Not-for-profit hospital operating margins continue to contract

Stunted operating margins persist for U.S. not-for-profit hospitals but improved cash on hand and cash-to-debt ratios bode well for the sector, according to a new report.

The Fitch Ratings report represented a mixed bag for not-for-profit providers.

Operating margins continued to deteriorate last year as salaries, wages and pharmaceutical costs increased. More Medicare and Medicaid beneficiaries came into the payer mix, and providers invested in new technology and resources to prepare for taking on more risk.

Cash on hand and cash-to-debt ratios improved thanks in part to robust returns in the equities market, which could cushion providers from economic hiccups, changing payment models and other disruptions, analysts said.

For the second consecutive year, median operating margins and operating earnings before interest, taxes, depreciation and amortization margins declined, reaching 1.9% and 8.5%, respectively, down from 2.8% and 9.5% the year prior, Fitch data show. Revenue growth dropped to 6.1% in 2017, down significantly from 11.5% in 2016 but nearly in line with the 6.4% average.

Median days' cash on hand improved to 213.9 last year, up from 195.5 the year prior while cash to debt increased to 159%, up from 142.8%. Notably, the cash on hand median was buoyed by highly rated providers while most systems regardless of rating saw their cash-to-debt ratios improve.

Fitch maintained a negative sector outlook given the ongoing margin pressures but gave a stable rating outlook to not-for-profits, citing their balance sheet strength.

"We focused our gaze on the strength of the balance sheet," said Kevin Holloran, a senior director with Fitch. "Operations can kind of come and go but a strong balance sheet gives you some flexibility to get through times of stress."

Fitch also implemented new ratings criteria including cash to adjusted debt and net adjusted debt to adjusted EBITDA that provide more level comparisons of balance sheet strength regardless of the size of an organization, Holloran added. They more accurately convey how much a system borrowed versus how much they promised to pay, he said.

More consolidation is on the horizon, according to the report.

Although size and scale alone does not guarantee success, consolidation will occur in response to the pressure to adopt value-based payment models, growing Medicare and Medicaid populations, increasing wage pressures, volumes decreasing and bad debt growing as patients shoulder more costs. A more adversarial managed care contracting environment could also spark mergers as providers look to offset the impact of comparatively weaker governmental reimbursement through their commercial contracts, analysts said.

The rationale driving mergers and acquisitions remains: size and scale can help reduce expenses, improve negotiating leverage with payers and vendors, and provide more access points and capital to better tackle population health, Holloran said.

"Does size and scale equal success? That's a longer question that you can't measure two months or even two years down the road," Holloran said. "Systems are taking a look back years later and asking, 'If we didn't do the merger where would we have ended up?'"

Healthcare economists and policy experts have vehemently opposed the belief that consolidation improves financial viability, saying that the cost of integration overshadows the potential synergies. Healthcare executives disagree.

A recent paper from the Wharton School at the University of Pennsylvania found that horizontal hospital mergers saved acquired hospitals $176,000, or 1.5%, annually on average, driven by geographically local efficiencies in price negotiations for high-tech physician preference items. There is only mixed evidence on acquirers' savings.

Not-for-profit providers will need to continuously focus on operational and clinical improvement to offset the impact of compressed reimbursement rates, according to the report.

The backdrop throughout the sector is that things are much more difficult as hospitals take on more Medicare and Medicaid patients, Holloran said.

"What we certainly see is that systems think they need to get bigger to prepare them for taking on more risk," he said.