Based on the bottom line, Eisenhower Memorial Hospital in Rancho Mirage, Calif., did everything right to turn around its faltering operations. The 261-bed hospital shed unprofitable capitation contracts, increased its volume of lucrative open-heart surgeries by acquiring a competing heart hospital, and renegotiated managed-care contracts with significant rate increases.
These and other steps turned an operating loss of $9.7 million in the fiscal year ended June 30, 2000, into a small operating profit for the fiscal year that just ended.
Yet when it came time for a review of its bond rating, the news wasn't good. Moody's Investors Service in July downgraded the hospital's outstanding bonds, worth $84 million. In its report, the credit-rating agency acknowledged the hospital's operational improvements but also noted that the hospital's balance sheet had weakened, the result of low liquidity and more debt. Much of the borrowing was to fund construction of a new cancer center and expansions of the emergency room, surgical facilities and patient areas.
Although the rating change, to A3 from A2, didn't have an immediate impact on Eisenhower Memorial's cost of capital, it could lead to higher borrowing costs in the future. Eisenhower serves as a stark example of how some hospitals are seeing their credit ratings deteriorate even while they make strides in improving operations and gaining market share.
Eisenhower's investment banker, Charles Plimpton, a director at the Los Angeles office of Merrill Lynch & Co., says the downgrade was a disappointment for hospital management, but it didn't come as a surprise. "By definition, extra debt is a negative to the credit rating," he says.
Increasingly, hospitals are being downgraded because they are taking on additional debt or are planning to borrow in the near future to finance new construction or added services. Although a flurry of downgrades in the industry that started two or three years ago was driven largely by operational problems such as losses on nonhospital operations and Medicare cutbacks, the industry appears to be experiencing more downgrades based purely on higher debt.
Figures released by Moody's show hospitals increased their leverage significantly from 1997 to 2000, even while cash increased (See chart). Analysts expect debt levels to go even higher as hospitals expand to meet heightened demand and increase market share, says Beth Wexler, a Moody's analyst.
The rating agencies say they expect to issue more "pure debt" downgrades. At Fitch, analyst Jordan Melick says about a quarter of the downgrades issued by his agency since January 2000 have been primarily because of increasing debt. Fitch lowered ratings on 24 hospital credits during the 18 months ended in June, vs. just one upgrade.
"Reduced debt-service coverage jeopardizes to some extent the ability of that organization to pay back debt to existing bondholders," Melick says. With financial pressures such as higher labor costs, "it's more difficult for hospitals to absorb new debt now," he says.
Hospitals are "still going to be challenged" in their ratings," Plimpton says. "But this time they're not going to be challenged by operations deteriorating. They're going to be challenged by increased indebtedness."
The problem is especially frustrating because many hospitals are attempting to expand emergency rooms and critical-care facilities to correct an undersupply of capacity in those departments. In other cases, hospitals are taking on additional debt to build heart hospitals and other facilities that are expected to generate profits.
However, higher patient volumes can be a financial burden rather than a blessing. In its recent second-quarter report, Standard & Poor's notes that many hospitals have been unable to translate volume growth into improved income because of rising costs associated with the increasing patient volumes, including staffing expenses. S&P cited additional debt as a contributing factor in its second-quarter downgrades of William Beaumont Hospital in Royal Oak, Mich., the Cleveland Clinic Foundation, and Cookeville (Tenn.) Regional Medical Center.
Beaumont, a tertiary referral center with 1,118 beds on two campuses, a top medical staff and broad range of services, allowed the hospital to boost admissions 20% from 1996 to 2000, increasing its market share about 5%.
Despite the strong growth, Beaumont was downgraded earlier this year as a result of its decision to issue debt to fund expansion projects, including larger emergency rooms and more private rooms. S&P lowered the hospital's rating by a notch, to AA- from AA, noting in its report that to finance the projects, the hospital would increase its long-term debt significantly, to $479 million in 2002 from $268 million in 2000.
Beaumont Chief Financial Officer Dennis Herrick says the hospital tried to counter analysts' concerns by stressing that issuing bonds would enhance liquidity and that the financial forecasts were rosy. But it had no success.
Fortunately, Herrick says, the hospital found strong demand for its bonds, despite the small drop in its rating.
"Sometimes there are short-term costs, but you feel strongly about your strategic vision, so you move forward."