Joel Swider:                        Hello, and welcome to the Health Care Real Estate Advisor podcast. I’m Joel Swider, and I’m an attorney with Hall Render. Today we’ll be talking with Ken Gacka, senior director and analytical manager for health care ratings at S&P Global Ratings, and Allison Bretz, associate director at S&p Global Ratings. We’re going to be talking about S&P’s 2019 outlook for the U.S not-for-profit health care sector, which is expected to be released early next year. Ken, and Allison thanks for joining me.

Allison Bretz:                     Thank you for having us.

Joel Swider:                       Walk me through the types of services that S&P provides to health system clients. Of course today we’re focused on the nonprofit health sector, but I assume this process will be similar in the for profit sector as well. Let’s say a hospital or a health system comes to you, says, “We want to issue tax exempt debt, we’re going to pay for a new hospital building. Take us from there.”

Ken Gacka:                         Sure, thanks Joel and thanks for having us. To give you some context, S&P is not for profit health care team it’s a part of S&P’s U.S public finance practice. U.S Public finance issues ratings on over 22,000 entities across the U.S, the not-for-profit health care team focuses on the health care especially. We cover a wide range of hospitals and health systems across the U.S, we have over 500 organizations that we rate. They range in size, and range in services offered, so we rate organizations with revenue basis as high as $75 billion to those as small as $30 million. So we have a wide range of clients that we interact with, and you have all shapes and sizes in between, large multi facility health systems, critical access hospitals, academic medical centers, integrated delivery systems that have both the provider arm and an insurance arm. We cover a wide range of organizations, and we find that to be very important as we analyze the sector and keep our finger on the pulse of the trends and emerging credit risks that may be out there. Our team is comprised of 16 health care specialists located across the U.S.

Ken Gacka:                        When we interact with our clients, you’re right it is typically tied to a debt issuance. So organizations will come to market, and we’re a key part of that process giving our opinion of the credit worthiness of the issuer. That starts really an ongoing relationship, so every year then we speak with the client, get an update on their financial position, their strategies, and so forth. And determine whether the rating needs updated, either upgraded, or downgraded, or through an outlook revision. It’s really part of an ongoing relationship that we have with each of our clients once we first initiate the rating.

Joel Swider:                       I suppose that depending on your analysis, then that may affect the borrower’s interested rate, or maybe the amount of debt that they’re able to issue. Is that right? What is the next step after that?

Joel Swider:                       (silence)

Joel Swider:                       And that’s all right if you don’t know. I realize that you’re not bankers here.

Ken Gacka:                        I’m sorry. No, that’s … sorry, I was on mute Joel. I’ll just start again here from your question. Yes, the rating is one piece of information that goes into determining interest rates that an organization may have to pay for their debt. I find often as well that the rating serves as a good benchmark for an organization, in fact we have some organizations that don’t have rated debt. They carry an S&P rating so that they have that discipline that comes with the process so that they can compare themselves to others in their peer group across the standard methodology like we have.

Joel Swider:                       Sure. I guess Allison, could you give us some more background as to … we’re looking at the sector outlook, what are these outlooks and what are they designed to do?

Allison Bretz:                     Sure. The sector outlook is a piece that we release at the beginning of every year that summarizes our expectations for the not-for-profit sector, the outlook encompasses our view of the whole sector and where we think the balance of rating actions might lead for the upcoming year. It’s an opportunity for us to address the big picture, the post to much of our work with covers individual hospitals or systems. It’s really our way of stepping back, looking at the sector as a whole and saying to the market, “Here’s where we think ratings might fall next year, and based on what we’ve learned in the last year here is why we think that.”

Joel Swider:                       Okay. Your … primarily in terms of the raw data that you’re looking at for the outlook, I assume you’re going to look primarily to the hospitals or health systems, whoever your clients are who you’ve been examining throughout the year. Is that right?

Allison Bretz:                     Right. We look at financial data that’s publicly released, audits and interim financials, as well as data that’s shared with us from these hospitals and health systems. We look at our conversations with the management teams, and the materials that they’ve provided to us. Since this is a more wholistic perspective, we also take a look at the industry as a whole. We look at the industry trends beyond just hospitals and health systems, state and national legislative moves, or things that we might see upcoming in the U.S economy as a whole. All the things that play a role in shaping the sector beyond just the players that we work with.

