Mark E. Grube
Ryan S. Gish
Sasha N. Tkach
When it comes to competitive performance, bigger is often better. But there are strategies that healthcare organizations of any size can use to achieve scale.
At a Glance
Growth to achieve scale requires the following strategic initiatives:
- Having a clear understanding of what the organization is and what it wants to become
- Ensuring a structured and rigorous growth process
- Leveraging size to achieve benefits of scale
- Recognizing the importance of physicians, ambulatory care, and primary care
- Establishing and maintaining accountability as growth occurs
In both the corporate and not-for-profit healthcare worlds, the capital markets have long favored larger organizations. Is this view held by investors, rating agencies, and bond insurers justified, and do size and growth drive exceptional, sustained organizational success?
Scale achieved through growth is commonly recognized as essential in the corporate world. As established in basic economics, large companies share five traits:
- Lower fixed- and variable-unit costs from the economies of mass production
- Increased market visibility, which, if accompanied by growth and above-average profitability, yields lower borrowing and capital costs
- Greater debt capacity and access to capital, which enable large companies to be innovators in their marketplace
- The ability to afford and attract expert management talent and specialists for research and development, thereby ensuring the capacity to introduce new and improved products
- The diversified geographic market or product/service mix needed to withstand cyclical industry downturns, abrupt market changes, shifts in consumer demand, and disruptions caused by technological breakthroughs (Thompson, A.A., Economics of the Firm: Theory and Practice , Englewood Cliffs, N.J.: Prentice-Hall, 1998)
As one of the world's largest and most profitable companies for decades, General Electric (GE) supports its platform for innovation and market leadership with an organic growth rate target of 8 percent per year. Growth and productivity initiatives have built GE to a scale achieved by only a handful of other companies. Its 2007 revenue of $173 billion, up 14 percent over 2006 with a 9 percent organic growth rate, makes it the world's sixth largest corporation. "Our companywide initiatives focused on organic growth, services, global expansion, and ecomaginationSM are delivering positive results," says CEO Jeffrey Immelt. "We achieved our twelfth straight quarter of organic revenue growth of two to three times global GDP" ("GE Reports Record Fourth-Quarter and Full-Year Results for 2007," press release, Jan. 18, 2008).
Procter & Gamble (P&G), the world's largest consumer products company, with 2007 revenue of $76 billion, built a strong foundation for consistent growth, which now averages 5 percent to 7 percent per year. Its new model for growth, called Connect and Develop, seeks to acquire half of its innovations from small to midsize entrepreneurial companies and university and government labs. P&G leverages its strength by using new ideas to grow core businesses and by developing higher margin and more asset-efficient businesses where it can achieve global leadership.
Both companies' approach to growth and scale includes:
- Development of leaders who can provide required focus on growth and management competence
- A solid plan that is developed, adhered to, and "played" hard every day
- A view of the growth process as a marathon, not a sprint
- Use of an innovation pipeline
- A balanced portfolio approach to existing/new businesses and geographic markets
Leaders of today's largest and greatest growth companies work vigorously to achieve dominance in their fields. They are vigilant about managing operations as efficiently as possible, but they also know that long-term success almost always requires continued top-line growth and increasing economies of scale, as cost-cutting and operational improvements have finite benefits.
Scale in Health Care Is No Different
Attaining critical mass enables not-for-profit healthcare organizations to obtain similar and increasingly essential benefits. Like their counterparts in other industries, hospitals and health systems that grow revenues and achieve a greater scale can better:
- Leverage their fixed-cost base
- Realize variable-cost efficiencies
- Build market visibility and leverage
- Diversify risk across markets or a broader base of programs and services
- Preserve long-term access to capital
- Access capital on more favorable terms
- Ensure ongoing competitive performance through strong capital reinvestment
Growth also has a direct effect on clinical excellence and the development of human capital, enabling organizations to attract and retain the best people, thereby improving the quality of patient care.
To quantify the financial benefits of scale, Kaufman Hall recently analyzed blinded data for the 270 healthcare organizations with more than $250 million in annual net patient service revenue in Moody's Investors Service's rating portfolio. The analysis focused on profitability, leverage, liquidity, and capital spending indicators between 2003 and 2006.
