Our Sector View Remains Negative

While the deep wounds from the loss of revenues related to the government shutdown of non-essential and non-emergent care may be in the rearview mirror, we believe acute-care hospitals and systems will continue to experience an uneven financial recovery into 2021. Our sector view (previously called a sector outlook) continues to be negative (see "Not-For-Profit Acute Care Sector Outlook Revised To Negative Reflecting Possible Prolonged COVID-19 Impact," published March 25, 2020, on RatingsDirect) as hospitals try to climb back to pre-COVID-19 volumes and margins. Hospitals in most regions are ramping up non-emergent and elective procedures and services, and we don't believe we will see a repeat of the widespread and extreme revenue and margin declines experienced in March and April. Still, over the coming months we expect most of our hospitals to continue treating a baseline level of COVID-19 patients, with additional pressure as regional case rates surge and recede. This unpredictability, coupled with broader economic pressures, may make it difficult for many providers to establish a "new normal," and will lead to a protracted and, in many cases, only partial recovery of lost volumes and revenues. The ongoing and uneven recovery is further exacerbated by existing challenges for the sector that we saw coming into calendar 2020 (see "U.S. Not-For-Profit Health Care 2020 Sector Outlook: A Precarious Balance As Evolution Continues," Jan. 9, 2020).

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We will continue to take a measured approach to credit ratings and still believe many of our credits--particularly those with strong business positions, healthy reserves, and proactive and disciplined management teams--should be able to weather this pandemic at their current rating. That said, and in line with our sector view, our year-to-date downgrades are higher than upgrades, and a sizeable percentage of our acute care sector credits have a negative outlook which is a shift compared to the outlook distribution in recent years. If ongoing surges and waves of COVID-19 patients generate more than expected pressure on financials, particularly over a longer period, there could be additional rating or outlook pressure for more credits. The combination of existing pressures going into the pandemic and the additional impact of COVID-19 on credits is also widening the credit quality gap. We believe that strong and highly rated credits will be better positioned to continue to execute on their strategies and investments once the COVID-19 situation stabilizes. We will also be monitoring covenant violations, particularly for credits with financial profiles that were weak coming into the pandemic. However, to date, largely due to federal stimulus grants we have not seen a significant number of covenant violations but this could become an issue for certain credits through the remainder of 2020 and into 2021. We further note that for many rated credits, a first-time technical violation would not result in acceleration of debt. Additionally, we've seen updated legal documents for several issuers that have revised the financial covenant language to ensure a one-year financial covenant violation doesn't lead to either a technical violation or event of default.

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Volumes returning, though COVID-19 waves may slow recovery

Volume trends through the early part of the recovery (May and June) have generally been favorable in many parts of the country; however, the question remains as to whether pent-up demand has been driving early volume rebounds and how COVID-19 waves, surges, and patient behavior will affect that trajectory over the remainder of this year and into 2021. As of July, procedural volume had generally reached between 70% and 90% of pre-COVID-19 levels for many providers, with a few providers even indicating that procedures are at pre-COVID-19 levels already. Specialty clinic visits continue to trend upward with diagnostics and lab volumes a little more mixed; certain volumes like emergency room visits and primary care visits are still lagging. While certain urgent services can't be put off, diagnostics and other preventative services could be delayed, thus possibly resulting in more complex and expensive services down the road. We expect an uneven volume recovery over the coming months, with variation by region, acuity, and service line.

Health professionals have also learned how to treat and manage COVID-19 patients better than at the start of the pandemic and these ongoing learnings could further reduce the length of stay as well as the costs of care for COVID-19 patients. We also note that these learnings, as well as better access to supplies, have allowed many providers experiencing recent surges of COVID-19 patients to continue to offer elective procedures and safely remain open to non-COVID-19 patients. Still, appropriate processes for testing and moving patients through the hospital could create certain inefficiencies and slow throughput with a backlog of volumes continuing through the next couple of months. Additionally, the diverse responses of state and local governments with regard to social distancing requirements, mask mandates, and shutdown of businesses have affected local COVID-19 volumes. We anticipate that smaller surges could continue for the remainder of 2020, particularly if some cities and regions open schools this fall. This will, in turn, require beds, equipment, and staff to treat COVID-19 patients in affected regions, and may dissuade other members of these communities from consuming elective care. Testing capacity and tracing capabilities of different areas, along with state and local oversight, may also affect the ebbs and flows of COVID-19 volumes. Finally, certain regional economies have been particularly hard-hit by the pandemic and related recession, and these areas may see a longer-term depression in patient volumes.

