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Fitch: For-Profit US Hospital Providers Will Continue to Face Escalating Industry Pressures in 2007.

NEW YORK -- Fitch expects the for-profit hospital industry to face many of the same challenges in 2007 that were seen in 2006, with rising bad debt expense and weak volumes offset by a favorable reimbursement environment. In 2007, Fitch expects the bad debt environment to continue to worsen but at a lesser rate than in 2006. Although Fitch anticipates little gains from same-store volume growth, continued strong pricing and acquisitions should contribute to overall revenue growth for the sector. In general, increased leverage is expected from time to time in the sector to fund internal growth and acquisitions; however, strong cash generation will allow companies in this sector to pay down debt quickly. Nonetheless, with potentially lower earnings, companies will have less flexibility in their credit metrics in 2007.

Key Credit Trends 2006:

Before forecasting 2007 performance, it is helpful to look back at the key trends that emerged among the seven issuers and over $44.8 billion of debt that Fitch rated in 2006. The challenges for the sector are evidenced by the fact that Fitch did not upgrade any issuers in this sector in 2006. Two providers were downgraded; on July 27, 2006, Health Management Associates' Issuer Default Rating (IDR) was downgraded to 'BBB+' from 'A-' due to lowered earnings expectations coupled with refinancing that resulted in increased interest expense and an expectation of increased share repurchases. On Nov. 20, 2006 Fitch downgraded HCA's IDR to 'B' from 'BB+' reflecting the capital structure and financial prospects for HCA after its leveraged buy-out (LBO). All issuers remain on Stable Outlook except Tenet Healthcare, which is on Negative Outlook.

In 2006, the sector continued to face EBITDA margin pressure from lackluster volume growth and, more importantly, bad debt. These pressures were felt regionally, but pricing remained strong nationwide. Credit metrics declined slightly but it is important to note that ratings in this sector allow for slight deterioration due to strong cash-flow generating abilities and relatively stable demand.

The Re-emergence of Private Equity:

One of the major news stories of 2006 was the LBO of HCA. The option of being privately held in the for-profit hospital sector is nothing new, as many of these companies came from private roots. The sector is attractive to private equity because of its strong cash flows, growth prospects from improved operations of recent acquisitions, and favorable long-term industry demographics. Despite the squeeze on margins due to industry pressures, cash flow generation from operations continues to be strong (between 6%-13% of Revenue compared to 8%-16% historically).

In 2007 Fitch expects that as margins continue to be squeezed while acquisition and capital spending remain close to historical levels, shareholder unrest will continue. Several issuers have announced share repurchase programs; however, drastic changes in company strategy regarding share repurchases are not expected. With continuing shareholder pressure, and depressed equity prices, Fitch believes that the potential for further privatization in the sector in 2007 is possible.

Bad Debt to Remain a Challenge in 2007:

The escalation of bad debt expense was one of the most significant trends for the sector in 2006. Although Fitch does not expect the same level of acceleration for 2007, Fitch expects that bad debt expense will continue to grow. Bad debt will continue to be driven primarily by the growing uninsured population and secondarily by increasing deductibles, co-pays and co-insurance among policy holders. In 2006, spikes in bad debt resulted in reevaluated bad debt methodologies and one-time charges. Going forward, Fitch expects that most providers are anticipating continued increasing bad debt. Accordingly, Fitch does not expect to see unexpected charges related to bad debt; however, continued revisions to bad debt methodologies are possible as providers are forced to take an even more conservative stance on collection expectations.

Bad debt is a regional phenomenon hitting some states harder than others, notably Florida and Texas. Providers are evaluating local economic factors with more scrutiny when performing acquisition due diligence and this local focus may contribute to strategic asset sales in 2007. Contributing further to the uninsured spike in 2006 was the reduction in Medicaid benefits, specifically in Tennessee. Fitch anticipates that similar large-scale Medicaid enrollment cuts will not occur in 2007.

Although the primary driver of bad debt expense is the uninsured population, the growth of Consumer Directed Health Plans (CDH) could have a significant impact in future years. Fitch expects the trend towards Health Savings Accounts (HSAs) and CDH plans to continue, although currently they represent only a small portion of hospitals' revenue base. CDH revenues currently represent only 3.6% of insurance company premium revenue, and expectations are that approximately 5.1% of premium revenues will come from these plans in 2007. This shift may have the ability to lower volume and increase bad debt expense, as participants often delay medical care and may put themselves at risk for severe health events for which they will shoulder a large portion of the responsibility to pay. Furthermore, it is more challenging for hospitals to collect payment from individuals than from managed care providers, resulting in a potential for increased bad debt if these plans become more prevalent. Since these plans are still relatively infrequent, the impact in 2007 should be limited, with the greater threat to bad debt coming from the rising numbers of uninsured. However, CDH represents a significant trend to monitor in the coming years.

Continued Pressure on Volumes:

Fitch expects volumes to remain essentially stagnant on a same store basis in 2007. Helping volumes slightly in 2007 may be the year over year comparison to 2006 which witnessed a weak flu season coupled with industry pressures. The drivers of this weaker volume include: increased uninsured leading to less utilization of health services, increased pricing visibility and consumer driven decision making, fairly stable aging population for the next few years, and another anticipated light flu season. Some providers are fairing better than others, achieving relatively strong volume growth, (Universal Health Services and Triad Hospitals) while others, namely Tenet, but also LifePoint, posted declines in volume for the past eleven and five quarters respectively. Population growth from immigration and regional migration may contribute favorably to certain providers; however, if growth in uninsured volumes outpaces profitable growth, volume wins will be negated. An improvement in volume growth for the overall hospital industry is not expected until the baby boom generation reaches ages of higher utilization (typically post 65 years of age).