Organizations were divided into four groups based upon net patient service revenue:
- $250 million to $500 million (94 providers representing 35 percent of portfolio)
- $500 million to $1 billion (87 providers representing 32 percent of portfolio)
- $1 billion to $2 billion (54 providers representing 20 percent of portfolio)
- More than $2 billion (35 providers representing 13 percent of portfolio)
Profitability. Key indicators of organizational profitability-total margin, defined as net income/total operating revenue, and operating margin, defined as (total operating revenue less total operating expenses)/total operating revenue-improved with scale. Organizations with more than $2 billion in revenue had operating margins (i.e., profitability from their core patient care and business operations) almost a full percentage point higher than organizations with revenues of less than $1 billion.
See Exhibit 1
Data related to operating cash flow margin, defined as (total operating revenue less total operating expenses plus interest expense plus depreciation and amortization expenses)/total operating revenue, also illustrate the benefits of size. In 2006, organizations with more than $2 billion in revenue achieved an operating cash flow margin of 9.6 percent; the margin for organizations with revenue of less than $500 million was 9.3 percent. From the capital markets perspective, this ratio is critical because it measures the level of cash flow generated by the organization to support debt service and capital reinvestment independent of financing decisions.
Differences in payer mix or case mix had relatively limited impact on profitability when viewed in light of the impact of scale. The average Medicare case mix index and average proportion of Medicaid and self-pay revenue were approximately the same for organizations across all revenue categories.
Leverage. The debt-to-capitalization ratio, which reflects the organization's level of leverage or debt financing (the lower the ratio, the lower the percentage of debt financing), and the debt service coverage ratio, which measures the ability of an organization's cash flow to meet its debt service requirements (with a higher number being better), also vary by size. Organizations with revenue of more than $1 billion have a higher debt service coverage ratio, and hence greater debt capacity, than smaller organizations.
See Exhibit 2
Capital spending. With higher profitability and greater access to capital, larger organizations would be expected to be able to invest a greater proportion of capital in facilities, technology, and programs. The data support this assumption. For the smallest orga-nizations in the sample, the capital spending ratio (defined as capital expenditures as a percentage of depreciation) was 1.41, while the ratio for the largest organizations was a significantly higher 1.86, representing a 32 percent increase in 2006 capital expenditures relative to the depreciation expense base.
Credit ratings. The analysis indicated that an organization's credit rating was substantially correlated to size, reflecting the importance of scale to the capital markets. Ninety-seven percent of the organizations with more than $2 billion in revenues had ratings of "Aa" or "A"; only 64 percent of the organizations with $250 million to $500 million achieved such ratings.
See Exhibit 3
Furthermore, organizations with greater scale were much more likely to be upgraded than downgraded in 2007. While the total number of upgrades (32) and downgrades (40) was relatively equal, the distribution of these actions was not. Of the rating changes for organizations with more than $1 billion in annual revenue, more than 80 percent were upgrades. Conversely (and proportionately), 79 percent of the rating changes to hospitals and health systems with revenues of $250 million to $500 million were downgrades.
Cost of capital. A separate analysis of the distribution of tax-exempt healthcare ratings by rating category by agency and the cost of 30-year fixed capital available to organizations at each rating category (at press time) indicates lower cost of capital for higher-rated organizations. There is, in fact, more than a 100 basis-point spread between capital costs for "AA"-rated organizations and "BBB"-rated organizations.
See Exhibit 4
The analyses clearly indicate that larger hospitals and health systems do better in many areas-higher margins, stronger debt ratios, higher credit ratings, lower cost of capital, and better ability to invest capital in facilities, programs, and initiatives that support continued organizational growth.
A Best Practice Approach to Scale
The growth required to achieve scale requires more than tactical initiatives, such as pricing changes, effective managed care contracting, and revenue cycle management, because high levels of return from such efforts are difficult to sustain for extended periods of time. Growth to achieve scale calls for strategic initiatives, such as market expansion efforts, program and service innovations, acquisitions, and physician alignment strategies, all of which increase and sustain top-line revenue and profitability over time. A description of selected growth strategies appeared in a recent article in this publication (Grube, M.E., "Growing the Top Line: 5 Strategies to Expand Your Business," hfm, May 2007).
Virtually every hospital and health system has growth opportunities. Few organizations achieve significant growth, however, without clear, well-planned, and high-impact strategies. The key to unlocking the benefits of growth opportunities is the development of a strong business case for growth, organizational commitment to the pursuit of such growth, and successful implementation of agreed-upon strategies. Significant risks must be understood upfront and successfully managed.
