Midway through 2022, not-for-profit hospitals and health systems face a difficult operating environment that, while easing from the extreme pressures of late December 2021 and early January and February related to the omicron surge, is still causing operating cash flow compression for many of them across the U.S. In our January 2022 sector view (see "Outlook For U.S. Not-For-Profit Acute Health Care: A Booster May Be Needed," published Jan. 6, 2022, on RatingsDirect), we had noted these operating pressures, but some of them are more pronounced than anticipated, with the financial flexibility provided by unrestricted reserves starting to lessen for certain organizations, as investment markets have been volatile since the beginning of 2022. Although many entities, particularly those with healthy business positions and unrestricted reserves, should be able to handle the stress as they implement near- and medium-term solutions, S&P Global Ratings believes those with weaker financial profiles and business positions or those that have had underlying operational problems in recent years or have less balance sheet cushion, could be at increased risk for a downgrade or negative outlook revision. Much will depend on the extent and duration of the operating pressures as well as the broader macroeconomic conditions.

The key risks remain labor and inflation, a weaker economy, the possibility of recession in the next year (see "Inflation, War, And COVID Drag On," May 17, 2022), and recent investment market volatility. In addition, higher interest costs are likely to make borrowing options more expensive. Furthermore, the re-introduction of sequestration and the likely end of the public health emergency later this year will also have to be absorbed into cash flow. The more limited provider relief funds in 2022 (and the federal government's lack of appetite for additional relief) reduce the external support that helped many providers in 2020 and 2021. That said, for many hospitals and health systems, underlying demand, including pent-up needs for care that was deferred during the omicron surge earlier in the year, remains sound. However, if a structural imbalance of labor supply and demand persists, it could be hard to meet those patient needs, thereby further elevating the human capital social risks that we capture under our environmental, social, and governance (ESG) factors. In the second half of the year, we will continue to monitor management teams' ability to improve earnings from the hurdles in late 2021 and early 2022 and at the same time, assess balance sheet flexibility to deal with what will be a strained operating environment for the remainder of the year and likely in 2023 as well.

Rating Action Trends Through The First Five Months Of 2022

Through May 31, 2022, we had even downgrades and upgrades, but we affirmed our ratings on most issuers that we reviewed. We took nine downgrades and nine upgrades; however, three of the upgrades were solely caused by M&A activity (table 1). The downgrades mainly were at the lower investment-grade or speculative-grade rating levels with some being multiple notches, as the industry pressures are greater for those providers with limited liquidity and financial flexibility, or with generally weaker overall financial profiles (table 2). Last year, in the same period, we took eight downgrades and one upgrade (with the latter due to M&A activity) as we reviewed several ratings that had been under pressure during and before the pandemic. Outlooks are mostly stable; however, we revised six to negative and four to positive (excluding M&A-related changes) (tables 3 and 4). Overall, outlook and rating distributions have not changed materially from year-end 2021. We anticipate affirming most ratings through year-end; for those ratings that we change, downgrades will likely outnumber upgrades. Lastly, for all issuers, but particularly those we rate at lower investment-grade or speculative-grade, we will continue to monitor covenant compliance and plans to manage risks related to any covenant violations.

Table 1

Table 2

Table 3

Table 4

Labor Cost Pressures Lessen From Early 2022 But Remain Well Above Pre-Pandemic Levels

In first-quarter calendar 2022, earnings were down for almost all rated hospitals and health care systems due to labor costs and other inflationary impacts. The questions are: How much of the heightened expenses are temporary due to the omicron surge at the beginning of the year versus how much is built into base salaries and will be ongoing? And when does the imbalance of labor supply and demand begin to ease? With staff shortages at all levels, maintaining and retaining the workforce and recruiting new employees is more costly and ties into the inflationary pressures that began accelerating in the sector over the last year as demand resumed and staff turnover increased. As well, retirements have risen, sometimes related to the burnout and fatigue of the past two years. In addition, while both near- and medium-term strategies are deployed to increase hirings, there is significant uncertainty on how long it might take to fill vacancies, reduce agency usage, address staff burnout, and return to a more balanced labor market.

Agency Use As Well As One-Time Retention And Bonus Costs Are Straining Margins

While agency use and costs are decreasing for most providers as critical staff shortages have decreased from late 2021 and early 2022, costs will likely remain higher for at least the next year and possibly for several years to come as staff shortages could continue and more workers may seek to become travelers (temporary workers who go from location to location, depending on the need) than before the pandemic (see chart 1). Although rates vary by location and type of employee, anecdotally, we've observed nurse agency rates of more than $200/hour from providers at the height of the omicron surge; for many, those rates have fallen and still vary widely, but may be closer to $130-$150--and are still higher than agency rates before the pandemic. For many providers, overall agency full-time equivalent rates remain elevated but are gradually falling to a lower level than early 2022. While management teams are making all efforts to reduce and minimize agency labor, it isn't clear how quickly use and rates will return to historical levels, given the structural imbalance of supply and demand for nurses and other staff. Other one-time related costs include signing and retention bonuses that are likely to continue to some extent throughout 2022, further weighing on overall labor expenses.