Increased Competition from Specialty Hospitals:

One potential drag on volumes for the sector in 2007 is competition from specialty hospitals, particularly for urban providers. Like bad debt, the impact of specialty hospitals varies by region, with the absence of Certificate of Need legislation a key predictor of specialty hospital competition. Of the roughly 130 specialty hospitals in the United States, over a third are in Texas and more than 70% are found in four states: Texas, Louisiana, Kansas and Oklahoma, according to the Department of Health and Human Services. In addition, specialty hospitals are more likely in urban areas where the size of the population warrants a specialized facility.

Several regulatory changes were announced in 2006 that could significantly impact the threat posed by specialty hospitals in 2007. The first major change was the expiration of the moratorium on the establishment of new specialty hospitals. The moratorium had been established in 2003 as part of the Medicare Modernization Act and was extended several times until Aug. 8, 2006, at which time the moratorium was removed. As a result, Fitch expects that 2007 will witness a growth in new specialty hospitals in certain urban markets, particularly in Texas, bringing new competition to hospitals in these markets. However, Fitch expects that the volume of new facilities will be nowhere near what had been seen prior to the 2003 moratorium.

Growth of new specialty hospitals should be tempered by the second set of regulatory changes announced in 2006, which relates to the government's payment system and oversight of specialty hospitals. The HHS announced that it will be revamping its inpatient prospective payment system (IPPS) over the next three years in order to better tie Medicare payments to hospital costs, increase the number of diagnostic-related groups (DRGs), and more accurately reflect the severity of illness. These changes are intended to reduce the 'cherry-picking' of the most profitable DRGs by specialty hospitals. However, the Centers for Medicare and Medicaid Services (CMS) has softened the impact of these changes since they were first announced, by extending the implementation over a period of three years and greatly reducing the impact in 2007, which will see only minor changes to the DRG classifications and a much smaller impact on reimbursement levels than originally proposed. CMS will also be reviewing financial arrangements between specialty hospitals and physician investors to detect inappropriate returns. Finally, CMS will more closely examine the classification of hospitals by changing enrollment procedures and ensuring the facility can handle the transfer of unstable patients, though it does not require the facilities to have emergency departments.

Fitch believes that the aforementioned regulatory changes will have the effect of encouraging specialty hospital competition in certain regions, particularly urban locations in the south and western states, leading to continued volume pressures for hospitals in these regions. However, the impact will be lessened by changes to the reimbursement procedures and oversight of specialty hospitals. Fitch also expects more government discussion of this topic in 2007.

In addition to specialty hospitals, providers will also face continued pressure from Ambulatory Surgical Centers (ASC), which provide outpatient surgical services, and entrepreneurial physicians. ASCs and certain physicians will continue to try to move outpatient procedures and ancillary services from a hospital environment to an independent outpatient facility or a doctor's office. Fitch expects providers to continue focusing on growing their own outpatient capabilities to counteract this trend. It will also be essential for providers to focus on physician loyalty and partnering in order to minimize the shift in procedures from the hospital environment. Providers will need to rely on their own initiatives to counteract this threat, as recent proposed regulations suggest a mixed outlook for ASC reimbursement, with the CMS proposing to significantly decreasing the payment rates for ASC procedures while also increasing the number of procedures that can be done by an ASC.

Reimbursement remains favorable:

Fitch expects a generally favorable reimbursement environment for hospital providers in 2007. The CMS released its final inpatient and outpatient payment rules for 2007, with strong pricing increases for both rural and urban providers. The average rate increase for inpatient services will be approximately 3.5% in 2007, down slightly from 2006 when the increase was 3.7%, but still relatively high compared to historical increases. The outlier payment threshold will also increase slightly, to $24,475 from $23,600 in 2006, but this is lower than the increase CMS originally proposed. As noted above, the CMS is moving to a cost-based payment methodology as well as to severity-adjusted DRGs over the next three years; however, the impact in 2007 should be slight. Outpatient rates will increase an average of 3.0% in 2007. Fitch expects Medicaid reimbursement to be relatively flat in 2007, with no major dis-enrollments projected.

Although there have been several high-profile contract disputes between hospital providers and managed care insurance companies, Fitch believes that managed care pricing will continue to be favorable for the sector in 2007. It is important to note that contract disputes have occurred in the past and will continue to occur in this industry. However, the quantity of insurer contract disputes among both investor-owned and non-profit hospitals appears to have increased, as has the publicity surrounding the disputes. These disputes are likely driven in part by the squeeze felt by hospitals on the bad debt front and their attempt to share the burden with insurers. Fitch believes that hospitals who have a leading position in their markets will continue to command strong price increases from managed care providers as they will continue to enjoy leverage in the negotiations. However, Fitch does expect contract disputes to continue in 2007 and for there to be some moderation in price increases. For 2007, Fitch expects overall rate increases from managed care to average in the mid-single digits.

Following is a list Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the for-profit hospital provider sector.

Urban Focused Hospital Providers:

--HCA, Inc. ('B'; Outlook Stable);

--Tenet Healthcare Corp. ('B-'; Outlook Negative);

--Universal Health Services, Inc. ('BBB+'; Outlook Stable).

Rural Focused Hospital Providers:

--Community Health Systems, Inc. ('BB'; Outlook Stable);

--Health Management Associates ('BBB+'; Outlook Stable);

--LifePoint Hospitals, Inc. ('BB-'; Outlook Stable);

--Triad Hospitals, Inc. ('BB-'; Outlook Stable).

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.
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Publication:Business Wire
Date:Dec 6, 2006
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