Not-for-Profit Health Care Adam Kates, Director September 20, 2012
Overview
Overview Where we ve been Where we are Where we are going 2
Overview Fitch Public Finance Health Care 10 public finance health care analysts Healthcare offices: New York (5); Chicago (4); San Francisco (1) 401 healthcare credits; 322 acute care and 79 senior living Acute Care Rating Distribution by Category BBB 26% Below BBB 8% AA 23% A 43% 3
Overview Era of Change The recession and health care reform and reimbursement cuts, oh my! The Cowardly Lion turned out to be a friend, but is the wicked witch around the corner? 4
Overview Rating Outlook History 2002: Negative 2003: Stable 2004: Stable 2005: Stable 2006: Stable 2007: Stable 2008: Stable 2009: Negative 2010: Negative 2011: Stable 2012: Stable 2013:????? Balanced Budget Act of 1997 Ends Medicare Modernization Act Rising supply costs and state budget cuts Deficit Reduction Act Rising expenses and competition with physicians Auction Rate Market Crashes Lehman Brothers Bankruptcy The Great Recession PPACA passed Budget turmoil PPACA Upheld (mostly)???? 5
Overview Nonprofit Rating Actions and Outlooks Despite industry turbulence, the majority of rating actions are affirmations and the majority of outlooks are stable Rating Actions Credit Outlooks 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% 8.4% 7.7% 2.5% 6.1% 11.2% 5.7% 7.8% 10.8% 8.3% 9.4% 5.7% 3.1% 7.2% 6.7% 80.8% 84.0% 88.1% 88.2% 85.7% 87.1% 85.5% 2005 2006 2007 2008 2009 2010 2011 Stable Positive Negative 6
Overview Fitch s Not for Profit Healthcare Portfolio Median Ratios 2006 2007 2008 2009 2010 2011 Sample Size 218 221 227 244 248 251 Days Cash on Hand 168.5 175.9 151.3 166.8 180.5 181.7 Cash to Debt (%) 104.2 105.5 101.3 104.8 112.8 113.0 Operating Margin (%) 2.8 2.6 2.2 2.8 2.6 2.7 Operating EBITDA Margin (%) 9.5 9.5 8.9 9.5 9.4 9.4 Operating EBITDA Debt Service Coverage (x) 2.9 3.0 2.8 3.0 3.0 3.2 MADS as % of Revenues 3.2 3.1 3.1 3.1 3.0 2.8 Cap Ex as % of Depreciation Expense 152.8 153.3 154.4 127.1 115.7 127.8 7
The Rating Process
The Rating Process Introduction A credit rating is a measure or assessment of the likelihood of timely and sufficient payment of scheduled debt service by the obligated entity Formal criteria updated and published annually Mix of quantitative and qualitative factors Committee process New issue ratings and ongoing surveillance 9
The Rating Process Quantitative Criteria Profitability Operating margin, operating EBITDA margin, personnel and supply expense as % of revenues Liquidity Days cash on hand, cushion ratio, cash to debt; days in AR; investment policy Leverage and Debt Burden Maximum annual debt service coverage, debt to capitalization, MADS as a percentage of revenues, average age of plant, capital spend as % of depreciation, capital structure 10
The Rating Process Utilization Statistics Inpatient Admissions Observation Cases Outpatient Visits Inpatient and Outpatient Surgeries Case Mix Index Payor Mix Average Length of Stay 11
The Rating Process Qualitative Criteria Market share / level of competition Service area demographics Medical staff and physician alignment Capital needs Governance structure Strength of management Legal provisions and bond security 12
The Rating Process Median Ratios Nonprofit Hospital and Healthcare System Median Ratios-2011 Rating Category AA A BBB Operating Rev ($ millions) 1,948.1 525.8 386.7 Days Cash on Hand 241.1 191.0 138.9 Cash to Debt (%) 169.4 116.4 82.7 Operating Margin (%) 4.0 2.8 1.9 Operating EBITDA Margin (%) 10.6 9.8 8.3 Operating EBITDA Debt Service Coverage (x) 4.2 3.3 2.5 MADS as % of Revenues 2.5 2.8 3.3 Cap Ex as % of Depreciation Expense 146.1 124.5 103.1 13
2012 in Review
2012 in Review Fitch s 2012 Healthcare Sector Outlook Operating Profitability Expected to be Maintained: Continued cost control efforts and revenue enhancement initiatives combined with lower capital spending should offset lower reimbursement increases and soft patient volumes. Capital Spending Expected to be Muted: Providers continue to focus on improving inpatient throughput, moving more services into lower cost outpatient settings and information technology. Consolidation Expected to Accelerate: The need for size and scale to drive greater efficiencies is increasingly important in a tighter reimbursement environment. Escalating Governmental/ Political Challenges: Continued investments in programs and strategies for full implementation of ACA combined with uncertainties of political and judicial challenges escalate overall credit risk to the sector. 15
