The European health care industry enjoyed a temporary respite during the summer and early autumn from the worst effects of COVID-19. Scheduled surgery and medical consultations resumed, although for many providers at levels still below those of 2019. From September, however, COVID-19 infection rates have spiked again in many European countries, and governments are restricting nonessential business and travel and hospitals are reactivating protocols to cope with COVID-19 patients. Taking that into consideration as well as recent financial disclosures from health care companies, we have updated our views about the shape of the recovery for European health care operators. We now see a recovery to normal operations for the middle of 2022, compared with our May projection for the end of 2021 (see "COVID-19: The Road Ahead Is Bumpy As The European Health Care Sector Recovers," published on May 19, 2020). First, we sum up our view of the industry, and then indicate where we think it's headed in the next six to 12 months.

Current state of the industry: Resilient with unchanged fundamentals, though many businesses are catching up rather than returning to 2019 growth

• For the first nine months of 2020, we observe that COVID-19 has taken less of a toll on operating and financial performance than we assumed at the outset of the pandemic, although with marked differences across the industry.
• Parts of the health care sector were hit harder than others, namely products and services associated with elective surgery, products and medicines reliant on new hospital admissions, and those administered in hospital settings.
• Nevertheless, even the most exposed companies reported lower revenue declines, in the low single digits for the third quarter, compared with double-digit declines on average in the second quarter.
• Hospitals and nursing homes benefitted from assistance programs provided by governments, compensating for lost revenues or higher costs (although the full extent of COVID-19 associated cost reimbursements in France remains unclear). In the U.K., the government also stepped in and reimbursed dental chains' lost revenues due to imposed closures at the levels of 2019, limiting the drain on cash flow.
• The performance of laboratories was higher than our previous base case due to substantial demand for COVID-19 testing that was higher than we expected. We also note that specialty testing proved more resilient and the rebound in routine testing was quick overall, although varying across countries.
• Pharmaceutical companies, including generics, were the best-performing segment, with most reporting continuing underlying growth, despite some quarterly volatility. There were exceptions for drugs that can be administered only in hospitals, or where treatment could be deferred, which recorded lower or declining sales at the peak of the pandemic, but most saw a reversal of the trend from June.
• Companies were able to cut parts of their operating costs relatively quickly, although most decided not to alter their cost structure beyond travel and marketing expenses. We saw little reduction in spending on research and development, sales teams, and cost of goods, as companies are still expecting a recovery next year.
• Labor-intensive sectors, namely health care and social services, incurred additional COVID-19-related costs for items like protective equipment, tests, or agency costs to cover absenteeism. In addition, some companies rewarded their staff with bonus payments. As a result, margins dropped for the most exposed sectors.
• Working capital was managed better than our initial assumptions as companies focused on cash collection, with only a few providing more favorable terms to their customers and some supporting their suppliers. Inventory levels increased for manufacturers but remained well managed.
• Liquidity remained healthy with less recourse to revolving credit facilities than we assumed. We saw no breached covenants, although some companies negotiated new covenants with a switch from leverage maintenance to minimal cash balances.
• Only a handful of listed companies decided to cancel, postpone, or reduce dividend payments, citing long-term growth prospects as the main reason for unchanged capital allocation polices, despite lower 2020 profits.
• Acquisition activity remained relatively muted among investment-grade companies, with only some bolt-on transactions concluded. Speculative-grade companies were more active, with private equity owners taking advantage of favorable market conditions and the perception of the resilient nature of the sector. We recorded several takeovers of companies. For instance, Permira acquired European CNS specialty pharma group Neuraxpharm from Apax Partners, KKR bought French private hospital ELSAN, and EQT and CDPQ Infrastructure combined resources in taking over France-based nursing home operator Colisée. These transactions did not increase leverage significantly. We also saw high levels of activity in the generics sectors, with companies like Cheplapharm closing several all-debt funded deals with nearly €1 billion of new debt raised in October 2020. Other transactions observed were the fund-to-fund transfer of Curium Midco Sarl from CapVest Fund III. CapVest Fund IV, along with third-party investors, undertook a secondary leveraged buyout of the nuclear medical imaging group, increasing the group's overall debt and delaying its deleveraging plan.