Reimbursement shifts and COVID-19 related expenses compound existing challenges

Reimbursement pressure was elevated going into 2020 with ongoing shifts to Medicare from commercial payor mix due to the aging population. With the recession and increased unemployment as well as possible state budgets cuts, reimbursement could further weaken for many providers (see "The U.S. Faces a Longer and Slower Climb From the Bottom," June 25, 2020; "A Recovery At Risk As COVID-19 Surges," July 22, 2020; and "U.S. States Mid-Year Sector View: States Will Continue To Be Tested In Unprecedented Ways," July 13, 2020). As individuals lose their commercial insurance through unemployment, they may shift to Medicaid, an exchange product, or even forgo insurance, which could weaken reimbursement and also increase bad debt expense. Those that are unemployed and uninsured or underinsured with high deductible plans may also delay health care services given their inability to pay while out of work.

Providers have been trying to control rising expenses for a number of years, but COVID-19 has resulted in certain new expenses, some of which likely need to be built into the operating base. These expenses tend to be incremental in scale but nonetheless are detrimental to margins and cash flow. The following key areas may continue to cause operating pressures:

• Accessing and using more personal protection equipment (PPE) at higher costs and broadening and diversifying the supply chain;
• Increased testing capacity to maintain safety and health of employees and patients;
• Slower throughput due to testing protocols and social distancing measures; and
• Maintaining adequate staffing with increased demand by frontline workers for health and safety benefits.

Resiliency, essentiality, and federal grants supporting year-to-date recovery

Despite the challenges wrought by the pandemic, we believe there are underlying strengths that continue to support many of our credits. As noted by the strong response when hospitals reopened, pent-up demand for needed services supported the initial volume recovery. We recognize that the demand could slow over the next several months for health and safety reasons, but the initial volume recovery also highlights the essentiality of hospital services that should continue to aid recovery through 2020 and into 2021.

Strong management teams and stable governance have played an important role for hospitals and health systems in weathering this pandemic. While safe and sustainable volume recovery remains a central area of focus, management teams have also doubled down on controlling expenses with both temporary and permanent expense cuts. Although temporary furloughs went into place in the spring, management teams have been careful with staff cuts, especially for areas that may be difficult to recruit or may have faster volume recovery. That said, teams are looking carefully at various programs and areas and where appropriate are rightsizing staffing. We note that those hospitals with strong functioning management teams often already have a carefully laid out strategy and a culture of improvement and performance, and will likely be able to react and be more flexible at this challenging time. Those credits that remain strong continue to look at implementing strategies and investing in capital and clinical services and programs, which we believe sets them up for success when COVID-19 subsides or stabilizes hospitals at a new normal.

Federal stimulus grants have also softened the blow of the revenue and volume declines as approximately $175 billion has been allocated to providers through various legislation (with about $115 billion distributed thus far, and the majority going to hospitals and health care systems). This has been helpful to many providers, and unallocated funds could address some, but perhaps not all, of the future challenges discussed above should volume and revenue recovery remain uneven for an extended time.

Recent financials partially supported by federal stimulus, but medium term view remains cloudy

We are likely to see lower margins and cash flow for the rest of the year, but the extent of those depressed margins and cash flow will depend on sustaining volume recovery, management actions to control or reduce expense, and potential additional federal support. Financials for the second calendar quarter show initial signs of recovery for many providers due to both volume recovery and federal stimulus fund grants described above; however we don't believe that picture necessarily indicates future performance. As S&P Global Economics assumes an effective vaccine doesn't become available until sometime in the second half of 2021, we believe that longer-term financial recovery is likely to be unpredictable given the reimbursement and expense pressures highlighted above and including the potential surges and waves of COVID-19 that could slow the non-COVID-19 volumes. Many management teams are not expecting their volumes to return to pre-COVID-19 levels by the end of the year. Congress is considering additional stimulus funds, which would certainly be helpful to offset lower cash flow margins that we are likely to see through the rest of this year and early 2021. Meanwhile, management teams are looking to reduce expenses with a near-term focus on temporary and permanent reductions as well as strategic considerations for the business such as service line rationalization and a smaller physical footprint.

