What's Behind Our Sector View?

Labor and other inflationary expenses still straining cash flow trends.   Our sector view of U.S. acute health care credit quality is negative given ongoing cash flow margin pressures that are still mostly due to labor expenses. These expense stresses, in addition to other supply and pharmaceutical expense increases, will continue through 2024 and could affect credit rating performance, depending on revenue trends and management's ability to garner offsetting efficiencies.

Potential for reduced balance-sheet flexibility as organizations consider capital needs and other spending strategies.   Balance sheets remain sound but have not strengthened materially for most organizations after declines from 2021, given weaker cash flow and uneven investment markets. Many organizations are restarting deferred capital projects and potentially looking to debt to help support spending and preserve reserves. For some, despite being strategically important or necessary, this spend could create additional pressure on the balance sheet and increased carrying costs at a time when cash flow hasn't fully recovered.

Varying credit quality trends depend on different factors, including geography and payer mix

There is a higher percentage of negative outlooks across our ratings scale.   While most rating outcomes are affirmations with stable outlooks, unfavorable outlook revisions relative to favorable revisions stand at just over 3:1 and almost one-quarter of rated entities carry a negative outlook as of Oct. 31, 2023. The key area of focus will be the pace of margin recovery with future credit stability hinging on management's ability to steadily improve operating performance. That said, even with improvement, it's likely margins could remain below historical levels for some time.

Many entities will continue to perform within rating expectations, albeit in a constrained operating environment.   A sizable number of rated organizations, particularly those in demographically favorable regions, exhibiting healthy demand and market positions, and/or located in states with favorable commercial rates and supplemental programs, will likely continue to perform in line with rating expectations, with healthy cash flow, albeit at slightly lower levels than pre-pandemic. S&P Global Ratings expects market characteristics, including the overall labor environment, as well as organization-specific characteristics related to culture and operating integration and discipline, will meaningfully influence credit quality trends in the next couple of years.

Further cash flow recovery in 2024, following broad but slow improvement in 2023, will be a key credit consideration.   Many organizations showed improvement in 2023 from 2022 due to management actions and use of less contract labor as permanent staffing levels improved, but recovery is still slower than expected and uneven. With ongoing losses or constrained cash flow for a meaningful portion of rated organizations and negative outlooks filtering across all rating categories, the level of cash flow improvement through 2024, and even 2025, will be key for our assessment of credit quality, along with other enterprise and financial factors. Over the next year, the crucial question for these organizations is whether they can still generate enough cash flow to fund appropriate investments to meet demand and satisfy necessary capital and strategic investments in an evolving and competitive sector.

Lower-rated entities will remain in a difficult position.   We expect many lower-rated and more pressured entities will have a difficult 2024 without meaningful partnerships or significantly improved labor conditions. They could struggle with capital spending, given projections of sustained higher interest rates (see "Economic Outlook U.S. Q1 2024: Cooling Off But Not Breaking," published Nov. 27, 2023, on RatingsDirect), tighter lending, and limited debt capacity, as well as the potential for ongoing covenant issues. Although covenant violations are not isolated among lower-rated organizations, the rating impact can be more pronounced, given these entities' inherently weaker unrestricted reserve cushion.

Sector Top Trends

Labor troubles linger

Although rates and usage of contract labor are generally falling, the pace of labor expense pressures has been slow to ease and complicated by heightened union activity, regional market difficulties, higher base labor rates, and less fruitful-than-expected international recruitment. Increased demand for services from an aging population also puts ongoing pressure on labor supply, which is just beginning to catch up from retirements and departures during and after the pandemic.

While many organizations are reimagining how clinical care is provided, including making more use of telemonitoring and artificial intelligence (AI), the industry is still in the beginning stages, with limited scaled efficiencies. To the extent that labor accounts for a higher percentage of expenses, teams will have to accelerate revenue growth, improve throughput and other staffing efficiencies, and make nonlabor expense reductions to improve earnings and cash flow. However, this is easier said than done because staffing shortages have resulted in offline beds and operating rooms, further limiting revenue growth. Nonlabor inflation rates (supplies and pharmaceuticals) also remain persistently high.

Organizations have seen some relief recently with volume increases, due in part to improvement in staffing that allows for more full utilization of beds and operating rooms, but also due to better throughput as post-acute care settings, including the home, have opened up and some progress is being made in reducing average length of stay.

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Generally good demand, but revenue is strained by payer and service mix dynamics

Although there have been some bright spots recently relative to historical governmental payment rates and continued benefits from Medicaid provider fee payment programs, governmental payments are generally below costs and certain programs, such as physician reimbursement and disproportionate share, are consistently under funding pressure. With redetermination at the end of the public health emergency in May, many individuals have shifted off the Medicaid rolls, which could increase self-pay, charity care, and bad debt. In addition, as the population continues to age into Medicare, we expect the typically more profitable commercial business will wane. This may be particularly evident in states and regions with stagnant and aging populations but might also spur innovative ways for some providers to accept and effectively manage Medicare risk.

