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What's Behind Our Sector View

Extreme operating pressures of recent years have eased materially.   Hospitals and health systems have made strides on managing labor challenges. That said, higher expenses related to both staffing and benefits, as well as drugs and supplies, require management teams to maintain aggressive annual operating initiatives. Management teams have made gains on efficiency and throughput to address the healthy demand and rising volumes, which have resulted in good revenue growth that has begun to outpace expense growth. Commercial rate increases, which still might not be at the level of expense growth experienced in the past few years, and enhanced Medicaid supplemental payments have aided the improvement.

Providers have also made meaningful adjustments to the expense base through staffing, service line changes, and divestitures of noncore service lines and reconsidered their portfolio to ensure broader strength of the enterprise. In some cases, health systems have adjusted their portfolio of hospitals with divestitures; in others, they're adding facilities for a wider or strategic presence. Many providers in the speculative-grade and 'BBB' categories continue to struggle and some higher-rated providers are still trying to return margins to higher levels or fill gaps from one-time nonrecurring revenue. However, S&P Global Ratings expects some of these initiatives could support incremental margin improvement in 2025.

Balance sheets remain sound, despite some modest decreases in certain ratios.   With solid investment market returns and a slower ramp-up of capital spending for many, balance sheets are supportive of credit quality. Reductions in pension liabilities, and pension terminations for some, have also been a credit positive. Days' cash on hand, which weakened in recent years, has stabilized for most providers as cash flow and investments support unrestricted reserves. While we saw a pickup of new money debt issuance in 2024, most providers were able to absorb the additional debt and debt service at the current rating. We continue to monitor spending, particularly for those issuers that have not fully recovered to cash flow targets. We're also monitoring how the additional spending and potential debt could influence credit quality.

Rating and outlook actions from 2024 highlight different stories among issuers relative to expected credit quality going into 2025.   In the past few years, credit quality modestly weakened across providers we rate, with a higher number of downgrades, but this has been partially offset by favorable shifts (such as mergers, new ratings, majority of affirmations, etc.). In addition, the percentage of negative outlooks fell to 17% at October 2024 from 24% at the end of 2023 and the negative outlooks are more concentrated at the lower end of the ratings scale than they were last year. Covenant violations have eased across the board and we believe are more likely among speculative-grade providers, which is also a shift from previous years when covenant violations were sometimes occurring at the higher end of the rating scale.

Finally, our recent trend of favorable outlook revisions outpacing unfavorable ones indicates some initial signs of stabilization in the coming year that we expect could continue. Although we expect that there could still be more downgrades than upgrades, we believe the rate should slow in 2025 as the more extreme operating pressures of recent years ease; this also supports our stable sector view.

Significant improvement initiatives in recent years have helped stem performance challenges, but a fragile heath care environment presents uncertainty and less rating flexibility for some providers.   We rate a broad mix of acute care hospitals and health systems that span the credit rating scale. A significant portion of these providers have consistently performed well and sustained credit strength with resilient management teams and a good operating culture. They operate largely in states and regions where there are favorable demographics and/or payor mix, often generous supplemental payment programs, and generally lower costs of living. However, for those at the lower end of the ratings scale or those still trying to improve and steady their cash flow and fill the gaps in nonrecurring revenue recognized in recent years, we believe there is less rating flexibility.

Some providers are facing a longer recovery and demonstrated progress in earnings and enterprise strength will be necessary to sustain ratings. We view recent years' operating improvement and strategic initiatives as helpful for many, but also acknowledge that headwinds and areas of uncertainty, including the changing administration and its priorities, could revise our view of sector credit quality should we see organizations' performance recovery slow or be strained/pressured and potentially result in delayed investments or balance-sheet stress.

Sector Top Trends

Staffing and labor expenses likely will remain a pressure point for several years to come.   According to data from the Bureau of Labor Statistics, the health care job openings rate relative to the hire rate is moving toward pre-pandemic levels and will likely continue to put pressure on earnings, although less so than in recent years. As demand and acuity continue to rise with an aging population, we expect organizations will use all strategies employed in the past few years to aid in retention and hiring. While we understand organizations are generally less reliant on external agency staff, overtime and agency costs remain at slightly higher use rates for many providers than pre-pandemic.

Future physician shortages also remain a potential risk both to expenses and managing demand. We expect that redesign of workforce and technology could provide benefits for more efficient labor usage, although likely over the medium term. Depending on the incoming administration's broader immigration and economic policies such as implementation of tariffs, supply and drug costs, along with the return of labor pressures in certain support areas, could cut into margins. Management strategies on efficiencies, process improvement, and meaningful changes to lowering the costs of care delivery need to be in constant focus to support targeted cash flow.