Coming into the pandemic, balance sheets had generally been a source of strength as investment markets were healthy and management teams balanced reserves and debt with needed and strategic capital investments. With the stress in the spring, many of our rated providers either had enough in reserves or accessed liquidity through lines of credit and Medicare advance payments (MAP) to manage near-term cash flow challenges. We continue to monitor credits with weaker underlying reserves (excluding lines of credit and MAP funding) as we believe these types of credits are more vulnerable to prolonged stress given their limited balance sheet cushion. We understand that some providers may ultimately convert short-term debt into longer-term obligations, driving up long-term debt and associated metrics. We also note that repayment of MAPs could have a credit impact, particularly as providers whose Medicare volumes have not rebounded to historical levels may need to repay that shortfall out of reserves. At the end of fiscal 2020, balance sheets will likely be weaker across all rating categories when compared with fiscal 2019. Given a healthy starting point in early 2020 for many, we believe most credits, particularly those in higher rating categories, can sustain some diminishment in unrestricted reserves, but this flexibility is limited, especially if coupled with multi-year revenue pressure, inability to adjust expense base, or a high debt load.

While we have not seen a dramatic increase in new money sales, approximately 8% of our credits have issued new money since March (taxable or tax exempt) generally to add financial flexibility should cash flow remain under recent years' levels. The initial wave of issuances was largely from highly rated credits, but as the pandemic has progressed, we have seen new money issuances from credits across the rating spectrum. Teams are postponing capital spending until COVID-19 stabilizes to manage reserves, but many have continued to complete inflight projects. Larger strategic projects are still in active discussion for most credits, but may be on momentary pause. We note that many credits are also preserving capital to be prepared in the event of opportunistic acquisitions or strategic investments over the coming year. If organizations don't feel they can adequately invest in capital and technology to remain healthy given the recent financial stresses, we believe that some historically independent organizations may reconsider the benefit of affiliation or acquisition after having endured the first wave of the crisis.

Not all credits are evenly affected by the pandemic

The pandemic is negatively affecting all the credits we rate to varying degrees; however, we feel that this crisis will further widen the gap between the strong and the weak. Compared to recent years, we note the increased percentage of negative outlooks, including our multi-credit rating action in April that affected speculative grade hospitals and those with less than 100 days' cash on hand (see "Outlooks Revised On Certain U.S. Not-For-Profit Health Care Organizations Due To Potential COVID-19 Impact," April 21, 2020), which has largely affected weaker credits as well as stand-alone hospitals (see charts 1-3). Broadly, downgrades have outpaced upgrades (see chart 4). We've had a few downgrades in the 'AA' and 'A' categories, with slightly more downgrades in the 'BBB' and below category. Those that had challenges coming into the pandemic, regardless of credit rating, have experienced more rating or outlook pressure. Those credits that came into the pandemic from a position of strength, with solid business positions and enterprise profiles and with healthy reserves, have held stable and would likely need to experience prolonged margin and cash flow stress and weakening balance sheets before we would consider a rating action. Overall, our ratings distribution has not changed materially as most of the actions taken thus far have been on outlooks (see chart 5).

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Certain credit characteristics have proved valuable for weathering the pandemic. We have observed that integrated providers with health plans have had a natural hedge against provider-based acute-care losses, given that insurers have done well through 2020 as medical use rates are much lower. Credits such as Kaiser Permanente and Intermountain Health have been challenged, but not to the extent of organizations that exclusively provide patient care services. Credits that provide tertiary and quaternary levels of care may also be able to weather this storm more comfortably, as they generally provide care and services that are higher acuity and cannot be delayed.

Credits with weaker overall financial profiles, particularly lighter unrestricted reserves or high leverage, may have limited flexibility to navigate through a prolonged period of operating stress. We note these credits typically also have less access to capital markets, and may not be able to tap lines of credit or other liquidity facilities if needed. Smaller providers and those with less sophisticated technology infrastructure may also struggle to effectively flex expenses in response to rising and falling patient volumes. Finally, we note that many organizations that provide a meaningful amount of lower-acuity services generally rely on emergency room visits for a large portion of their inpatient volumes. For most providers, emergency department volumes have not rebounded significantly from the lows of March and April, and hospitals that depend on those patients will likely suffer more acute long-term pressure.

As providers learn to co-exist with COVID-19, management teams are revisiting their broader strategic platforms to ensure long-term financial strength and credit stability. The pandemic has reaffirmed many initiatives, but has also forced leadership to re-think many aspects of the hospital operating model. We anticipate an acceleration of certain strategies, including:

• Expansion of telemedicine services and related digital platforms;
• Development of care-at-home and hospital-at-home models;
• Re-consideration of the ambulatory and administrative footprint, as more services are now being performed remotely; and
• Diversification of supply chains, particularly for personal protective equipment.

We expect credits with sophisticated management teams and relative financial flexibility to be more successful in furthering these strategies over the coming years, which may further widen the already existing credit gap.

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