2015 Outlook - US Not-for-Profit Healthcare OUTLOOK Cash Flow Settling into Low Level of Growth Amid Negative Outlook Summary ANALYST CONTACTS Daniel J Steingart 949-429-5355 VP-Senior Analyst kimberly.tuby@moodys.com Lisa Martin Senior Vice President lisa.martin@moodys.com 212-553-1423 Lisa Goldstein 212-553-4431 Associate Managing Director lisa.goldstein@moodys.com Our negative outlook for the US not-for-profit healthcare sector reflects our expectations that the fundamental business, financial and economic conditions in the sector will remain weak over the next 12-18 months. After falling each year, from a recent high of 7% in 2009, we expect operating cash flow growth will be low, but relatively stable over the next two years, ranging from -0.5% to +1.5%. This forecast reflects weak revenue growth stemming from a variety of reimbursement pressures and margin contraction related to investments hospitals are making to comply with the Affordable Care Act (ACA) and new reimbursement models. We expect weak operating cash flow growth in 2015. We forecast that median growth will range from -0.5% to +1.5%. However, we expect that operating cash flow will decline even more for smaller hospitals, while the largest systems will grow cash flow at a stronger rate. Operating margins will weaken in 2015. Investments in physician practices, IT systems and other strategic resources will continue to pressure margins. Revenue growth will remain low in 2015. Median top-line revenue growth will be below 4%, which is in line with the last several years, but well below historical norms of 6%-8% prior to 2009. In recent years, acquisitions and various nonrecurring payments have supported revenue growth. Impact of the ACA will vary by state in 2015. To date, the ACA has had only a modest impact on our rated portfolio, due in large part to uneven implementation across the country. Hospitals in the states that expanded Medicaid eligibility and aggressively enrolled individuals for healthcare insurance in 2014 will see the greatest benefit. What could change the outlook. Projected growth in operating cash flow is a key driver to future outlook revisions. We could change our outlook to stable if projected operating cash flow grows 0%-3%. Kendra M. Smith 212-553-4807 MD-Public Finance kendra.smith@moodys.com
Operating cash flow growth will remain low in 2015 We project aggregate operating cash flow growth will be low in 2015, ranging from -0.5% to +1.5%. Our projections are based on interim financial performance in 2014 and our future same-facility revenue growth and margin forecasts. Our projections reflect a clear trend among not-for-profit hospitals. The largest hospital systems with revenue above $2 billion will likely achieve growth of 3%-4%, while most hospitals with revenue under $1 billion will likely generate negative operating cash flow growth. Meanwhile, growth at the smallest hospitals (those with less than $500 million in annual revenue) will decline 2% or more. These growth patterns reflect a long-term trend that accelerated following the financial and economic crisis of 2007-09: the largest hospitals are getting stronger, while the smallest hospitals are getting weaker (see Exhibit 1). Large hospitals have long generated stronger operating margins and revenue growth owing to their economies of scale, greater geographic diversity of acute care operations, stronger propensity for acquisitions and ability to drive higher organic revenue growth through expanded services. We expect this trend to continue over the next several years as reimbursement growth slows and hospitals rely on cost cutting and productivity gains to generate the majority of cash flow growth trends that, in general, favor larger hospitals. Exhibit 1a Operating Cash Flow Growth is Stronger at Larger Hospitals Exhibit 1b Revenue Growth Correlates with Hospital Size Source: Moody's Investors Service This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2
Although we project that operating cash flow will decline year over year for the majority of hospitals we rate, we expect that aggregate cash flow for the industry will grow slightly. As a result, the industry should settle into a period of very low, but stable growth that ultimately could lead us to change our outlook to stable. These projections are summarized in Exhibit 2. The trajectory of the projected median growth rate weighted by hospital size is higher given our expectation of stronger growth among the largest hospitals, while the projected median growth among all hospitals is lower due to the preponderance of small hospitals in our rated portfolio. Exhibit 2 Operating Cash Flow Projected to Remain Negative for All but the Largest Hospitals Source: Moody's Investors Service Operating margins will weaken further in 2015 Hospitals have exhausted many of the low-hanging fruit strategies to preserve margins over the last several years, and we expect further expense reductions will be harder to achieve because: Hospitals are operating under two very different reimbursement models, which is contributing to margin erosion. Traditional fee-for-service, in which higher patient volume leads to higher revenue, has different incentives and staffing models from emerging reimbursement models that emphasize preventative care and the avoidance of hospital stays. The ACA and purchasers of healthcare are encouraging shifts in reimbursement models in an effort to reduce healthcare spending. Labor is the biggest hospital expense, yet hospitals often view labor reductions as a last resort, preferring to cut the work force through attrition. Physician employment is growing as hospitals build networks of healthcare providers. Physician practices often reduce consolidated hospital margins, especially in the first few years of employment, as their benefit and expense structures migrate to the acquiring hospital's structure. Hospitals are making significant investments in electronic health records and other IT systems. These investments are often expensed in the year they are made and not capitalized, which reduces operating margins. Revenue growth will be low, but is unlikely to contract further Following many years of declining revenue growth, we project growth to remain low, but steady at 3.5%-4.5% over the next several years (see Exhibit 3). 