Growth amid signs of strain

Health systems’ strong revenue growth couldn’t prevent sagging operating margins in 2006, a Modern Healthcare survey found, a sign that the hospital sector’s recent strength might be ebbing.

Net patient revenue rose to $315.6 billion last year, a 25.1% jump from the previous year, but the overall net operating margin dipped to 4% in 2006 from 4.6% in 2005 for the 179 health systems in Modern Healthcare’s 31st annual survey of the sector that reported data for both years. (The Veterans Affairs Department is excluded from aggregate figures because of differences in its accounting methods.)

The survey findings, though not a scientific sample of the industry, underscore rising pressure on hospital operations from several trends: smaller gains from insurers, flagging patient volume, losses from uninsured and underinsured patients, and continued competition from entrepreneurial physicians.

“There are a wide variety of incremental pressures that are facing the healthcare sector,” says Martin Arrick, a Standard & Poor’s managing director. Arrick called profits among not-for-profit hospitals and health systems “a little strained,” but noted that overall operations remained stable in 2006.

Net operating income rose 6.8% to $12.5 billion from $11.7 billion a year earlier, among systems surveyed by Modern Healthcare.

Net revenue and income, which include investments, spiked 23.5% and 33.6%, respectively. For 2006, systems surveyed reported aggregate net revenue of $343.6 billion and combined net income of $17.9 billion. Systems’ 2006 net margins rose to 5.2% from 4.8% a year earlier.

Healthy net income gains provide systems with a cushion to offset struggling operations, but poor investment performance can quickly wipe out those reserves, analysts caution. Operating income and margins better reflect systems’ financial health. “Nonoperating income is a little like a fair-weather friend,” Arrick says. “All you can do is try to manage it.”

Modern Healthcare’s survey compiled 2006 and 2005 operating data from systems that represent a total of 2,193 hospitals. Organizations must own, lease or sponsor two or more acute-care or psychiatric hospitals to be eligible to participate. The 2006 survey includes: 105 secular not-for-profits; 31 Roman Catholic systems; 17 religious, non-Catholic systems; 15 public systems; 11 for-profit companies; and one system that had a joint Catholic/other-religious affiliation.

Prominent systems that declined to participate in this year’s survey or didn’t respond by deadline include: Adventist HealthCare, Rockville, Md.; Alegent Health, Omaha, Neb.; Allina Hospitals & Clinics, Minneapolis; Ardent Health Services, Nashville; LifePoint Hospitals, Brentwood, Tenn.; Lifespan, Providence, R.I.; and ProMedica Health System, Toledo, Ohio.

Industry giant Ascension Health, St. Louis, the largest U.S. tax-exempt private system by revenue, reported a modest gain in operating margin to 4.6% in 2006, up from 4% in 2005. (Operating margin is net operating income divided by net patient revenue.) The largest U.S. for-profit hospital operator by revenue, Nashville-based HCA, saw its operating margin slip to 4.9% last year from 5.4% a year earlier. The public sector’s largest system, the VA, posted a 2.5% operating margin in 2006, a significant drop from 5.3% in 2005.

This year’s survey included responses from 180 systems, up from 164 last year. Of those surveyed, 178 operated acute-care hospitals. Some 81%, or 146 systems, reported home-care operations and roughly three-quarters of survey respondents, or 138 systems, operated skilled-nursing facilities. Forty-seven systems reported operating long-term acute-care hospitals. Home-care and skilled-nursing operations were also among the most reported operations in last year’s survey. Of the 164 respondents in the survey published in 2006 with 2005 results, 133 had home-care facilities and 101 operated skilled-nursing facilities.

Diagnostic imaging and physical therapy/ sports medicine tied as the most commonly reported outpatient services among respondents in this year’s survey, each reported by 125 systems. Those services ranked No. 1 and No. 2, respectively, in last year’s survey.

