A solid year

Not-for-profit healthcare systems on average showed a strong financial improvement in 2010, based on aggressive cost-control efforts and gains in revenue from patient care and investments.

For-profit hospital operators, in contrast, also made strides on the operations side of the business in 2010, even while they took on far more expenses related to uncompensated care and continued acquisition activity compared with their tax-exempt peers.

Those were two key lessons from the latest annual Modern Healthcare Hospital Systems Survey, which included two years of detailed financial and operational data from just under 200 health systems.

The survey also confirmed another ongoing trend: Health systems are getting larger, as factors such as federal healthcare reform, mandated information technology spending, and the sustained contraction from the 2007-09 recession push stand-alone hospitals and small systems into the arms of more-stable buyers.

The number of acute-care hospitals owned by the 210 systems participating in the survey rose 2%, to 2,123, while the number of beds in those systems rose 1% to 401,879.

“There is an increased receptivity on the part of potential hospitals to be acquired,” says James LeBuhn, a senior director and head of the U.S. public finance healthcare group at Fitch Ratings. “As individual hospitals look at the greater challenges from health reform coming down, there is a greater willingness to join larger systems and receive those economies of scale.”

A total of 199 systems are ranked in the survey financial analysis because some did not provide all necessary financials or did not meet all criteria on number of facilities as specified upon data collection. The Veterans Affairs Department was removed from all financial analysis.

Overall, the 199 analyzed systems reported earning an average of $1.98 billion in net patient revenue and $2.2 billion in total net revenue, and posting an average $122 million in net income.

That meant the systems spent an average of $2.08 billion in 2010, or about $92 million more than they earned from patient care.

That patient-revenue shortfall was in line with the long-running trend reported last year in Modern Healthcare that hospitals as an industry do not draw enough revenue from treating patients to pay all of their expenses (Aug. 2, 2010, p. 6). However, the 2010 shortfall was less than the previous year, when hospitals spent on average $140 million more than they took in from patient care.

Average total net revenue rose 5.9%, to $2.3 billion per system. On average, 91% of not-for-profit hospitals' net revenue came from patient care. In contrast, 96% of investor-owned systems' revenue came from patient care, according to the survey data.

Not-for-profit hospitals in the survey, on average, saw their net incomes in 2010 rise 133% over the prior year, to $113 million from $48 million, with most of it coming from core operations like patient care. About $70 million of the average $113 million rise in average net income at not-for-profits came from core operations.

At the same time, not-for-profits tried to suppress expenses, posting an average growth in spending of 2.7% on the year, the figures show. Experts say the industry has benefitted greatly from low overall cost inflation for supplies and labor.

The result was that not-for-profits' average net profit margins rose to 5.2% for the year, compared with 2.5% seen the year before. However, net operating margins rose to 3.4% from 2.9% the year before.

Lehigh Valley Health Network in Allentown, Pa., illustrated many of those trends.

The system, which has 893 beds between two hospitals in east-central Pennsylvania, posted a 252% increase in its net operating income, to $40.1 million in net revenue of $1.4 billion. That made for an operating margin of 2.9%.

Those results followed a 2009 in which Lehigh Valley posted $11 million in net income on net revenue of $1.3 billion, for an operating margin of 1%.

Joseph Felkner, chief financial officer for the system, says Lehigh Valley “retrenched” in late 2008 and put a focus on its fundamentals—a strategy that paid off.

“It was kind of back to basics, and the core fundamentals of the operations,” he says. “Maximizing revenue, the revenue cycle … and an extreme focus on expense management.”

Indeed, calculations based on the survey data show that Lehigh Valley's expenses increased only 0.2% between 2009 and 2010. Felkner says one of the key expense-control measures was an across-the-board wage freeze, which was eventually lifted, after which employees' salaries were restored to what they would have been under the traditional annual raise system.

But the system did not have to reduce the workforce to achieve its payroll goals. “I think it was just the commitment of the board and the management team to avoid layoffs,” Felkner says. “They stuck to that philosophy and were able to overcome the challenges that the system faced and get to the other side of the hill, if you will.”

One thing the system did not do, Felkner says, was panic when the bottom dropped out of its investment portfolio.

Lehigh Valley allocates 60% of its investments in equities—a decision that blew a hole in the system's net income figures during the recession. Including investment revenue, the system's net profit margin in 2009 was written in red ink: a negative 3.1%.

As the stock markets rallied during fiscal 2010, the system's net margin jumped back to 4.6%. Today, the investments have recovered “all of our losses, plus some, at this point,” he says. However, unlike many health systems, Lehigh Valley is in a position of not having to rely on investment income to subsidize patient care: “We do not count on investment income to sustain the operations of the health system. Our philosophy is the health system has to stand on its own on operations.”

Investor-owned systems saw their net incomes rise by 50% year-to-year, but gains in patient-care income were offset by heavy increases in spending. In many cases, that led to for-profit systems showing less net income than operating income.

One of the most extreme examples of that was Vanguard Health Systems, which recorded an 8% increase in operating income, topping $326 million in 2010. But the system's spending increased by 8.5% at the same time, driving down its total net income in 2010 to a $49 million loss on the year.