3
Exhibit 3 Revenue is Settling Into Low, But Steady Growth: Forecasted Range of 3.5% - 4.5% Source: Moody's Investors Service Low revenue growth is a result of many factors including: Medicare inpatient rate increase of 1.4% for federal fiscal year 2015; Medicare accounts for 44% of hospital patients, on average. The ongoing impact of the Two-Midnight Rule which is shifting more inpatient cases to outpatient status; hospitals are reimbursed for outpatients at a significantly lower rate and thus revenue growth is lower, even though actual patient volume is unchanged. Payor mix shift to governmental payors caused by the ageing population and the ACA; reimbursement by governmental payors is under pressure and is likely to grow more slowly than commercial reimbursement. Lower reimbursement growth from commercial payors than historical levels. Generally anemic patient volumes characterized by outpatient growth and inpatient declines. Many of these factors have been in place for several years, resulting in the current state of low revenue growth. Other than the ongoing shift to governmental payors, we do not project significant changes in these factors over the next 12-18 months. However, there are other developments that could tip the balance toward stronger or weaker revenue growth. On the positive side, growth in the insured population under the ACA could compensate for weak underlying patient demand; combined with lower bad debt and less of a need to provide charity care to an uninsured population, this could positively impact revenue growth. On the negative side, cuts to supplemental payments from Medicare for treating uninsured patients, which accounted for a disproportionate share of hospitals' revenue, and the loss of various one-time revenue items like meaningful use reimbursement (federal stimulus money that encouraged the adoption of electronic health records) would lower revenue growth. Similar to our projections for operating cash flow, we expect the smallest hospitals to have the lowest revenue growth rates. These hospitals have the weakest bargaining position with commercial payors and the least capacity to implement new growthoriented strategic initiatives. 4
The ACA s impact is uneven; Medicaid expansion states will see a larger benefit To date, the ACA s impact on hospitals' financial performance has been modest. This is due, in part, to the law s rocky start with malfunctioning healthcare exchanges and a late surge of insurance enrollments resulting in many people not gaining insurance coverage until March 2014. Additionally, because each state exerts significant influence over actual implementation of the law, influencing everything from the insurance exchange to how aggressively the uninsured are recruited, the ACA s impact on hospitals' financial positions varies from state to state. As expected, differences are emerging among states that expanded Medicaid eligibility and those that did not. In states that expanded eligibility, the law s primary impact has been to reduce the level of uncompensated care provided by hospitals and increase their Medicaid exposure. Bad debt declined significantly in the states (including Washington DC) that expanded Medicaid, with median bad debt down 5.6% through June 2014 (see Exhibit 4). Among states that did not expand Medicaid eligibility, bad debt grew 6.8%, which is slower than recent years, but stands in stark contrast to states that expanded eligibility. Exhibit 4 Bad Debt is Falling Faster in States that Expanded Medicaid Source: Moody's Investors Service Payor mix is also shifting, with Medicaid programs growing for hospitals in all states, although hospitals in states that expanded Medicaid eligibility are seeing stronger growth (Medicaid is still growing in non-expanding states due to the woodwork effect, whereby individuals who were unaware of their eligibility begin to enroll in Medicaid). Because the ACA contains both positive and negative elements for hospitals and because the law s impact varies so widely throughout the country, we expect the effects of the ACA to increase throughout 2015 and drive more significant changes in the second half of the year and 2016. We expect the following effects from the ACA in 2015: 5 The national uninsured rate will remain low by historical standards. Hospital bad debt will continue to trend lower, particularly in states that expand Medicaid. Medicaid enrollment will grow in all states, but faster in states that expand Medicaid. Financial benefits to hospitals will accrue slowly as the positive benefit of expanded insurance coverage is mitigated by the effect of high deductible plans and low reimbursement growth.
