Not-for-Profit Hospitals Face Some Headwinds
Cost and competitive pressures for hospital operators are being ameliorated in many cases by rising demand for specialized services and stronger balance sheets.
This article is from the second-quarter 2019 edition of The Muni Quarterly.
Health care remains an essential service and we expect continued growth in demand for high acuity hospital-based services. However, due to a tight labor market and the high cost of medical supplies and pharmaceuticals, we expect expense growth in the not-for-profit hospital sector to continue to outpace revenue growth. Revenue growth constraints will result from reimbursement pressures and limited additional upside from Medicaid expansion. What’s more, we believe that growth likely will remain below historical norms due to three other key factors:
- Modest rate increases by commercial payers
- Pressures to use lower cost settings for care and reduce a patient’s length of stay and
- A negative payer-mix shift.
In addition to these ongoing challenges, certain cuts to reimbursement, starting in 2019, may cause additional strain.
The Backdrop: Rising Expenses, Competitive Labor Market
Expense growth of 5.7% outpaced 4.6% revenue growth in 2017, based on Moody’s not-for-profit hospital medians, and we expect 2018 medians, once available, will show a continuation of this trend. Low unemployment continues to drive salary and wage growth that exceeds inflation in many markets. The tight labor market is also leading to an increase of temporary contract labor and overtime, especially in nursing and other key areas. The cost of physician employment also continues to weigh on margins, as hospitals must offer lucrative contracts to doctors to avoid poaching by competitors. Spending on supplies and pharmaceuticals is likewise not expected to abate in 2019.
Health Care Mergers and Market Share Pressure
Hospitals continue to report modest rate increases from commercial payers as negotiating leverage increases. To control cost, insurers are increasingly teaming up with providers. One example is the 2018 merger of Aetna and CVS. Aetna plans to add clinics to CVS stores that can perform services now offered at more expensive physician clinics or urgent care centers. This strategy could easily disrupt traditional referral streams, as CVS-employed practitioners refer patients to specific hospitals or even bypass hospital care altogether in lieu of more cost effective options. Similarly, Optum, UnitedHealth’s healthcare services arm, has been acquiring physician practices, including the anticipated acquisition of DaVita Medical Group, one of the nation’s largest medical groups.
Due to non-acute entrants entering the care delivery space, as described above, we also expect pressures on hospitals’ outpatient market share. To remain competitive, hospitals will be forced to invest in outpatient facilities such as freestanding emergency departments, urgent care centers and medical office buildings. Pressures from both commercial and governmental payers are causing more hospitals to shift to outpatient settings for care, causing downward pressure on revenues. Hospitals also remain under pressure to lower patients’ length of stay while maintaining high quality standards.
Medicaid Expansion and Reduced Medicare Payments
While Medicaid expansion has had a positive impact on hospital volumes and revenues in recent years, we believe there is limited additional upside on this front, as only a handful of additional states are likely to implement expansion. Furthermore, some states’ plans to expand Medicaid involve Section 1115 waivers that include conservative provisions expected to negatively impact ultimate enrollment. Medicaid expansion is anticipated in Utah and North Carolina but would include work requirements for the new enrollees. Ohio and Virginia have already expanded Medicaid, and requested federal permission to add work requirements. The result would likely be a decline in Medicaid enrollment in those states, leading to an increase in uninsured patients and hospital bad debt.
Hospitals are experiencing a pronounced shift from commercial to governmental sources of payment, which we expect to continue (see chart). Commercial pay has declined over the last decade, to 33% of revenues in 2017 from 40% in 2004. Going forward, we expect the share of commercial pay to decline and Medicare to grow as the population ages.
Medicare, Medicaid Account for Increasing Share of U.S. Hospital Revenues
Source: Moody’s MFRA, JPMorgan (latest available data, as of April 15, 2019).
Demand for Hospital Care to Increase in Some Cases
On the positive side, we expect continued growth in demand for high acuity hospital-based services as chronic diseases are effectively managed and the population ages. In particular, hospital systems offering more specialized and complex services unavailable elsewhere in the market will experience strong demand.
In addition, 2017 hospital medians showed another year of peak balance sheet measures, as hospitals have saved cash and pared back on debt issuance in order to strengthen their balance sheets. Robust balance sheets will allow hospitals flexibility to make ongoing strategic improvements and serve as a buffer in the event of an economic downturn.
Summing Up: The Prognosis for Hospitals
Although the healthcare sector faces headwinds, health care remains an essential service and there are a range of healthcare credits with many large systems successfully growing through acquisitions. We will continue to invest in those hospitals that we identify as being best positioned to succeed and offer value.
This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.
References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.
A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.
The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.
The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
About The Author
THE MUNI QUARTERLY
The Second Quarter 2019 edition offers insights from our analysts on key topics for municipal bond investors, along with essential market information.