Joel Swider:                       Who’s the primary audience then for your … again, talking about the outlook in particular, who’s the primary audience for that?

Allison Bretz:                     Our audience is the investor communities, so the individuals that read our reports. But as Ken alluded to earlier, our hospital and health systems also read the outlook with great interest and so of course they can frequently get bogged down in their own individual issues. So I think it’s a helpful perspective for them to look at how we’re viewing the industry as a whole, and what we’re hearing from other players in the market.

Joel Swider:                       As we’re looking toward 2019, I was reviewing your 2018 outlook. We’re not 20 … 11 months into the year, 10 months since you released the 2018 outlook. I’d like to look at some of the topics that you have focused as being significant factors that contributed to your outlook, and maybe get a feel for whether those predictions really came to fruition, or whether we’re going to see maybe some changes in those particular areas for next year. Starting with M&A activity within the sector, you had mentioned in your 2018 outlook that M&A activity remains heightened within the sector, and at that generally supports credit quality depending on merger effectiveness. Could you explain that a little bit? How does the heightened M&A activity support credit quality?

Ken Gacka:                        Sure. I might take a step back with this one, and talk a little bit first about the reasons why we’re seeing so much M&A. I think then that would dovetail nicely with the question of the supporting credit quality. M&A in health care has been around for a long period of time, we’ve been seeing mergers and acquisitions for decades. Now, I think the reasons why you see M&A has evolved over the last several years, in the past I think the players were often very clear it was going to be a large, strong health system acquiring a perhaps struggling smaller standalone hospital. You were going to see the M&A driven by desire to scale up so that you can take advantages of economy’s scales, and have more leverage to pay or send suppliers. What we’re seeing now is those reasons are still very important, but we’re also seeing that these mergers and acquisitions are driven by competency based needs, so organizations that may be looking to add a service line, or a geography that they don’t have that’s important to their longterm strategy.

Ken Gacka:                        Also, I think there is a real play based on the nature of the operating environment being difficult, I think a lot of organizations do see the need in the time of tightening margins to be able to partner with a larger organization to be able to expand or to invest in IT infrastructure which is very costly. When we see some of these organizations pair up with another organization, we often see the smaller troubled credit maybe getting bought up by a large organization still today. In fact as we look at our rating actions this year, we’ve got quite a few that were upgraded just by virtue of being acquired by another organization. For instance, present health, a triple B category credit was acquired by Ascension this year and that was an upgrade. That sort of lens to one of those reasons why one may consider partnering with another organization.

Joel Swider:                       Sure. I’m going to ask a dumb question, if we see a general increase in terms of credit quality because of … as you mentioned, you might have an entity with weaker credit quality being acquired by a higher rated hospital or system. Is there any sense in which you want to maintain a bell curve? Or does it look bad if we’ve got all of these tax exempt hospitals having very high credit ratings, and very few in the lower categories? Or does that not even really come into play?

Ken Gacka:                        It muddies the numbers a little bit because you do … if you did look at our rating distribution over time, you would see a pretty clear bell curve. Oftentimes those on the far right of the curve, so the non investment grade credits are acquired and that double B rating goes away and it becomes an A if it’s taken on by a stronger organization. I don’t think it’s a bad thing, but it muddies the water a little bit on … it mutes how loud the view is of the negativity in the sector.

Joel Swider:                       Another issue that you had discussed in your 2018 outlook was legislative and administrative risks, you had said that they would remain ongoing and that the ACA repeal and replace initiatives, and the likelihood would also impact as well as the likelihood of raising uninsured rates. What are we predicting for next year? Obviously we just had an election, any difference in that category?

Allison Bretz:                     I would say that the election did present some changes, I think we’ve identified a few key factors. With Democrats now in control of the House, I don’t think we expect further repeal and replace legislative efforts. We did see several of those over the last two years, but I think that will cease now that Republicans no longer control the House. With that said, I think we do expect some movement from Washington still that could decrease insurance coverage. There’s been a lot of conversation about allowance of short term, or skinny insurance plans which may not fully cover basic benefits meaning that even if individuals appear to be insured, they still are not paying out of pocket, or not being able to pay for many services. We’re also seeing supportive, more stringent requirements for Medicaid work requirements which may result in lower coverage. But on a state level, we did see voters in Idaho, Nebraska, and Utah vote to expand Medicaid. We saw general improvement in ratings in states that initially expanded Medicaid under the Affordable Care Act, and so also I think expansion will be generally positive for hospitals and health systems operating in those systems; Utah, Idaho, and Nebraska.

