Wed 09/13/2023 14:52 PM
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Kyle Owusu, CFA
Credit Research

With second-quarter 2023 earnings completed, we discuss healthcare industry trends with a focus on hospital companies, as well as inpatient/outpatient rehabilitation operator Select Medical, ambulatory service center operator Surgery Partners and kidney care provider DaVita.

Key takeaways are as follows:

  • Volumes were robust throughout the first half of 2023, with admissions growth ranging from mid to high single digits. We expect year-over-year average admissions growth to moderate to the low-to-mid-single-digit range for the second half of 2023, and calendar-year 2024.

  • Proposed rule changes from the Centers for Medicaid & Medicare Services, or CMS, suggest low-to-mid-single-digit rate increases in 2024. However, operators who derive a greater portion of revenue from commercial payors will likely see 2024 unit revenue growth in the mid-single-digit range. Increased economic weakness would likely translate to slower commercial payor growth because patients with copays and deductibles - typically commercial payors - are most sensitive to pressure on household income.

  • Continued improvement regarding lowering contract labor expenses may be offset by wage and/or supply inflation, but we do not expect significant margin deterioration, especially since we anticipate moderation in year-over-year wage growth given relatively high inflation in the second half of 2022.

  • We think the relatively short-dated Select Medical and Surgery 2026 bond and term loan offer downside protection, as well as attractive returns.


We anticipate that volume growth will moderate in the second half of 2023, and calendar-year 2024, to a low-to-mid-single-digit range.

With the exception of Denver-headquartered kidney care service provider DaVita, first-half 2023 admissions growth ranged from mid to high single digits. Patient day growth - or in some instances decline - suggests reduction in length of stay:

CFO Steve Filton said during Pennsylvania-headquartered hospital and behavioral facility operator Universal Health’s second-quarter 2023 call:

“[P]art of what we're experiencing certainly in the first half of this year is what both, I think, providers and payers have anticipated for some time. And that is during the pandemic there was some amount of deferral and postponement of procedures. And I think what both providers and payers have been reporting in the last quarter or two is that we’ve seen an uptick in volumes, particularly lower acuity volumes, elective and surgical procedures.”

He added that it is difficult to try and determine how much current volume is “an exhaustion of demand that was sort of postponed or deferred during the pandemic.”

Management’s estimates for Universal Health assume “the level of revenue growth [to probably moderate] a little bit … [with] the makeup of that revenue growth chang[ing] to somewhat less volume, somewhat more acuity in pricing,” implying a “return to sort of that mid-single-digit level of topline growth in acute care that has sort of long been the model.”

Tennessee-based hospital and surgical center company HCA Healthcare’s management team said on Tuesday, Sept. 12, that the company operates in great markets that have experienced outsized population growth with full employment. Management said that while it is hard to tell how much volume growth was pent-up demand versus normal activity, the year-over-year increase was more due to macroeconomic factors than deferred demand. The company anticipates a return to normal seasonal patterns and volume. (for example, mid-single-digit growth with seasonal sequential spikes in the first and fourth quarters).

Texas-headquartered hospital and surgical center company Tenet Healthcare’s CEO Saumya Sutaria noted on the company’s second-quarter 2023 earnings call that the company “[has] not really seen or viewed patterns that suggest … a large fraction of [acute care volume growth] is deferred and somehow going to be one and done.” The midpoint of the company’s estimates assumes 2.4% admissions growth in the second half of 2023.

However, when asked during the company’s second-quarter 2023 earnings call whether Pennsylvania-headquartered critical illness recovery and inpatient/outpatient rehabilitation facility operator Select Medical’s inpatient rehabilitation facility and outpatient rehabilitation volume growth was “mostly deferred care flowing through a system” or “more sustainable volume,” CFO Martin Jackson responded “We don’t really think that it’s a function of pent-up demand due to the pandemic … we think we’ll continue to see increases like this.”

