By Michael Waterhouse
Recent Medicare payment reductions and further potential Medicare cuts associated with the debt ceiling legislation have reignited fears over reimbursement pressure in the health-care industry, and as a result, health service providers have faced some of the most severe stock price declines among the sector. Tenet Healthcare (THC) and Select Medical (SEM) have witnessed nearly a 20% stock price reduction since July, while HCA Holdings (HCA), Kindred Healthcare (KND), and Skilled Healthcare (SKH) saw over 45% declines during the same period. We have long viewed reimbursement pressure as particularly troublesome for the no-moat health-services industry, which supports our belief that these businesses face slim chances of creating economic profits. Although not completely immune to industry trends, we think undervalued wide and narrow moat health-care companies like Pfizer (PFE), Abbott (ABT), Novartis (NVS), Medtronic (MDT), Covidien (COV), and WellPoint (WLP) can navigate health-care industry headwinds with less difficulty and provide greater investor opportunity.
Reliance on Government Payments Quashes Economic Moats for Health Service Providers
We think health service providers, including hospitals, skilled nursing facilities, and home health agencies, have not been able to carve out moats. High levels of market share fragmentation in these industries keep these operators relatively powerless against consolidated bases of payers and suppliers. As seen in Figure 1 below, a large portion of health service provider revenue stems from government payments through Medicare and Medicaid. Higher-margin private insurance payments result primarily from the large managed care organizations, such as United Health and WellPoint. For health service providers, facing a large consolidated base of payers makes negotiating favorable reimbursements difficult. Acute hospital operators HCA and Tenet focus on building market share in key urban markets, primarily in Florida and Texas, creating greater negotiating leverage with payers in these fast-growing Sun Belt states, which typically see less government oversight of insurance premium hikes. Additionally, the size of these larger operators increases economies of scale and purchasing power. However, non-profit operators, which receive tax advantages in addition to dedicated donors, comprise a large portion of this industry. While HCA, Tenet, and other larger private operators may gain certain competitive advantages, they still face a tough road ahead from all payers, especially from Medicare and Medicaid.
Changes to Medicare and Medicaid Offer Little Hope for No-Moat Health Service Providers
While reimbursement pressure is not a new concept for the health services industry, the recent passage of the Patient Protection and Affordable Care Act (PPACA), deficit reduction legislation, and the dismal economy add to the gloomy future of these no-moat health service providers. Every year the Centers for Medicare and Medicaid Services (CMS) sets new Medicare reimbursement rates for medical procedures. Hospital Medicare payments are based on nearly 750 Medicare severity diagnosis related groups (MS-DRGs), which incorporate a market basket update based upon labor and non-labor costs. The labor component includes a local wage index adjustment, while the non-labor component includes annual changes to medical service price inflation. Other health services, such as laboratories or ambulatory surgery centers, use the consumer price index as an inflation measure. Hospitals can also receive additional payments related to outlying patient cases, treating a disproportionate share of uninsured patients, teaching hospital status, rural critical access, and technology implementation. PPACA introduces mandatory cuts to yearly payment increases, reimbursements tied to quality of care, and an annual productivity adjustment equal to the 10-year moving average of annual economywide private non-farm, multi-factor productivity. These measures introduced in PPACA seek to incentivize greater operating efficiency by health service providers.
In addition to these PPACA adjustments, CMS can also add other payment provisions, such as recent payment cuts intended to recoup overpayments made during the 2008 rollout of the MS-DRG program. For example, CMS estimated government fiscal year 2011 payments would fall 0.4% as a result of a 2.5% market basket increase, offset by a 2.9% MS-DRG coding adjustment and a 0.1% PPACA subtraction among other positive and negative adjustments. On average, CMS expects hospitals will receive a 1.1% net increase in payments next fiscal year. Skilled nursing facilities will face a more draconian fate after CMS announced an 11.1% Medicare payment cut for next year after payments under a newly implement resource utilization group system exceeded budget neutrality. Although the 11.1% cut is an isolated event, the maneuver showcases CMS's unilateral power nonetheless. Medicare payments now face additional uncertainty after recent debt ceiling legislation included a potential 2% Medicare cut triggered upon failure by the congressional supercommittee to approve alternative reductions.
Rising unemployment and its effect on Medicaid enrollment and the uninsured have strained state budgets and Medicaid payments. The Kaiser Commission on Medicaid and the Uninsured estimates that a 1% rise in unemployment results in a 3% to 4% decrease in state revenues in addition to nearly a 1% increase in Medicaid and uninsured patients. Kaiser further estimates that the most recent recession added nearly 4.5 million Medicaid enrollees and 5 million uninsured. Figure 2 shows unemployment's direct correlation with Medicaid enrollment growth and inverse relationship with state tax collection growth. As a result, Medicaid, which comprises nearly 17% of state budgets on average according to Kaiser, has come under increased pressure. In an attempt to cover the state budget shortfall, the federal government's American Recovery and Reinvestment Act of 2009 boosted spending to states, including nearly $87 billion in temporary funding for the Federal Medical Assistance Percentage (FMAP) payments to Medicaid. With this temporary assistance ending in June 2011, many states have been forced to cut Medicaid spending to maintain balanced budgets, which places additional pressure on health service providers dependent on Medicaid payments. For example, Florida and Texas, two key markets for HCA and Tenet, have instituted 12% and 8% hospital Medicaid cuts, respectively. HCA has disclosed the Florida Medicaid cut will reduce payments by approximately $50 million between 2011 and 2012.
Commercially insured individuals, which include the bulk of higher profit patients, remain a key factor in maintaining provider profitability. However, incentives under PPACA for states to increase oversight of insurance premium increases and government pressure to keep healthcare cost growth subdued should also pressure this payer segment.
Reimbursement Pressure Should Slow Profit Growth for Health Service Providers
We think reimbursement pressure will weaken health service provider profits. In 2009, rising payments under the new MS-DRG system and cost containment measures from the recession sparked considerable margin expansion, but we expect EBITDA margins to recede as CMS slashes reimbursements to recoup overpayments, PPACA's provisions become enacted, and cost containment efforts become more difficult in a recovering economy. As seen in Table 1, adjusted EBITDA (which excludes nonrecurring items) margins began to show weakness between 2010 and 2011. Note that these growth figures include the effects of acquisitions and divestitures. For example, HCA's EBITDA margin peaked in 2010, as EBITDA grew 7.2% despite 2.1% revenue growth. During the second quarter of 2011, HCA's EBITDA growth reversed course, falling 4.7% from the previous-year period, and we imagine margins will continue to erode. However, HCA and Tenet's acquisitions of outpatient clinics, which have a higher portion of commercially insured patients, will assist in stemming profitability declines. Kindred's recent acquisition of higher-margin Rehabcare should also offset some reimbursement pressure, while Select Medical's rehabilitation operations help insulate it from Medicare and Medicaid payments. Skilled Healthcare's relatively undiversified business and considerable reliance on government-based payments should drive significant margin erosion.
Moats Offer Best Opportunity for the Health-Care Industry
Although the health-services industry faces a rising tide of patients from the aging baby boom generation and newly insured patients under health-care reform, we expect reimbursement pressure will do little to improve returns on capital going forward. While nearly every health-care industry participant faces some risk from lower Medicare and Medicaid payments, we think the lack of moats in the health-services industry places it in the weakest relative position. Wide moat health-care companies with little exposure to Medicare or Medicaid should be able to navigate such headwinds with greater ease. Pfizer, Abbott, Novartis, and Medtronic are four wide-moat companies that we currently give 5-star ratings. Also, Covidien and Wellpoint are two narrow-moat health-care companies currently in 5-star territory.