Recent interviews with senior executives of high-growth hospitals and health systems, ranging in size from $400 million to more than $11 billion in annual revenue, provide insight about specific approaches and strategies used to achieve scale through growth (see sidebar at right). The interviews revealed that these organizations share five attributes, which, if purposefully and properly pursued, are within reach of other organizations.
1. Understand Clearly What the Organization Is and What It Wants to Become
Vision and mission provide the organization's raison d'être and, ultimately, the foundation and motivation for sustainable growth. Guiding statements may be broad in scope, such as "Excellence in all we do," but the profiled organizations are not trying to be all things to all people. Rather, they define their areas of distinct competence and "play these hard."
For example, Palomar Pomerado Health's objective is to be the dominant player in northern San Diego County for defined services, including cardiovascular, orthopedics, neurology, neurosurgery, and vascular surgery. Integris Health, the leading hospital system in Oklahoma, targets areas of community need. "Because the state's projected population growth rate is limited, we focus on identifying where patient needs are not currently being met in core business areas," comments Wentz Miller, CFO, Integris Health. "As opportunities emerge, we understand and respect the organization's capabilities and limitations." Notes Barry Arbuckle, PhD, president and CEO of MemorialCare Medical Centers, "Because we're not a publicly traded company, we don't have to focus on quarterly returns, but can be very deliberate and selective to make sure that the strategies we pursue and the entities we acquire will be consistent with the organization's mission, vision, and values and accretive to the system as a whole."
2. Ensure a Structured and Rigorous Growth Process
Development of a sustainable growth strategy involves disciplined, organizationwide planning with four core components: a strategic market assessment, capital capacity assessment, growth strategy development, and financial impact analysis.
See Exhibit 5
Profiled organizations use a team approach to such planning, involving both local-entity and system leadership, with specific input sought from physicians and the community through governance and advisory councils.
A capital planning group at MemorialCare Medical Centers, for example, includes hospital CEOs and system executives and reports to local and system fiduciary boards. This group also brings initiatives to the Physician Society, which was established more than a decade ago. Although the society does not play a fiduciary role, member input is considered critical to the success of initiatives.
Palomar Pomerado Health has district-based healthcare advisory councils that provide community input to organizational priorities. Additionally, executive leadership works with medical staff leadership and the foundation board to prioritize areas of focus for clinical development.
Ascension Health brings more than 100 local and system leaders together to conduct capital planning on a biannual basis. "Our challenge is to ensure that we're tapping into our talent pool of 106,000 associates at all times in order to make decisions," comments Robert J. Henkel, FACHE, president, healthcare operations and COO.
Successful organizations make growth decisions based on solid data and analyses , most often facilitated by extensive market research and use of software-based planning tools. Not all growth is profitable growth, so organizations must assess and understand the variation in financial performance across markets and service lines to ensure that the recommended portfolio of growth opportunities meets the organization's overall goals.
In local ministries and the system, Ascension Health uses a portfolio management matrix to assess opportunities related to community need, market growth, partnerships, divestiture, and capital allocation and investment decisions. Developed by a task force of health ministry trustees, CEOs, and financial executives, and updated annually, the matrix is comprehensive in scope, with plotting, scoring, and analysis of the following data.
See Exhibit 6
Financial performance. X-axis data include measures of financial strength (liquidity and debt leverage), effectiveness of capital and operations (cost structure, patient care intensity, profitability, and return on capital investment), and evidence of growth (level of local competition and recent and projected revenue growth).
Market potential. Y-axis data include measures of demographics and community need (population, average income, and availability of qualified staff), pricing flexibility (hospital charge index and average hospital occupancy in the community), and competition (payer environment-mark up-to-deductible ratios).
The figure below provides the relevant guidelines for capital investment decisions in the context of where an organization is located on the market potential/financial performance matrix. For example, Ascension Health will invest capital in facility replacement and entity expansion in strong growth markets (organizations in squares A, B, and C of the capital investment matrix). "Many of our organizations fall into the middle boxes, where we're focusing our investment capital on keeping them strong," says Henkel.
See Exhibit 7
For organizations in squares D, G, H, and I, investments generally are limited to initiatives that improve operational efficiency and effectiveness. "Because we're a Catholic health system, we also overlay community need and assess whether or not we're meeting our mission to serve the poor," adds Henkel.
