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Sector View Is Driven By Expectation For Sustained Operating Pressures

Uncertainty about near-term performance is even greater than in prior years.  The level of uncertainty tied to both expenses and revenues is much more than in previous years with management teams having difficulty even forecasting 2023 performance. In addition to the challenges around expenses, the pace of revenue and volume recovery has many elements of unpredictability. Will lower stimulus funds be offset by patient revenue growth or will patients continue to delay and avoid care? With the ending of the public health emergency likely in 2023, will there be material shifts in the payer mix on top of the historical migration to Medicare given the aging population? Will the heightened case mix index remain permanently higher? Will patients continue to seek lower cost care sites such as urgent care and telehealth or will old patterns emerge, bumping up emergency department volumes again? These questions are unanswered for now, but we do not believe revenue growth or reimbursement rates will fully offset expense inflation in the near term.

Outlook revisions and recent rating changes point to a challenged 2023.  Further supporting our sector view is an acceleration of unfavorable outlook revisions that span the rating scale and affect both stand-alone hospitals and health care systems (two-thirds of unfavorable outlook revisions have occurred since June) (see chart 2). In addition, we have seen increased rating downgrades (14 since June compared to nine in the first half of the year), including four multi-notch transitions from 'BBB-' into speculative grade, although the number of downgrades at the higher end of the rating scale is limited (see chart 3). We expect these trends will continue through 2023 with weakened financial results leading to more covenant challenges, including violations and increased waiver requests. While a covenant breach alone would not necessarily result in a rating or outlook change, it could cause more rating stress, particularly if it requires collateral posting or triggers an event of default leading to an acceleration of debt.

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Top Sector Trends In 2023

Margin compression is likely but duration and magnitude are key questions.  Availability of labor (see chart 4) and the effect on labor-related expenses remain the biggest challenge for health care entities and while we have seen some improvement in terms of lower agency use and lower rates, labor costs remain stubbornly high relative to pre-pandemic levels. Turnover and vacancy rates have also improved, but remain generally uneven across providers and still higher than pre-pandemic levels heading into what we expect to be a busy winter flu and respiratory illness season which could demand even greater labor needs. These labor pressures, while not accelerating, are also not improving at the rate initially expected and will likely be one of the biggest factors impeding cash flow and margins in 2023 and beyond. Even as temporary labor costs decline, providers have increased pay and enhanced benefit packages that will long remain part of the expense base. Organizations are employing near-, medium-, and long-term solutions, so while we expect some improvement in 2023, we recognize that there is a longer runway to return to near pre-pandemic margins. Ongoing challenges that could reduce flexibility for individual credits at a time of operating stress include inflation in the cost (and disruption in availability) of supplies, including drugs; cyberattacks; and an increase in weather-related events.

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Good demand, but revenue trends may be mixed.  Revenue has been rising compared with 2020's low and there appears to be generally good demand for health care services due in part to virus surges, particularly at the start of 2022, and patients feeling more comfortable returning to receive care. However, for some credits revenue has been constrained by an inability to staff beds and operating rooms due to labor shortages, throughput issues stemming from difficulty discharging patients to lower care settings, and in certain parts of the country continued reluctance to seek health care. In addition, a continued shift in treatment patterns has resulted in more virtual and ambulatory care that is reimbursed at lower rates and third-party insurance companies have generally been reluctant to reopen contracts or consider additional rate increases for acute care providers, in some cases denying payments per our discussion with management teams. We expect management's ability to secure meaningful rate increases from insurance companies to remain difficult as their employer customers are concerned about keeping their own benefit costs low. Revenues are further constrained by government payers which often account for 50% or more of revenues. Finally, the reduction in COVID-19 relief funds and resumption of sequestration have left big holes in many budgets and will further unveil some of the underlying operating challenges for certain providers. The upcoming winter will be a test of how COVID-19 related illnesses and other respiratory illnesses will be managed along other health care needs. With all of this, the pace of revenue and volume recovery has emerged with many elements of unpredictability that contribute to difficulties in forecasting performance.

