Q & A

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With provisions of the Affordable Care Act beginning to be implemented, investors are determining their outlooks on the healthcare sector and anticipating how reform legislation will impact the industry. Hospitals and health systems will need strong management, access to capital markets, and a strong physician alignment strategy, says Todd Sisson, senior analyst at Wells Capital Management's Tax-Exempt Municipal Bond Group. Three analysts from Wells discussed the investor's perspective at the 12th Annual Non-Profit Health Care Investor Conference in New York, sponsored by Citi and HFMA. Sisson recently shared with hfm his insights into what investors are expecting from the healthcare industry and the role reform legislation will play.

Q:What is the difference between how you look at a hospital or health system and how a rating agency does?  

A: The rating agencies typically focus on the underlying credit, while we consider the bond offering as an overall investment decision. So in addition to credit, we review factors the rating agencies may not consider, such as pricing, structure, security provisions and disclosure practices. This review also includes participating in the institutional investor call where we can follow-up with management and the bankers underwriting the deal. In many instances, our purchase decision will come down to how the bonds are structured and priced relative to other healthcare bonds in the market.

Q:Why is it so important to address those issues and get that kind of information?  

A: When investing, we are risking capital and will continue our surveillance on an annual, semiannual, or quarterly basis depending on the strength of the credit. This is why the disclosure package is important to our overall purchase decision. The action of the rating agencies can affect pricing of the bonds, so it is important for us to be able to monitor the credit through frequent disclosure. When appropriate, we may increase or decrease the size of our position if we believe the trends justify an upgrade or downgrade by the rating agencies.

Q:What are you looking for in a hospital or health system as evidence that it is preparing adequately for healthcare reform and other changes in the delivery system?  

A: We expect reimbursement in the future to favor systems that adequately document improved quality of care and lower costs per patient. We look to providers with comprehensive IT systems that can measure quality metrics going forward. Physician alignment strategies are important to the new accountable care organization (ACO) models where primary care physicians, specialists, and hospitals work together to meet quality benchmarks and share in cost savings. Reimbursement will change to a fixed payment model for an episode of care with the risk of loss falling to the hospital or ACO. Successful systems in this environment will have strong management teams that can orchestrate the various components to work together and control costs.

Some have compared this fixed-payment model to the old capitation model of the 1990s. The new bundled-payment model is less risky in our opinion because providers will assume risk only for a particular service rather than care for an entire population. We see this as more risk, however, than the current fee-for-service model now in place. Adequately investing in IT and physician practices requires a healthy balance sheet, healthy operating cash flow, and access to capital markets, which many lower-rated providers may not have.

Q:What do you expect to see from hospitals as they shift to a value-based business model?  

A: We continue to see providers acquiring physician practices. Primarily, it has been physician groups looking to affiliate with hospital systems. It may be easier for physicians from a reimbursement and business perspective to join a provider with the infrastructure and IT systems already in place to meet the new reporting guidelines. We're concerned some systems may overspend on physician alignment, which may raise costs without necessarily achieving the goal of increased quality. Moody's recently reported that hospitals now account for 51 percent of all physician employment which is up from 11 percent in 2004. We expect this trend to continue.

Q:What merger and acquisition [M&A] activity do you expect in the coming two to five years?  

A: We expect M&A activity to increase. Some hospitals do not have the capital or market access needed to adequately prepare for reform. Many will seek to be acquired or affiliate with stronger systems. We have seen for-profit and private equity firms acquire not-for-profit systems, but the majority of activity, in our opinion, will be acquisitions between not-for-profit systems.

Q:With the merger and acquisitions, we talked about the business side. What's it going to mean for patient care?  

A: We believe it will be positive for patients if the goals of increased quality and hospital efficiencies are achieved. The reason for investments in IT and electronic medical records is to adequately measure quality benchmarks and improve efficiencies. These goals should be positive developments for the patient.

Q:What concerns do you have about the future of freestanding community hospitals?  