Each of the profiled organizations identifies and evaluates growth opportunities within an integrated strategic and financial planning process with a long time horizon. "People often look at us like we have three eyes when we speak of a 10-year plan, but we really do believe that stretching the horizon allows our planning to be more robust," says Robert V. Stanek, president and CEO of Catholic Health East. CHE looks at both intrinsic "same-store" and extrinsic "new-store" growth in its vision for 2017. This vision centers on a comprehensive care management model, the operational and financial feasibility of which CHE is already testing in numerous settings.
Successful growth organizations understand the relative risks and rewards of a selected portfolio of opportunities. They recognize that a strong credit position, based on meeting financial targets and maintaining adequate cash, is critical to their ability to implement selected initiatives.
Scott & White's aggressive growth strategy of doubling revenue in 10 years is based on defined and rigorous expectations regarding strategic market share and financial performance. "In the early, heavy-investment years, our challenge is to maintain financial performance and credit strength because start-up costs often exceed incremental revenues," says Alfred B. Knight, MD, CEO. "Further out, as we reduce risk through geographic expansion and program diversification, we anticipate significant gains in our market share and overall financial performance."
These leading organizations regularly update and monitor their strategic financial plans. "Disciplined planning and monitoring of plans are critical, but you also have to be prepared to execute quickly. Knowing your market and having specific contingency plans are essential," comments Miller of Integris Health.
3. Methodically and Purposefully Leverage Size to Achieve Benefits of Scale
Joseph R. Swedish, president and CEO of Trinity Health, articulates the approach: "We believe that scale matters. Based on that belief, management must effectively grow the organization to leverage skill and scale." Swedish cites the ability to diversify Trinity Health's ministry portfolio as one benefit of scale: "Large-scale organizations have the ability to build a well-balanced portfolio that will ultimately reduce long-term risk."
Swedish also cites the benefits of cross-pollinating clinical best practices that enable Trinity Health to "reach beyond the normal" in health care to the "transformational." A highly integrated IT system supports the rapid dissemination of clinical and operational best practices systemwide. "Some of our smaller organizations in rural areas are now enjoying the benefits of this technology, which wouldn't have been possible for them as stand-alone facilities," says Swedish.
Ascension Health has a staff dedicated to research and development and transformational work. Reporting to the chief strategy officer and located in the corporate office, these staff members are focused on identifying and developing innovations that Ascension Health will need beyond the system's existing five-year strategic and financial plan in order to achieve its goal of transforming health care by 2020.
In the payment arena, most of the profiled organizations indicate that their size enables them to achieve more favorable rates with payers. "Size lets us bring a network that is attractive to employers and thus critical to health plans," comments Barry Arbuckle of MemorialCare Medical Centers. "Health plans realize that they can't do without us in their network."
Large, credit-strong organizations are able to garner an enhanced bond rating and efficient access to capital for their affiliated smaller hospitals, even in states with regulations that require the smaller hospitals to issue debt on their own, separate from their parent systems' master trust indentures. For example, an Albany, N.Y.-based hospital in CHE's network obtained a "BBB stable" rating for its recent $200 million-plus bond issue, notwithstanding the fact that the hospital's financial medians fell below those in the "BBB" category. In boosting the hospital's stand-alone credit, the rating agencies cited CHE's financial, operational, and strategic support and its commitment to the region.
Scale enables the profiled organizations to recruit top clinical and management talent and achieve preferred status in joint venture, merger, and other partnership initiatives. "Scale makes a difference in recruiting top physician and nursing talent interested in being a part of an organization with a solid reputation in, and commitment to, the quality arena. It also makes a difference in recruiting executive leaders interested in growth opportunities within the organization," says Henkel of Ascension Health.
See Exhibit 8
4. Recognize the Importance of Physicians, Ambulatory Care, and Primary Care
Executives of successful organizations take a proactive approach to engaging physicians, recognizing that strong hospital-physician relations are critical to sustainable growth. "We won't enter a service area unless we either employ physicians there or have strong relationships with physician groups, which are comfortable working with us in the area," says Knight of Scott & White.
Pursuit of opportunities in new primary care venues are a key part of strategic growth plans, as are partnerships and practice support arrangements with primary care physicians. MemorialCare Medical Centers and Palomar Pomerado Health are opening minute clinics, whose hospital name-branding capabilities in the market are central to the strategy. Palomar Pomerado Health recently secured a 20-year agreement with wellness-focused managed care giant Kaiser Permanente, which allows Kaiser physicians to use Palomar Pomerado Health facilities.