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Payor pressures, demographic shifts, and focus on affordability are likely to present reimbursement challenges despite recent revenue positives.   Providers have meaningfully benefited from increased commercial rates (using better data around costs and quality) and enhanced Medicaid supplemental payment programs that often pay closer to average commercial rates for Medicaid managed care patients and could continue to proliferate. Both of these have helped partially offset factors that we believe will continue to put steady pressure on revenue yield and underscore management teams' focus on revenue cycle improvement and revenue diversification strategies. These factors include the growing Medicare patient mix and the denials and administrative challenges providers have faced from commercial and Medicare Advantage (MA) insurance companies. In addition, the incoming administration could further encourage enrollment into MA plans from traditional Medicare. Those organizations that are succeeding under value-based care contracts and taking risk are likely to benefit longer term, particularly as more individuals move under Medicare.

In the past year, there have been more MA terminations by providers and we expect they could continue. Those organizations with stronger positions, large networks, and must-have status with commercial payors, may have the financial ability to terminate their MA contracts without material impact.

Furthermore, there could be regulatory and legislative initiatives to help control Medicare and certain Medicaid costs following leadership changes with the incoming administration. We could see more services transition to site neutral payments, changes to the 340B program, and focus on other areas that could affect provider revenues. Allowing the enhanced Affordable Care Act premium subsidies to expire after 2025 or initiating changes to Medicaid programs could reduce coverage and/or provider revenues. All of this and the above-mentioned dynamics with payors will require management teams to work harder on revenue yield as federal and state governments and employers try to slow the growth of health care costs and focus on affordability.

Forecasts show providers' desire to increase capital spending for both renewal and replacement as well as strategic and growth opportunities.   Spending has been curtailed for many, but not all, providers over the past few years. Investments in technology and outpatient services remain priorities but we also understand there is a desire in certain markets for continued investment for inpatient services, particularly higher acuity services or replacement of older facilities. We believe many providers we rate have some balance-sheet flexibility for some additional debt; however, there may be less flexibility on whether cash flow can support that spending and potential additional debt service. That said, healthier non-operating income via investments is helpful, but could place cash flow reliance in an area with less control.

Furthermore, increased events in the sector (cyber, physical, and other industry-related challenges) have caused cash flow and liquidity disruption at a time when many organizations still have less operating flexibility; these events could take management's attention and slow or disrupt various initiatives and investments.

We've also seen organizations raise cash through the sale of lab businesses as well as through more creative financing tools such as monetization of pharmacy businesses and energy-asset lease transactions to support necessary infrastructure investments, which we typically view as debt-like structures. As organizations try to maintain their balance-sheet strength, we expect they'll use more of these types of financings.

Data and technology are increasingly central to furthering operational gains in 2025 and beyond.   The use of data and technology is necessary for both generating efficiencies and operating improvements and for improving care delivery and quality. Organizations that are savvier with their data and have a strong operating culture can use it to their operational and strategic advantage, especially in this tough health care environment where cash flow margins have tightened. The access to data and appropriate technology also supports the ability to take advantage of AI and could provide better and more efficient care. The application and use of AI is still in its early stages, and the government and organizations are still determining appropriate oversight. These investments in AI and technology are expensive but are likely to radically change many aspects of health care; they could begin to materially affect providers over the next several years.

Mergers and acquisitions (M&A) and partnerships remain an important potential avenue to strengthen an organization's credit profile.   Although not all M&A activity and partnerships yield stronger credit quality, particularly when they include aggressive new strategies or significant debt, many to date have been successful and led to maintenance of or credit quality improvement. That said, we've also recently seen divestitures as many organizations are stressed by cash flow constraints and as they re-examine how to best meet the needs of their patients and afford the necessary investments. We expect increased partnerships, particularly in areas that may not be core or need to be controlled, but still need alignment to reduce care costs and improve care delivery (rehabilitation, urgent care, etc.). There is more scrutiny around these strategies, particularly the full mergers, from state and federal agencies and an inability to enter into these types of arrangements could be a credit negative for the sector.

Ratings Performance

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Related Research

• U.S. Not-For-Profit Health Care Rating Actions, October 2024, Nov. 15, 2024
• U.S. Not-For-Profit Health Care Outstanding Ratings And Outlooks As Of Sept. 30, 2024, Oct. 21, 2024
• U.S. Not-For-Profit Acute Health Care 2023 Medians: Remarkably Level With Prior Year, But Performance Remains Notably Below Historical Norms, Aug. 30, 2024