Hospitals’ Stable to Improving Net Pricing Power

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Richard Evans / Scott Hinds / Ryan Baum

203.901.1631 /.1632 / .1627

richard@ / hinds@ / baum@sector-sovereign.com

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January 24, 2012

Hospitals’ Stable to Improving Net Pricing Power

  • Hospitals trade at a 30+% discount (’13 PE forward) to cap-weighted Healthcare and the SP500; fundamental concerns appear centered on a combination of weak volume / procedure mix, and the effect of Budget Control Act (BCA) related Medicare rate cuts in 2013
  • US healthcare demand has slowed for almost entirely cyclical reasons; 2010 was a 50-year low for the cyclical components of demand (per-capita ‘units’ and ‘mix’). Improvements to volume and mix are more likely than either continuation of the 50-year low or further declines; this augurs well for volume-sensitive healthcare sub-sectors generally, and hospitals specifically
  • In addition to poor volume / mix, hospital valuations imply weak pricing; in contrast we believe the aggregate price trend across all payors (Medicare, Medicaid, commercial) is at least stable, and in fact may improve
  • Hospitals have rising commercial pricing power as 2014 approaches; assuming the Affordable Care Act (ACA) remains reasonably intact, health plans hoping to participate in 2014’s enrollment gains need premier hospitals in their networks more than they need to control these hospitals’ prices. 2014’s marginal enrollees are likely to have been un- or under-insured beforehand, and so are unlikely to be familiar with local health plans. These same potential enrollees are likely to be very familiar with higher-profile local hospitals; and the presence or absence of preferred hospitals should have a large effect on which plans new enrollees choose
  • This dynamic appears to have played out during Massachusetts’ ’07 – ’09 reform-related enrollment expansion; across this period MA teaching hospitals had greater margin gains than both their smaller MA peers specifically, and the nation’s hospitals more generally
  • We believe hospitals as a group are undervalued, and their near-term fundamentals underestimated; accordingly we believe the group should outperform the broader healthcare index. The primary risk to our call is that the Supreme Court dismantles ACA sufficiently to reduce the likelihood of 2014 enrollment gains, thus reducing hospitals’ commercial pricing power, not to mention the adverse effect this would have on longer-term expectations regarding both patient volumes and uncompensated care

Share Prices Imply Weak Volumes and Price; We See Stable to Improving Volumes and Price

Hospital shares have underperformed recently for a host of reasons; on a capitalization-weighted basis hospitals now carry 2013 PE forwards that are roughly 30 percent below both the broader healthcare group and the SP500

Much of hospitals’ total downward earnings revisions came in late July of 2011, just as details of Medicare payment rate cuts in the Budget Control Act (BCA) were made public (Exhibit 1); though patient volume- / procedure mix-related earnings misses in this timeframe make it impossible to argue that the associated weakness in hospital share prices is entirely due to concerns over Medicare pricing. It’s nevertheless reasonably clear that hospital valuations imply a continuation of weak patient volumes / procedure mix into 2013, and a compounding of these earnings effects by BCA-related Medicare rate cuts

Drivers of Slow Demand are Cyclical, Implying (Eventual) Improvement

In our last note[1] we showed that: 1) all of the slowdown in US healthcare demand is attributable to a drop in per-capita ‘units’ and ‘mix’ of care; 2) that this decline is due almost entirely to cyclical (employment and income) related factors; and 3) that the fall in per-capita ‘units’ appears to be far more important than any change in average per-capita ‘mix’. We believe the cyclical drivers of healthcare demand are more likely to improve than remain static (2010 was a 50-year low) or decline in the near-term; and, since valuations in volume-sensitive subsectors (e.g. non-Rx consumables, hospitals, HMOs) imply an inherently unlikely two or more- year extension of a 50-year low in demand, that these volume-sensitive names are generally undervalued. On this basis alone we would tend to be bullish on hospitals; however we also believe hospitals have more pricing power than is generally appreciated – even after accounting for BCA-related Medicare payment cuts in 2013

Commercial price gains are a long-standing offset to Medicare rate cuts

Hospitals have long used commercial pricing gains to offset Medicare pricing losses (Exhibit 2); accordingly the effect of any drop in the 2013 Medicare payment rate has to be considered net of available commercial pricing offsets. The for-profit, publicly traded hospitals tend to collect substantially more of their revenues from commercial payors than from Medicare (Exhibit 3); meaning the use of commercial price gains to offset 2013 BCA-related Medicare rate cuts is at least mathematically feasible

Commercial price offsets appear practically feasible as well. The pending Medicare cuts are of a known (≤ 2%) magnitude, and fall in a year for which many hospital – HMO contracts have yet to be finalized. Crucially, very few HMOs truly compete on the basis of negotiating lower input (e.g. hospital) costs than their local peers; in fact, as long as a given HMO pays hospital rates that are at least no higher than those paid by other HMOs in the same market, the HMO stands to make a larger absolute profit on higher local hospital costs

The preceding hospital v. HMO pricing dynamics have been generally true for quite a few years, and on this basis alone we would believe that hospitals have sufficient negotiating leverage visavis commercial payment rates to at least mitigate the 2013 Medicare cuts. Importantly, however, we believe hospitals have considerably more commercial pricing power in 2013 than in practically any year before

Hospitals are the brand names that drive health plan choice in 2014; thus 2014’s large potential enrollment gains mean increased commercial pricing power for hospitals