A: We're concerned with the community hospital model. Clearly they have smaller balance sheets and limited access to capital markets and they will struggle to adapt to reform. That being said, many community hospitals provide critical essential services to rural communities. Because of this, we don't think community hospitals will go away. Some may close down inpatient services and transition to a clinic model with larger systems absorbing higher acuity care. Some rural markets can provide feeder systems to larger hospitals if they're close enough geographically. So we see that as a potential.

Q:What communication do you expect from hospitals that you invest in?  

A: We're in the middle of the largest change in health care in the past 45 years, certainly bigger than the Balanced Budget Act of 1997. Frequent communication between healthcare management and the investment community is critical to successfully investing in this environment. We prefer quarterly disclosure and Q&A conference calls with management for all levels of credit quality. We believe the municipal market is moving too slowly toward the corporate model of disclosure where quarterly information is consistently provided.

Q:How does communication differ depending on a hospital's performance?  

A: If by performance you mean higher-rated versus lower-rated systems, we clearly require a higher level of disclosure and security for a BBB-rated hospital than for a AA system. Although many higher-rated hospitals can provide less disclosure and weaker security provisions, we will typically not participate in a BBB- or lower-rated hospital without quarterly disclosure and a certain level of security such as a fully funded debt service reserve. That being said, we believe higher-rated systems should move toward more frequent disclosure. We agree with the need for stronger security provisions for lower rated credits, but the industry should move toward consistent disclosure practices regardless of rating. With AAA bond insurance no longer available and the industry changing rapidly, consistent disclosure practices are needed to successfully invest in this environment. Ideally, disclosure packages should provide quarterly operating performance with utilization statistics and management discussion. These should be followed by periodic investor calls that allow Q&A sessions between investors and management.

Q:What metrics do you look at for financial health?  

A: We try to understand not only financial ratios supporting a hospital's performance but also the market they serve. We analyze several operating and balance sheet ratios to assess operating strength, liquidity, and leverage relative to industry medians and our own internal database. We look closely at trends in financial performance and utilization statistics to assess where the system may be heading. A hospital's primary service area and market strength relative to competition are important for admission patterns and leverage with third-party payers. What are the regional demographics and the payer mix supporting net revenue? Financial ratios are the primary metric we review and tell the story of where the hospital has been. Having access to management, however, allows us to assess where the hospital and the industry may be heading, which is important as the industry continues to adapt to reform.

Q:What are some expectations when it comes to revenue growth?  

A: Longer term, most expect revenue per patient to decline and patient volumes to increase once the fully insured model comes on-line. We expect to see less charity care and bad debt expense with more insured patients. The expectation is for the increase in patient volumes to offset declining revenue per patient. For this model to work hospitals must be successful at reducing costs.

Q:How do hospitals grow outpatient volume to offset lower inpatient volume under this model?  

A: The trend has been for more and more inpatient procedures to be performed in an outpatient setting, which makes sense given the increased sophistication of medical procedures and less costs in an outpatient setting. We expect this trend to continue as outpatient procedures become a higher percentage of total revenue for hospitals. Many health systems have outpatient clinics throughout their service area that can feed higher-acuity services into their inpatient settings.

Q:What challenges will hospitals face in providing high-quality care as this payment system changes?  

A: Clearly they're going to have to lower costs. Can management line up the physician groups, specialists, and hospital staff to get everyone working together with the IT systems in place to lower cost of care by service? From the investor's perspective, communication between hospital management and investors is critical to understanding this process and successfully investing in this changing environment.

Q:Do you think that the management team understands the importance of communicating with you and others in this arena?  

A: In our opinion, we're not there yet. Through publications such as this, we hope to increase awareness that the municipal market as a whole needs to continue to improve disclosure practices, especially in a sector as dynamic as health care. The new model of disclosure in this sector should emulate the corporate model, in our opinion, with quarterly disclosure and frequent investor calls whether the hospital is rated BBB or AA so investors have the data to make informed investment decisions.
 

Publication Date: Monday, August 01, 2011

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