The bond rating agency giveth, and the bond rating agency taketh away.
BJC Health System, a St. Louis powerhouse, received a coveted Aa2 rating from Moody's Investors Service on $225 million in bonds expected to be issued this week.
In the same new issue report, published July 23, Moody's also revised its outlook for BJC to "negative" from "stable."
That doesn't mean the sky is falling. But it means that BJC, like many other integrated delivery systems, faces daunting challenges in maintaining its financial health and good name. Observers could draw from the report some conclusions about how the tightening operating environment for large systems is likely to play out in upcoming credit ratings on other issues.
Ed Stiften, BJC's chief financial officer, says he is very pleased with the credit rating. "Aa is what we have been and what we should expect to continue to be," he says.
Bruce Gordon, who wrote the analysis for New York-based Moody's, points out that only one hospital issue in the whole country has a higher rating than this-BJC's St. Louis neighbor, Sisters of Mercy Health System, which Moody's rated Aa1 last summer (July 28, 1997, p. 38).
The rating applies to BJC's total portfolio of debt, which will be about $509 million once the new offering is out. About $284 million of the total is Series 1993 debt. The interest rate on that debt doesn't change. "It's all system debt now," Stiften says. "Individual hospitals don't have debt in their own name."
Moody's cites several factors to support BJC's high credit rating: It leads the hospital sector with 31% market share and has increased market share every year since 1990. Its tertiary specialties are pulling in referrals from outlying areas, and its alliance with the Washington University School of Medicine "provides BJC with a dominant position for certain high-end tertiary procedures," according to Moody's report.
That aside, Moody's predicts utilization, which is high in the St. Louis area, could decline as managed care grows. Managed-care penetration has stalled at about 25% in the market (June 29, p. 150). Also, large insurers have recently suffered heavy losses, and they might move to reduce payments to providers.
Moody's change in outlook refers to long-range, underlying factors that could affect a credit rating in the future. They focus on trends and developments that could occur over the next six to 18 months.
"It doesn't mean a rating downgrade is imminent or likely," says Gordon. "What it suggests is a direction, a trend of recent developments." The reasons for the BJC outlook downgrade include:
n A 17% decline in operating cash flow in 1997, to $167 million from $202 million in the previous year, which is not expected to recover to 1996 levels until 2000.
n BJC management predicts operating cash flow will decline even further in 1998. For one thing, last year's balanced-budget law will cut revenues $19 million in 1998 and $14 million in 1999. In the first six months of 1998, operating income declined to $6 million from $25 million the year before. That's a 1% margin, compared with a 4% margin last year. System operating revenues for 1998 are expected to total $1.8 billion, up from $1.7 billion last year.
n After the Series 1998 bonds are issued and $164 million in Series 1994 bonds are defeased, unrestricted cash and investments will be about $580 million, or 136 days' cash on hand, down from a peak of $791 million, or 208 days' cash at year-end 1996.
Stiften says another major contributor to the negative outlook is related to what BJC regards as a long-term investment, namely physician practices. BJC, like many integrated delivery systems, has bought primary-care physicians practices. "That's part of a long strategic migration from a cost reimbursement environment in healthcare to a global capitated environment in the future," Stiften says.
Specifically, BJC is losing money on the nine primary-care sites and 58 physicians it acquired from Group Health Plan in 1997. Moody's attributes its negative outlook partly to a $20 million increase in physician losses related to Group Health and a $6 million loss on the Group Health capitated contract.
Those operating losses are on a declining trend, Stiften says, "so they're contained; they're not spiraling out of control. We are managing that number to be smaller and smaller as we go." There are no clear projections on when the businesses will end up in the black.
Another big expenditure item cited in the Moody's report is year-2000 systems upgrades. BJC is taking a $5 million write-off this year and an additional $5 million write-off in 1999 for software and equipment that are being junked. They're being replaced with new systems, which will have the corollary benefit of being year-2000 compliant.
BJC also must cover 64% of the $17 million in losses on a health plan, Health Partners, which it operates with the Washington University faculty practice group. That figure includes projected future losses on a contract covering Missouri state employees.
BJC, like many other systems, has reorganized its debt structure so that the system-not the individual operating units-issues and pays down debt.
That, in fact, is another reason for the downward revision in outlook: "The parent has virtually no assets of its own and will rely on agreements between itself and its legal subsidiaries, which require the subsidiaries to upstream cash to the parent to support debt service."
Known as a "restricted affiliate" legal structure, it's replacing the "joint and several obligation" of all operating organizations for systems. Jordan Melick, a director at Fitch IBCA, a New York-based credit-rating agency, says it's regarded as weaker because "the one signing the documents doesn't have the ability itself to pay it off.
"It's a change in the actual obligor on the debt. In the one case, the parent and all obligated members (pay off the debt)," Melick says. Under a restricted affiliate structure, "only the parent is legally responsible, but the others are indirectly responsible. It's a weaker structure because the parent is more or less a shell organization, does not have the balance sheet or the cash-generating capacity to pay off the debt on its own merit," he says.
The new arrangement is desirable for far-flung systems because it effectively simplifies their debt structure. Under the old "joint and several" obligation, it would be very hard to sell off or dispose of an individual operating unit.
Stiften, who came to BJC from the defense industry four months ago, notes that most commercial businesses don't require the various operating units to pay the debt.
"You just obligate the corporation," he says. "We're doing it as well. All the cash from all the hospitals is upstreamed to the parent, every day. The parent invests the cash and/or incurs the debt. It's just an acknowledgement of how we and other healthcare systems exist today."