Hospital companies, once among the healthiest performers in the market, may have already passed their prime.

For years, hospital operators have counted on their soaring profits to really take off when aging baby boomers started to hit hospital beds in droves. But one veteran health care analyst now wonders if the baby boom -- which has fueled so much expansion in the industry -- might actually turn out to be a bust.

Fulcrum analyst Sheryl Skolnick readily acknowledges that her view "violates conventional wisdom." But she has collected enough evidence to at least question a crucial assumption that's powering growth expectations for the industry.

She wonders whether the industry's revenue can really grow enough to offset mounting expenses.

"The irony of the situation is apparent to us," acknowledged Skolnick, who has a cautious view on the sector. But "we see a margin squeeze just at the time when hospitals should be enjoying unprecedented increases in volume-driven profits. ... In short, we think that it is possible that the impact of the baby boom on the hospital industry is more likely negative than positive."

The squeeze could hit leaders such as

HCA

(HCA) - Get Report

and

Tenet

(THC) - Get Report

as well as smaller players, Skolnick's research suggests. Hospital stocks in general, known for delivering double-digit profit growth, have recently faltered and are down nearly 3% on average over the past three months.

Margin Squeeze

To be fair, Skolnick admits that hospital stocks may actually rise on third-quarter reports that show stabilization in bad-debt expense.

But she believes that bad debt -- a recent market concern -- is just one of several problems now surfacing throughout the industry. Namely, she expects supply and labor costs to keep rocketing as well.

Looking ahead, Skolnick sees hospital stocks taking a potential hit as a result.

"We do not believe that investors have adequately discounted those risks into current valuations of ... the hospital group," Skolnick wrote on Monday. "We think that late 2004 will be dangerous for owners of these stocks and 2005 will be very unpleasant."

Already, Skolnick points out, hospitals are struggling with supply costs. When issuing their latest reports, HCA and Tenet blamed high-tech devices -- particularly drug-eluting stents -- for a surge in supply expenses. But Skolnick says that other pricey devices, such as orthopedic and cardiac implants, are also hurting profits at some hospitals.

Peter Young, a business consultant, who recently hosted an industry meeting in Florida, agrees. He says that Florida hospital CEOs who attended the meeting reported that implants used in joint-replacement surgeries had turned the orthopedic procedures into money-losers. He said the price of such implants has rocketed 115% during a 12-year period when Medicare reimbursements for the devices have risen only 12% to 15% for hospitals and have actually fallen 25% for physicians. Meanwhile, he said, the new drug-eluting stents have cut into angioplasty margins and eliminated the need for many lucrative heart bypasses as well.

Normally, Young pointed out, orthopedics and cardiology have been nice profit centers for hospitals. But now, he said, costs are growing faster than revenue.

"This is not a growth industry anymore," he stated. "Margins are going down."

Nurses Getting Scarce

Skolnick sees further threats to come. Most notably, she expects the nursing shortage to grow worse and drive labor expenses higher. And she blames the baby boom in part.

"The industry has been building beds in anticipation of increased demand over the next five to 10 years, yet we barely have enough nurses to staff the existing beds today," she noted. "As the economy improves, the aging nurse workforce (average age today is about 51) thins, exacerbating the growth."

In the meantime, Skolnick believes the sector could take a hit to revenue even as it battles with soaring expenses. Specifically, she suspects that hospitals may never realize the full Medicare reimbursements they are currently expecting. She says that proposed Medicare rate hikes for 2005 look "too high" and will probably weather cuts as Congress looks for ways to fund the new prescription drug bill and still keep the Medicare trust fund solvent.

Still, Skolnick foresees a potential "window of relative calm" in the sector before this happens.

For now, at least, Skolnick is maintaining her neutral rating on the largest for-profit hospital chain in the industry. She says she has a "slightly more positive impression" about HCA after attending the company's investor day last week. And she specifically applauded the company for making "everyone smarter about bad debt and uninsured accounting" through disclosures at the meeting. But she also recognized that disclosing the problems didn't necessarily make them go away.

Rather, she expects HCA and the entire hospital group to struggle with bad debt and new "systemic" problems -- including those posed by the baby boom -- for the foreseeable future.

"We ... recognize that our concerns are, perhaps, too long-term for investors who are judged on an annual or quarterly basis," she confessed. "Nevertheless, our overall stance remains one of extreme caution."