Gary Willis, Vanguard's senior vice president and chief accounting officer, declined to elaborate on the figures, as the company is in a media “quiet period” in advance of its planned $600 million initial public offering.

On average, the investor-owned systems recorded $369 million in net operating income, but just $250 million in total net income.

This year's survey includes financial data from only 13 for-profit systems, but they tended to include the larger players in the market, including HCA, Community Health Systems, and Tenet Healthcare Corp.

That meant that the average total figures for the for-profit systems tended to be larger than the not-for-profits. Average net revenue, for example, was $5.9 billion at investor-owned systems compared with the $1.9 billion at not-for-profits.

Investor-owned chains boosted their operating margins in 2010 even as volume weakness limited the growth in net revenue because the chains managed their expenses well, according to two hospital stock analysts.

Investor-owned companies that responded to the magazine survey, including operators of medical-surgical, psychiatric and long-term acute-care hospitals, boosted their operating margins from 6.5% in fiscal 2009 to 6.9% in fiscal 2010.

Darren Lehrich, a managing director with Deutsche Bank Securities, says 2010 was very much a continuation of 2009 in those two respects—good cost control offsetting weak volume.

“I think all of these companies have been aggressively managing their cost structures and have been very effective in managing expenses in a tough economy and a slowdown in overall revenue growth,” Lehrich says.

Volume was particularly challenging in the summer and fall of 2010 before improving a bit at the end of the year, Lehrich says. Deutsche Bank's monthly survey of more than 500 hospitals, including both investor-owned and tax-exempt hospitals, showed about a 1% decline in admissions and a 1% increase in outpatient visits for 2010, Lehrich says.

So far in 2011, those metrics have improved, he adds—admissions are flat, and outpatient visits are growing about 2%.

The investor-owned chains have controlled labor and supply costs particularly well, says Gary Lieberman, a managing director and senior analyst at Wells Fargo Securities.

“In 2009, it became a buyer's market for employers,” Lieberman says. “Nurses became more available, and they reduced the amount of contract labor. They continued to do that in 2010.” Hospitals seem to be maintaining that control of labor costs in 2011, he adds.

On supplies, hospitals have gained the upper hand in negotiations for orthopedic and other implantable devices, one of the biggest contributors to their operating performance improvement, Lieberman says.

The largest nonfederal system in the survey by a large margin continued to be HCA, with $30.7 billion in net patient revenue. The second-largest nonfederal system by revenue was a not-for-profit: Ascension Health with $13.9 billion in net patient revenue. The largest provider on the list was the U.S. Veterans Affairs Department, with $50 billion in net patient revenue.

Not only were systems on the list growing in size, but their service lines were expanding as well.

Notable expansions in 2010 included the number of skilled-nursing facilities (11% growth), continuing-care retirement communities (9%), and long-term acute care hospitals (9%).

The number of free-standing outpatient care clinics spiked 14% in 2010. That increase meant that, on average, each system had eight outpatient clinics for each of its acute-care hospitals.

“That's a trend we continue to see,” Fitch's LeBuhn says. “As more and more goes in an outpatient setting, that's where the growth is in terms of service line delivery. Many systems are looking at their outpatient (offerings) as way to expand out into the community.”

Meanwhile, the number of facilities offering urgent care jumped by 20% in 2010, and the number offering women's health jumped by 23%.

Along with the growth in some services, hospitals have been directly employing more physicians.

All told, the 210 hospital systems on the list reported employing a total of 95,528 doctors—an average of 61 employed physicians per hospital at each system.

However, legal prohibitions on the corporate practice of medicine in some states makes employing doctors illegal. Also, many of the systems answered “yes” to the question of whether they employ doctors, but then reported zero when asked how many.

That left 179 systems that reported something other than zero in the number of doctors employed. Among those, the average system reported employing 71 physicians per hospital.

The employment of physicians was another factor driving down supply costs at hospitals, Lieberman says. While employing physicians can put pressure on labor costs, as employees, such physicians are much more likely to follow their hospital's group purchasing organization contracts when choosing implantable devices, he says. As a result, hospitals are paying less per device, as more of their procedures involve devices that are discounted under their GPO contracts, he says.

Lehrich and Lieberman say they will be watching the news out of state capitals on changes to Medicaid programs, especially as greater federal matching percentages end June 30. With good access to capital, the investor-owned companies should continue their pursuit of acquisitions, particularly of not-for-profit systems, they say.

“These deals are picking up steam, and we think every company in the investor-owned space is going to participate in some way,” Lehrich says.

In the short term, acquisitions can drag down operating margins, Lieberman notes. “In the first year of an acquisition, you're going to be acquiring a hospital at 0% (earnings before interest, taxes, depreciation and amortization) margin, and it's going to take two or three years to get to 12% to 15% EBITDA margins,” Lieberman says.

Other factors are pressuring margins as well. Down the road, LeBuhn says he does not expect to see the kind of rosy operating figures that were reported in the most recent cycle, notably because of expected challenges to reimbursement and the long-term unsustainabilty of the tactics employers used to control labor costs during the recession.

“What we're beginning to see is some compression in operating profitability,” LeBuhn says. “In 2010, there was fairly stringent labor cost control … this year, with solid operating performance, managements understand the need to compensate their employees, and we expect to see some compression in operating performance in 2011 and going forward.”