Overall, analysts say hospital operators continue to enjoy relatively strong finances. Community hospitals’ aggregate profits hit an all-time high in 2005, totaling $28.9 billion, according to the latest American Hospital Association figures, while net patient revenue rose 7.5% to $505 billion in 2005 vs. $470 billion in the prior year. The aggregate margin reached a seven-year high at 5.3%. The figures include data from 4,936 nonfederal, short-term, general and specialty hospitals.

In a February note on its not-for-profit credits, S&P said 2006 marked the fourth consecutive year of strong financial and operating performance among not-for-profits in its portfolio. The New York-based ratings agency noted performance may have hit a plateau in 2006, which will continue this year, and possibly 2008. That’s after a strong 2005 in which large systems fared far better than smaller hospitals. Of the ratings agency’s 34 downgrades that year, 28 dropped to BBB or lower; most of the downgrades were small hospitals (Feb. 13, 2006, p. 20).

Rumblings of congressional moves to curb Medicare spending likely won’t result in changes until after the upcoming presidential election, the ratings agency said in its February note, and the industry’s focus on cost controls and the revenue cycle continues to yield results. For the second consecutive year, S&P raised more ratings than it lowered for not-for-profit hospitals and health systems.

However, hospital operators see a handful of encroaching pressures beginning to erode margins, though stressors vary by market and system, Arrick says. Hiring doctors—a strategy to offset increased competition or flat population growth—drives revenue gains but typically eats away at profits, he says. Employed doctors may fuel referrals and gains in market share, but at a cost. “Strategically, it’s part defensive, it’s part offensive,” he notes. “You want to protect your base.”

At Sacramento, Calif.-based Sutter Health, expanding the system’s physician base is critical to executives’ growth plans, Moody’s Investors Service reported in April. Ranked No. 8 on Modern Healthcare’s survey by net patient revenue, Sutter owns seven foundations that contract with more than 1,700 doctors. The system, which has 21 acute-care hospitals, hopes to contract with another 200 physicians in 2007 in a bid to build its market share. That’s a switch from prior years, when acquisitions and strategic partnerships fueled Sutter’s growth, Moody’s noted. Sutter’s operating margin totaled 5.2% in 2006 on operating revenue of $7.1 billion, according to the ratings agency.

Less favorable managed-care increases have also added stress to hospital systems, which can now expect 5% to 6% annual payment increases compared with 8% to 9% hikes providers negotiated in recent years, Arrick says. Consolidation among insurers will likely give plans greater leverage in coming years. In addition, health plan products that shift more healthcare costs to patients—which have gained favor among employers—can boost losses from unpaid bills or bad debt while curbing patient volume.

Systems reporting losses from patients who failed to pay their bills saw bad debt erase a greater share of earnings in 2006, according to analysts.

Moody’s found bad debt increased to 6.2% of net patient revenue in 2006 compared with 5.9% in 2005 among single-state, not-for-profit systems and stand-alone hospitals in its portfolio, says Bruce Gordon, a senior vice president with the New York-based ratings agency. A glimpse at some systems’ financials highlights the trend.

Catholic Health East, which ranks No. 4 among Catholic systems in this year’s survey based on staffed beds at its 23 acute-care hospitals, reported a 47.6% increase in bad debt in its fiscal 2006, which ended Dec. 31. Losses from unpaid bills climbed to 8.2% of the system’s 2006 patient revenue, up from 5.8% in 2005, according to annual financial filings. Meanwhile, the Newton Square, Pa.-based system’s 7.9% rise in operating expenses handily outpaced its 5.1% growth in patient revenue, yearly financial records show.

Scott Share, a Catholic Health East spokesman, attributed the system’s rising bad debt to a changing mix of payers and higher rates of uninsured and underinsured patients. Share also cited the devastating 2005 hurricane season as another possible culprit. Storms crippled businesses; any resulting job losses may have cost employees their health benefits, he says. Hurricane Wilma’s “economic after-effects” contributed to an $11 million loss at 450-bed Holy Cross Hospital, Fort Lauderdale, Fla., as did slumping volume and increased charity-care costs, Moody’s noted in a March 2007 report on Catholic Health East.