What could change the outlook We would consider changing our outlook to stable if our projections for operating cash flow for the sector reached 0%-3% for the next 12-18 months. Although this growth rate would be very low by historical standards, its steadiness over that timeframe would influence our outlook. Additional factors that could lead us to change our outlook to stable include a resurgence in hospital patient volumes that compensate for revenue pressure, significant reductions in bad debt that lead to improved financial performance, or expansion of Medicaid eligibility in more states. Moody's Related Research 6 Two-Midnight Rule Will Reduce Revenue for Most Hospitals, March 2014 (165866) US Healthcare Reform: Three Risks Reduce Credit Positives for Not-for-Profit Hospital, March 2014 (166602) Building Value: Investments Aimed at New Priorities Create Opportunities for Not-for-Profit Hospitals, May 2014 (170100) Revenue Growth and Cash Flow Margins Hit All-Time Lows in 2013 US Not-for-Profit Hospital Medians, August 2014 (174260)
2014 Moody s Corporation, Moody s Investors Service, Inc., Moody s Analytics, Inc. and/or their licensors and affiliates (collectively, MOODY S ). All rights reserved. CREDIT RATINGS ISSUED BY, INC. AND ITS RATINGS AFFILIATES ( MIS ) ARE MOODY S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND CREDIT RATINGS AND RESEARCH PUBLICATIONS PUBLISHED BY MOODY S ( MOODY S PUBLICATIONS ) MAY INCLUDE MOODY S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODY S DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK, MARKET VALUE RISK, OR PRICE VOLATILITY. CREDIT RATINGS AND MOODY S OPINIONS INCLUDED IN MOODY S PUBLICATIONS ARE NOT STATEMENTS OF CURRENT OR HISTORICAL FACT. MOODY S PUBLICATIONS MAY ALSO INCLUDE QUANTITATIVE MODELBASED ESTIMATES OF CREDIT RISK AND RELATED OPINIONS OR COMMENTARY PUBLISHED BY MOODY S ANALYTICS, INC. CREDIT RATINGS AND MOODY S PUBLICATIONS DO NOT CONSTITUTE OR PROVIDE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS AND MOODY S PUBLICATIONS ARE NOT AND DO NOT PROVIDE RECOMMENDATIONS TO PURCHASE, SELL, OR HOLD PARTICULAR SECURITIES. NEITHER CREDIT RATINGS NOR MOODY S PUBLICATIONS COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULAR INVESTOR. MOODY S ISSUES ITS CREDIT RATINGS AND PUBLISHES MOODY S PUBLICATIONS WITH THE EXPECTATION AND UNDERSTANDING THAT EACH INVESTOR WILL, WITH DUE CARE, MAKE ITS OWN STUDY AND EVALUATION OF EACH SECURITY THAT IS UNDER CONSIDERATION FOR PURCHASE, HOLDING, OR SALE. MOODY S CREDIT RATINGS AND MOODY S PUBLICATIONS ARE NOT INTENDED FOR USE BY RETAIL INVESTORS AND IT WOULD BE RECKLESS FOR RETAIL INVESTORS TO CONSIDER MOODY S CREDIT RATINGS OR MOODY S PUBLICATIONS IN MAKING ANY INVESTMENT DECISION. IF IN DOUBT YOU SHOULD CONTACT YOUR FINANCIAL OR OTHER PROFESSIONAL ADVISER. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY LAW, INCLUDING BUT NOT LIMITED TO, COPYRIGHT LAW, AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided AS IS without warranty of any kind. MOODY'S adopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources MOODY'S considers to be reliable including, when appropriate, independent third-party sources. However, MOODY S is not an auditor and cannot in every instance independently verify or validate information received in the rating process or in preparing the Moody s Publications. To the extent permitted by law, MOODY S and its directors, officers, employees, agents, representatives, licensors and suppliers disclaim liability to any person or entity for any indirect, special, consequential, or incidental losses or damages whatsoever arising from or in connection with the information contained herein or the use of or inability to use any such information, even if MOODY S or any of its directors, officers, employees, agents, representatives, licensors or suppliers is advised in advance of the possibility of such losses or damages, including but not limited to: (a) any loss of present or prospective profits or (b) any loss or damage