Palomar Pomerado Health also is taking other steps to support primary care growth in its market area, including providing hospital-based educational opportunities for University of California, San Diego, residency programs, and offering legally structured partial-loan forgiveness to young primary care physicians willing to locate in expensive San Diego County. Integris Health is actively recruiting physicians using a variety of models, including employment of specialists and primary care physicians, as are many of the other profiled organizations.
Successful organizations are continuing to specifically target ambulatory care as a growth strategy. Integris Health is joint venturing with physicians and a small for-profit firm on a high-tech proton therapy center for treatment of oncology patients. After having to unwind a number of ambulatory joint ventures with physicians due to the Stark II regulations, MemorialCare Medical Centers is looking again at other models for ambulatory surgery, imaging, and oncology centers.
CHE's care management model, mentioned earlier, envisions a more radical new look of person-centric care. Brick-and-mortar facilities will not be at the center of healthcare provision in this model; rather they will be one of many spokes in an integrated community-based hub, which includes home care, housing, community agencies, skilled nursing facilities, and assisted living, among others. "We think a very significant part of our growth will be in the non-acute side," says Stanek of CHE.
5. Establish and Maintain Accountability and Cultural Alignment as Growth Occurs
Successful growth organizations assign accountability for specific growth targets and rigorously monitor market and financial performance using consistent criteria. Regular monitoring allows managers to identify problems and address challenges and issues in a timely manner.
At Scott & White, the focus on growth involves everyone, but assignment of responsibility to a specific office to "make it work" has allowed the organization to move quickly. "To take advantage of strategic opportunities, we've had to learn to respond with agility and flexibility," says Knight. "Organization and accountability have been critical."
Numerous profiled organizations use incentive compensation programs to ensure that executives, managers, and physicians gain when the organizations achieve the growth targets.
Managing the culture and change process is critical to the success of high-growth organizations. "Bigger is not always better," comments Stanek of CHE. "Cultural incompatibility can compromise ability to leverage scale, so we choose our strategic partners carefully." CHE's due diligence process for evaluating affiliates and partners includes thorough consideration of culture. "Albeit soft, fuzzy, and hard to get your arms around, culture is one of the most critical issues to talk through, particularly for a faith-based organization such as ours," says Stanek.
Ascension Health uses a list of values-based questions when assessing the cultural compatibility of strategic partnership opportunities. Questions probe such issues as benefits programs, social justice-related policies, decision-making processes, and leadership style. "We believe in distributed leadership, meaning that we are looking for organizations in which the local CEOs want to make decisions and run their markets," says Henkel.
"Growth to achieve scale is all about a common language," says Swedish of Trinity Health. "You have to crystallize and communicate your objectives in a way that inspires people." Strategic objectives, people, organization, and culture must be properly aligned. This requires leaders who are focused on, and assume responsibility for, growth, a solid plan that reflects a clear understanding of the organization, use of a structured growth process, a pipeline of innovative growth strategies that engage physicians, and a balanced portfolio to leverage the benefits of scale.
Making It Work and Keeping It Going
In summary, rigorous growth planning, as present in all of the profiled organizations, ensures identification, evaluation, and prioritization of strategic opportunities best able to build revenue, profitability, and scale. Revenue growth builds capital capacity, which funds expansion of the organization's mission-based activities and continued investment to ensure competitive facilities and technology. These attributes attract the human capital required for clinical and service excellence and continued growth.
By attaining the benefits of scale through top-line revenue growth, organizations enter a healthy cycle of improved competitive and financial performance characterized by increased access to capital, ability to maintain competitive facilities and technologies, and increasing physician, staff, and patient satisfaction. As in the corporate world, not-for-profit hospitals and health systems must understand the direct relationship between scale and growth, achieving both for long-term competitive success.
Mark E. Grube is a partner, Kaufman, Hall and Associates, Skokie, Ill., and a member of HFMA's First Illinois Chapter (email@example.com).
Ryan S. Gish is a senior vice president, Kaufman, Hall and Associates, Skokie, Ill. (firstname.lastname@example.org).
Sasha N. Tkach is an assistant vice president, Kaufman, Hall and Associates, Skokie, Ill. (email@example.com).
View Profiled Organizations
Publication Date: Thursday, May 01, 2008