The U.S. health care industry is showing signs of recovery from the COVID-19 pandemic. Reports of increasing elective surgery volumes will have a stabilizing, if not yet positive, effect on hospitals and related health care service providers and medical product suppliers.

The nondiscretionary, defensive nature of health care helped insulate the industry from an even worse downturn and negative impact on ratings, compared to other more vulnerable industries, such as leisure and retail. This is also a key reason S&P Global Ratings expects health care demand to recover more quickly than other industries'. However, we expect sector ratings quality to continue to deteriorate. The industry already faces increasing challenges, and the impact of COVID-19 only weakens its hand and raises uncertainty.

Health care will also face challenges from unprecedented unemployment, which could lead to payer mix shift from commercial to less-profitable government sources, as well as higher uncompensated care from uninsured patients.

Getting Healthy, But Ratings Will Still Struggle

U.S. health care is in the early stages of its post-COVID-19 recovery.   We expect very limited negative rating actions in the industry due to the pandemic. This compares to 28 negative actions in an early three-week period. There are signs of recovery in the industry, such as the gradual increase in elective surgical procedures and reopening of offices in the hard-hit dental service organization subsector.

Ratings recovery will be uneven.   This is similar to the impact from COVID-19 on the industry, with 72% of our negative rating actions concentrated on nine of 25 health care subsectors (Table 1). We expect the recovery from a business and ratings standpoint to be uneven as well. The pace will largely depend on each company's service lines and geographic exposure, though we project the majority of subsectors should be back on pace from a credit metrics standpoint by the end of 2021 or middle of 2022.

Business and competitive positions remain intact short term, but the long-term picture is murkier.   For the majority of companies, we believe post-pandemic business should return relatively quickly to normal and that market shares and competitive positions will remain largely unchanged. Longer term, however, we are concerned with accelerated industry shifts brought on by the COVID-19 pandemic (e.g., telemedicine) and mergers and acquisitions (M&A) that may have implications on companies' competitive positioning.

Our view of the sector outlook is a return to (still) negative.   U.S. health care ratings as a group have held up relatively well versus other industries, such as retail and oil and gas, given the sector's largely nondiscretionary nature. But even as we expect more companies with ratings on CreditWatch with negative implications or with negative outlooks due to the COVID-19 pandemic to begin turning toward stable, our industry ratings outlook remains decidedly negative. This is due to continued pricing pressures from payers, legislative scrutiny, ongoing disruption, and high leverage from M&A.

Unprecedented high unemployment will be a wild card.   Health care is typically defensive and noncyclical. But U.S. unemployment has reached recent record lows. With U.S. health care coverage closely tied to employment, as well as the already ongoing trend of consumers paying a larger portion of medical and dental costs out of pocket, there may be higher uncertainty in what is traditionally a relatively predictable industry.

All Clear? Tentative Post-COVID-19 Prognosis

The COVID-19 pandemic has entered into its 15th week (the World Health Organization declared the outbreak a pandemic on March 11, 2020). A steep dive in elective medical procedures and hospital patient volumes (emergency room visits dropped by 42% in the first five months of 2020 versus the prior year, according to a recent report by the U.S. Centers For Disease Control and Prevention) contributed to 46 negative rating actions in the U.S. corporate health care sector. But we are seeing early signs of recovery in terms of patient volumes, with no rating actions related to COVID-19 in the past four weeks after peaking in the week of March 30-April 3 (Chart 1). Furthermore, of the last three rating actions, two were positive, stable rating outlooks from CreditWatch negative listings. We expect more positive actions in the near future, absent a potential second wave of coronavirus infections, as states gradually reopen their economies and previously delayed medical procedures slowly return.

Chart 1

The essential nature of health care somewhat limits the operating and ratings impact from the pandemic, with the sector consistently in the middle of the pack versus other industries in terms of rating actions. Thus, the relatively quicker recovery in demand versus other industries, such as airlines and retail, is not surprising.

Chart 2

Ratings Impact Was Uneven, And Recovery Will Be Similar

Just as the COVID-19 ratings impact was uneven (Table 2), concentrated in subsectors reliant on more discretionary/nonurgent health care (e.g., dental and orthopedic surgeries), the recovery will be also be uneven. It will depend on companies' service line and geography, as some parts of the U.S. economy reopen quicker than others.

