U.S. PUBLIC FINANCE JANUARY 2010 OUTLOOK Annual Sector Outlook for Not-For-Profit Healthcare for 2010 Negative Outlook Continues Due to Sluggish Economy and Government Budget Deficits Table of Contents: SUMMARY OPINION 1 Moody’s outlook for the U.S. Not-for-Profit Healthcare sector remains negative. This outlook expresses WEAK ECONOMY, SLUGGISH RECOVERY Moody’s expectations for the fundamental credit conditions in the industry over the next 12 to 18 AND GOVERNMENT FISCAL PRESSURE months and does not speak to the expected balance of rating changes during this timeframe. SUPPORTING NEGATIVE OUTLOOK 2 NEGATIVE FACTORS 3 POSITIVE FACTORS 11 Summary Opinion APPENDIX 15 RELATED RESEARCH 30 Moody’s is maintaining its negative outlook for the U.S. Not-For-Profit Healthcare industry. The outlook was initially revised to negative from stable in November 2008 based on Analyst Contacts: disruptions in the credit and liquidity markets, as well as declines in patient volumes and financial performance driven by a weakening economy. Since March 2009, equity and credit NEW YORK 1.212.553.1653 markets have partially recovered, but the lingering effects of the weakened economy remain Lisa Martin 212.553.1423 and recovery of not-for-profit hospitals will likely be delayed until well after the broad Senior Vice President economy heals. High unemployment, consumer pessimism, weakened employer insurance [email protected] coverage, and unprecedented government budget deficits at the federal and state levels are Lisa Goldstein 212.553.4431 Senior Vice President - Team Leader now dominant factors driving our negative outlook. These economic effects constitute a [email protected] common thread underlying many pressures on not-for-profit hospitals, including sluggish John C. Nelson 212.553.4096 patient volumes, uncertain government and private payer reimbursement rates, and the Team Managing Director prospect of second and third rounds of increasingly difficult cuts in operating expenses. [email protected] CHICAGO 1.212.553.1653 Many not-for-profit hospitals are more dependent on state and federal budget decisions than Mark Pascaris 312.706.9963 for-profit hospitals because they are larger proportionate providers of Medicare, Medicaid Vice President-Senior Analyst and charity care services, and they are subject to more scrutiny due to their tax-exempt [email protected] status. Federal stimulus subsidies buffered not-for-profit hospitals to some degree in 2009, but if this relief ends in late 2010, we expect operating performance at many not-for-profit hospitals to come under even greater pressure. Federal healthcare reform presents one of the largest medium-term uncertainties facing the sector. Although the likelihood of a comprehensive healthcare reform bill is clearly reduced, projections of deep multi-year federal budget deficits strongly suggest Medicare spending will nevertheless need to be curtailed. As the federal government pushes providers harder for more spending efficiencies, not-for-profit hospitals will remain at risk for significant payment reductions beyond 2010. U.S. PUBLIC FINANCE Over the next 12-18 months, we believe the relative abilities of different not-for-profit hospital management and governance teams will become more apparent as they face one of the toughest environments in decades. In 2009, there was a wide variation among not-for-profit hospital operating performance with some health systems responding quickly by reducing costs significantly while others struggled. We expect to continue to see uneven effects of the weak economy on not-for-profit hospitals in different regions of the nation, depending on management quality, size, and payer mix. As a result, we expect the gap between high and low performers to widen. Negative factors supporting the outlook include: » Sluggish patient volumes as high unemployment and reductions in employer healthcare coverage drive patients to defer elective procedures » Pressure on all hospital revenue streams, including Medicare (from strategies to recoup presumed hospital overpayments), Medicaid (as states struggle to close budget gaps), and commercial payers (as they experience financial challenges) » Greater difficulty cutting additional costs following significant expense reductions last year and due to anticipated increases in pension, interest, bad debt and physician-related expenses » Debt structure and liquidity risks, driven by hospitals’ higher bank exposure and a less than full recovery of investment losses » High capital needs after a temporary slowdown last year » The conclusion of the federal stimulus program in December 2010 Positive factors include: » For some hospitals, strong management capabilities, enabling the quick response to operating and