Extraordinary government support is coming to an end.  With COVID-19 stimulus funds and other related reimbursement coming to an end, and more governmental and external scrutiny on providers, we don't expect additional material support to providers despite ongoing pressures. We view requests for one-time support from FEMA and potentially state American Rescue Plan Act funds as providing short-term relief but won't offset the broader structural mismatch of revenues and expenses.

Broader strategies to generate financial improvement will be critical to maintain rating stability.  While management teams address labor challenges, organizations are also identifying other ways to generate cash flow improvement including personnel cuts in non-clinical areas, revenue cycle opportunities often using external resources, throughput improvements and length of stay reductions, and renegotiated supply and payer contracts--although the latter has not yielded significant benefits for most. Other strategic efforts include closure of service lines and facilities, revenue diversification, strategic investments into higher margin businesses such as specialty pharmacy business, lab services and other related business services, as well as longer-term care delivery model redesigns using technology and data to lower costs of care. With a higher number of covenant defaults, many organizations are relying on consultants to both serve as a cure under bond documents for a rate covenant violation, and to help accelerate improvement initiatives and provide a clearer lens on industry standards. While we have always viewed management teams as an important credit factor, we have seen heightened executive turnover since the start of the pandemic, creating some challenges with developing and implementing strategic and financial improvement plans.

Balance sheets will remain critical for credit stability given expected uneven operating performance over the next year.  The significant improvement in reserves during 2020 and 2021 have helped support credit quality despite declines in the investment markets through 2022 as reserves are generally still consistent with 2019 levels. Unrestricted reserves are still providing some, albeit more limited cushion during this period of operating volatility. In the year ahead we may see the following:

• There could be erosion of this cushion depending on investment market performance, prolonged inflationary pressure, effects from a possible recession, and cash flow and capital expenditure trends. While there was ample debt issuance during the pandemic associated with historically low interest rates, some of the borrowing replenished balance sheet reserves and in general did not materially impact leverage, especially given the continued rise in capitalization driven by the benefit of stimulus funds and market returns.
• Investment market returns could help improve balance sheet flexibility over time; however, we do not expect material improvement in unrestricted reserves over the next year due to likely weaker cash flow and potentially pent-up capital spending needs after two years of relatively thin spending by many organizations coupled with higher construction costs due to inflation.
• Capital needs persist given the capital-intensive nature of the sector, competition, and the fact that many strategic growth initiatives have a capital requirement; however, addressing these needs will be especially challenging given a focus on preserving unrestricted reserves in the current environment. A renewed focus on fundraising or issuing debt to support capital needs could be options, although higher interest rates for the latter could make that more difficult.

A recession could make things worse.  Our chief U.S. economist has indicated a recession is likely in 2023 (see "Business Cycle Barometer: Worsening Near-Term Growth Prospects," published Oct. 24, 2022, on RatingsDirect), which could complicate efforts by hospitals to improve financial performance. On the one hand, a recession could improve labor conditions, but we also recognize that other factors such as bad debt, volume shifts due to higher deductible plans, and payer mix changes could negatively influence volumes and revenue for many providers, although these latter indicators generally lag and will depend on the extent and duration of any recession if it happens. Further, investment markets could continue to move sideways, potentially resulting in more pressure to credit quality as reduced cash flow, likely slower fundraising, and capital demands slow unrestricted reserve growth.

On balance, legislative and administrative actions likely to be less favorable to providers.  There are no signature pieces of health care legislation that we believe will materially affect providers over the next year. That said, in that it is a highly regulated sector and with heightened focus on health care costs and operating policies, we expect continued debate at the federal and state level, although providers will likely have less upside in the near term.

• We continue to monitor such areas as the 340b program revenue as that has become an increasingly meaningful portion of revenue and earnings; the impact of sequestration; and Medicare PAYGO payment cuts. While Medicare provided better rate increases this year, they don't offset the higher expenses. Price transparency has also become an increasing area of discussion, particularly as affordability remains a focus and governments support an increasing portion of the health care costs.
• The continued scrutiny of mergers and acquisitions by federal and state regulators could afford fewer options for struggling providers. While many of the recently announced transactions are more strategic in nature, we believe broader efficiency opportunities will rise in importance given the current operating climate. Separately, some health care systems may try to divest of certain facilities to better focus resources, but with sector challenges, some of those divestitures could be slower.
• The end of the public health emergency may lower the number of individuals covered by Medicaid, partially offset by a few states that recently expanded or will expand Medicaid. However, if those individuals do not re-enroll for health insurance on the individual exchanges, or the plans they enroll in have higher deductibles, hospitals could see less demand for services as well as higher bad debt and charity care expense that will incrementally pressure finances.
• One bright spot has been the additional funding support from enhanced state supplemental funding programs in states such as Kentucky and Florida and the continued adoption of Medicaid expansion in certain states.