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Where the industry is headed in the next six-12 months: We see stagnant growth at best for most subsectors before a return to sustainable pre-pandemic levels of growth by 2022.

Our assumption of a gradual recovery still stands, but we've pushed the window out further, owing to greater hesitancy about the phasing out of government support, and the toll that new medical protocols are taking on the management and operations of medical facilities as industry and regulators are grappling with a second wave of the pandemic, overlaid with a seasonal uptick in respiratory disease and influenza. The situation should improve through the summer months of 2021, once vaccines and improved treatments result in a reduction in hospital admissions and stays. Once COVID-19 is perceived as a more manageable and predictable medical condition, health care services should be able to return to more normal operational levels in 2022.

S&P Global Ratings still believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

• We anticipate that the industry's performance may continue to suffer in 2021, albeit to a lesser extent than in the 2020, based on the assumption above and the following considerations: Lessons learned in the spring of 2020 about safety and medical protocols should better protect medical staff and patients and avoid prolonged shutdowns of health care facilities. There will be special efforts to keep open departments like cardiology, oncology, and other serious noncommunicable diseases, to reduce increases in death rates from all causes.
• Although we will continue to see disruptions to non-urgent procedure scheduling, there will be efforts by private facilities to minimize them because elective surgery tends to be more profitable both for doctors and facilities.
• We anticipate the wider availability of COVID-19 testing with decreasing cost per test and faster response time. This is especially important for health care providers that need to monitor staff and patients to avoid disruption to services.
• Efficiency and cost-saving measures put in place in the first half of 2020 should continue to benefit margins, but further savings will be more difficult to achieve. In the health care service sector, there is a visible climb in the wages of nurses and care staff. With state budgets already strained, health care providers will most likely have to bear part of these costs, weakening profitability.
• Supply chains will continue to be resilient, and we expect limited disruptions.
• Liquidity should remain healthy, helped by focused working capital management and cautious capital investments.
• We do not rule out future merger and acquisition deals in health care, despite current high multiples, as companies will continue to take advantage of favorable funding conditions and investors' perceptions that it is a defensive sector.

Disciplined capital allocation will determine credit quality

Although the speed of return to sustainable growth will be key for an improvement in credit metrics, capital allocation policies will also play an important part in determining credit quality.

We factor in our base case a gradual recovery of revenue close to pre-COVID-19 levels by the middle of 2021. However, growth prospects will trend lower owing to the following factors:

• Volumes will continue to recover because of the backlog of patients waiting to see consultants and to be diagnosed for treatment.
• Government funding for health care will remain tight because budgets have been squeezed by emergency spending needed to lessen the economic blow of the pandemic. As a result, increases in tariffs and reimbursements might be inconsistent or slow.
• There have been few redundancies in the sector so far. Companies have invested greatly over the past few years to build effective sales forces and these, together with manufacturing and R&D costs, are more of a fixed nature and will require steady increases to help improve margins. In the services sector, shortages of qualified medical staff and growing wages will slow a recovery in cash flow.
• Those that previously invested in digital technology will be at advantage as the pandemic escalated acceptance levels, not only among health care professionals, but also among the elderly, who embraced connectivity tools as a means to obtain safer and quicker access to medical services.

Given the significant cost of returning to business growth, we believe capital allocation policies will be a critical credit differentiator at this point. We view as a supporting factor in our credit assessments flexible financial policies that preserve cash in order to protect both current debt service and future deleveraging through investing in profitable growth.

So far, we have taken very few negative rating actions in the sector as a result of the pandemic. Nevertheless, most European health care companies have no or limited ratings headroom. As we anticipate an increase in M&A activity going into 2021, fully debt-funded acquisitions without a revision of capital allocation policies will likely lead to downgrades.

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Pharmaceuticals, including generic drugs manufacturers: COVID-19 is more of a headwind than a disruptor

European pharmaceutical companies, including generics players, have performed in line with our expectations. A strong first quarter of 2020, marked by strong demand due to an overstocking effect in March, was followed by a softer second quarter as the stockpiling unwound, with a pickup in the third quarter. Activity at many companies decreased, attributable to fewer visits to doctors and pharmacies. Margins have not been dramatically eroded thanks to tight cost controls, especially for marketing and promotion. Furthermore, despite some minor disruption, we note that most fears regarding preservation of the supply chain and access to active pharmaceutical ingredients did not materialize. Overall, we expect performance to remain resilient, especially for companies with diversified portfolios and well-established drugs. We anticipate some time lags driving quarterly volatility, and a full recovery by the second half of 2021.

