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Stock Strategist Industry Reports

Like Their Patients, Hospitals Are Ill

After a tough 2008, hospitals are set to face more pain in 2009.

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Long considered recession-resistant, hospital operators are suffering in the most recent downturn. In 2008, hospitals faced revenue and profitability pressures, and we expect head winds will continue through 2009. In this industry update, we will outline the laundry list of challenges facing hospitals, a couple of bright spots, and some of our expectations for 2009.

Patients Delaying Care
The U.S. consumer is hurting. Cash-strapped individuals are delaying purchases and re-evaluating potential expenditures for just about everything, including nonemergency medical procedures. In our opinion, some commercially insured patients faced with high co-pays and deductibles are delaying treatment for non-life-threatening conditions, cutting into admissions growth rates at hospitals. In 2008,  LifePoint Hospitals (LPNT), an operator of mostly rural facilities, saw adjusted admissions (which measures the combined impact of inpatient and outpatient visits) decline about 1%. Another operator,  Health Management Associates (HMA), experienced adjusted admissions declines in two of the four quarters in 2008, with relatively flat figures for the year. Despite the challenging environment, some operators managed to drive positive same-hospital admission growth in 2008, including  Community Health Systems (CYH). We expect it will be difficult for hospitals to gain admission traction in 2009 without improvements in consumer spending, and in our opinion, negative admissions growth is a very real possibility for many hospital operators this year.

Unemployment and Bad Debt Rising
By law, hospitals must treat all patients in need of emergency care, regardless of whether they have insurance. As a result, hospitals write off millions of dollars per year in charity care and bad debt expense for patients who can't or don't pay their medical bills. More unemployment means more uninsured patients, and more uninsured patients means higher expenses for hospitals. For the fourth quarter of 2008,  Tenet Healthcare (THC) reported a 110-basis-point increase in bad debt as a percentage of revenue compared to the prior-year period. Tenet also reported a decline in its quarterly self-pay collection rate compared to last year. Although many hospitals have taken measures to step up the aggressiveness of collections, we believe collection rates will continue to decline in 2009. It's not news that job cuts continue to pile up across the country. Unemployment has breached 10% in a few states, and it is expected to go higher in 2009. Consequently, we're forecasting an uptick in bad-debt expense as a percentage of revenue for all hospital operators in our coverage universe. Higher bad-debt expense will eat away at profitability in 2009.

Medicaid and Payer Mix under Pressure
Rising unemployment has an additional adverse effect on hospitals. Fewer patients with steady income--and fewer people covered by employee-sponsored insurance--translates into greater reliance on Medicaid. Medicaid receives the majority of its funding through state budgets, which are hurting during the recession. A recent study by the Center on Budget and Policy Priorities stated that at least 46 states are currently facing or will face budget shortfalls in the next year. Income and sales tax revenues are down at precisely the same time that Medicaid needs additional funding. To cover budget shortfalls, states often target Medicaid as an easy place to start cutting. As Medicaid funding declines, so does hospital revenue. Moreover, commercially insured patients are the most lucrative for hospitals, and the average revenue generated per patient declines as more people leave the managed care coverage and fall back on Medicaid.

Emergency Funding for Medicaid and COBRA
Hospitals will see some relief from the economic doldrums in the recently passed stimulus bill. The recovery package includes more than $15 billion in Medicaid assistance to be distributed immediately to help close budget gaps. Total Medicaid assistance in the bill is about $85 billion.

COBRA benefits, which provide temporary continuation of health coverage after a job is lost, generally last for 18 months, and the longer job cuts pile up, the more likely it becomes that COBRA will run out for employees let go at the beginning of the recession. In our opinion, COBRA creates somewhat of a lag between initial higher unemployment and higher bad debt expense for hospitals. To keep more people insured, Congress added $25 billion to the stimulus package to expand COBRA. Both Medicaid and COBRA funding will provide much-needed aid to keep struggling hospitals afloat.

High Leverage Make the Story Even Worse
As if slow admissions growth and a deteriorating margin weren't enough, high financial and operating leverage worsens the diagnosis for hospitals in 2009. Hospitals generally employ high levels of financial leverage to magnify slim but usually consistent profits. However, the recession has derailed the game plan of many operators, and investors hammered highly leveraged operators when the credit markets seized up in late 2008. Health Management Associates, Community Health Systems, and Tenet Healthcare each have very high financial leverage and could trip debt covenants if hospital fundamentals continue to deteriorate. As a result, we have modeled in bankruptcy scenarios with a corresponding $0 fair value estimate for each company.

In addition to financial leverage, the business models of hospital operators include a high degree of operating leverage. Hospitals count on a steady flow of patients to their facilities to offset the high fixed costs of employing a staff and stocking medical supplies. When admissions decline and fewer beds are occupied, hospitals have a harder time covering these fixed costs. Thus, even small declines in admissions are magnified on the hospital's bottom line. This is a bit like filling seats on an airplane: The airline still has to fly the route and pay fuel and crew costs, even if the plane's seats are only half full. The same goes for hospital beds.

The credit crisis has also hamstrung hospitals' ability to procure funds for technology upgrades and even fund some day-to-day operations. Hospital operators have shelved many upgrades and expansion projects, and we think this could lead to slower revenue growth down the road.

Not Much Light on the Horizon
We don't see many positive catalysts on the horizon for hospital stocks. Despite help from the stimulus bill, hospital operators are still facing tighter consumers, high unemployment, and potentially damaging shifts in payer mix. We have placed a high uncertainty around our stock calls in the hospital space, and thus require a large discount to our fair value estimates before recommending any of these companies. Even with all the negative factors affecting the industry, we think some stocks look undervalued. However, none of these companies are very close to our Consider Buying prices. We would approach this industry with great caution.

 

Jeffrey Stafford does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.