How Will Credit Quality Be Affected?

We take an individualized approach.  We expect to review our portfolio credit-by-credit but may prioritize organizations that appear to be weakening at a more rapid pace than others and may no longer be in line with their current rating. If possible, and given increased financial uncertainty, we would prefer to take an outlook action first, which affords us time to see results of management's operational improvement and strategic initiatives as well as a longer period of directional trends. However, there will be situations with rapid financial deterioration, particularly at the lower rating levels or for credits already at the precipice of a lower rating, when an immediate downgrade is appropriate. Over time and depending on the duration and extent of the current challenges, we could see average credit quality for the sector decrease. While we always review with a fresh perspective, we do not expect to see a meaningful number of favorable outlooks or rating actions given that the sector's challenges appear to be widespread. In the past we also had a significant number of positive actions related to mergers and acquisitions, but the pace has slowed given increased regulatory scrutiny.

Monthly and quarterly trends will likely remain more relevant.  While the timing of reviews could matter given the unstable environment, we look at quarterly and monthly performance trends to better understand the trajectory and incorporate these details as well as management's forward-looking expectations into our credit rating and outlook decisions. In addition, while we view medians as an important rating tool, we recognize that drawing clear comparisons in a rapidly deteriorating credit environment is more challenging.

Determining flexibility at a particular credit rating.  We also look at how well credits are sitting at their specific rating, both the enterprise and financial profiles, as those that have been lighter or are less balanced in their overall credit profile, may experience more pressure. Those credits that were more reliant on their exceptional financial performance to offset a lighter balance sheet, for example, may be more vulnerable to rating pressure. At a particular rating, some providers may have some flexibility to generate lower margins than historic levels given our criteria and our holistic review of credit characteristics.

Not all credits are under the same operating stress.  There are credits that continue to perform well and in line with rating expectations by generating good operating and cash flow margins that support still healthy balance sheets albeit likely weaker than the peaks in 2021. We believe these credits have room within their ratings to withstand a certain amount of financial weakness depending on other aspects of their enterprise profiles and strategic initiatives. Furthermore, we believe there are certain organizations that may be better positioned to recover from financial weakness that may not warrant an immediate downgrade or outlook change. These may include health care providers that have uniquely strong enterprise strengths, such as a dominant market share, favorable service area economic fundamentals, or operate an integrated delivery and financing system, that we believe are sufficient to support the rating through multiple years of financial difficulties. In addition, organizations that have already been downgraded during the pandemic probably have a longer runway to a second rating change or negative outlook given much of the weakness would have likely already been incorporated into the prior rating change.

Quality of management will remain key.  Along with the service area and competitive position, the quality of management and the organization's culture can play a strong role in financial recovery. While the sector and management teams have exhibited resilience in tackling problems over the last several years, we believe the next two years could be a true test. We view positively those teams that are able to make meaningful and transformational organizational changes to better manage under the current stress and to position their organization for future success by accelerating the shift to outpatient and lower cost centers, adopting a customer orientation, embracing data and technology, and transforming care models. This is particularly critical given growing stakeholder concerns regarding affordability, medical debt, and collection practices.

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Related Research

• U.S. Not-For-Profit Health Care Rating Actions, October 2022, Nov. 16, 2022
• U.S. Not-For-Profit Health Care Outstanding Ratings And Outlooks As Of Sept. 30, 2022, Oct. 18, 2022
• U.S. Not-For-Profit Acute Health Care 2021 Medians: Peak Performance Highlights Cushion As Sector Encounters A Challenging Period, Aug. 24, 2022