Key downside risks to recovery.   We see limited risks to recovery because, even under an unlikely comprehensive second lockdown, the movement of medicine and medical goods would not be restricted. There might be temporarily reduced access to hospitals during COVID-19 spikes as hospital reprioritize capacity, but we believe efforts will be made not to delay or postpone treatments for prolonged periods. We do not anticipate major supply chain disruptions, as companies are now holding higher levels of stock as a precautionary measure.

Contract manufacturing operators: Resilient due to strong customer demand

Resilient demand from big pharma groups and generic drug manufacturers, coupled with limited supply chain disruption, have allowed contract manufacturing operators (CMOs) to weather the COVID-19 fallout well. We have observed higher inventory and trade receivables than we had expected that have reduced working capital in some instances, but this was offset by spreading out capital expenditures. We note that, to preserve cash as a precautionary measure, CMOs have generally delayed planned capex during the first half of 2020. We expect capex to pick up in 2021 as activity gradually recovers, although we do not rule out further phasing depending on the intensity of a COVID-19 second wave.

Key downside risks to recovery.  Prolonged capex phasing could delay future growth and deleveraging. Shortages of staff and personal protective equipment (PPE) could hamper production and volumes, as absenteeism could increase, driving up costs.

Medical equipment manufacturers: Those reliant on elective surgical procedures hit the hardest

Medical equipment manufacturers, especially those specializing in elective surgery, where severely hit by the pandemic, recording double-digit rates of revenue declines in the second quarter of this year, with some recovery in the third quarter, but generally still below 2019 levels. Profitability weakened despite cost-saving measures, as volume growth is needed to offset their relatively high fixed-cost base.

Key downside risks to recovery.  As the sector predominantly relies on hospitals and other health care facilities remaining accessible to patients, the management of COVID-19 patients and the pandemic's impact on remaining capacity will remain crucial. In addition, because of the growing backlog of elective procedures to be performed, orders will likely continue to be volatile in the next two quarters. We also assume that margin recovery could take some time as volume growth will continue to be slow.

Laboratories: Benefiting from PCR testing

Laboratories confirmed our expectation of a rapid and strong recovery, with most posting performance above our current base case, supported by rapid uptake of COVID-19 testing, recovery of routine testing, with specialty testing holding up. The extent of benefits from COVID-19 tests will depend on an ability to win contracts and efficient infrastructure. Overall, laboratories have reduced their capital expenditure through a selective investment approach. They had to invest in new machines and kits for COVID-19 PCR testing while reducing other investments. Nevertheless, in most cases, laboratories achieved greater cost savings than we expected because of a reduction in some personnel costs, even though most of their costs are fixed.

Key downside risks to recovery.  Current trends show strong demand for COVID-19 testing, and we believe that such demand is unlikely to fall away before routine testing recovers. Nevertheless, health care authorities could at some point decide to cut the price of PCR testing to contain spending.

Nursing homes: Better equipped to face the second wave, but recovery depends on government measures and operational robustness

Nursing home operators performed better than we expected, even though they faced unfavorable prospects because of the vulnerability of their residents. Although occupancy rates at most groups have dropped from the end of March to early June 2020, when they stopped admissions and fatality rates increased, the rate remained above 70%, which we view as an approximate break-even point. Countries like France, Belgium, and Germany were supportive toward the sector, reimbursing part of lost accommodation revenue, as well as additional costs. By contrast, in Spain and Italy central support was subdued and depended on local municipalities. From end-June the recovery was quick in France as providers were able to restart commercial activity, reaching occupancy rates of 90%-95%, but in other places, such as Belgium, Spain, and Italy, the rebound is slower. We believe that occupancy rates will stagnate in the last quarter of 2020, reflecting the recent increase in cases and further disruption of commercial activity, recovering to their pre-pandemic levels by mid-2021 for French operations and in the first half of 2022 for those in other countries. On the cost side, most rated groups recorded high one-off COVID-19-related costs, which authorities are likely to partly reimburse in the second half of 2020 in both France and Belgium, and, therefore, margins should hold up for this year.

