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When The Cycle Turns: Rising Leverage And Disruption Weaken Speculative-Grade Health Care Companies

We believe the U.S. for-profit health care sector is more vulnerable in a cyclical downturn than it was in previous recessions. While we continue to view the health care industry overall as a traditionally defensive industry, leverage levels across U.S. corporates have been climbing over the past 10 years, and U.S. for-profit health care industry leverage has been consistently above the corporate average. This is especially true for the speculative-grade health care companies, which have seen median leverage exceed 6x since 2017 compared to 5x for the larger speculative grade-rated corporate universe. This is in part a function of private equity interest in the sector and is apparent in the distribution of ratings, with a significant percentage of new issuers rated in the 'B' category. The record leverage and lower-than-average EBITDA interest-coverage ratio among the speculative-grade health care credits are occurring against a backdrop of a changing landscape in the health care industry, including industry disruption, which is also contributing to deteriorating health care credit quality. We believe these developments make the rising number of low-speculative-grade health care borrowers, as a group, more vulnerable to adverse credit cycle changes than we've previously seen.

Health Care Credit Quality Has Deteriorated

Speculative-grade debt issuance has exploded in the past three years, often with low interest rates and lenient covenant protection. As investors continue to hunt for yield, the number of speculative-grade companies has been on the rise. With more than 60% of health care issuers rated in or below the single 'B' category, we see little room for error for many U.S. health care companies.

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The health care industry is also undergoing an unprecedented level of change, as both public and private payors seek to control rising costs. A shift away from fee-for-service payment models to alternative payment methodologies, including value-based care, has brought private equity attention and funds to niche companies. These investments have encouraged a significant amount of consolidation among exceedingly fragmented markets, and caused many service companies to create new business models in order to operate under changing payment forms, encouraging them to invest heavily with the expectation of addressing the evolving market. Consequently, debt issuance over the past several years has been used to gain market share, grow top- and bottom-line earnings, fund capital expenditures and strategic business initiatives, supplement organic revenue growth with a significant level of mergers and acquisitions, and fund shareholder-friendly activities.

The shift in business models caused by disruption in the industry has also led to a deterioration in EBITDA for some incumbent companies. This has contributed to the deterioration in credit metrics and ratings in the sector.

Chart 2

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Chart 3

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Debt-to-EBITDA and FFO-to-debt ratios are just two of the measures S&P Global Ratings uses to measure leverage (see "Corporate Methodology: Ratios And Adjustments," published Nov. 19, 2013). As of Dec. 31, 2018, leverage across speculative-grade health care companies is at a historic high. While the added debt has strengthened the business propositions for some of the speculative-grade companies, we believe the added financial risks attributable to this debt are significant, given excessive leverage can leave a company more vulnerable to disruptive business conditions and liquidity problems due to rising financing costs. Rising debt amounts, combined with the increasing debt to EBITDA ratios, also suggest the anticipated returns of debt-financed investments have not yet fully materialized, or were overestimated.

We believe health care companies with extremely high leverage can suffer in an economic recession, even absent weakened operating performance, if capital markets deteriorate, leading to valuations decline, rising financing costs, and liquidity constraints in the face of refinancing risk.

Coverage ratios have declined below the corporate median over the past few years, amid historically low interest rates. FFO to interest has declined from lofty levels over the past 10 years to the corporate average, after being well above that average for that decade. With the health care industry becoming increasingly innovative and the number of small niche service companies rising, issuers may be facing greater-than-expected competition. Investments in changing business models in order to adapt to an evolving health care environment that is increasingly focused on value and consumerism may take longer to materialize into EBITDA, with many companies going through periods of margin decline before seeing any benefit. Meanwhile, newer issuers capitalizing on recent trends have also landed in the lower rated categories, as high valuations and aggressive capital structures burden balance sheets, leaving little room for error.

Chart 4

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Health Care Services Crowd The Low End Of The Ratings Spectrum

Among the 15 companies with the highest expected leverage and lowest coverage ratios in health care, 10 are health care service providers (as opposed to pharmaceutical and medical device companies, which on average maintain lower leverage and stronger coverage ratios). Of the 15, four are rated 'CCC+' and are viewed as highly dependent upon favorable business, financial, and economic conditions to meet financial commitments.

  • New Millennium (CCC+/Negative/--) has been facing continuing operational pressures, a diminishing cash balance, and EBITDA generation that is trailing its fixed charges. The company will need access to capital markets in the coming year in order to refinance its 2020 maturity.
  • StoneMor Partners L.P. (CCC+/Negative/--) recently entered into its eighth credit agreement amendment. Its revolving credit facility lenders have frozen the company's access to the revolver and accelerated the revolver maturity to May 1, 2020. We expect the company to meet its covenant requirements, but believe that covenant headroom will be very tight and the company will have to cut costs substantially to meet the minimum EBITDA requirements in 2019.
  • Lanai Holdings III Inc. (CCC+/Negative/--) continues facing operational disruptions, leading to significant order fulfillment, collections, and customer service issues, which hurt revenues and cash flows. We expect the company to face tightening financial covenants as soon as this year, and to look to access capital markets ahead of the revolver maturity in 2021.
  • While BioScrip Inc.'s (CCC+/Stable/--) operating performance has improved sequentially over the past several quarters and we expect the company will meet its debt obligations for at least the next 12 months, compliance on its consolidated net leverage covenant is dependent on the company's ability to execute on its cost improvement plan and grow EBITDA.

Of note, we currently consider StoneMor, Lanai, and BioScrip's liquidity as less than adequate, because the sources and uses of cash are at a level that offers scant protection against unexpected adverse developments. This also reflects a likelihood that the companies will not be able to absorb low-probability adversities, even factoring in capital-spending cuts, asset sales, and cuts in shareholder distributions. While we believe health care industry demand is somewhat inelastic, in an economic downturn, companies could experience short-term disruptions in demand that could, even if temporary, reduce EBITDA and cash flows.

Cash And Liquidity Take Center Stage

While speculative-grade health care companies have seen few defaults in the last 10 years, high leverage ratios and deterioration of interest-coverage ratios leave the sector exposed to potential cash flow and liquidity issues. Speculative-grade health care companies will need to rely on capital markets access to meet upcoming maturities and, potentially, new debt issuance to cover capital expenditures and permanent working capital. Even without a more risk-averse credit environment, sufficiency of cash flow, particularly for very low quality borrowers, becomes a real risk due to rising interest rates and potentially reduced capital-market access.

Related Research

  • When The Cycle Turns: Leverage Continues To Climb--Has It Finally Peaked?, Oct. 9, 2018
  • U.S. Corporate Issuers Brace For Slower Growth And Increased Recession Risk In 2019 As The Cycle Turns, Article Says, Dec. 13, 2018
  • Credit FAQ: When The Cycle Turns: Assessing How Weak Loan Terms Threaten Recoveries, Feb. 19, 2019

This report does not constitute a rating action.

Primary Credit Analyst:Sarah Kahn, New York (1) 212-438-5448;
sarah.kahn@spglobal.com
Secondary Contacts:Arthur C Wong, Toronto (1) 416-507-2561;
arthur.wong@spglobal.com
David P Peknay, New York (1) 212-438-7852;
david.peknay@spglobal.com
Research Assistant:Sanjana Rao1, Pune

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