Davita Excess Mortality

DaVita’s volumes remain challenged as a result of excess mortality, mostly driven by Covid-19, as patients who would otherwise be on dialysis for several years have passed away earlier than expected. Excess mortalities were at about “6,500 at the beginning of COVID on an annualized basis.” In 2022, the figure was reduced to the “low 4,000s.”

In the first quarter of 2023, there were 900 excess mortalities, followed by “between 500 and 600” in the second quarter of 2023. CFO Joel Ackerman said on May 10 that the company is assuming “elevated mortality throughout the year, somewhere in the 2,500 to 3,000 range.”

The company’s guidance calls for year-over-year volume growth of negative 3% to flat. As shown above, DaVita’s volume growth was at the top of its guidance range in the first half of 2024; CEO Javier Rodriguez said “if [those] trends continue, we would anticipate delivering volume growth in 2024.”
Revenue Per Patient Day

We expect a low-to-mid-single-digit year-over-year increase in average revenue per admission for the back half of 2023, and for 2024, with positive or negative variations due to payor mix.

Commercial Payors

A breakdown of revenue by payor type shows mid-to-high-single-digit growth in Community Health Systems, HCA Healthcare and University Health commercial payor revenue:

Community Health’s improvement in payor mix was more pronounced in the second quarter of 2023 because during the first quarter the company’s payor mix was negatively affected by economic uncertainty. “All of our increased level of business in Q1 was from Medicare Advantage patients, who did not have an economic barrier to coming back in the system,” President and CFO Kevin Hammons noted. The company’s first-quarter 2023 revenue per adjusted admissions fell 7.1% year over year and 0.6% sequentially.

During the second quarter, Community Health’s payor mix improved. Hammons noted that “the Medicare age population … was down about 100 basis points. Commercial is up 100 basis points … as that continues to improve further in the back half of the year, it will certainly lead towards a higher net revenue per adjusted admission statistic.” Hammons expects the “biggest improvement late in the year before co-pays and deductibles reset again.”

Similarly, Tenet’s commercial and outpatient volumes are “tracking stronger” than its aggregate inpatient and outpatient volumes.

CEO Samuel Hazen highlighted commercial admissions growth on HCA’s second-quarter 2023 earnings call. He said that the company views its payor mix dynamic positively and has seen commercial admissions outpace total admissions, which is “reflective of a strong economy and job positioning.” He anticipates “those will continue on into the last half of this year” and “optimistic that [the trend] will continue on into the future, at least, in the near term.”

On Sept. 12, HCA management said the company was about 70% contracted for 2024 with major insurance companies, at “reasonable rates,” and about “30%, 40% for the year after that,” giving them “an indication that [the company is able] to secure contracts and reasonable rates and pacing.”

CMS Proposed Reimbursement

CMS’ proposed changes to hospital inpatient, hospital outpatient and long-term care hospital prospective payment systems, as well as inpatient rehab facility, outpatient rehab clinic and end-stage renal disease rates, suggests low-to-mid-single-digit growth in government payor revenue:

  • Hospital inpatient: In April 2023, CMS issued proposed changes to the hospital inpatient prospective payment system, or IPPS, fiscal-year 2024 rates. The proposed payment and policy changes are expected to yield an average 2.8% increase in Medicare payments for hospitals in urban areas, and for proprietary hospitals, in fiscal year 2024.

  • Hospital outpatient: CMS, in July 2023, released proposed policy changes and calendar-year 2024 hospital outpatient and ambulatory surgical center payment rates. CMS anticipates that the combined impact of the proposed changes will yield an average 2.8% increase in medicare hospital outpatient payments for urban area hospitals and an average 3.4% increase for proprietary hospitals.

  • Long-term care hospital prospective payment system: The standard federal rate for fiscal year 2024 is $48,117, up 3.6% from $46,433, the standard applicable rate in 2023. The update includes a 3.5% market basket increase, minus a 0.2% productivity adjustment.