2012 in Review Fitch s 2012 Healthcare Medians Report Stable Profitability and Liquidity Metrics: Expense management, physician alignment and revenue enhancement initiatives offset shifting payor mixes and soft volumes to stabilize profitability and cash flows. Ongoing Capital Investments: Capital spending continued at prior years levels for AA and A rated credits, but remain below pre-2009 levels while continuing to decline amongst BBB credits. Weakened Performance for Non-Investment Grade Credits: The credit gap is expected to continue to widen due to stronger credits ability to invest. Downgrades Outpace Upgrades: Majority of downgrades concentrated in the BBB and non-investment grade categories. Continued Uncertainty in Healthcare: Despite stabilized performance in 2011, many challenges exist in the medium term. 16
2012 in Review Highlights Impact of the Economy: Soft utilization trends, increasing uncompensated care, payor mix shifts Healthcare Reform: PPACA upheld, providers prepare for a changing landscape including value based reimbursement, population management, physician alignment and information technology Consolidation Activity: Continued consolidation driven by both strategic and financial needs Capital Spending: Primarily focused on ambulatory facilities and information technology Reimbursement Pressure: Medicaid cuts, increased uncompensated care and shifting payor mixes 17
2012 in Review Politics Budgetary pressures at federal, state and local levels continue to build Risk will further increase throughout 2012 as the fiscal cliff approaches Presidential and federal elections will provide further direction or disruption Lame duck congressional session could create additional uncertainty The need of local governments and municipalities for additional revenue sources may increase scrutiny of property and sales tax exemptions Continued uncertainty makes planning difficult. 18
2012 in Review Reimbursement Pressures Medicaid cuts to reimbursement and eligibility Examples of Hospital Medicaid Cuts Arizona 5% Florida 12% Oregon 11.5% Texas 8% Nebraska 2.5% Some headline cuts offset by provider taxes and other supplemental funding Medicare: 2% potential cut in January 2013 due to sequestration Increasing bad debt and charity care Delayed elective procedures due to economic conditions Shifts from inpatient admissions to observation stays 19
2012 in Review Impact of Reimbursement Cuts Fitch analyzed it s portfolio of hospitals and health systems to assess the impact of a hypothetical 2% cut to Medicare reimbursement, holding all other factors constant. On average, a 2% Medicare cut decreased operating margins by 80 basis points and impacted lower rated credits to a greater degree. Fitch is following hospitals in Florida and Texas to assess the actual impact of Medicaid cuts in each state the results are mixed. Some hospitals have been able to offset reimbursement cuts with cost management and revenue enhancement initiatives. However, many hospitals have already picked the low hanging fruit (productivity management, flexible staffing, supply chain management revenue cycle, etc.) Providers are increasingly looking towards clinical redesign to achieve further efficiencies. 20
2012 in Review Clinical Redesign Clinical redesign incorporates information technology, data warehouses, development of clinical protocols and quality measures. Fitch Ratings attempted to establish a link between operating performance with both quality of care and investment in information technology. Fitch broke separated its not-for-profit hospital portfolio into four categories and compared various metrics between the groups Portfolio Hospitals (291) Quality Hospitals (75) Information Technology Hospitals (24) IT and Quality Hospitals (12) 21
2012 in Review Clinical Redesign (cont.) Hospitals that received recognition for quality of care and/or investments in IT exhibited greater growth in utilization, revenues and profitability. A positive correlation exists, but that doesn t mean causation. CAGR (2005-2009) Fitch Portfolio Qua lity T e chnology IT & Q Admissions -1.4% 0.5% 4.7% 4.4% ALOS 0.1% -0.4% -1.0% -1.8% T ota l Re venue 7.4% 8.3% 11.9% 11.9% Ope ra ting Ma rgin -2.4% -1.2% 4.3% 2.8% EBIT D A -0.4% 1.0% 9.0% 9.0% 22
2013 and Beyond
2013 and Beyond Near Certainties Amongst the Uncertainty Reimbursement pressure expected to continue Medicare: Sequestration 2% cuts Medicaid: State budget pressures continue Lingering unemployment Continued cost shifting to employees Transition to value-based from volume-based reimbursement Both political parties agree that bending the cost curve is a necessity PPACA Medicare vouchers Medicaid block grants 24
