Hospital Recovery Stalls

The sector continues to be hampered by tepid growth, confounding rising expectations.
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Despite hopes for a recovery, the hospital sector has yet to land back on its feet.

Following a strong first quarter that brought a crowd of flu-related admissions and some temporary relief from the uninsured, hospital companies have found themselves ailing once again. Indeed, some observers are starting to wonder whether the once-booming hospital sector was ever as healthy as it seemed.

UBS analyst Kenneth Weakley posed that possibility this week, nearly three years after exposing unsustainable pricing games at

Tenet

(THC) - Get Report

-- the nation's second-largest for-profit hospital chain -- and ending the company's long run as a Wall Street darling. The entire industry has suffered a downturn since then.

"The market is still coming to grips with the idea that the strong results of 1999-2002 were an illusion, one-time events driven by a strong economy, the restructuring of the gatekeeper HMO model and the givebacks associated with the post-Balanced Budget Act environment," wrote Weakley, who has a cautious view on the sector. "The bulk of history since the introduction of (Medicare) diagnostic-related groups in 1983 has witnessed weak inpatient admits and challenging economic prospects, an environment still applicable today."

Weakley offered his dark prognosis after reviewing second-quarter hospital results defined by weak vital signs -- low volumes, high bad debt and poor pricing -- that could mean chronic problems for the industry.

No Relief

Weakley is simply more bearish than most. Prudential analyst David Shove saw his own hopes for a recovery dashed after industry leader

HCA

(HCA) - Get Report

followed up a strong first-quarter performance -- which sparked a rally in the sector -- with reports of troubling, if familiar, problems in the more recent period.

"Weak paid admissions appear to be the problem," concluded Shove, who has an unfavorable outlook on the sector. And "better economic conditions won't help. When will relief come?"

By now, Weakley has been betting against a recovery for some time.

The analyst has specifically challenged some of the most popular, big-picture assumptions fueling current optimism about the industry. And he has suggested that much can be learned from "an honest read" of history instead.

"During the 1990s, for example," he notes, "hospital admissions did not experience two consecutive years of more than 1% growth until 1999 -- a full eight years after the macroeconomic trough of 1991."

Weakley then goes on to say that recent expectations for admission growth, linked to both an aging population and an economic recovery, have relied on "a fair degree of spurious analysis." He also doubts that job gains will cure one of the industry's biggest headaches -- bad debt from the uninsured -- either.

"Academic research has shown that the primary driver to the uninsured is not fewer Americans working or fewer employers offering medical coverage but instead that fewer individuals, upon being offered medical coverage, are actually taking them up," Weakley explains. "The proportion of individuals that are refusing medical insurance today is approximately 20% -- up from less than 10% two decades ago. ... We have argued before, and do so again today, that the root cause of the uninsured in the country is simply that healthcare costs too much."

Weak Pricing

Even so, Weakley's research shows, hospitals have found themselves unable to raise prices as they once did.

Following backlash from the Balanced Budget Act of 1997 -- which caused many hospitals to go under -- the industry managed to steadily increase hospital prices for years, Weakley notes. But those price hikes peaked in June 2003, he says, and this June hit their lowest level in nearly three years.

Excluding prices paid by government insurers, Weakley notes, the trend is even worse. Prices hikes for private insurers -- the sector's most lucrative source of business -- and "eligible consumers" plummeted from 10% in late 2002 to 5.1% in June of this year. Moreover, he says, such pay increases for outpatient services have now spiraled to a new six-and-a-half-year low.

Thus, he concludes, "we believe that, despite company comments to the contrary, pricing power is eroding across the industry."

Weakley points to revenue per adjusted admission -- an especially crucial hospital metric -- as evidence for his theory. During the second quarter, he notes, both urban hospital operator HCA and rural hospital chain

LifePoint

(LPNT)

"experienced significant deceleration" in pricing as reflected by this metric. He portrayed the pricing power at

Health Management Associates

(HMA)

, another rural player, as similarly weak. Indeed, he noted, only two hospital companies --

Community

(CYH) - Get Report

and

Universal

(UHS) - Get Report

-- enjoyed any year-over-year pricing gains.

Weakley highlights revenue per adjusted admission as the only metric that matters when it comes to hospital pricing. But he points to admissions in general as the most important key to hospital success overall.

Missing Ingredient

There, of course, Weakley found weaknesses as well.

Admission growth, which briefly bounced in the first quarter, is once again on the decline. In fact, troubled Tenet has enjoyed no relief at all. By now, Weakley calculates, the company has seen admissions decline for at least six quarters in a row.

"On the urban side, THC came in with the sector's worst performance (the fourth time in five quarters) of a 1.4% decline -- of course, more indicative of company-specific issues," wrote Weakley, who has an underweight rating on Tenet's stock. "THC remains a story of numerous troubling trends, particularly on the patient volume side, with little resolution in sight on the legal side, either."

As a result, Weakley excluded Tenet from much of his industry evaluation so that the company would not negatively skew the overall results. But his findings still proved dismal.

HCA, he noted, "was soft on admissions and worse on bad debt." Even the rural operators showed signs of weakness, he said. For example, he said, Community -- which has boasted "the best growth story over time -- posted just a tepid 0.3% admission gain in the first quarter. Moreover, he added, LifePoint's "solid" admission growth came as a result of easy year-over-year comparisons.

To be fair, Weakley had warned in advance that bad news could be coming. Specifically, he pointed out that hospital leaders themselves -- who have been unloading large chunks of company stock -- seemed to be questioning the "turnaround" in their own industry.

"Insider sales across the space, we believe, are still a reliable (if admittedly noisy) signal," Weakley wrote. "The preponderance of signals from managements across the sector continues to imply a lack of conviction regarding the supposed recovery."

Peter Young, a business consultant at HealthCare Strategic Issues, tends to agree.

"Does this help put the insider selling into perspective?" he asks. "I think it does. ... This does not spell an opportunistic business environment."