arising where the relevant financial instrument is not the subject of a particular credit rating assigned by MOODY S. To the extent permitted by law, MOODY S and its directors, officers, employees, agents, representatives, licensors and suppliers disclaim liability for any direct or compensatory losses or damages caused to any person or entity, including but not limited to by any negligence (but excluding fraud, willful misconduct or any other type of liability that, for the avoidance of doubt, by law cannot be excluded) on the part of, or any contingency within or beyond the control of, MOODY S or any of its directors, officers, employees, agents, representatives, licensors or suppliers, arising from or in connection with the information contained herein or the use of or inability to use any such information. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY S IN ANY FORM OR MANNER WHATSOEVER. Moody s Investors Service, Inc., a wholly-owned credit rating agency subsidiary of Moody s Corporation ( MCO ), hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by Moody s Investors Service, Inc. have, prior to assignment of any rating, agreed to pay to Moody s Investors Service, Inc. for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,500,000. MCO and MIS also maintain policies and procedures to address the independence of MIS s ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually at www.moodys.com under the heading Investor Relations Corporate Governance Director and Shareholder Affiliation Policy. For Australia only: Any publication into Australia of this document is pursuant to the Australian Financial Services License of MOODY S affiliate, Moody s Investors Service Pty Limited ABN 61 003 399 657AFSL 336969 and/or Moody s Analytics Australia Pty Ltd ABN 94 105 136 972 AFSL 383569 (as applicable). This document is intended to be provided only to wholesale clients within the meaning of section 761G of the Corporations Act 2001. By continuing to access this document from within Australia, you represent to MOODY S that you are, or are accessing the document as a representative of, a wholesale client and that neither you nor the entity you represent will directly or indirectly disseminate this document or its contents to retail clients within the meaning of section 761G of the Corporations Act 2001. MOODY S credit rating is an opinion as to the creditworthiness of a debt obligation of the issuer, not on the equity securities of the issuer or any form of security that is available to retail clients. It would be dangerous for retail clients to make any investment decision based on MOODY S credit rating. If in doubt you should contact your financial or other professional adviser. For Japan only: Moody's Japan K.K. ( MJKK ) is a wholly-owned credit rating agency subsidiary of Moody's Group Japan G.K., which is wholly-owned by Moody s Overseas Holdings Inc., a wholly-owned subsidiary of MCO. Moody s SF Japan K.K. ( MSFJ ) is a wholly-owned credit rating agency subsidiary of MJKK. MSFJ is not a Nationally Recognized Statistical Rating Organization ( NRSRO ). Therefore, credit ratings assigned by MSFJ are Non-NRSRO Credit Ratings. Non-NRSRO Credit Ratings are assigned by an entity that is not a NRSRO and, consequently, the rated obligation will not qualify for certain types of treatment under U.S. laws. MJKK and MSFJ are credit rating agencies registered with the Japan Financial Services Agency and their registration numbers are FSA Commissioner (Ratings) No. 2 and 3 respectively. MJKK or MSFJ (as applicable) hereby disclose that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MJKK or MSFJ (as applicable) have, prior to assignment of any rating, agreed to pay to MJKK or MSFJ (as applicable) for appraisal and rating services rendered by it fees ranging from JPY200,000 to approximately JPY350,000,000. MJKK and MSFJ also maintain policies and procedures to address Japanese regulatory requirements. AUTHOR Daniel Steingart DATA VISUALIZATION Lisa Mahapatra 7
8