2013 and Beyond Near Certainties Amongst the Uncertainty (cont.) Increased physician alignment and coordination of care Changing relationships and roles of insurers and providers providers assume risk Continued shift of services from inpatient to outpatient settings driven by technological advancements and need for lower cost setting Continued industry consolidation could widen the credit gap Potential for increased scrutiny of tax exemptions 25
2013 and Beyond Healthcare Reform Coverage expansion of the PPACA to take effect in 2014 should be credit positive due to increased utilization and decreased levels of uncompensated care Medicare reimbursement reductions will present challenges Adoption of Medicaid expansion and insurance exchanges will vary by state Will the incremental revenue gains and lower levels of uncompensated care offset the decreased reimbursement? 26
2013 and Beyond Insights from Fitch s Capital Expenditures Survey Historically, capital spending has been correlated with operating profitability Fitch asked hospitals to indicate which factors were expected to influence future capital spending the most over the next five years Potential reimbursement cuts, not the PPACA, were identified as having the most influence on expected capital spending levels 88% of hospitals indicated that other factors were likely to moderately to greatly impact capital spending, highlighting the multitude of issues facing the industry Greatly Somewhat Greatly Moderately Somewhat Moderately Not at all The impending implementation of the PPACA 23% 25% 28% 18% 7% The current state of the economy 10% 28% 43% 11% 8% Potential and/or actual decreases in Medicare and Medicaid reimbursement rates 32% 34% 29% 2% 3% The shift of services from the inpatient setting to the outpatient setting 25% 30% 38% 8% 0% Increasing patient co-pays and deductibles 3% 10% 48% 25% 15% Other factors 12% 29% 48% 5% 7% 27
2013 and Beyond Capital Expenditures by Areas of Importance Information technology, physician alignment and outpatient capacity were identified as the areas of greatest importance Rank Information technology 1.7 Physician alignment 2.6 Outpatient capacity 2.9 Clinic access points 3.6 Inpatient capacity 3.8 1 - Most Important, 5 - Least Important 28
2013 and Beyond Items with the Greatest Impact on Inpatient Volume Trends Clinical advancements and intentionally shifting to lower cost structures were identified as having the greatest impact on inpatient volume trends Rank Clinical advancements increasing outpatient care capabilities 2.2 Intentionally shifting care to lower outpatient cost structures 2.3 Reducing unnecessary admissions and readmissions 2.7 Economic conditions & unemployment 3.3 Increased patient co-pays and deductibles 4.2 1 - Most Important, 5 - Least Important 29
2013 and Beyond Drivers of Consolidation Strategic benefits and preparation for healthcare reform were cited as the two most significant drivers of consolidation Overall, all factors were of moderate importance Rank Strategic benefits 1.8 Preparation for healthcare reform 2.3 Financial need 2.7 Access to capital 2.9 1 - Most Important, 4 - Least Important 30
2013 and Beyond Is the Sky Falling? No. Fundamental credit strengths of sector remain intact Fitch believes that the not-for-profit healthcare sector maintain certain core credit strengths that should provide counter-weight to some of economic and legislative pressures that are impacting the sector. These key characteristics include: The essentiality of services Major employer in most communities Strong and improving liquidity Strong political voice and access at the state and federal level 31
Questions? Contact: Adam Kates 312-368-3180 adam.kates@fitchratings.com 32
Disclaimer Fitch Ratings credit ratings rely on factual information received from issuers and other sources. Fitch Ratings cannot ensure that all such information will be accurate and complete. Further, ratings are inherently forward-looking, embody assumptions and predictions that by their nature cannot be verified as facts, and can be affected by future events or conditions that were not anticipated at the time a rating was issued or affirmed. The information in this presentation is provided as is without any representation or warranty. A Fitch Ratings credit rating is an opinion as to the creditworthiness of a security and does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. A Fitch Ratings report is not a substitute for information provided to investors by the issuer and its agents in connection with a sale of securities. Ratings may be changed or withdrawn at any time for any reason in the sole discretion of Fitch Ratings. The agency does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS AND THE TERMS OF USE OF SUCH RATINGS AT WWW.FITCHRATINGS.COM. 33