Assuming the Affordable Care Act (ACA) remains sufficiently intact for health plans to anticipate large one-time enrollment gains in 2014, these same plans naturally should prioritize capturing as many new 2014 enrollees as possible. Bearing in mind that many – perhaps even most – potential new enrollees have had limited exposure to (and thus limited familiarity with) health plans, how marginal enrollees decide amongst numerous unfamiliar health plans is of critical importance. Whether one’s physician is in-network is clearly important, however many of 2014’s marginal enrollees are unlikely to have pre-existing primary care relationships. Instead, we believe a common means by which new enrollees choose health plans will be on the basis of whether or not desirable hospital(s) are in a given plan’s network. In short, we think local hospitals are the recognizable brands that help new enrollees decide which of several unfamiliar health plans is best for them – all of which means that preferred hospitals should see their commercial pricing power grow as 2014 approaches

Consistent with this thesis, Massachusetts hospitals appear to have gained pricing power during that state’s health reform roll-out (generally ’07 – ’09). Market share and average daily charges appear well correlated (Exhibit 4), and the ’07 – ’10 change in average daily charge shows at least weak evidence of a relationship with market share (Exhibit 5). We can’t rule out that higher average charges at larger institutions are in large part a by-product of more expensive case mix. However, the fact that Massachusetts teaching hospitals showed better margin gains during the period of expanding enrollment than both their non-teaching Massachusetts peers and the national hospital average suggests brand-name pricing power played a non-trivial role (Exhibit 6). If anything we would expect expansion-related commercial pricing gains by national hospitals to be greater than those enjoyed by MA hospitals; the Congressional Budget Office (CBO) and the CMS Office of the Actuary (OACT) estimate an 8.7 percent gain in commercial enrollment after ACA is in full effect[2], or nearly three quarters greater than the 5 percent enrollment gain seen as a result of MA’s reforms

Thus subjectively, we have particularly strong reasons to believe hospitals can at least mitigate 2013 BCA-related Medicare rate cuts with higher commercial pricing. Objectively, the question remains whether the available commercial pricing gains are sufficient to offset the effect of Medicare cuts entirely

As aggregate pricing has slowed, so have input cost trends; very small commercial price gains can completely offset the 2013 Medicare rate cut

The 2013 Medicare rate reduction is at most a two percent cut relative to baseline, the baseline being defined as the rate that should have otherwise been in place without the passage of BCA. We estimate the impact of the BCA cut on total hospital pricing by simply weighting BLS’[3] payor-specific hospital pricing indices to reflect the payor-mix of the publicly traded for-profit hospitals, and trending the resulting combined estimate forward to 2013 (Exhibit 7). This implies a 2013 weighted average (nominal) pricing gain of roughly 1.8% at our estimated ‘pre-BCA cut’ baseline, or 1.3% after the cut. If we were to further assume zero volume growth, zero productivity gains, and zero change in any price trend other than the BCA cut to Medicare, we could estimate the effect of the Medicare cut on hospital margin by simply comparing pricing and input cost trends. We build a pro-forma composite hospital cost index by weighting BLS indices for various input costs according to the average cost structures of US hospitals (Exhibit 7, again), and trend this forward to 2013 just as was done for the pricing index. Because input costs have been growing marginally more slowly than pricing, we would have a baseline expectation of margin expansion (from 3.2% in 2011 YTD to 5.6% in 2013) before the effect of Medicare rate cuts, again assuming no other changes to price, and no changes to either volume or non-price related productivity. Applying the 2 percent BCA Medicare cut lowers the 2013 margin estimate by 60 bp to an even 5.0%. Conversely, we can think of the Medicare rate cut effect in simple terms of how much commercial pricing is needed to completely offset the change to Medicare pricing; here we find that a 3.6% increase in 2013 commercial pricing (v. a 2013 baseline assumption of 2.6% and a five-year rolling average of 3.8%) is sufficient to fully offset the BCA-related Medicare cut in 2013

Thus even assuming no improvement in volumes or productivity, the 2013 Medicare rate cuts can be fully offset by moving the commercial price only 1 percent above the (decelerating) baseline trend. In light of the traditional pattern of using commercial pricing to offset Medicare cuts, the incremental commercial pricing power hospitals should enjoy as 2014 approaches, and the small absolute commercial pricing gain required to offset Medicare cuts, we see hospitals as having at least stable aggregate pricing into 2013. More realistically hospitals should see the added benefit of at least some volume gains – bear in mind 2010 was a 50-year low in per-capita ‘units’ and ‘mix’. Thus all in we’re more bullish on both volumes and pricing than present valuations imply, and are accordingly bullish on for-profit acute care hospitals as a group

  1. “US Healthcare Demand Slow for Cyclical Reasons; Volume-Sensitive Names are Undervalued” Sector & Sovereign Research, January 12, 2012
  2. For the record, we believe eventual enrollment gains will be considerably smaller after the fact than either generally expected or forecast by CBO or OACT. Nevertheless before the fact health plans’ actions generally should be governed by an expectation of +/- 9 percent enrollment gains; this expectation of large 2014 enrollment gains is more than sufficient to give hospitals considerable 2013 commercial pricing power. For more on our ACA-related volume expectations, please see: “Post-2014 Reform-Related Volume Gains are Modest” Sector and Sovereign Research LLC, March 2nd 2011
  3. Bureau of Labor Statistics
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