Nonprofit hospital funding stable, but clouds on horizon.

Nonprofit hospitals' bond ratings might be stable in 2006 but the future beyond this year appears challenging, according to two recent rating service reports.

Fitch Ratings recently released its 2006 Nonprofit Hospitals and Health Care Systems Outlook, which anticipates a stable year for the sector, but questions "the sustainability of current trends" beyond 2006.

The report expects "continued implementation of management best practices and a relatively stable revenue environment to offset pressures related to rising expenses, competition with physicians," and inadequate Medicaid reimbursement.

"Potential declines in Medicare reimbursement, a downward shift in growth rates on payor contracts and growing capital needs" in the sector contribute to Fitch's concerns after 2006.

Standard & Poor's, meanwhile, expects the gap between high-rated hospitals and low-rated hospitals to continue over time, according to its U.S. Not-for-Profit Health Care 2006 Outlook: Emerging Evidence of a Turning Tide, released in early February.

"The overall improvement in the sector has calmed the concerns of many investors and bond insurers about the quality of health care credits--concerns that were readily apparent four to seven years ago," said Standard & Poor's credit analyst Martin Arrick. "Investor confidence in the sector, combined with renewed interest of the municipal bond insurance companies, has helped launch a wave of significant capital spending, addressing both pent-up needs as well as strategic growth initiatives, and this increased level of capital spending is clearly expected to continue.

"A number of providers, however, continue to struggle despite the favorable environment and the gap in credit quality in the sector that emerged over the past several years will remain evident during 2006 and beyond," Arrick said. "In addition, some of the factors driving today's strong sector performance arc already beginning to show signs of erosion."

Upgrades outpaced downgrades in the S&P's report by a 1.6-to-1 ratio, while the Fitch report maintained a 1.4-to-1 ratio of downgrades to upgrades. Both reports anticipate the gap between high-rated and low-rated hospitals to widen. It was the first time since 1998 that S&P raised more ratings in the sector than it lowered.

Bond ratings range from AAA, the highest, to D, the lowest. Anything rated B or lower is regarded as speculative, or junk bonds. Interest rates for borrowing are based on an organization's bond rating; the better an organization's bond rating, the better the interest rate when it wants to borrow.

Bigger is better?

S&P's upgrades were concentrated on larger organizations, which "are using their size, market leverage, market access, and managerial talent to differentiate themselves--in many cases successfully translating these efforts into stronger financial performance and improved credit strength."

On the flip side, most of S&P's lowered ratings over the past few years occurred mostly in small and mid-sized health systems, with relatively low levels of debt.

"While size does not necessarily drive ratings changes, larger hospitals and systems tend to have better business positions, more tertiary services, and often related strengths of revenue and geographic diversity," the report stated.

"Larger facilities can convert these strengths into better reimbursement rates from managed care payors given their greater market clout and more efficient operations, often through 'economies of scale,' which, over time, helps improve financial profiles. Larger systems also benefit from a greater ability to attract the best physician and management talent. In addition, larger systems and academic medical centers are often better positioned to manage the rising level of direct physician competition as their reputation and resources, and in some cases, basic business model, keep physicians more tightly bound to help the provider."

Capital concerns

It's the capital needs related to aging hospital facilities that are a primary challenge for nonprofit healthcare.

Last year, project delays and cost overruns were contributing factors in some of Fitch's downgrades. "Hospitals will need to more accurately forecast project costs to include contingencies that can account for delays or rising material costs."

Marcelo Olarte, associate director for public finance-healthcare for Fitch Ratings, said capital improvements are the most immediate need for hospitals, as the median age of facilities in the industry is almost 10 years old, a figure that's been increasing in Fitch's portfolio since 1997.

Nonprofit hospitals will continue to find themselves surrounded by aging buildings not able to handle the modern needs of health care. A majority of hospitals were built decades ago when 80 percent of their services were outpatient, he said, but these days the split between inpatient and outpatient services is more balanced, at about half.

Focused, strategic capital planning is needed for improved credit worthiness, he said. Fitch looks for projects that have a guaranteed maximum price before bonds are issued. "We see that as a strength when rating a new bond issue," Olarte said. As a result of increased fuel costs, steel and raw materials, there are construction projects that are costing more than originally envisioned. A maximum price is a "very good offset to that."

In addition to aging buildings, "necessary investments in high-price information technology to meet minimum clinical quality and patient safety standards threaten the competitive positions of many hospitals," the Fitch report stated.

Capital spending and access to capital remain key measures of viability for hospitals, as are information technology capabilities becoming a growing necessity, according to the S&P report. "Stronger providers consistently reinvest in their plant to ensure recruitment of top physicians and to maintain their attractiveness to patients, who often have many choices.

"Capital spending remains a key marker of the credit gap between strong and troubled credits, and is an important measure of the future viability of hospitals and health systems."

Bad debt for hospitals should continue to rise in 2006 "due to the increasing number of uninsured and underinsured patients, as well as rising co-payments and deductibles," according to S&P.

Median bad debt, as a percentage of total revenue of Fitch's rated hospitals, was 5.7 percent in 2004, the highest ever recorded by the ratings service.

"Contrary to Fitch's expectation, there were a minimal number of mergers and acquisitions in 2005," partly because of the current relatively good credit environment, resulting in higher earnings, and therefore pricing, because most sales are derived from cash flow earnings. Consolidations and mergers also will be limited this year, according to Fitch.

Stand-alone community hospitals, particularly those in suburban settings, could seek "more formal partnerships with clinically reputable academic medical centers or regional health care systems to improve their standing in their markets."

While the S&P report forecasts challenges for providers in the current environment to intensify in 2007 or later, "a good number of organizations will demonstrate stability while those in a declining credit situation could face closure, acquisition or other difficult choices."

Best practices

"Hospitals continue to make significant efforts on revenue cycle management, supply chain management, clinical quality and patient safety outcome, and asset-liability management," according to the Fitch report.

"Hospitals that have been slow to implement best practices have made, at most, a marginal improvement in their finances, while more focused hospitals have bettered their financial footing. Fitch believes hospitals should continue to focus on their core competencies, divest unprofitable businesses and select strategic investments in high-growth service lines and areas."

What The Raters Say

Areas of continued improvement and opportunity

* Management best practices: tax-exempt status, accountability and internal controls over financial reporting, management of revenue cycle and supply chain, strategic capital allocation and asset-liability management.

* Physician alignment

* Access to capital: availability of bond insurance, interest rate environment, minimal spread between high- and low-rated deals.

* Health care information technology (HIT)

* Medicare and managed care

* Consumerism and quality initiatives

Industry pressures and risks

* Capital needs and spending

* Revenue constraints beyond 2006: managed care, Medicaid, Medicare and volume

* Rising expenses related to bad debt, labor, supplies and pensions

* Physician issues, such as competition for doctors and physician shortages

* Malpractice environment

* Project management and construction costs

Source: Fitch Ratings 2006 Nonprofit Hospitals and Health Care Systems 0utlook