  • Inpatient rehabilitation facility: The standard federal rate for fiscal year 2024 is $18,541, up 3.7% from $17,878; the update includes market basket increase of 3.6%, minus 0.2% productivity adjustment.

  • Outpatient rehabilitation clinic: Physician fee schedule payments are expected to decrease in 2024. CMS expects that its proposed policies for 2024 would result in a 2% decrease in Medicare payments for the therapy specialty. (Select Medical still anticipates that its 2024 outpatient rehab rate will “rebound back” to approximately $102 to $103, from $100 in the second quarter of 2023, due in part to improved non-Medicare contracts).

  • End-stage renal disease: In June 2023, CMS issued a proposed rule to update the Medicare end-stage renal disease, or ESRD, prospective payment system payment rate. The proposed rule would increase ESRD facilities’ average reimbursement by 1.6% in 2024. DaVita CEO Rodriguez said on the company’s second-quarter 2023 earnings call that “the proposed rate increase falls short of expected cost inflation in 2024.”

Tenet’s quarterly report explains that the proposed CMS rules imply “a 3.7% increase in [its] annual Medicare FFS IPPS payments,” as well as “4.2%, for [its] acute care hospitals and … 2.6%, for [United Service Partners International, or USPI’s ambulatory service center, or ASC] surgical hospitals.”

Select Medical CFO Jackson told analysts on the company’s second-quarter 2023 call that the 3.5% long-term care hospital CMS rate was a “good number to use in [their models]” for medicare reimbursements.

However, he noted that commercial rates would see higher increases - “in that 5-plus percent range.” In a similar vein, Community Health President and CEO Hammons said on the company’s second-quarter 2023 call that management expects a 4% to 6% rate increase for its managed care contracts in 2024.

We anticipate continued industrywide improvement with regard to contract labor costs, partially offset, in some instances, by increased wage inflation as companies continue ramping up full-time hiring efforts and competing for talent.

University of Oklahoma affiliate OU Health’s March 31 presentation highlights the reduction of contract labor costs, driven in part by an increase in full-time hiring:

The trend continued through the first half of 2023. However, contract labor expense reductions were, in certain instances, offset by increased salary, supply and other operating costs, resulting in margin declines:

Not-for-profit corporation OU Medicine Inc., dba OU Health, reported its results for the 12 months ended June 30 on Aug. 29. The company’s total revenue rose 13.5% year over year to $2.208 billion; EBIDA increased 6% year over year to $122 million.

Net patient revenue per day rose 3.2% year over year to $6,729; although contract labor expenses per patient day fell 32% year over year, salaries and benefits per patient day, which made up a much larger component of the overall cost base, rose 9.8%.

OU Health’s overall revenue growth was partly due to a spike in specialty pharma sales, which rose 142.9%; the cost of specialty pharma supplies, however, increased 164%. There has been growth in retail pharmacy, as well as activity under the 340B drug pricing program, which is a federal program requiring drug manufacturers to sell outpatient drugs at discounted prices, allowing hospitals and clinics that treat low-income and uninsured patients to buy discounted (25% to 50%) prescription drugs.

Since cost growth outpaced revenue growth, the company’s EBIDA margin fell 40 bps to 5.5%. In January, OU Health implemented expense management initiatives, including a temporary 401(k) contribution matching pause and a temporary reduction of paid-time-off, or PTO, accrual. The 401(k) match and PTO accrual programs were reinstated at the normal benefit level beginning in fiscal year 2024.

Ohio-based healthcare system ProMedica, on the other hand, saw its adjusted EBIDA margin turn positive as contracted fees as a percentage of revenue fell almost 500 bps year over year to 13.1%.

Within Select Medical’s critical illness business, registered nurse, or RN, agency cost and utilization trends have helped improve EBITDA margin to 11.4% from 3.7% in the second quarter of 2022.

Nurse Hiring

In 2022, HCA’s nurse hiring rose about 6%, with growth coming from a “pipeline of new graduate nurses,” as well as nurses that took “traveler assignments during COVID” when rates were at their peak, and are now returning back to full-time employment.

