S&P Global Ratings maintains its sector view as stable given healthy balance sheets for many providers, effective leadership that has continued to pivot and use data and technology to manage near-term challenges, and our view that demand for services and improved revenue yield will continue to support hospitals, although likely from a new baseline and potentially with some unevenness as COVID-19 variants remain present. We also expect some stimulus and FEMA funds to provide additional, though modest and temporary, support to providers over the next year. The sector has continued to weather the pandemic well, albeit with the benefit of considerable federal aid, but there are operating headwinds given significant ongoing expense and revenue pressures likely to continue over the next year.

While we expect operating margins to be weaker in 2022 for many providers, compared to 2021, we believe that most organizations should be able to navigate these challenges given the above-mentioned supporting credit factors. However, depending on the severity and duration of operating pressures, there could be increased stress to credit quality, particularly for weaker credits or those with less margin or balance sheet flexibility at their current rating. Furthermore, a sustained weakening of operating cash flow could affect more credits over time, particularly if providers have to limit strategic operating and capital investments and aren't able to maintain their core enterprise and competitive strengths.

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Rating Actions Through 2021 Contribute To Stable Sector View

Downgrades through 2021 and leading up to 2022 have slowed and many negative outlooks have been revised to stable, further supporting our stable sector view. Downgrades and upgrades through 2021 have started to even out. Many of the downgraded credits were experiencing weaker trends leading up to the pandemic, which we believe will take longer to address. Similarly, other than a few credits that were upgraded due to mergers, the remaining upgraded credits had been performing well prior to COVID-19 and continued to remain in-line with the higher rating. We expect that, for many credits, balance sheet strength will sustain credit quality in 2022 even with some modest operating stress, although prolonged operating weakness may reduce flexibility at an organization's respective rating.

Questions That Matter

1. What's next for the acute care sector and COVID-19?

We expect there could be ongoing COVID-19 surges over the coming year, with growth in cases and hospitalization rates varying with regional vaccination rates and variants, should more emerge. These surges may in turn influence volumes, revenue, and expenses.

What we think and why

Ongoing waves and surges of COVID-19 may occur but vaccinations, therapies, and drugs could temper that.  Uptake of the COVID-19 vaccination varies across the country. At the same time, new variants continue to emerge, including more recently the Omicron variant. These trends, coupled with varying policies on and adherence to mask mandates and social distancing, will likely lead to ongoing regional surges of COVID-19 in 2022. That said, in addition to attempts to increase vaccination rates and boosters, new therapies and drugs could slow those waves and reduce COVID-19 related hospitalizations and lengths of stay over time.

COVID-19 will affect performance in 2022.  While hospitals have learned to coexist with COVID-19, significant surges could force providers to temporarily delay elective procedures, which will in turn affect revenue. Instances of temporary delays in elective procedures have occurred in the past and have occurred again for some providers with the recent surge. Even if this does not become a wide-spread issue, ongoing waves of COVID-19 will mean increased spending on testing and protective equipment. Most significantly, COVID-19 surges could continue to pressure staff that have already operated through nearly two years of the pandemic. Revenue has become more difficult to control and predict but management's focus on accessibility through both in-person and digital channels, consumerism, and safely treating non-COVID-19 patients are important revenue generating actions. Those credits with more revenue diversity, payor flexibility, and stronger enterprise characteristics may be better able to manage through the next year.

Relief funds will be more limited and other pandemic support is likely to wane.  Hospitals affected by COVID-19 may be eligible for additional relief funding in late 2021 and in 2022, notably FEMA distributions, rural grants from the American Rescue Plan Act (ARPA), and additional provider relief funds. Still, we anticipate the dollar amounts to be lower than aid distributed in 2020 and early 2021, and may be insufficient to offset the full revenue and expense pressures related to COVID-19. Finally, certain federal actions which supported hospitals over the past two years, such as the public health emergency declaration which maintains higher Medicaid funding, a 20% add-on for COVID-19 Medicare patients, as well as delays in sequestration, could end and add incremental stress to revenues at a time when margins will likely already be pressured.

2. How will labor dynamics affect providers?

Labor expenses and shortages pose the biggest near-term risk for most providers and will likely remain a pressure point beyond 2022. Labor, by far, is the highest expense category for a health care organization--typically more than half of annual expenses--so even minor disruptions can be costly. Although the health care industry has always had periods of staffing challenges, those ignited by the pandemic are more widespread, severe, and expensive to address.

