity procedure volume has declined, and it has had a far reaching, multi-subsector impact. For example, when a hip or knee replacement is rescheduled, not only do hospitals and surgery centers lose the volume but anesthesiologist and radiologist groups are negatively affected, as well as the orthopedic implant companies. Laboratories may see an increase in COVID-19 testing, but have also experienced a significant decline in routine testing and testing related to discretionary procedures. The impact to the medical device companies will be uneven, depending on the mix of each company's product lines. We believe business volume will return fully post-pandemic, but it may take some time as surgery procedures have to be rescheduled and surgery centers and physicians may have capacity constraints. Companies that have limited cushion at the current ratings, including investment-grade companies, may see downgrades if their credit metrics weaken too much for too long.

Moderate/Low level of risk

Example: Lifesciences, dialysis  We see limited ratings impact in this group. The nondiscretionary nature of procedures like dialysis or products like pharmaceuticals won't change because of COVID-19. However, there are potential operational consequences, such as supply chain vulnerabilities (generic pharma) and, longer term, lower profitability should there be a significant shift in payor mix due to increased unemployment (dialysis providers; see "DaVita Inc. Rating Under Pressure On COVID-19 Impact; Financial Policy Will Be Key," published April 13, 2020). Companies in this category, such as lifescience companies, will also see an impact on demand, though it will come down to each company's mix of diagnostics and lifescience revenues. Companies with a higher level of exposure to academic and government research will be hurt more, given the near shutdown of lab research activity. Also, companies with a higher mix of hardware sales will face postponed purchases by customers. Consumables used in diagnostic testing, such as for medical procedures and environmental testing, would also see decline. Meanwhile, sales to the pharmaceutical and biotech industries for research and development (R&D) and manufacturing should remain solid and there could be increased demand for select products due to increased COVID-19 testing. Still, business should resume quickly post COVID-19 pandemic, and given the solid liquidity and largely investment-grade profiles for the rated lifescience universe, we do not envision any widespread negative actions in this subsector.

Low level of risk: Limited impact to demand, operations, and ratings.

Example: Pharmaceutical  This category is characterized by health care products and services that are nondiscretionary and their delivery is largely unaffected by the pandemic, such as pharmaceuticals. We see very limited impact to the pharmaceutical industry, given that pharmacies remain open and there are alternate methods, such as home delivery and mail order, for obtaining prescriptions (see "Pharma Industry Only Moderately Affected While Helping Mitigate COVID-19 Pandemic Impact," published March 16, 2020). Telemedicine will also aid patients in getting new prescriptions. Still, even subsectors in this category will be pinched, particularly pharmaceutical marketing and R&D operations. However, companies in this category are relatively best positioned and we expect very limited, if any, negative rating actions in these subsectors.

Rating Actions

Over the past three weeks we've taken 29 rating actions in U.S. health care corporates for which COVID-19 was a factor. The actions have mainly been concentrated in outpatient surgical, physical therapy, and dental and dental products, areas that have seen an immediate drop in volume due to the pandemic.

Table 2

In The Specter Of A Prolonged Recession, Health Care Is Still Defensive

Despite the nondiscretionary nature of many of its products and services, the industry remains defensive. However, public and legislative scrutiny on health care costs are again a leading issue in a U.S. Presidential election, and the specter of recession increases the scrutiny. Per S&P Global economists, the U.S. has fallen into a recession and the toll on U.S. GDP will more severe than we thought, with contraction in the first quarter worsening substantially in the second (see "It's Game Over for the Record U.S. Run; The Timing of a Restart Remains Uncertain," dated March 27, 2020). Health care costs account for a growing portion of GDP (17.8% in 2019) and, given the predicted drop in GDP, will account for an even larger portion this year, drawing further attention. The rising unemployment rate, and the resultant change in payor mix, further add to the uncertainty. Thus, we believe the industry is more vulnerable to major changes, such as driving payors to become more aggressive in lowering costs (such as UnitedHealth's recent moves to cut reimbursement rates to staffing companies; see "The Health Care Credit Beat: What Will Be The Next Target Of UnitedHealth Group's Contract Termination Spree?" published March 4, 2020) or increasing the likelihood of legislative changes (such as balance billing legislation).