Novant Health, an eight-hospital not-for-profit system based in Winston-Salem, N.C., boasted net operating income of $10.5 million for its first quarter ended March 31, a healthy 50% jump from the same quarter last year. But even with that striking improvement in operations, the system's bottom line sank 61%.
The mystery ingredient that soured Novant's financial recipe? The stock market.
During the past few years, many not-for-profit systems have relied heavily on investment income to cushion their ailing operating profit margins. But just as some are beginning to see operational recoveries kick in, they are getting the rug pulled out from under them by a volatile equities market.
Novant, for example, lost nearly $5.4 million on investments during the first quarter, compared with investment earnings of $4.8 million in the same period last year. The plunge in investment earnings meant that despite an improved operating margin, the system's bottom line sank to $4.2 million from $10.7 million.
"You do see volatility from month to month, but usually by quarter's end, it works itself out," says Dean Swindle, Novant's executive vice president and chief financial officer. "It obviously didn't during the first quarter."
During 1999, Novant suffered the reverse, losing $64 million on operations and making $32 million on investments to end up with a $32 million net loss.
"In the past several years, the healthcare industry has been helped, as we've gone through operating difficulties, that the market has gone one way, and that's straight up," Swindle says.
But this year, providers have received a harsh reminder that what goes up can also go down. Novant is not alone, according to a recent report by New York-based credit-rating agency Standard & Poor's. The report shows that even hospitals with investment-grade bonds have relied heavily on investment income during the past few years (See chart). Those with thin margins are especially vulnerable to swings in the market, according to S&P.
Not-for-profit hospitals have seen their overall investment income decline, while their liquidity has at best remained stable, according to S&P. The agency warns that the recent market swings could damage the credit quality of some not-for-profit hospitals, although no ratings actions have yet been tied exclusively to drops in investment income. Organizations that have weak operations or are overly reliant on investments could see their credit quality suffer.
"When they become more reliant on investment income, it means their profitability is reliant on a more-volatile source than their fundamental business, which is patient care," says Liz Sweeney, director of not-for-profit healthcare ratings for S&P. "It means when the stock market drops 20% like it did through the end of March, it kind of exposes the risks hospitals have been taking through this reliance on investment income."
Credit stability at risk
The market's downturn may in fact slow the trend toward credit stability that S&P expected this year, according to the report.
Hospitals generally have relatively conservative investment strategies. Novant, for example, has about $500 million of unrestricted cash, about $350 million of which is invested. Historically, Novant has invested about 55% of its portfolio in stocks and about 45% in bonds, Swindle says, although recently the system has trimmed its stock portion to 52%.
Swindle says the system does not plan to change its overall investment strategy as a result of the first-quarter loss because its investment strategy is long-term.
"We realize that long-term, you can't make your bottom line off of investment earnings," he says. "What investment earnings can do is . . . help you get through a period of heavy capital items."
Already, during the month of April, the first-quarter loss reversed itself, Swindle says, although there is no guarantee the improvement will continue throughout the year.
M. Craig Kornett, senior director of healthcare for Fitch, another New York-based credit-rating agency, says heavy reliance on investment income can mask operational problems. The first-quarter market downturn, if anything, has exposed some of the more vulnerable systems. It is the same kind of wake-up call that came with the Balanced Budget Act of 1997, which forced systems to take a look at their operational strategies and pare back on unprofitable noncore business lines.
"The cushion is not there," he says. "The safety net has been removed."
Novant was lucky in that it had achieved some of its operational turnaround while the market was still strong, but other systems that are still trying to right their operations don't have that luxury, he says.
A positive development
Some hospitals, however, have actually benefited from the market recently.
Erlanger Health System, a 536-bed public hospital in Chattanooga, Tenn., is required by board policy and its legal structure to invest only in fixed-income instruments.
For the nine months ended March 31, Erlanger generated net income of $5.2 million. Its $2 million operating loss was buffered by a $7.2 million gain on investments, says Marvin Kurtz, senior vice president and chief financial officer. That's about double what Erlanger had achieved by the same time last year.
But even organizations using only fixed-income investments can be hurt in this economic climate, because declining interest rates can translate into declining returns.
Where others suffered because of stock market exposure, Erlanger so far has benefited from its conservative investment policy. But Kurtz says the hospital prefers to keep its attention fixed on its operating margin, or lack thereof.
"We really try to focus on the operating income, which is the biggest portion of what we have control over," he says. "The interest income and the investments are kind of at the whim of whatever's going on in the markets."
A year ago, Erlanger was losing about $3 million on operations through the first three months of the year, so this year's $2 million loss represents slight progress.
"We always keep hoping it's going to improve, and we keep working to make it improve," Kurtz says. "We keep trying to get ours into the positive range, and we're pretty close."