What we think and why

The ability to absorb higher staffing and labor expenses is a key area of credit focus.  Staffing challenges and related expenses have accelerated in recent months due to early retirements, resignations due to the pandemic, loss of staff due to quarantine or illness, and opportunities for additional compensation through temporary agency companies. There are labor shortages at all staffing levels as health care competes with other industries for jobs such as housekeeping, maintenance, technology, and clerical staff. Management teams have responded by offering incentives and bonuses, increasing use of agency staff, and increasing hourly rates including their minimum wage, which will affect budgets in perpetuity. As an offset, labor pressures also continue to drive standardized and transformed care models with staff performing at the top of their license, which can help manage labor costs through improved job satisfaction, and could reduce turnover. Some health systems, particularly large ones, may also be able to shift staff between care sites depending on timing of surges and demand. Other strategies include developing an in-house staffing agency with lower overhead costs and looking to international sources for additional nurses. However, there still may not be sufficient staff available, which could lead to bed and facility closures further negatively impacting revenues. Those providers in already tight labor markets could be even further pressured.

Additionally, certain hospitals and health systems have recently had difficult negotiations with their labor unions which in some cases have caused revenue disruption and one-time expenses, increased friction between management and staff, and potential increased expenses to absorb related to the negotiated contracts. In addition to managing the direct labor costs effectively, relationships with labor will remain important for execution of strategic initiatives and maintenance of long-term strength.

Investment in workforce and well-being will be critical but will add additional expenses.  Management teams are investing in capabilities to ensure a pipeline of staff as well as maintain existing staff. Investment in nursing and other technical programs, as well as innovative educational programs for internal career mobility, are key strategies but could take time to show benefits. Investments in physicians, who are also experiencing burnout, will also be needed to minimize turnover and coverage gaps. With certain non-clinical staff able to work from home, organizations are also tapping into workforce that may not be in the immediate area. Additionally, management teams are making significant investments in mental health services and other wellness benefits for staff and clinicians. These initiatives come with upfront costs that not all organizations can afford, but they could support long-term staffing across the delivery system.

Acceleration of technology innovations to manage care could provide some relief but likely in out years.  Certain management teams are incorporating technology solutions to help manage through the higher labor expenses and shortages, with focus on nursing and clinical care but also on automation for back-office functions. For example, some providers are using virtual care and data monitoring to change the mix of staffing needs. More advanced data and technology monitoring capabilities over time could improve clinical care and efficiencies to prevent certain disease states or unnecessary hospital admissions or emergency department visits thus also lowering staffing needs.

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3. Which credits will be able to minimize operating margin compression?

As in recent years, management actions will play a key role in lessening the softening of operating margins but will also vary depending on a variety of credit characteristics, including enterprise profiles and regional differences in vaccination and COVID-19 rates.

What we think and why

Expenses will have the largest dampening effect on margins.  In addition to labor, supply inflation has also been exacerbated by the pandemic with increased use of personal protective equipment, higher prices for in-demand supplies, and increased inventory to ensure that shortages do not recur. Pharmaceutical costs also remain high concurrent with high-profile challenges to the 340B drug discount program. While S&P Global's economic forecasts project easing of certain inflationary trends toward the end of 2022 (see "Economic Outlook U.S. Q1 2022: Cruising At A Lower Altitude," published Nov. 29, 2021, on RatingsDirect), we do not expect labor pressure to lessen over the next several years. Lastly, those with scale or that use group purchasing organizations may be able to mitigate the impact of expense growth.

Management actions could help temper performance pressure.  We believe that the unprecedented operating environment over the past two years has created opportunities and imperatives for management to make bolder, swifter, and more comprehensive changes than we would typically expect. With a number of new leaders transitioning into organizations over the next year, along with existing tenured CEOs, we believe many organizations will continue to exhibit resilience in a likely more rapidly changing and challenging environment. In addition to M&A and strong controls around revenue cycle and expense opportunities, teams continue to focus on enterprise and market strengths, including opportunities for revenue diversity which can lessen risk. This was especially evident during the pandemic for integrated delivery and financing systems with heighted provider losses in many cases offset by improved health plan performance due to lower claims.

Underlying location and credit characteristics matter.  While many operating decisions are within management's control, certain fundamental elements of health care organizations, such as payor mix and the economy, can influence margins and are more difficult to change. The continued aging of America into the Medicare program and away from commercial insurance will continue to pressure revenue for some credits more than others as government typically reimburse at levels below cost. More generally, there could be benefits from additional states expanding Medicaid (specifically Missouri and Oklahoma) and from expanded insurance coverage and premium support for exchange products should the Build Back Better legislation move forward. For those organizations located in regions with a young and growing population as well as high wealth and income, underlying volume and revenue concerns could be comparatively less pronounced. Finally, providers in areas susceptible to increased weather events may have to demonstrate additional balance sheet strength or geographic diversity to offset that risk.

4. Will balance sheets continue to support credits as the operating environment tightens?

Solid balance sheets with robust unrestricted reserves and low to moderate debt levels could help offset a limited period of weak operations, so long as investment markets remain stable. We anticipate that balance sheet stability will be necessary for rating stability in 2022 given the continued operating headwinds.