Allison Bretz:                     We’ll be watching to see how quickly the expansions are implemented, and the ultimate size of the newly covered populations. But I think that’s generally a credit positive for operators in those states. Overall I think the election was mostly positive from a health care perspective, but we will continue to see some push out of Washington to decrease insurance coverage … maybe not through explicit legislation, but through some of these efforts at the margins.

Joel Swider:                       Sure. It’s interesting to think that sometimes gridlock is a good thing when it comes to not seeing seismic shifts in some of these policies. Another point that you made in your outlook last year was looking at nontraditional players and their significance in the market, you had said at that time you didn’t really see that happening within the year, in other words by 2018 year end. Does that remain for 2019 too? Or is this going to be the year we start seeing some more shifts in terms on those nontraditional players; Amazon, CVS, and those types entities?

Allison Bretz:                     I think we’re expecting this to not be a major issue in 2019 as it has not been in 2018, at least for our hospitals. Let’s say we are I think likely to see some more tangible things, the CVS at the merger was recently approved, the Berkshire Hathaway, JP Morgan, and Amazon company has named it CEO and seems to be forming a structure. 2019 should provide some clarity on strategy from these nontraditional players, but I don’t think we expect yet to see them really eat into the market of our traditional providers at the hospitals. We are seeing more movement to nontraditional revenue streams from our hospitals, and I think inpatient revenue used to be their bread and butter, and where they made most of their money. That’s really no longer the case, we’re seeing much more revenue driven from outpatient ventures, other joint ventures that are not necessarily the traditional heads and beds that hospitals have provided.

Allison Bretz:                     I think we do expect that to continue in 2019, and to see competition from ambulatory surgical companies, urgent care, and other providers that maybe do provide care outside of the traditional hospital setting, but maybe not from these disruptors that have been making the news so much. I think that might be a little bit slower to move into the industry.

Joel Swider:                       And you’re talking Allison too … I mean do you think that there is any sort of siphoning off of some of the maybe healthier patients? In our own office, every year we’ve got to get a physical for insurance purposes, or it gives us a benefit in terms of our insurance rate. Some people will go and get their physical at let’s say at Walgreens, or CVS, or one of these doc in the box type places. Are we going to see any kind of siphoning off of some of the healthier patients in these nontraditional settings, which I guess would in turn leave hospitals with the older, sicker patients, which presumable are less profitable? Any truth to that?

Allison Bretz:                     Absolutely, there’s truth to that. I think that’s already very much happening, and it has created some of the revenue pressure that is reflected in our median, the decreasing operating margins over the last few years. We have seen hospitals and health systems invest more meaningfully in getting a piece of that pie, so they’re buying up Urgent Cares, they’re partnering through joint ventures with Urgent Care providers. Some of them are putting their own clinics into Walmart, CVS, Walgreens, et cetera. They’re really making an effort to get a foot in the door and provide services in more convenient lower cost settings of care because they recognize that many young healthy commercial insured individuals don’t want to come to the hospital for basic services, and if they don’t need to they’ll seek it in a more convenient setting. So I think going forward the providers we expect to be most successful are those that are able to provide care in more creative ways, and a different setting than just traditional hospital.

Joel Swider:                       In terms of some of the raw data that you analyze through your outlook, I looked toward the end of your 2018 outlook. You have several charts, and you showed an increase in the 2017 data regarding the number of ratings downgrades and revisions as compared with recent years. There were also more negative than positive downgrades and revisions, has that trend continued so far in 2018?

Allison Bretz:                     Yes, it has. To the first nine months of 2018, we’re seeing a similar trend with slightly more negative rating actions than downgrade. We’ve had 29 negative outlook changes, and 21 positive outlook changes. Of the 279 rating actions, we’ve had for the first nine month of the year about 7.5% were upgrades, and 10.4 were downgrades. So that trend has continued, but it’s important to note that 82% of those rating actions were affirmations. Overall there is tremendous underlying stability of the sector, and that really reflects the stable outlook we had coming into the year. We have seen more downgrades than upgrades, more negative rating actions, but overall 4-5 rating actions, or a little more than that were affirmations reflecting that real underlying stability in these credits.