Other social care providers, such as behavioral and mental health care institutions, seem to have been more resilient to the pandemic, with lower death rates given the younger age of patients and continuing new admissions due to the essential nature of the services. In the U.K., these care providers were supported by extra funding by the National Health Service and local authorities to cover extra COVID-19 costs.

Key downside risks to recovery.  The key downside risks, in our view, relate to the ability of operators to control their cost base, including COVID-19-related costs, and cope with the shortage of qualified medical staff. Volumes could decrease as a result of fewer public tenders due to delays in the release and processing of public funds, and private beds could suffer from lower demand due to lower disposable incomes.

We also note that final revenue and cost compensation could be less favorable than what was announced at the start of the crisis because of high demand from both the public and private sectors.

Private hospitals: Those benefiting from less favorable state support will be hit the hardest, especially as COVID-19 hospitalizations increase again in the fourth quarter

Most rated hospital operators have performed in line with our expectations, reflecting favorable government support. We observe that strong support packages in France, Germany, and Sweden are compensating for revenue lost to treating COVID-19 patients, while margins are holding up because the decline of medical purchases and staff costs have compensated for lower top lines. In contrast, hospitals in Spain suffered revenue deterioration in the second quarter, with no recovery in the third quarter, and there is continued uncertainty about compensation for their efforts in combating the spread of the virus.

The operating environment was back to normal for most companies at the end of June, which then started catching up on the backlog of postponed procedures. However, in recent weeks, COVID-19 cases have surged, leading them to dedicate part of their resources and intensive-care beds to COVID-19 patients and again start to defer elective surgery. We do not believe this trend will be as strong as in March 2020 given the new protocols and improved optimization of resources.

Key downside risks to recovery.  The key risk will come from the hospitals' prolonged inability to cope with COVID-19 patients, leading to cancelation of elective and routine procedures and with governments phasing out their support in 2021. In addition, the capacity of health care facilities to comply with social-distancing measures and stricter cleaning requirements could remain reduced.

Although most providers should receive compensation for their one-off COVID-19 costs, we believe that final amounts could be less than states announced at the start of the crisis due to higher-than-anticipated one-offs reported in both the public and private sectors. Access to qualified medical staff will remain restricted and higher salaries proposed by some governments, if not fully compensated for, will reduce profitability as salaries form significant portion of costs.

Veterinary clinics: Recovery depends on the severity of restrictions with well-diversified international groups weathering a second wave better than others

Veterinary clinics in Europe have performed broadly in line with our initial expectations, reflecting the recession-resilient nature of pet services overall. Although the beginning of the pandemic started off on a bumpy path, as predicted, large and geographically diversified veterinary clinics managed to face COVID-19-related disruptions better than smaller and more locally centered ones. The pandemic affected sales differently depending on the region and rigidness of the lockdown, which varied from country to country. In the U.K., for instance, veterinary services were strictly limited to emergency-only procedures during the beginning of the lockdown whereas in other markets, such as the Nordics, clinics remained fully open and provided all services. As lockdowns eased, volumes picked up quite rapidly, with sales volumes recovering in June and July to our initial pre-COVID-19 base case expectations. In addition, we believe acquisitions after COVID-19 will start to accelerate and lead to greater consolidation.

Key downside risks to recovery.  The biggest downside risk to a rapid recovery is strict confinement measures in key geographies like Europe and the U.S., impeding routine checks and emergency procedures. However, we note that countries, such as the U.K, which had initially severe restrictions on veterinary services, would probably allow a greater number of procedures to happen than under the first lockdown. Plus, we also view that continuing compliance with COVID-19 safety protocols for staff and premises can be another risk to a full recovery of EBITDA to pre-COVID levels.

