Even though integration is paying off in improved profit margins, providers had better beware of the dangers that lurk ahead.
That is the red flag Moody's Investors Service is waving with its recent analysis of not-for-profit healthcare credits and a separate report to be released this week on hospital integration strategies.
While both reports from the New York-based credit-rating agency conclude that providers ultimately will be strengthened by the movement to create larger, integrated networks, the journey may be a perilous one.
Allegheny Health, Education and Research Foundation, based in Pittsburgh, is the most obvious example of a system whose aggressive empire-building resulted in financial collapse. AHERF's July 21 Chapter 11 bankruptcy filing (July 27, p. 2) prompted Moody's to downgrade AHERF's bond ratings. Its Philadelphia group of hospitals saw its bond rating blunted to Caa1 from B2.
AHERF's $1.3 billion debt reflects in part its enormous appetite for physician practices.
William Douglas Jr., a senior vice president and manager of the national healthcare finance group at George K. Baum & Co. in Denver, is constantly astounded by the number of hospitals and healthcare systems that invested in physician practices as a defensive strategy, with little regard to the economics of those deals.
"In any other business, you couldn't get away with (such inattention to detail), I don't think," Douglas says. Even though the physician practices fall outside a provider's "obligated group," the financial drain they pose can weaken the parent organization's credit quality, he says.
But physician acquisitions weren't AHERF's only problem. The system also was more aggressive than most in acquiring hospitals and assuming insurance risk.
"AHERF had a lot of irons in the fire," says Kevin Ramundo, an analyst with Moody's. Management's aggressive strategy exceeded its ability to execute, exposing the organization to significant financial risk, he says.
"Other systems nationally are likely to face the same types of pressures, but maybe not to the same degree (as AHERF)," adds Moody's analyst Lisa Martin. "They pursued everything to the `nth degree.' The differences are the degree of deterioration."
By no coincidence, Moody's August 1998 report on not-for-profit credits bears the same title as its 1997 version: "Volatility Ahead for Health Care Industry." But this year's analysis sounds a louder note of caution.
Instead of just "looking into the crystal ball," there are now some solid examples of difficulties providers have experienced, says Bruce Gordon, a vice president in the public finance healthcare group at Moody's, which rates 478 healthcare providers with $57 billion of debt outstanding.
The report cites several examples of "premier organizations" whose "stable" outlooks were lowered to "negative" because of increased financial pressures:
Dallas-based Baylor Health Care System's "weakening financial performance" could hinder its ability to compete in a consolidating market, Moody's says. Baylor's operating margins declined to 2.1% in 1997 from 6.6% in 1993, in part because of losses on physicians.
Durham, N.C.-based Duke University Medical Center's acquisition of two acute-care hospitals and a continuing-care retirement system will require a "precipitous escalation" in debt and poses integration issues, the agency concludes.
Actual downgrades of healthcare organizations still lag behind credit upgrades, but the tide seems to be turning. Last year the dollar volume of downgraded debt exceeded upgrades.
Moody's expects merger-and-acquisition-related risk to contribute to many future downgrades. That point is made clear in a just-published analysis of various integration strategies, which outlines some of the bumps providers may encounter.
Getting medical staff "buy-in" before a merger, for example, is considered a key factor to success. In the Philadelphia market, Pennsylvania Hospital's proposed merger with University of Pennsylvania Health Services "alienated key physicians," prompting Moody's to downgrade Pennsylvania Hospital's Baa2 rating to Baa3 and assign a negative outlook.
Because Pennsylvania Health Services had to devote time and resources to ironing out its merger partner's financial difficulties and physician relations, Moody's also lowered that system's outlook to negative. More recently, its bond rating was cut to A1 from Aa3, reflecting the merger and other issues affecting the bottom line.
Moving hastily ahead clearly can damage a provider's credit quality, at least in the short run. But maintaining the status quo in a consolidating market is equally foolish.
Just last week, Moody's downgraded Mercy Hospital, a stand-alone facility in Miami, to Baa1 from A3. The credit action, prompted by Mercy's declining financial performance resulting in part from a $2.5 million loss on a capitated contract, also reflects its delay in finding a partner.
After terminating two years of merger talks with Miami-based Baptist Health System, Mercy now is exploring other partnerships, Moody's says. Management expects to make a decision in six to eight months.