What we think and why

Investment market challenges would be a limiting factor.  Healthy investment returns have allowed many providers, particularly those with sophisticated investment strategies, to add significantly to reserves for additional stability and boost non-operating income in 2021 and years prior, which has helped to offset weaker operating cash flow and to maintain stable debt service coverage. However, sustained market volatility could undo that. Management teams typically maintain strong investment portfolio oversight, including asset allocation, liquidity, and performance against benchmarks, while also supplementing non-operating income with philanthropic contributions and donations. While most providers maintain appropriate oversight and we recognize there can be short term volatility, an increased dependency on investment returns could lead to risks that are outside of management's control and challenge ratings.

Organizations with strong balance sheets are less likely to experience a negative rating or outlook action; weaker credits may continue to struggle.  Some of the lower-rated credits, which typically have light balance sheets, have seen additional liquidity pressure through the pandemic and we expect this to continue in fiscal 2022 as providers repay Medicare accelerated and advance payments (MAAP) and payroll tax deferrals, particularly if cash flow remains pressured. This in turn, could prevent reinvestment in both capital and strategic initiatives, further widening the credit quality gap if other solutions are not made available. For stronger credits, these payments will not materially influence credit quality as we have removed the larger MAAP funds (and draws on lines of credit for liquidity purposes) for our underlying credit analysis.

Low interest rates and access to debt have allowed for additional flexibility.  Low interest rates have helped providers reduce interest costs via refunding transactions and maintain access to capital, which has helped provide additional flexibility since the start of the pandemic. Many providers have also maintained or entered into new lines of credit over the past two years as a buffer for unforeseen events or possible cash flow decline. If interest rates rise, access to additional funds may be more difficult and less cost efficient, limiting the flexibility many providers have benefited from for many years. Furthermore, weaker credits could be disproportionately impacted in a high interest rate environment.

Increased capital spending and strategic investments could limit reserve growth.  We expect capital spending to accelerate as providers catch up on deferred spending and focus on long-term strategies and continued shifts to evolving consumer demands including ambulatory care and expanded accessibility through both in-person and digital channels. That said, acute care hospitals also need reinvestment and, sometimes, expansion. We expect management teams will have a prudent approach given industry uncertainty, balancing investments appropriately. We also continue to discuss project costs with management teams given inflationary pressures that affect both labor and supplies during the construction and onboarding of assets. Aside from the absolute level of unrestricted reserves, we expect heightened expenses will provide incremental pressures to days' cash on hand through higher daily cash expenses.

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5. What other factors could affect the sector in 2022?

COVID-19 has accelerated changes in the sector, many of which incorporate data and technology. Given the recent experiences with the pandemic, coupled with evolving consumer demand, and as many revised strategic plans address goals with greater urgency, we believe the industry could incorporate changes tied to data and technology more quickly over the next few years. This may further widen the credit gap, as smaller providers and those with more limited balance sheets may lack the scale, sophistication, or resources to invest in necessary infrastructure and workforce to support these efforts.

What we think and why

Effectively harnessing data and technology provides avenues for improved quality and efficiency.  The use of data and technology for efficiencies and clinical care improvement could accelerate due to investments made over the last several years and with increased willingness to change due to pandemic disruptions. Many of the larger hospitals and health systems have been integrating data analytics and technology efficiencies for a number of years, but the current environment and operating challenges may necessitate these areas moving faster. For example, certain technologies could reduce length of stay or help keep care outside of the hospital (hospital at home model) helping to offset current labor challenges and improve patient satisfaction. Many of the non-traditional competitors continue to capture consumers through primary care, other ambulatory services, and frictionless experience which is causing many traditional providers to harness technology and digital investments themselves.

Many providers are focused on being value ready even if payment models slow to shift.  With increased access to data and data analytics, many providers continue to look for ways to improve care and reduce costs to prepare for the ongoing shifts toward value-based reimbursement, although the pace of this transition is highly variable in different markets and could slow due to the pandemic. The legislation on surprise billing and price transparency could also further move payment discussions toward value. The need for a more stable payment model benefitting from lowering the cost of care has spurred a number of discussions with payors across the country particularly as data and technology are incorporated into care models.

Partnership opportunities for efficiencies and strategic investments are likely to evolve.  The need for ongoing investments, both technology and capital, will likely involve strategic partnerships and, potentially, more complete alignment for certain providers. The pandemic has continued to force weaker providers to consider merger opportunities as a method to improve efficiency and make necessary investments, and we expect this will continue. While not all mergers are credit positive, many are. Government actions limiting mergers and acquisitions, as appears to be the case under the current administration, may make it more difficult for certain providers to find efficiencies and potentially execute on certain strategies that require scale.

Appendix

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