The trend continues, as HCA’s second-quarter 2023 nurse hiring rose 9% year over year, and its nurse turnover rate was 17%, compared with about 18% to 18.5% in the fourth quarter of 2022. Pre-pandemic turnover rates ranged from about 13% to 15%.

Management anticipates that the company’s recruiting efforts will continue to “[yield] strong hiring” in the second half of fiscal year 2023. The increased full-time employee hiring and reduced turnover helped contribute to a 20% year-over-year decline in contract labor costs.

Community Health’s nurse hiring rose 5.3% year over year. Almost 400 nurses joined the company’s hospital teams via international recruitment programs. International nurses generally come at a lower cost and have longer contracts, CFO Hammons explained on the second-quarter 2023 call. Contract labor costs declined by about 50% year over year to $74 million and management expects to exit at about $60 million to $65 million.

Wage Inflation

There are signs of wage inflation, though in some instances it has been moderating and fourth-quarter 2022 wages were relatively high.

OU Health’s March presentation highlighted lower contract labor costs, but it also noted that salaries and benefits rose 11% year over year as the company continues to increase its core RN staff.

Similarly, California-based Loma Linda University Medical Center saw its employee compensation increase 8.5% year over year for the nine months ended March 31, in part due to increased volumes, as well as market and living wage adjustments implemented in January 2022 and mid-March 2023 in order to recruit and retain employees.

HCA’s second-quarter 2023 results released on July 27 show a 7.1% year-over-year increase in salaries and benefits, an acceleration from 2.1% in the first quarter; similarly, Tenet’s salaries and benefits rose 7.5% year over year, compared with 3.5% in the first quarter. ProMedica’s second-quarter 2023 salaries, wages and benefits rose 5% in the second quarter, up from 4.1% in the first quarter.

DaVita’s base wage increases are “well above historic pre-pandemic levels,” though its contract labor expenses have also declined.

For some operators, there have been signs of stabilization. Community Health’s average hourly wage rate rose 2.8% year over year and fell 0.8% sequentially. The average hourly wage rate increase in the first quarter of 2023 was about 5.9% (5.4% on a same-hospital basis).

Within the behavioral market, Acadia Health saw wages rise 6.3% year over year in the second quarter of 2023, representing a deceleration from 7.5% year over year in the first quarter.

The company continues to see improvement and expects to end the year at a “sub 5 rate,” management said during a Sept. 6 call with investors and analysts. However, there is “continued instability” from a labor perspective.

In the fourth quarter of 2022, Acadia invested in markets where it was not competitive vis-à-vis wages. Similarly, HCA had to make “some outsized wage adjustments in the last half of last year to be responsive to the market,” management said on Sept. 12.
Coverage Denial

Hammons said during Community Health’s second-quarter 2023 earnings call that as volumes return, the company is seeing “a higher number of denials and more pressure from the managed care payers.”

Filton warned on Universal Health Services’ second-quarter 2023 call that “with a lot of the payers reporting an increase in their own medical loss utilization … we’re going to see more aggressive behavior on their part to, whatever it may be, limit length of stay on the behavioral side or challenge more inpatient versus observation classification on the acute side.” Unlike Community Health, University Health Services has not “seen that change in a measurable way just yet.” Filton explained that “sometimes takes a quarter or two for that information to sort of play out.”


In the Marietta Memorial Hospital case, the question before the court was whether a group health plan that provides limited benefits for outpatient dialysis - but does so uniformly for all plan participants - violates the Medicare Secondary Payer Act, or MSPA.

The dispute started because of a conflict between regulatory guidance that CMS issued regarding the rule, and the interpretation of the rule.

The court held that a group health plan providing limited benefits for outpatient dialysis on a uniform basis does not violate the terms of the MSPA, regardless of whether a participant has ESRD.

The Marietta Memorial Hospital Supreme Court ruling introduces the risk that patients may be shifted from commercial insurance to Medicare. Each shift of 10% of the commercial payor segment to Medicare fee for service takes $20 million out of operating income.