Meanwhile, SSM Health Care, St. Louis, reported bad debt rose 19% for the first nine months of 2006 compared with the same period a year earlier, based on unaudited financial results. The system, which has 14 acute-care hospitals, ranked ninth among Catholic systems by hospital beds; it reported bad debt of $84 million through Sept. 30, 2006, compared with $70 million for the same nine months in 2005.

Partners HealthCare System, Boston, posted a more modest 7% increase in bad debt in 2006 to $101 million, financial statements show. The system—which has seven acute-care hospitals and ranked No. 10 among secular not-for-profit systems by hospital beds—posted $95.3 million in bad debt for 2005.

Rising bad debt comes as Congress, lawyers and patient advocates put increasing pressure on not-for-profit systems to better promote charity care for uninsured and underinsured patients and offer more generous discounts to uninsured patients who pay the so-called sticker price for services. Insurers negotiate discounts off the sticker price for enrollees; uninsured patients have no such leverage.

Figures from the AHA show uncompensated care rose 7.1% to $28.8 billion in 2005, the most recent figures available. However, the tally includes costs from bad debt and charity care for patients who qualify for free or discounted care. Overall, uncompensated care as a percentage of total expenses held steady between 2004 and 2005 at 5.6%.

For-profit hospital companies continued in 2006 to see two operating trends that have hurt their earnings: bad-debt expense and weak patient volume, says Frank Morgan, a healthcare stock analyst in the Nashville office of Jefferies & Co.

The earnings weakness led to another significant trend, this one financial: hospital companies have low valuations on their shares, Morgan says, the lowest among facility-based healthcare companies.

The low valuations drew the interest of private-equity firms to healthcare services companies, Morgan says.

“It all started with HCA,” Morgan says, referring to the $33 billion leveraged buyout of the Nashville giant completed late last year. “The HCA transaction opened the eyes of the world to the possibilities of private equity in healthcare.”

Two private-equity firms took a shot at buying Triad Hospitals, Plano, Texas, earlier this year, but that bid was trumped by a larger offer—at $6.8 billion, it was $400 million larger—from Community Health Systems, Franklin, Tenn. The returns that private-equity firms were willing to provide for public shareholders played a role in some other large moves, Morgan says, such as Health Management Associates, Naples, Fla., paying a one-time dividend of $10 per share as financed by debt. Privately held Iasis Healthcare, Franklin, also took on more debt to make a payout to its investors.

In the first quarter of 2007, volume figures were improved, but still were not very impressive, Morgan says. Bad debt, however, showed small signs that it may be leveling off, he adds. The numbers for total uncompensated care and the percentage of admissions by uninsured patients flattened in the quarter compared with the fourth quarter of 2006. It’s too soon to say whether that’s the first sign of anything more lasting, but it’s a possibility, at least, Morgan says, and something that he will be watching closely for the rest of this year.

He also expects that hospital companies will have solid, predictable earnings for the rest of 2007, in contrast to the volatility in 2006 that came from charges for buildups in bad-debt expense. Morgan says another major buyout deal is unlikely.

Gordon says he doesn’t anticipate any significant effort to curb Medicare spending growth until President Bush’s successor takes office in 2009, which could help deliver another year of stability for hospitals and health systems in 2008. “I don’t think anyone’s expecting dramatic declines,” in the near future, he says.

But Caroline Steinberg, senior vice president for trends analysis for the AHA, contends the picture isn’t entirely rosy. She noted that the Medicare Payment Advisory Commission projected in March that Medicare’s negative margin would expand to a negative 5.4% in 2007 after holding steady at a negative 3.3% in 2005 and a negative 3.1% in 2004.

The entitlement program for U.S. elderly accounts for roughly 40% of hospital payments, she says, so worsening Medicare margins could stress bottom lines across the hospital sector, as could the need for investments in technology and workforce development. “I would say (the industry) remains fragile,” Steinberg says.

For the complete ranking of hospital systems, additional charts and an alphabetical list of respondents to this year’s survey, click here.

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