moody's investor service report on nfp hospitals

SPECIAL COMMENT

U.S. PUBLIC FINANCE MAY 21, 2014

Table of Contents:

IT SPENDING IS NECESSARY BUT COSTLY 2 HOSPITALS ARE RAMPING UP INVESTMENT IN OUTPATIENT STRATEGIES 2 THE RISE OF PRICE SENSITIVITY IS CREATING NEW COMPETITORS 4 MOODYS RELATED RESEARCH 6

Analyst Contacts:

SAN FRANCISCO +1.415.274.1708

Brad Spielman +1.415.274.1719 Vice President - Senior Credit Officer [email protected]

NEW YORK +1.212.553.1653

Lisa Martin +1.212.553.1423 Senior Vice President [email protected]

Kendra M. Smith +1.212.553.4807 Managing Director - Public Finance [email protected]

Building Value: Investments Aimed at New Priorities Create Opportunities for Not-For-Profit Hospitals

Hospital systems that are focusing investment dollars on information technology, outpatient services and improved efficiencies will be best prepared to mitigate the negative impacts of declining inpatient utilization, shifting payer models and increased competition from nontraditional participants in the healthcare industry.

Due to growing consumer price sensitivity and the growth of consumer choice, the ability for hospital systems to offer value will be a driver of success. Strategic and appropriate investment in information technology (IT) and outpatient services should be a long-term credit positive, but this type of expenditure frequently has an immediate negative impact on income statements and balance sheets, depending on the size and success of the investment.

There are three areas of primary consideration:

IT spending is necessary but costly: Achieving value can be expensive, and there is an immediate consequence to high IT investment.

Hospitals are ramping up investment in outpatient strategies: Declining inpatient utilization and the shift to outpatient services are reducing hospital revenues, spurring hospitals to make greater investments in ambulatory capabilities and physician recruitment.

The rise of price sensitivity is creating new competitors: Driven by heightened consumer price sensitivity, new competitors are beginning to enter the outpatient arena and defining what value means.

U.S. PUBLIC FINANCE

2 MAY 21, 2014

SPECIAL COMMENT: BUILDING VALUE: INVESTMENTS AIMED AT NEW PRIORITIES CREATE OPPORTUNITIES FOR NOT FOR PROFIT HOSPITALS

IT spending is necessary but costly

Many organizations have hitched their pursuit of value to the acquisition and implementation of comprehensive and expensive IT systems. The return on these investments can be allusive, while the cost can immediately weaken both income statements and balance sheets.1

Spurred in part by financial incentives built into the Affordable Care Act (ACA), hospitals have escalated spending on IT systems with many systems announcing large, big-bang system conversions. In many instances, these projects represent significant portions of the organizations capital budget over a period of several years. For large systems, the total cost can near, or exceed, a billion dollars.

Depending on project configuration, much of the cost may be expensed rather than capitalized, reducing operating income. Also significantly, these projects can increase debt, decrease cash, or both. Stage I of the Meaningful Use provision of the ACA has provided approximately $22.5 billion of supplemental funding to hospitals since 2011, yet in all cases that we have reviewed, the cost of an acquired IT system has dwarfed the Meaningful Use funds received.

The short-term credit implications are generally neutral to negative, depending on the size of the investment and the success of the initial implementation. Rocky conversions can result in a spike in accounts receivable, decreased cash flow and lost revenue. Among rated hospital systems, the impact has varied, with some systems reporting significant margin degradation during implementation and other systems experiencing minimal impact.

Longer term, a well-functioning IT system that integrates electronic medical record management, clinical oversight, billing, revenue management and customer interfacing may well be a minimum requirement for organizational success, especially among larger systems. A comprehensive IT system that has been implemented successfully and is integrated into the strategy and culture of an organization can be key to an organizations value proposition, and be a long term-credit positive.

Hospitals are ramping up investment in outpatient strategies

The shift to observation stays and outpatient services is resulting in decreased inpatient utilization and lower hospital revenue.2 Hospital systems that can supplement inpatient revenue with new, diversified revenue streams are more likely to remain successful and enhance consumer value. These investments are generally less expensive than building inpatient capacity and can help mitigate inpatient utilization declines.

As indicated in our fiscal year (FY) 2013 preliminary medians, median revenue growth dropped in FY 2013 and remains among the lowest in recent years. Concurrent with this drop, median expense growth also dropped but not by as much, leading to median margin degradation. This is the second year in a row that expenses grew at a rate higher than revenues (see Exhibit 1).

1 Moodys Investors Service, 2014 Outlook US Not-for-Profit Hospitals 2 Moodys Investors Service, Profitability and Revenue Growth Drop in US Not-for-Profit Hospital Preliminary Medians

This publication does not announce a credit rating action. For research publications that reference Credit Ratings, 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.

U.S. PUBLIC FINANCE

3 MAY 21, 2014


EXHIBIT 1

Revenue Growth Remains Low and Continues to Trail Expense Growth

Source: Moodys Investors Service; 2013 is based on audited financial statements of 203 organizations; the data prior to 2013 are from different sample sets. However the multiple years of data accurately reflect the trend in the industry over this period.

A major driver of suppressed revenue growth is the shifting utilization trends. Per our FY 2013 preliminary medians, median admissions have been relatively flat over the last two years (increasing slightly from 23,215 in FY 2011 to 24,027 in FY 2012, and then dropping slightly to 23,380 in FY 2013) while median outpatient visits have grown significantly, increasing from 298,927 in FY 2011 to 319,886 in FY 2012, and increasing further to 345,870 in FY 2013 (see Exhibit 2).

