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Fixed-Income Insights

Amid shifting industry dynamics, which types of issuers may be poised for outperformance? 

[Note: This article is from the forthcoming issue of The Muni Quarterly.]

We remain neutral and cautious on the not-for-profit hospital sector—similar to our view in 2017, a year characterized by flattening volumes and revenues, outpaced expense growth, weaker margins, and overall negative credit rating agency activity.  We believe margins will compress further in 2018 due to a continuation of the pressures seen in 2017.  (See Chart 1.) While hospitals continue to invest in delivery-system reform and focus on value orientation, they are being undercompensated for these investments. That said, as pressures mount, the divide between winners and losers in the sector will become increasingly defined, and many healthcare systems are well prepared for the environment.


Chart 1. Low Reimbursement Rates Compress Revenue Growth Relative to Volumes

Source: Moody’s Investment Service.
Note: Estimates for 2017 are based on year-to-date financials from a sample of hospitals. Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.


Hospitals will continue to face many headwinds in 2018.  New non-acute entrants to the space, including urgent care companies, large retailers, and tech companies, are posing disruptive threats in their quest to lower costs by keeping patients out of hospitals. Recent examples of disruptive activity include OptumCare’s purchase of Surgical Care Affiliates in 2017, CVS Health’s proposed purchase of Aetna, and Humana’s plan to purchase Kindred Healthcare.

In addition, recent and pending legislative and administrative changes are expected to increase the number of uninsured and exacerbate bad debt, which had been decreasing in recent years.  These challenges include a broad range of state waivers likely to negatively affect Medicaid reimbursement and enrollment; weakening of health insurance exchange provisions that are driving higher premiums in 2018; the repeal of the Affordable Care Act’s individual mandate under 2017 tax reform legislation; the Trump administration’s proposal to ease regulations on association health plans and expand the availability of short-term health insurance not subject to ACA rules; and recent reductions to the 340B Drug Discount Program.  

Revenue Pressures
In addition, we expect to see a continuation of reimbursement pressures. Drivers include modest rate increases and stricter rules from commercial payers, increasing use of lower revenue outpatient treatment options, the continued growth of narrow/tiered networks offered through exchanges and employer plans, a continuation of Medicare’s multiyear trend of very low rate increases, and cuts to Medicaid’s Disproportionate Share Hospital payments, which went into effect in October 2017, with additional cuts scheduled each year over the next eight years. Further, an adverse payer mix shift likely will continue to drive reimbursement downward (see Chart 2). The shift is being driven by the aging population, resulting in a growing percentage of patients qualifying for Medicare, and higher Medicaid business due to expansion during recent years. 


Chart 2. Increasing Reliance on Government Payers Will Temper Revenue Growth for U.S. Hospitals
% of gross patient revenue by payer type

Source: Moody’s Investment Service. Chart illustrates changes in indicated metrics from 2006 to 2016.


Also affecting revenues is the lackluster inpatient volume growth seen in 2016 and 2017, which is expected to continue, as there is limited additional upside from Medicaid expansion and as the broad movement to value orientation continues. 

Amid modest revenue growth, expenses are growing faster than expected, resulting in weaker operating margins. The major driver is high labor costs, driven by full employment and nurse shortages, and is most pronounced in major metro areas with strong economies and high competition for labor. Increased specialty pharmaceutical costs and drug-supply shortages also are driving up expenses, as well as upfront investments and continuing outlays for IT, outpatient facilities, and other elements of delivery-system reform.

Positive Factors
Despite these headwinds, we believe that the sector will benefit from many positive factors in 2018 and beyond. Demand for high-acuity hospital-based services is expected to grow as the population ages. Furthermore, the sector benefits from sophisticated management teams that successfully have navigated several years of reimbursement pressures and uncertainty. Delivery-system reform continues to drive greater efficiencies and better value and quality, making providers more attractive to payer networks. 

Furthermore, the sector has seen several years of strengthening balance sheets, with year-over-year growth in absolute cash and declining leverage. In addition, hospital mergers and acquisition activity accelerated in 2017, a trend that is expected to continue and create stronger health systems. The majority of recent and pending mergers are “horizontal” deals—that is, involving the merger of two acute-care health systems. Notable 2017 deals include the mergers of Baptist Memorial Health Care and Mississippi Baptist Health Systems, and Pinnacle Health and University of Pittsburgh Medical Center, while pending deals in 2018 include Providence St. Joseph Health and Ascension Health, Dignity Health and Catholic Health Initiatives, and Aurora Health Care and Advocate Health Care. The uptick in activity is largely a defensive play, as health systems seek to enhance their market positions in order to gain leverage with payers and fend off declining reimbursement and relevance in the face of more procedures being performed in non-hospital settings. 

While the sector faces numerous challenges, we think that certain hospitals and health systems are positioned to outperform. These include hospitals with the leading market share in their service area, solidified through a broad network of outpatient centers and physician practices, as well as a robust non-acute presence. In addition, outperformers will include hospitals with centers of excellence and evidence of superior quality and cost outcomes, making them indispensable to payers and patients, as well as hospitals made indispensable by geographic isolation and a long travel time to competitors.  The healthcare sector historically has offered many strong opportunities for investors, and with a careful, disciplined approach to security selection, we believe it should continue to provide good returns going forward. 



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