liquidity challenges and solid operating performance last year » Benefits from a partial recovery of the equity and debt markets, providing liquidity relief and a window for restructuring debt, with a greater focus on liquidity and debt issues » Anticipated increase in merger and acquisition activity, which we believe is a long-term positive on balance for the industry Weak Economy, Sluggish Recovery and Government Fiscal Pressure Supporting Negative Outlook The health of the economy has a direct impact on all of the factors discussed in this report. Even with some economic recovery, we believe there could be a lag on the healthcare sector as the full effect of the downturn is still being felt by some hospitals. Additionally, the expiration later this year of temporary federal assistance to states and the unemployed could prolong the rate and pace of recovery. As published in January, 2010 in Moody’s Global Macro-Risk Scenarios 2010-2011, Moody’s continues to believe that a sluggish recovery is the most likely global macro-economic scenario. In other words, we believe that the global economy is not going to rebound strongly in 2010 and 2011, but rather return to trend growth rates, with persistent unemployment and budget deficits. This is in line with the “hook”-shaped recovery scenario which Moody’s introduced in May 2009 and which 2 JANUARY 2010 OUTLOOK: ANNUAL SECTOR OUTLOOK FOR NOT-FOR-PROFIT HEALTHCARE FOR 2010 U.S. PUBLIC FINANCE stipulated that the crisis will leave lasting scars, with many economies not returning to their previous output paths. The primary effects of a weaker economy on hospitals include: » Lower patient volumes as patients defer elective healthcare services » Rising charity care and bad debt expense due to a high level of unemployment and the loss of - or reduction in - health insurance » Budget pressure on federal and state levels forcing intensifying reviews of Medicare and Medicaid reimbursement rates » Unfavorable changes in payer mix away from commercial due to rising unemployment and the expiration of COBRA benefits » Financial pressures and lower membership at healthcare insurers, contributing to lower commercial rate increases for hospitals While broad economic factors are likely to affect most hospitals in the industry, not-for-profit hospitals may face greater challenges than for-profit hospital companies, primarily because on average not-for-profit hospitals have greater reliance on governmental (Medicare and Medicaid) funding and are at greater risk to increasing charity care and bad debt. For-profit hospital companies have larger revenue bases and more geographic diversity than many not-for-profit hospitals and health systems, which reduces the impact of economic forces and state Medicaid funding cuts in any one state. Additionally, for-profit hospital companies have maintained generally consistent access to capital during the recent period of market stress. Negative Factors Volume Growth Likely to Lag Economic Recovery Following sudden volume declines in the fall of 2008, volume trends somewhat recovered throughout 2009, the degree of which depends on the region and competitive environment. However, we believe several positive factors that helped to temporarily support higher volumes in 2009 may not continue in 2010. Therefore, we believe the lagging effects of a sluggish economy will continue to drive underlying pressures on patient volumes. Although patient volumes appeared to rebound in some regions of the country during 2009, we believe volume trends are tenuous and underlying pressures will become more apparent throughout 2010. The weaker economy has resulted in higher insurance co-pays and deductibles for employees with employer-provided health insurance, or the loss of healthcare insurance for those affected by layoffs or employers dropping coverage. As a result, demand for discretionary healthcare has declined, particularly for surgeries, as patients defer elective or non-emergent procedures. Additionally, growth in observation cases continues to be a trend, replacing more profitable admissions cases and directly affecting hospital revenue. Growth in observation cases is due to stricter classification of patients by Medicare and commercial payers as well as hospitals adjusting patient classifications in anticipation of RAC audits. In some regions, increasing competition from hospitals and physicians are affecting volumes for individual hospitals. 3 JANUARY 2010 OUTLOOK: ANNUAL SECTOR OUTLOOK FOR NOT-FOR-PROFIT HEALTHCARE FOR 2010 U.S. PUBLIC FINANCE We believe several factors contributed to buffering volume issues in 2009, some of which may be temporary or create a lag effect. Federal subsidies have increased the use of COBRA and will continue to partially