EXHIBIT 2

Admissions Remain Stagnant While Outpatient Visits Rise

Source: Moodys Investors Service

Observations stays, which pay less than inpatient admissions, have also increased significantly in recent years. In FY 2012, the median growth rate of observation stays was a significant 10.4% and in FY 2013 it was 8.0% (see Exhibit 3).

3%

4%

5%

6%

7%

8%

9%

10%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Median Annual Revenue Growth Rate Median Annual Expense Growth Rate

250,000

270,000

290,000

310,000

330,000

350,000

370,000

15,000

17,000

19,000

21,000

23,000

25,000

27,000

29,000

2011 2012 2013

Admissions Outpatient Visits

U.S. PUBLIC FINANCE

4 MAY 21, 2014


EXHIBIT 3

Median Observation Stays Increase Significantly

Source: Moodys Investors Service

Many hospital systems began preparing for this shift several years ago by investing in outpatient service centers and urgent care centers. Several communities have seen a marked increase in the number of urgent care centers, large full-service outpatient centers and even stand-alone emergency departments. In some cases, the facilities are large, costing hundreds of millions of dollars and rivaling the capital cost of inpatient facilities. In most cases, however, the capital costs are more modest and represent enhanced value, operating at a lower cost. Hospital systems that are not successful at adapting business strategies and creating additional revenue streams run the risk of losing both revenue and market share.

A challenge with a more outpatient-oriented business strategy is the need to further align with both primary care physicians and specialists in order to provide both volume and staffing for outpatient facilities. Hospitals are engaging in a variety of strategies to achieve this, including forming joint ventures, purchasing physician practices and offering independent physicians incentives (such as participation in an IT system). Acquiring physician practices is the most direct method to create physician alignment, but it is also the most expensive.

The rise of price sensitivity is creating new competitors

Growth in high deductible plans and private exchanges is driving consumer price sensitivity, which is in turn driving growth in less expensive outpatient services. Nontraditional competitors are responding, and healthcare services provided by drugstores and unaffiliated outpatient centers are diverting volumes and revenues from traditional hospital providers. Hospitals will need to make additional investments or form partnerships in order to effectively compete.

Over the last several years, the popularity of high deductible plans has increased, which has been concurrent with an increase in bad debt as measured on a median basis (see Exhibit 4). This shift is a further driver of reduced hospital revenue growth. This trend is also apparent in the rise of other alternative insurance models, which hospital systems are attempting to prepare for by upgrading IT systems. As the dominant healthcare model in the country shifts from volume to value, income pressures will increase, putting hospitals income statements at further risk.

4,797

5,736

6,263

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2011 2012 2013

U.S. PUBLIC FINANCE

5 MAY 21, 2014


EXHIBIT 4

Bad Debt Grows with Popularity of High Deductible Plans

Source: Moodys Investors Service; Kaiser Family Foundation

The increase in consumer price sensitivity and the demand for increased pricing transparency is a further consequence of the rise of high deductible plans. Nontraditional participants have responded to this opportunity by significantly growing retail medicine. There are currently approximately 1,600 retail-based walk-in medical clinics across the country3, and it is estimated that this number will double over the next three years.4 This shift towards retail medicine is driving volume and revenues away from hospital systems and other traditional providers. As retail medicine grows and begins to incorporate other services, it will become an increasing threat to hospitals income statements.

Retail medicine is changing how consumers view value within healthcare services. In so far that value means higher quality at lower cost, consumer focused delivery is helping redefine high quality as convenient. This shift represents a serious threat to hospitals because they will have a hard time competing based on convenience and their overhead for the same services is significantly higher.

Hospitals will either cede this territory and attempt to make up the lost revenue elsewhere, or they will need to form partnerships or find other ways to compete. Some hospitals have begun investing in self-branded retail services located within malls and other venues. The returns on these investments so far are mixed, and are reliant on generating additional patient referrals back to the hospital. In the final analysis, hospitals will find ways to more effectively compete, diversify revenues, and offer enhanced consumer value, or they will likely lose market share and income. Hospitals that can build true consumer value are more likely to have long-term success.

3 Convenient Care Association 4 Accenture, Retail Medical Clinics: From Friend to Foe?

0%

5%

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25%

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

2009 2010 2011 2012 2013

Median Bad Debt ($000) People in High Deductible Plans (%)

U.S. PUBLIC FINANCE

6 MAY 21, 2014


Moodys Related Research

Median Report:

Profitability and Revenue Growth Drop in US Not-for-Profit Hospital Preliminary Medians, April 2014 (167463)

Sector Comments:

US Healthcare Reform: Three Risks Reduce Credit Positives for Not-for-Profit Hospitals, March 2014 (166602)

Two-Midnight Rule Will Reduce Revenue for Most Hospitals, March 2014 (165866)

Federal Proposal Helps Essential Hospitals But Discourages Narrow Networks, March 2014 (165635)

Special Comment:

Academic Medical Center Hospitals Maintain Stronger Credit Characteristics Than Other Not-for-Profit Hospitals, January 2014 (162049)

Industry Outlook:

2014 Outlook US Not-for-Profit Hospitals, November 2013 (160569)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

U.S. PUBLIC FINANCE

7 MAY 21, 2014


Report Number: 170100

Author Brad Spielman

Production Specialist Wendy Kroeker

2014 Moodys Corporation, Moodys Investors Service, Inc., Moodys Analytics, Inc. and/or their licensors and affiliates (collectively, MOODYS). All rights reserved.

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moody's investor service report on nfp hospitals

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