Dental chains: Bumpy road ahead from potential postponement of elective procedures, local regulatory support schemes to remain critical to cash flow

Dental chain operators were severely hit by the pandemic, confirming our expectations at the start of 2020. We observed a very sharp drop in revenue and earnings from mid-March through to end-June, due to the cancelations of routine procedures for the duration of the lockdown restrictions imposed by national health care systems. As a result, we observed monthly revenue drops of up to 60%-70% on average in April through to the end of June in Continental Europe.

In the U.K., operating performance, from a cash flow perspective, for dental chains that perform work for the National Health Service was sheltered largely by its decision to continue to extend monthly cash payments for originally agreed contracted volumes, even though companies were unable to perform them during lockdowns. Dental chains across Europe were mostly back to full reopening at the end of June.

The recovery is uneven across countries, mainly due to the pace of the lifting of restrictions by national health authorities. In the U.K., for instance, we anticipate very slow recovery for the only rated dental chain operator, operating under the mydentist umbrella (Turnstone Midco 2 Ltd., CCC/Negative/--). This is because national authorities, particularly Public Health England, require a one-hour fallow period between surgeries, resulting in a reduction in the number of patients a practice can treat during the day. We understand the U.K. is the only country in Europe currently with such a period in place, and there is uncertainty as to when this condition will be lifted.

Key downside risks to recovery.  We believe the threat from a second lockdown, or, at the very least, the reintroduction of local and regional restrictions on movements, pose the biggest downside risk to recovery for the sector. This could prolong the recovery in terms of patient volumes and could weaken liquidity. This is especially relevant for a sector that has attracted the attention of private equity groups in recent years, resulting in very highly leveraged financial risk profiles. We believe that high financial leverage, combined with the inability to return to pre-COVID-19 patient volumes and extra operating costs (for example, for PPE), could weigh on business prospects for some large dental chain operators.

Dialysis providers: Continued low impact on revenues to underline resilience, but some hits to profitability from extra PPE for smaller providers

Dialysis service providers have thus far exhibited resilience, in line with our expectations, reflecting the nature of the services for patients as crucial and life sustaining. COVID-19 had a limited direct impact on revenues as clinics remained fully operational across all geographies. Most rated dialysis providers in Europe are also global players, and we understand that they took early measures to preserve their supply chains. We have observed a mixed picture from a profitability perspective for private providers, however. In the U.S., for instance, the Coronavirus Aid, Relief, and Economic Security (CARES) Act has been very effective and has been even supportive for cash generation through advance payments under the CMS Accelerated Advance Payment Program, which helped cash flow generation for Fresenius Medical Care (BBB/Stable/A-2). In Europe, on the other hand, we have observed a decline in profitability for main players, primarily because of extra PPE procurement.

Key downside risks to recovery.  We do not expect a significant negative impact from second lockdowns or the reintroduction of local or regional restrictions of movements on the sector, given the nature of the services. That said, we believe the COVID-19 pandemic will likely continue to weigh on profitability for the rest of the year, with larger global players relatively more sheltered.

Funeral homes operators: Profitability hurt by social-gathering restrictions despite high mortality rates

As expected, we observed a substantial increase in mortality rates during the first and especially the second quarter of 2020 that was accompanied by a considerable drop in price per service. Social- gathering restrictions and other social-distancing measures hurt funeral home operators because they were forced to cater for much reduced ceremonies. Furthermore, strict safety procedures and the interruption of operations in certain locations due to infections further eroded margins. We nevertheless note that, with the easing of social restrictions, prices per service have started to recover and margins are steadily increasing. In fact, we note that price per service in some areas are almost back to pre-COVID-19 levels. For 2021, we expect volumes to drop considerably as mortality rates will likely be lower next year than this year, which will be offset by a better pricing mix as restrictions on gathering ease. Capex activity will likely also resume in the second half of 2020 after funeral homes delayed projects in the first half to preserve cash. Having said that, uncertainty around potential stricter lockdowns could push these plans into 2021.

Key downside risks to recovery.  An uptick in infections will lead to a return to restrictive measures on gatherings, mobility, and scale of ceremonies that will squeeze margins for funeral home operators. This would prolong the deleveraging path of our rated issuers and will likely trigger further cash preservation plans such as capex deferral of RCF drawings. Although we note that funeral homes are now better prepared to manage such drastic situations, the extent of renewed lockdown measures could lead to a very difficult operating environment.

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