Chart 1

Underlying salaries and wages are also rising, having climbed to a much higher rate than previous annual increases of around 3% and often higher than what was budgeted. Some hospitals and health systems are making further wage and benefit adjustments midyear to retain and attract staff (see charts 2 and 3). All of this is in addition to absorbing the agency and one-time impacts previously mentioned. Some near-term solutions are one-time retention and signing bonuses, managing volumes with staff working at the top of their licenses, rethinking staffing patterns and using care team models, implementing technology solutions when appropriate, and creating internal agency and float pools across care sites. Those with strong workplace cultures may also benefit from lower turnover, which can help differentiate certain hospitals and providers, such has been the case at many of our rated children's hospitals as well as some of our rated general acute care hospitals. In addition, we have observed some regional variation due to tighter labor markets possibly tied to overall regional demographic trends and regulations (for example, increased required staffing in California).

Chart 2

Chart 3

Medium-term strategies include funding more education, greater use of technology to help reduce demand on staff, upskilling employees, and recruiting internationally, but these will likely yield results in later years. That said, we expect that with the demand for staff outpacing the supply (see chart 4), and with certain solutions taking longer to take hold, higher labor expenses likely will continue at least for the next year and possibly longer.

Chart 4

Nursing Shortages Could Begin To Hit Near-Term Revenues

To the extent that there is not enough staff to meet patient demand, this could limit revenues due to inability to meet demand or decisions to close services that are unsustainable with heightened labor costs. Fortunately, while COVID-19 cases have risen in recent months, corresponding hospitalization rates in most markets have not increased at the same pace. Nevertheless, variants remain an uncertainty and if a new, more serious variant emerges, it could also affect staffing and revenue again. In addition to affecting revenue, elevated staff turnover and heightened agency use rates can generally hinder certain quality measures and clinical operating efficiency.

Other Inflationary Pressures Are Causing Intermittent Problems But Could Increase In Risk Closer To 2023

Other supply and drug expenses are also increasing, although for many organizations most supply expenses have been locked in for the year through supplier and group purchasing organization contracts, albeit at higher prices than previously. The risk remains though, if there are supply shortages, which have occurred intermittently due to COVID-19 related disruptions and other broader supply chain issues, that hospitals and health systems must go out of contract to find necessary items or face disruption in care delivery. Recently, for example, there have been shortages in contrast dyes, which have subsequently affected imaging procedures for certain providers. Supply costs will likely rise again in 2023, although those with more market power might be able to negotiate slightly lower rates of increase. We expect this to be a broader pressure point in 2023. We believe the high-cost drugs for therapies and treatment will also remain an ongoing issue for the medium-to-long term as those areas of treatment and drugs expand. However, in some cases this is offset by rising 340B revenue, but which could become a medium-term risk if there are changes to the 340B program.

As well, notable inflationary expenses related to capital spending persist, particularly for those hospitals and health systems that have significant upcoming projects without final cost negotiations or a guaranteed maximum price contract in place (see chart 5). In addition, there could be delays for supplies, which would slow overall project timing as well as potentially further boost costs. We've observed management teams trying to plan for higher costs, but this remains an added risk as inflation in this area continues. (see "Construction Cost Inflation Weighs On U.S. Public Infrastructure," April 14, 2022). A related issue: The onboarding of new capacity can worsen a provider's existing labor shortage.

Chart 5

Broader Macroeconomic Conditions Could Exacerbate Financial Pressures

Following exceptional investment returns in 2020 and 2021, most organizations experienced flatter-to-slightly lower unrestricted reserves through the first quarter of 2022 due to weaker investment returns and that, along with increased expenses, has resulted in a slight drop in days' cash on hand. However, many organizations entered 2022 from an unusually high unrestricted reserve position and with better funded defined-benefit pension plans, given the strength of the investment markets in the past several years. For some, proceeds from taxable bonds that were issued to provide increased balance sheet flexibility or fund future capital needs that may be delayed, provide additional near-term flexibility. However, if soft investment markets continue through 2022 and operating cash flow remains stretched, flexibility could decrease, which would weaken a key credit strength that has supported many of these entities in the past few years. In addition, softer investment markets could also hurt those providers that have increasingly become reliant on nonoperating revenue for debt service coverage and cash flow at a time when operating cash flow is also likely to be strained due to the inflationary pressures discussed above.

With many states having received American Rescue Plan Act money from the federal government last year, state budgets are in reasonably good shape for now and thus we don't anticipate any cuts to Medicaid programs in the near term. However, if the economy begins to slow and that reduces employment, we could see incremental shifts in the payor mix. In addition, we believe the end of the public health emergency and automatic Medicaid re-enrollment could disrupt the payor mix of certain providers, while at the same moderating some Medicaid supplemental funding with the enhanced federal match rate expiring.

Providers Look To Additional Solutions To Manage Near- And Medium-Term Risks

We are monitoring commercial payor negotiations to understand what relief there might be for providers to manage higher inflationary expenses. We expect these won't come into play for most providers until multiyear contracts are up for renewal. A small minority of providers have contracts tied to inflation indexes, which could provide some relief over the next year. We expect any success in this area will be mixed, though, and will vary by market and provider. In addition, with government payors accounting for almost half of patient revenues, commercial rate improvements likely won't be a total solution for any provider.

As management considers options such as payor negotiations and expense and labor initiatives, we expect some may look to M&A to accelerate strategic investments and identify longer-term solutions for current challenges, such as labor. Several mergers closed in early 2022 (among them, Beaumont Health with Spectrum Health and Intermountain Healthcare with SCL Health) and several have been announced, including a definitive agreement between Atrium Health and Advocate Aurora Health (see table 5). However, given recent denials by the Federal Trade Commission and other regulatory agencies, this option may be increasingly difficult to deploy. If these denials affect organizations that are already struggling operationally, options could become increasingly limited for certain providers.

Table 5