Joel Swider:                       Another interesting chart that you guys had published in your 2018 outlook was days cash on hand, it looked like that had been increasing while longterm debt and capitalization percentages had been decreasing. Do you have any idea why that is? And whether that might have an impact on, for example, building, and construction in the future?

Allison Bretz:                     Days cash has been increasing for a few reasons. I think over the last few years we’ve had very strong investment markets, and not for profit hospitals … not universally, but generally tend to carry thoroughly large investment portfolios. So as the markets have done well, they’ve seen real growth and liquidity so that’s helped support growth of days cash on hand. At the same time we have seen construction slow down somewhat across the industry, large projects do continue but I think they are fewer than they were several years ago. We’re not seeing as many major towers, or large scale patient bed construction projects. Instead investment is a little bit more strategic, so many hospitals and health systems as I alluded to before are looking to invest in smaller scale outpatient facilities either on their main campuses, or in the markets were they’re located. Then we’re also seeing investment in IT, so not physical improvements to buildings but investments in software system and other technology that helps them remain competitive have and become more efficient.

Joel Swider:                       One last chart I wanted to focus on from your 2018 outlook, you had shown that nonprofit median operating margins fell sharply … pretty sharply anyway from 2015-2016, and S&P put out another set of medians in July of 2018 which showed a continuance of that trend. To the untrained eye this looks bad, is this a red flag?

Allison Bretz:                     Sure. I’m not sure it’s a red flag, but I do think it’s a trend that we expect to continue. It’s one that we’ve seen for last few years as operating margins continue to decline. Revenue growth has really plateaued, reimbursement continues to worsen, so payer mix deterioration which includes movement from patients on commercial insurance to patients on Medicare, as well as weaker reimbursement from those commercial payers is affecting that overall revenue base. Then on the expense side we’re seeing really significant growth and supply costs, especially for pharmaceuticals, specialty pharmaceuticals in particular, and salary and wage pressure as competitions for providers … especially nurses, and other mid level providers grows. Those two things combined as you might expect is very much squeezing operating margins across the industry, and I think we do expect that to continue. What we’ve seen over the last few years, particularly with healthy investment market is that non-operating returns have offset some of this, and so debt service coverage remains reasonably healthy and overall cashflow is fairly strong. I think the red flag, or something to be concerned about as we look into 2019 is the fact that investment markets may slow.

Allison Bretz:                     We’ve seen a downturn just over the last few months, and I think there is some concern that we’re not going to see the kind of investment returns we have historically or certainly over the last few years which would both affect liquidity as we’ve talked about, we might see slower growth on days cash on hand, but also will affect cashflow. Those investment returns are going to decline, and may no longer be able to offset the fact that operating margins are getting weaker.

Joel Swider:                       Let’s shift and talk a little bit more about 2019, I’m assuming that you’re well underway in terms of looking at your outlook for next year. We’ve talked about a few issues, any other thoughts about what you’re seeing for 2019? You had mentioned briefly in the 2018 outlook about the Tax Cuts, and Jobs Acts, and also the removal in advance for fundings. What are we seeing in those areas, and in the other areas in 2019?

Allison Bretz:                     As we mentioned, I think we’ll continue to see softening operating margins, I think the challenges that we’re seeing across the industry will not abate and competition is becoming more fierce everyday. These nontraditional providers are coming in, and there are just more places than ever as you alluded to for people to get some of the services that they have traditionally received at hospitals. That continues to be a challenge, and I think we expect operations to be difficult. Mergers and Acquisition activity is likely to slow somewhat, partly because there are just some markets where there is no one left. There’s not any further layers, or any further mergers that can take place. But there are certainly still plenty of small hospitals that will continue to struggle, and many of them may seek part partners in these larger systems. And they need that support from a larger scale provider, so maybe some slowdown on M&A but I think we do expect it to continue. Then from the Tax Cuts, and Jobs Act, from that perspective, advance refundings are gone, they’re no longer legal except in cases of murders and acquisitions.