Table 1

The key to the recovery will be how quickly and strongly elective surgeries return, as they are typically higher-margin procedures for hospitals with a domino effect on medical staffing companies, physician groups, and outpatient surgical centers. We also believe the recovery will more gradual, given what we expect will be some reluctance of patients to return too quickly despite the lifting of stay-at-home precautions. For some subsectors, such as dental and physical therapy, given the relatively lower acuity and close contact between provider and patient, there could be further delays in recovery.

Table 2

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We want to note that while it was quiet on the ratings front for health care from a pandemic viewpoint, there could be further negative rating actions. However, we believe they will most likely be in the higher-risk categories and more due to individual company situations.

Longer-Term Outlook For Credit Metrics

No health care subsector is unaffected by the pandemic. Even industries such as branded pharmaceuticals, which we categorize as low risk, was hurt mostly through disrupted research and development, clinical trials, and promotional activities. Thus, financial metrics, especially for more affected industries such as dental, physical therapy, and physician groups will be weak for the ratings. In our modeling, we do not exclude the impact from COVID-19. However, we are taking a longer-term view of when companies' credit metrics are back in line with our respective ratings. The general guidance on the outlook time frame for speculative-grade ratings, which make up 60% of our rated health care universe and have taken 42 of 46 pandemic-related negative rating actions, is one year. For affected companies, we will likely look forward 12-18 months as to when credit metrics will materially return to 2020 projected levels, consistent with current ratings. Assuming a mid-year 2020 recovery for health care demand, which depends on service line and geography, we expect the majority of credit metrics to be materially restored at the end of 2021. Companies we project will not restore credit metrics until beyond 2021 have a higher chance of a downgrade or remaining with a negative outlook.

To estimate the timing of a recovery, we looked at the 25 subsectors and highlighted the time frame we believe they should essentially achieve the financial credit metrics we modeled for full-year 2020. We attempt to answer the question, how far off pace has each subsector been pushed by the COVID-19 pandemic?

Table 3

Theoretically, there could be a greater-than-normal burst of activity in the second half of 2020, as patients return en masse and companies work through their backlog of procedures. For example, hip and knee replacements delayed during the pandemic will be quickly rescheduled and procedure volume higher than normal, limited only by the capacity of surgeons and facilities. However, we do not assume a higher-than-normal level of procedures during the recovery period until 2021.

Business And Competitive Positions Are Unchanged ... For Now

In our 46 negative rating actions, we made no changes in market share or competitive position assessments. We do not expect to in the near term (Table 3). We believe as previously delayed procedures are rescheduled and backlogs worked down, market shares will remain stable and patients will for the most part return for procedures done at originally scheduled facilities. On the pharmaceutical front, new patient starts may be affected, as pharmaceutical companies' promotional activities are disrupted. We assume all companies have been equally disrupted, and prescribing patterns should not materially change. The vulnerability is that if this pandemic continues, the chance of changes in competitive positions increases. However, for now, S&P Global Ratings is not assuming material changes in competitive positions and business risk profiles.

Longer term, we have two major concerns that may result in negative changes to competitive position. One of our key questions is what happens to M&A in the industry. There was high of consolidation in health care, companies seeking the benefits of size, scale, and synergies to offset increasing pressures from the major managed care payers that also merged in the past several years. A number of companies we rate are private equity-owned and highly leveraged, with business models reliant on aggressive expansion via M&A or de novo strategies. (see "Private Equity-Backed Investor Interest In Health Care Has Taken A Toll On Ratings", published March 2, 2020). Financial capacity originally earmarked for aggressive expansion may have been used instead to fund operations during the pandemic shutdown. The inability to conduct M&A, especially if rivals resume their previous pace, may have negative implications for their competitive positions. Pushing already-high leverage higher to support M&A also increases ratings risk.

