The Health Care Service Sector: Key Observations

So far in 2024 S&P Global Ratings already downgraded six health care service companies. The only upgrades were of two companies that we raised to B- from SD (selective default). Of the 18 health service companies with negative outlooks, 7 (39%) are for companies in the 'B-' category, and 8 (44%) are in the 'CCC' category.

The ratings distribution continues to deteriorate with 64% of health care service companies rated 'B-' or below (as of April 25, 2024) as compared with 53% in 2022, and 41% in 2021.

As of April 25, 2024, we rated 14 health care services companies in the 'CCC' category or below as compared with four in 2022 and only one at the end of 2021. The health care services portfolio has a higher percentage of negative outlooks than both the pharmaceutical and medical device portfolios.

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Our Rating Perspective

Overall credit trends for the roughly 70 company health care services companies we rate remains relatively weak, despite a recovery in demand and moderating labor and inflationary pressures. In fact, this subsector is the only one of our major corporate health care subsectors that continues to hold a negative outlook (pharmaceuticals, medical devices/life sciences, health care business services/IT, and health insurance are all stable).

We believe this negative outlook, and ongoing ratings deterioration, will persist through the first half of 2024. For historical perspective, we characterized 2022 as a trough year and expected 2023 to be better. Industrywide that was the case as the labor environment improved and inflation eased as the year progressed. Better recruitment and retention of permanent staff, and decline in contract labor rates and utilization, enabled many companies to increase capacity. Better capacity coupled to some extent with patients catching up with deferred care contributed to pretty good patient volume trends in several subsectors, particularly in the second half of the year and into 2024. However, given the very diverse nature of health care services and their local markets, there was significant variance among the many services subsectors.

We have observed that smaller, narrowly focused companies tend to struggle more. Often, they have a good credit story that in theory aligns well with the future direction of the industry such as the shift to lower cost sites and payment transitions to value-based care. Yet they continue to struggle from factors related to labor challenges, changing competitive dynamics in their niche, or simply better but still-lackluster patient volume trends such that they find themselves well behind where they expected to be by now. They may not have contemplated this underachievement prior to the pandemic, often finding themselves unable to meet near-term financial challenges.

The considerable variation in the pace and magnitude of improvement is very evident as a key factor for rating activity. For instance, the for-profit hospital companies we rate are experiencing meaningful declines in contract labor and good patient volume increases in their acute care business (adjusted admissions) that started to gain momentum last year.

This did contribute to rating/outlook decisions such as our revision of our rating outlook on LifePoint Health Inc. (B/Stable/) to stable from negative. In contrast, Knight Health Holdings LLC (B-/Negative/--) is still contending with relative patient volume weakness in its specialty hospital segment. As a result, we revised the outlook to negative from stable given the uncertainty about its ability to achieve necessary operating and cash flow improvements. Another example is Athletico Holdings LLC. We recently downgraded the company to 'CCC+' with a stable outlook from 'B-' with a negative outlook even though revenue is increasing at a good pace. We noted liquidity issues, cash flow deficits, ongoing margin headwinds, and capacity constraints due to the weak reimbursement environment and labor challenges.

Our negative outlook on the sector takes into account these challenges. The most vulnerable companies are those rated in the 'B-' or 'CCC' categories. Many of them are burdened by dramatically higher cash interest expenses that they did not anticipate when they incurred the debt. And although labor challenges have eased, they have not disappeared.

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Key things to watch

Patient volume and revenue expectations.  Patient volume was quite strong in 2023 and this is continuing in 2024. Contributing factors include the still-improving labor environment that has increased providers' capacity to treat patients and what we expect to be a further catchup of deferred care. We expect some leveling of patient volume in the second half of the year as patient visits and acuity approach levels that several companies have indicated are more normalized. Longer term, we believe demand for health care services will remain solid given demographic trends and a return to more normal patient demand patterns. Hence, we think patient revenue will grow in the range of low-single-digit to high-single-digit percent areas depending on the services subsector. We expect hospital companies to generate mid-single-digit revenue growth.

Labor.  The labor environment for health care services companies improved significantly in 2023 and early 2024. Better recruitment and retention for nurses reduced the need for premium labor and sign-on bonuses. However, the structural shortage of nurses and physicians will not completely abate despite the recent easing and that in turn will result in more aggressive recruitment/retention efforts, higher permanent staffing costs, ongoing use of staffing companies, and continuing margin headwinds. We expect physician recruitment to be particularly difficult for at least the next few years.

Margins.  We expect inflationary cost pressures across the board but particularly for labor, and we expect the relatively weak reimbursement environment to continue to drag on margins for health care service companies. Overall, we believe margins could decline unless aggressive management intervention can preserve or limit downside margin risk. Companies are deploying several strategies for margin preservation. Although labor challenges are easing, companies will need to achieve greater efficiencies by using technology to optimize labor utilization, and have other titles such as nurse practitioners to work to the top of their licenses. We expect capital allocation and M&A strategies to increasingly include higher-margined business with a greater focus on higher acuity, scale, and diversity.

Cash flow and capital structure.  We consider health care services companies' cash flow and capital structure issues to be the most significant factor underscoring recent downgrades and negative outlooks. Even though cash flow for these companies as a group has generally improved, cash flow for highly leveraged companies with ratings of 'B-' and below remains problematic. We expect cash interest expense to remain much higher, certainly much higher than what many companies expected when they originally incurred debt. Coupled with higher permanent wage expenses (despite less contract labor) and operational challenges, including for some the impact of the No Surprise Act, many of these companies have not been able to generate adequate sustainable cash flows and may even continue to suffer cash flow deficits.

Many lower-rated companies have been dealing with upcoming maturities at the same time as their cash flow difficulties. This has resulted in several debt restructurings, and is the source for the unprecedented number of companies in this portfolio we rate in the 'CCC' category. We believe more cases will arise in which companies will improve their performance, but not enough to avoid additional distressed transactions.

Early Election Year Thoughts

Health care is usually a heavily debated issue in the months leading up to the U.S. presidential election. So far it's been relatively quiet. We don't see the return of heavily debated topics from the last election like "Medicare for All," or any major changes in transparency.

Some issues we believe will become more prominent as the election approaches include the next steps beyond the Inflation Reduction Act's provision that gave Medicare the ability to negotiate to lower the prices on 10 prescription drugs, and a proposed cap of $2,000 on drug spending per individual. The future of the ACA may also reemerge as Donald Trump has said he wants to eliminate it, but we think there is very little risk to that occurring because the ACA is very popular as evidenced by record enrollment of 21.3 million people during the 2024 open enrollment period and because there doesn't appear to be an alternate plan.