The greatest risk comes from smaller self-insured plans, which accounted for about 10% to 15% of total payor mix in June of 2022. Rodriguez said during DaVita’s June 2022 business update call that the impact would be limited in 2023, with changes being felt in 2024 and beyond. DaVita has implemented a verification process and may prevent certain plans from having access to its centers if an employer eliminates a network dialysis benefit for its members.
Relative Value

Comparables are shown below:

(Click HERE to enlarge.)


The trading levels of HCA, Select Medical and Acadia’s credits reflect: i) HCA and Acadia’s relatively low leverage; ii) Acadia’s presence in behavioral care, which should benefit from long-term trends including $54 billion from pharmaceutical manufacturers relating to opioid settlements that will be disbursed over the next decade (70% of funds are required to be spent on programs oriented toward treating opioid use disorder); iii) HCA’s scale as a leading urban hospital operator, which is reflected in its best-in-class acute care EBITDA margin; and iv) Select Medical’s 2026 maturity and improving critical illness EBITDA margin.

We are cautious regarding Acadia because although it has relatively low net leverage at 2x, the company has not been shy about potentially using its balance sheet to support acquisitions, which it said in December 2022 could include tuck-ins or larger deals. On Sept. 6, CEO Christopher Hunter said Acadia’s M&A pipeline is “as strong as it ever has been.” Management has determined that there are “100 under-bedded sizable MSAs in the US.” Acadia is willing to do proactive outreach, and the company’s “balance sheet is very strong,” he said, adding that “[companies] see [Acadia] as the acquirer of choice and they know M&A is a part of [Acadia’s] strategy and that [Acadia is] financially strong.”

HCA trades relatively tight, and its debt to adjusted EBITDA ratio is near the low end of its stated 3x to 4x leverage range. However, it is best-in-class within an industry that is slowly improving. Nevertheless, we like Select Medical’s 2026 bond because of the potential for the company to continue deleveraging ahead of a relatively short-dated maturity as its business prospects improve.

DaVita’s cash flow metrics are attractive, the company may still benefit from continued volume recovery, it has lower net leverage than Tenet and Surgery Partners at 3.7x, and management has a stated target net leverage ratio of 3x to 3.5x. DaVita’s risks include: i) slower volume recovery due to excess mortalities and ii) a payor mix that is about 68% Medicare, Medicare Advantage, Medicaid, Managed Medicaid and other government, ii) a potential reduction in EBITDA resulting from the shift of patients from commercial insurance to Medicare, resulting from the Supreme Court’s Marietta Memorial Hospital ruling.

Tenet and Surgery Partners both derive over half of consolidated EBITDA from their ambulatory service center, or ASC, business lines. ASCs are an important part of the healthcare ecosystem and will likely benefit from long-term tailwinds because ASCs can provide care at lower cost, and patients who are treated at ASCs can often return home earlier than they would in an inpatient hospital setting, which is usually more comfortable for the patient and also minimizes the likelihood of infection. However, consolidating ASCs comes at a cost; Tenet and Surgery Partners both invest their free cash flow (Tenet $250 million annually, Surgery Partners $200 million annually) acquiring facility centers and making distributions to noncontrolling interests.

Nevertheless, we think investors are being adequately compensated for risk with Surgery Partners’ term loan because: i) ASCs trade at high-single-digit to low-double-digit EBITDA multiples, ii) business trends are positive and Surgery Partners is focusing on high-paying service lines and iii) the company may benefit from organic cash flow growth as its portfolio matures.

The L+375 term loan trading at par and maturing in 2026 is a relatively attractive part of the structure to be in because it is secured, matures in 2026 and there is $1.4 billion of term loan debt outstanding compared with $320 million of bonds. One red flag worth highlighting with regard to the term loan is that there could be a lot of unencumbered value, given that in 2018 almost all the company’s EBITDA was generated by nonguarantors.
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