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While cost shifting to commercial payers typically picks up some of the slack, recent commercial rate increases have generally been insufficient to cover rising expenses, even as certain providers have successfully negotiated higher-than-typical rate increases by reopening contracts or as part of the annual renewal process. In addition, some relationships remain contentious, as demonstrated by several high-profile contract terminations or willingness to terminate, and widespread difficulties reported with claims processing and denial rates, including more challenges with Medicare Advantage plans. A separate issue is that the shift in services from inpatient to outpatient creates more downward pressure on revenues and a focus on backfilling lost inpatient services. Revenue cycle management teams continue to demand extensive managerial and personnel resources to combat broad payer payment stresses, in certain cases resulting in an uptick in outsourcing.

Merger and acquisition dynamics evolve

Recent merger and acquisition trends have moved away from stronger organizations acquiring weaker providers and with few exceptions, we believe this will continue, as acquiring hospitals and systems are reluctant to bring on assets that would dilute already-weakened financial profiles unless there's an overwhelmingly strong strategic purpose and clear path to a turnaround. We believe this could result in heightened entity distress, as challenged hospitals might have limited options for financial improvement. Other affiliations tied to service lines and physician-aligned relationships with larger health systems could be supportive for smaller or strained organizations.

Alternatively, large system-to-system mergers, increasingly in noncontiguous markets, are steadily growing as management teams seek size and scale solutions to expense pressures and for broader strategic purposes. However, the ability to close mergers, particularly in a timely fashion, is still delayed by often-protracted Federal Trade Commission and state review processes, which we believe is influencing sector dealmaking.

Mixed trends of divestitures and joint ventures, all seeking stronger control and focus on core service lines

Some large multistate systems are increasingly divesting or joint venturing portions of their portfolios where performance has lagged to focus on core regions and service lines. Others are doing the opposite and entering into joint ventures regionally to strengthen market presence and potentially gain additional benefits from size and scale through corporate function consolidation, shared capital investment, clinical consolidation, and potentially improved negotiating strength with payers.

These arrangements do not always have to be hospital to hospital; we also see an uptick of organizations working with niche providers, such as urgent care and ambulatory surgery, to improve efficiencies and diversify revenue, often outside the hospital, and to expand their outpatient footprint. We evaluate these joint ventures based on cash flow, growth potential, and diversification of the revenue base, among other factors.

Efficiency focus is necessary to improve operating model

With constrained revenue, management teams, even those doing well relative to sector trends, are accelerating their expense management initiatives to lower the cost base. Performance improvement plans, many with the aid of consultants due to requirements after a covenant violation or a desire to accelerate progress, are widespread. Opportunities include more traditional strategies, such as group purchasing, throughput and average length of stay, productivity, and labor management, as well as:

• An increase in outsourcing to third parties, especially for IT and revenue cycle services in an effort to gain expertise and efficiencies;
• Rising use of AI for clinical, productivity, business, and labor purposes. Ease and use of AI could be influenced by evolving views on AI oversight, including the president's recent executive order to develop broad AI standards;
• Asset sales, for example, outpatient clinical labs, that generate cash at the time of the sale and potentially lower costs because services are run more efficiently at scale and with increased expertise;
• Service line consolidation or elimination of certain services to focus on revenue-generating opportunities and lower cost of care through fewer sites of service; and
• Reduction in operating leases or monetization of owned assets with an increasing virtual workforce.

Increased capital spending and debt issuance are likely

Debt issuances have slowed as many organizations defended the balance sheet and reduced spending or the commencement of larger capital projects amid operating pressure and drastically increased borrowing costs. However, health systems and hospitals can't continue to delay capital-intensive strategic initiatives and capital spend indefinitely and may begin to restart or accelerate those plans. Due to rising interest rates and weaker-than-normal operating performance, we believe access to capital will be difficult for lower-rated entities, potentially putting them at a long-term strategic disadvantage. Even for those that borrow, the higher interest rates will layer on additional costs at a time when lowering costs is a priority. Organizations might pivot to less cash-intensive strategies such as using operating leases but we view these as debt-like structures that will still weigh on our analysis of earnings and leverage. Finally, recent investment market volatility, coupled with the weaker cash flow, could complicate the credit profile as sizable projects and investments restart.

Event risks place ongoing pressure on organizations for both financial and management resources

Cyber security events, along with weather and other physical risks, require planning and investment to minimize financial and operating disruption. The unexpected nature of these events, which appear to be increasing, requires ongoing management attention at a time when management resources are already stretched. Although these increasingly recurring events are often considered one-time in nature within a fiscal year's performance, one of these events could result in rating pressure should it slow or reverse performance improvement needed to maintain the rating.

Ratings Performance

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Related Research

• U.S. Not-For-Profit Health Care Rating Actions, October 2023, Nov. 6, 2023
• U.S. Not-For-Profit Health Care Outstanding Ratings And Outlooks As Of Sept. 30, 2023, Oct. 18, 2023
• U.S. Not-For-Profit Acute Health Care 2022 Medians: Historically Low Metrics Signify A Long Road To A New Normal, Sept. 15, 2023