The hospital industry could face a long stretch in the recovery room.

Already, the group appears to be suffering through another painful quarter. But the sector's biggest headaches -- including weak patient volumes and bad debts from the uninsured -- may only worsen next year. Moreover, a new study shows, the government may fail to deliver expected relief and cut its support for hospital operators instead.

PriceWaterhouseCoopers this month published a report showing that hospital companies may continue to ail during President Bush's second term in office. The report notes that Bush has pledged to dramatically reduce the country's swollen deficit and, as a result, will need to exercise "significant spending restraint" to achieve his goal. Thus, the study predicts that the government may choose to slash Medicare spending just as it did when it passed the Balanced Budget Act of 1997, which crippled the industry -- and killed some players off altogether.

"The BBA reduced Medicare spending by $110 billion over a five-year period and had a tourniquet-like effect on providers," the report states. "In today's dollars, a similar level of reductions in the Medicare program would amount to a cut of about $450 billion over the next 10 years -- roughly the same as the increase in spending" under the new Medicare Modernization Act.

Those cuts, if realized, would simply add to the sector's injuries. Some experts also expect a

hit to the government-run Medicaid program, which would leave even more people without health insurance. Moreover, those with coverage have begun to favor more affordable plans featuring high deductibles and co-payments that present significant collection challenges for hospitals. And the insurers themselves seem to be growing stingier.

Meanwhile, the industry has just weathered one poor quarterly checkup, and some believe it could be headed for another. As a result, some experts now warn that hospital companies may not be as healthy as their rising stock prices indicate.

UBS analyst Kenneth Weakley -- best known for diagnosing problems at

Tenet

(THC) - Get Report

before the industry downturn -- is among those who foresee additional pain ahead.

"Since the GOP sweep in early November, the hospital group has bounced up about 5%, in line with the market," Weakley acknowledged. But "following a rather suspect quarter ... we believe that the bounce may be short-lived."

Weak Vitals

Third-quarter results exposed troubling vital signs at many hospital companies.

Weakley pointed to a slew of complications: soft patient volumes, weak pricing, lower margins, disappointing returns, inconsistent cash flow and, of course, bad debt from the uninsured. He spotted only one relatively immune player in the group. He upgraded

Triad

(TRI) - Get Report

to buy after the company beat Wall Street expectations. Looking ahead, he sees opportunities for Triad to grow its low margins and continues to take comfort in the company's slow acquisition pace and its strong organic growth.

Weakley says nearly the opposite about another hospital company, though. Along with Tenet, he continues to single out

Health Management Associates

(HMA)

-- long a Wall Street favorite -- as particularly vulnerable.

He has portrayed pricing strategies at both Tenet and HMA as more aggressive -- and thus less sustainable -- than most. But he also questions HMA's dependence on acquisitions. He says that recent acquisitions have stretched the company's balance sheet while generating slower returns. Meanwhile, he says, the company's same-store margins continue to deteriorate.

Going forward, Weakley warns that HMA's stock -- which enjoys a 55% premium over the group average -- could take a painful hit.

"In our view, declining returns on investment and a less flexible balance sheet will result in a more subdued acquisition pace down the road, in contrast to the pace and price of deals recently," he wrote. "While we would view a slowdown as a healthy development, we think those who still see HMA as a mid-teens grower would likely be disappointed."

Weakley reiterated his reduce rating on HMA and cut his price target on the stock from $18 to $15 a share. The stock slipped 4 cents to $22.19 Wednesday afternoon.

Sick Ward

Still, Tenet looks much sicker.

The company continues to suffer from negative industrywide trends. But it also saw its own third-quarter admissions fall as physicians referred their patients elsewhere. It faces multiple investigations -- and a criminal trial -- over its financial arrangements with physicians.

Weakley worries about even some cases that do wind up in Tenet hospitals. He believes that high-priced cases, which trigger so-called stop-loss payments from insurers, could become less profitable for the company down the road. As a percentage of revenue, he notes, Tenet relies on stop-loss payments far more than most.

"In our view, the probability of THC's sustaining a stop-loss ratio two times to the likely industry average is very low," Weakley wrote. And "we believe the erosion here of stop loss may be quite harmful to the company's cash flow and operating income results."

Given his concerns, Weakley now expects Tenet to simply break even -- rather than report a modest profit -- in 2005. Moreover, he believes the company's operating performance will continue to suffer for the next two to four years. As a result, he now pegs the company's long-term growth rate at zero. He values the company's stock, up 3 cents to $10.95 on Wednesday, at just $7 a share.

Weakley also cautions investors against expecting a rebound like the one that

HCA

(HCA) - Get Report

enjoyed when addressing its own regulatory problems.

"One clear difference between the HCA recovery from 1998 to 2003 and THC today is that HCA's recovery occurred when admissions, occupancy and pricing were all heading higher," wrote Weakley, who has a reduce rating on Tenet's shares. "In contrast, for THC, the industry metrics are working against its recovery."

Second Opinion

Banc of America analyst Gary Taylor offers a similarly dark prognosis for the group.

For one thing, Taylor foresees no material improvement in bad debt expense going forward. He notes, in fact, that bad debt has "never gone down -- only up -- over the last decade." Meanwhile, he says, hospital companies have weathered a drop in same-store revenue growth over the past 13 quarters. And he fears another tough quarter ahead.

Taylor believes the industry suffered a "very weak October," on the basis of a recent survey of nonprofit hospitals carried out by his firm. He said that only 37% of respondents reported a year-over-year increase in October inpatient admissions -- and he called that trend the weakest of the year. Now, he questions whether some hospital companies may be on their way to fourth-quarter misses.

Prudential analyst David Shove followed up with his own concerns after reviewing last month's Medicare billing data. He said that Medicare outpatient visits dropped by 6.1% -- and inpatient admissions fell an even harder 8.2% -- from a year ago.

"Compared to October 2003, both inpatient and outpatient volume growth was pathetically weak and potentially marked a trend reversal," wrote Shove, who has an unfavorable view of the hospital sector. "This raised some troubling questions."

For now, Shove seems inclined to blame the slump on the lingering effects of recent hurricanes. But he worries about a lasting setback as well.

"Should Medicare inpatient volumes not rebound significantly, we then face the possibility that

the inpatient volume growth trend run rate is much lower than we thought," Shove wrote. And "the weaker Medicare inpatient volume growth makes the hospital industry's earnings recovery incrementally more difficult."

Government cuts would further deepen the wound. And PriceWaterhouseCoopers has clearly hinted at that possibility. The firm pointed out that hospitals already account for the largest component of national health care spending. And it questioned whether hospitals will really be able to collect the increases promised under the new Medicare law.

It went on to suggest that the budget deficit "may create 1997 deja vu" for health care providers.

"Medicare reimbursement increases to health care providers, promised under the MMA, may become unsustainable in light of commitments to reduce the federal budget deficit and other spending priorities," the group wrote. And "hospitals, which are the largest recipients of these payment increases, also may be the target for the greatest payment cuts."

Weakley, too, warns of weaker Medicare pricing gains -- coupled with ongoing industry challenges -- going forward.

"Not exactly a pretty picture," he concludes.