Allison Bretz:                     For six months after a merger acquisition you can’t do a tax exempt refunding to consolidate debt, so leading up to that in late 2017 we saw a flurry of issuance from players concerned that there would be no tax exempt funding at all. That fortunately turned out not to be the case, but we did see a fairly slow pace if issuance in early 2018 since many people accelerated those plans and went ahead in late 2017 although things have picked up later in the year. Going forward, I think we started to see some less traditional or different debt structures as a response to the Tax Cuts, and Jobs Act. We’re seeing more taxable refundings, or taxable that issuance is generally. That market continues to mature, and then variable rate debt structures have also become more popular. So some changes in the structure of the debt that we’re seeing issued which I think is somewhat a response to that Tax Cuts, and Jobs Act.

Joel Swider:                       Interesting.

Ken Gacka:                        The only thing I would add Joe is … I agree with everything else and said on trends that we expect to continue, and we are in the phase now of evaluating the data in preparation for the launch for 2019 outlook. That will be coming in early 2019, so be on the lookout.

Joel Swider:                       Okay. Well, great. Before I let you guys go, whenever I get the chance to talk with somebody who’s an expert in their particular field, I just love to hear how they came to be at their current position. Allison, curious how you came to be in the public finance world, and also in particular in the health care sector?

Allison Bretz:                     Right. My undergraduate degree was in public policy, I’ve always been very interested in policy, and the nature of the public sector. I worked briefly after college for the city of Chicago, and then in finance for a large private university. So really started to get some experience in the not-for-profit sector. During that time I was also volunteering extensively in hospitals, and got really interested in the business of hospitals, and how hospitals operate. I ultimately went to graduate school and got a degree in health policy and administration, and I’ve been at S&P ever since. I really became interested in the inner section of health care policy in business, and hospitals sit really nicely in at that intersection. This has been a great role for me to learn about that world.

Joel Swider:                       Well, great. Thanks again Allison. And Ken I was looking at your bio, I saw that you had a background working at a health system in the past in Pennsylvania. Tell me about that and how you came to S&P?

Ken Gacka:                        Sure. I’ve been in health care for a long time, over 15 years in different capacities, different sides of the table. My first job out of undergrad was working as a financial analyst for the Commonwealth Health System in western Pennsylvania, I worked there for about five years in the finance area. Went back to grad school, I got my MBA and realized I really really enjoyed health care, the dynamic nature of the operating environment and decided that I would continue in the sector but on a different side. I got into health care consulting doing strategy consulting, reimbursement consulting, visibility studies. That got me to the point where I started to interact more with the rating agencies, and opportunity came up with S&P about 10 years ago and I was thrilled to join the not-for-profit health care team as an analyst. I’ve been here for 10 years, and pleased to say I now have the opportunity to lead a great team of analysts covering the evolution of our health care operating environment. It’s been a great journey, and we still have a lot of exciting times to come in our health care world.

Joel Swider:                       Yep, you’re absolutely right we do. Well, before I let you go, is there … where can people go to learn more? Is there a subscription list? Or other … where can people access your 2019 outlook when that is released?

Allison Bretz:                     I would encourage people to visit our website with is spratings.com/healthcare that site is great because it provides a combination of materials from our team not-for-profit health care, as well as our for profit team which includes for profit hospitals, medical devices, and pharmaceuticals, as well as our insurance team which covers the insurance industry. It’s a really nice marriage of materials from all three of our groups, and it also includes reportings of webcasts that we’ve done over in the last year, announcements and events that we host. We do host a few events around the country every year, and I would encourage people to attend if that is of interest to them. As well as articles that we’ve published, both sector outlooks, the medians, and other subject specific articles about the health care industry. So that’s sptratings.com/healthcare for all your health care needs.

Joel Swider:                       Great. Well, Ken and Allison, thanks again for joining me.

Allison Bretz:                     Thank you so-

Ken Gacka:                        Thank you.

Allison Bretz:                     … much for having us.

Joel Swider:                       If you like what you heard on this podcast, please subscribe on iTunes. If you’re interested in additional content from Hall Render, you can send me an email at jswider@hallrender.com J-S-W-I-D-E-R@ hallrender.com to subscribe to our month newsletter. Thanks again.