The second major concern is the acceleration of ongoing changes in health care. Pre-pandemic, the industry was already undergoing an unprecedented wave of disruption (see Industry Top Trends: 2020, published Dec. 13, 2019) on several fronts: technology (e.g., telemedicine, value-based care, gene-based therapies, telemedicine), payers (e.g., CVS Health Corp. and Aetna Health Holdings LLC merger), and potential legislative changes. For example, telemedicine usage, which was already penetrating the market, has increased significantly during the pandemic, as patients could not or were reluctant to go to medical facilities. What does this mean for health care providers dependent on patient volumes? These two developments could impair issuers' business risk/competitive positions--and most likely lead to negative rating actions.

Supply Chain Impact Is Limited, But Changes Are Likely Coming

The pandemic's impact to the supply chain has been relatively muted versus other industries. There were major headlines on potential stock-outs of key pharmaceuticals and active pharmaceutical ingredients (APIs) for the manufacture of drugs, as well as very real stock-outs of medical equipment (ventilators), personal protective equipment (PPE), and diagnostic tests. But none resulted in significant financial impact or negative rating actions. China and India manufacture a large number of APIs. However, the pharmaceutical industry typically maintains 5-6 months', if not more, of raw materials on hand. Pharmaceutical manufacturing facilities are also very tightly controlled environments and seen as essential, and there were no major manufacturing site shutdowns. Medical equipment and supplies, however, had inadequate manufacturing ability and lack of safety stocks to meet the unprecedented increase in short-term demand.

We expect companies to rethink manufacturing and supply chains, including relocating sites to the U.S. With U.S. tax reform, there is less reason to base manufacturing sites offshore in tax favorable sites, such as Ireland and Puerto Rico. However, this is a longer-term development, given the lead time needed in relocating manufacturing, as well as the time, expense, and regulatory approvals needed. In the shorter term, working capital uses could rise across the industry, given prudent increases in safety stocks of key ingredients and on-hand inventories of medical supplies. Thus, there could be increased capital expenditure and working capital needs for health care issuers, as well as some margin pressure as companies transfer manufacturing away from lower-cost China and India.

A Return To A (Less) Negative Industry Outlook

Of the 46 negative sector rating actions during the pandemic, 30 were outlook revisions to negative and CreditWatch negative listings. This increased the percentage of rated health care firms with a negative bias to 39%, from 23% at the end of 2019 and 16% from the end of 2018.

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With the prospective recovery, our view of the industry outlook will improve. However, we want to emphasize this remains firmly negative and will likely be even more so compared to before COVID-19. Industry credit ratings have deteriorated the past three years, due mainly to a combination of pricing pressure from newly merged payers, heightened leverage due to increasing M&A activity among both investment-grade pharmaceutical issuers and private equity owned speculative-grade services companies, and the accelerating pace of industry innovation and disruption from developments such as value-based care, biosimilars, and gene-based therapies. This has not changed. But the industry is now operating in an environment with record unemployment.

Chart 6

Over half of the people in the U.S. obtain health care coverage through their employers. While there are public payers, such as Medicaid and through the Affordable Care Act, reimbursements are generally lower. Furthermore, patients are shouldering increasing out-of-pocket expenses and household budgets will still be squeezed. The industry, especially speculative-grade issuers in subsectors most affected by the pandemic, will face these increased challenges with weaker balance sheets and financial flexibility. Thus, while we will see an improvement from the 39% negative industry bias, as COVID-19 driven outlook revisions to negative and CreditWatch negative listings reverse, we believe credit quality will continue to deteriorate, possibly at an accelerated pace, in 2020 and beyond.

Table 4

Related Research

• U.S. Health Care Staffing Companies See A Rough Road To Recovery, Filled With Detours, Risks, and Behavioral Changes, June 18, 2020
• Health Care Leveraged Finance: Condition Leans Negative, But CLO Exposure To COVID-19 Is Largely Balanced, June 8, 2020
• A Bumpy Recovery Is Ahead For Hospitals And Other Health Providers As Non-Emergent Procedures Restart, May 26, 2020
• COVID-19: The Road Ahead Is Bumpy As The European Health Care Sector Recovers, May 19, 2020
• The Health Care Credit Beat: Growing Health Care Ratings Contagion From COVID-19, April 15, 2020