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When The Cycle Turns: Health Care Subsectors Ranked By Vulnerability To Economic Downturn

Health care is a defensive industry. Still.

Demand for health care products and services is largely inelastic. However, we believe issuer credit ratings in the for-profit health care sector are more vulnerable to a cyclical downturn than in previous recessions. Credit quality markedly declined in the decade since the last recession. Over half (54%) of all for-profit corporate health care issuer credit ratings were investment-grade as recently as 2005, but only 20% now. The shift primarily reflects a surge in smaller, mainly private equity-owned health care issuers. The average quality of a care company is also lower, with 'B' ratings the most common at 66%.

Within the speculative-grade group, credit metrics eroded in recent years, reflecting increased private equity interest in the sector, industry disruption eroding EBITDA, and the lateness in the current credit cycle (see "When The Cycle Turns: Rising Leverage And Disruption Weaken Speculative-Grade Health Care Companies", published March 4, 2019). That leaves ratings in the industry more sensitive or vulnerable to a recession.

Chart 1


While we believe health care is more insulated from economic downturns than other industries, such as autos and commodities, it is not absolute. Health care spending growth in the U.S., according to data from Centers for Medicare & Medicaid Services (CMS), declined in 2007-2008. For the major subsectors, it has yet to recover to pre-Great Recession growth rates (Chart 2; only nondurable medical products have recovered to near pre-2008 recession growth).

Health spending falls during recessions as people choose to spend less on health care and insurance policies become less generous. State budgets, with falling revenues, may cut Medicaid reimbursement rates or restrict eligibility. Providers may also cut back on investments in facilities and programs.

Given the increasing role consumerism plays in health care decision making and the expansion of Medicaid programs in a number of states (as part of the Affordable Care Act) over the past decade, we believe a recession, depending on the severity, may have a greater impact on U.S. health care expenditure growth.

Chart 2


The industry is also undergoing unprecedented disruption. Whether it be in technology (gene-based therapies, genomic data, health care information technology), services (value-based care, migration to lower cost settings), or among payers (CVS Health Corp., Aetna Health Holdings LLC, Inc.), health care and many participants' business models (for example, pharmacy benefit managers) are being disrupted.

This is not new and contributed significantly to lower ratings. However, we believe it is in the early stages and that the pace is quickening.

Given the diversity of health care subsectors, spanning higher-margin and highly rated pharmaceuticals to lower-margin, lower-rated services, which industries are more vulnerable to downgrades? Looking at the diverse subsectors, we rank them by what we believe is their ratings vulnerability to an economic downturn, a factor included in the ratings on the respective companies.

Chart 3


Health Care Subsectors, Least Vulnerable To Most Vulnerable

Medical products/devices/equipment: Baxter International Inc., Abbott Laboratories, Becton Dickinson & Co., Hologic Inc.

From gauze pads to orthopedic implants to multimillion-dollar diagnostic machines, this is a wide subsector. Demand should not drop significantly for consumable medical products providers such as Becton Dickinson & Co. (syringes) and Baxter International Inc. (IV bags), though there is some exposure to patient and hospital admission volumes. Implant procedure (hips/knees) volumes remain steady through downturns. Some companies that sell higher-end diagnostic machines are exposed, as health care facilities, already under pressure, work with squeezed budgets, and delay equipment upgrades. However, the subsector does not have a large target on its back, in terms of cost control, versus the pharmaceutical industry.

Life sciences: Danaher Corp, Thermo Fisher Scientific Inc., PerkinElmer Inc.

This includes companies that provide instruments and consumables for scientific research, diagnostic testing, and manufacturing. Prospects rely heavily on pharmaceutical and biotech research and development (R&D) activity, and increasingly biologics manufacturing. We believe R&D activity and pharmaceuticals and biologics manufacturing demand would remain steady, providing a strong revenue base. The majority of sales are consumables, so there is a large repeat sales component. Hardware (tools) sales (such as Illumina Inc., which sells high-priced genomic sequencers) may drop, but that is a relatively smaller component. A number of life science products are also used in diagnostic testing. Given the increasing use of diagnostic tests and the overall demand resiliency in health care, it further supports our opinion that the life sciences subsector is more insulated from an economic downturn.

Similar to contract research organizations (CROs), life sciences benefit from strong R&D activity. However, life sciences has much broader applications, providing products for pharmaceutical and diagnostics manufacturing and increasingly products for non-health care uses (such as water safety testing), end markets that we consider less cyclical. In the last downturn, sales and EBITDA declined for several rated life sciences companies, though it was relatively short-lived (less than a year). We believe the short-term weakness was likely caused by customers seeking to tighten budgets and lower inventories of supplies, but that longer-term demand was largely stable.

Pharmaceuticals/biotech: Pfizer Inc., Amgen Inc., Teva Pharmaceutical Industries Ltd.

The pharmaceutical industry is one of the more insulated health care subsectors, given the nature of demand. That may shift slightly in a downturn, such as further switching to lower-cost generic and biosimilar alternatives. With the increased use of high-deductible insurance plans, a greater consumer component, it further leads to switches to lower-cost options. But these trends are already largely happening even before a potential economic downturn (noted in the slowdown in overall pharmaceutical spending growth). Our major concern is whether, in an economic downturn, the pressure to control drug costs at the federal and state level further accelerates and exposes the industry to legislation (abolishment of rebates, Medicare for All, price controls) that would have a detrimental impact on revenue and cash flow generation.

Distributors of drugs and medical products: McKesson Corp., Cardinal Health Inc., Owens & Minor Inc.

Amid criticism of "middlemen" in the ongoing debate on controlling U.S. health care costs and moves to increase transparency, such as abolishing rebates, the industry continues to play a critical role in distributing pharmaceutical and medical products. Given the expected steady demand for both categories (see the above two industries), distributors are ranked close to their clients on our list of exposure to a downturn. Also, compared to CROs, the distribution subsector is also more of an oligopoly, which should lessen the impact to our view of their business risk. Or at least until Amazon gets into the industry.

CROs: IQVIA Holdings Inc., PAREXEL International Corp., Charles River Laboratories International Inc.

Pharmaceutical CROs benefit mainly from R&D spending, which is largely stable through a downturn. However, demand unexpectedly decreased during the 2008-2010 downturn. While R&D spending is generally resilient--it's difficult to stop an ongoing clinical trial--funding for less well-financed biopharmaceutical startups conducting preclinical and early stage clinical trials dried up. Thus, volatility would be higher for CROs that focus on earlier stage preclinical work (including Charles River Laboratories Inc.), as earlier stage projects are also easier to put on hold. In the last downturn, there was a multiyear slowdown in preclinical R&D activity.

For CROs focusing on clinical stage work, the slowdown is less pronounced. Larger trials are more difficult to delay and involve later stage prospects that have a higher likelihood of succeeding, thus companies are less willing to delay. However, in the next economic downturn, the slowdown may be more widespread. CROs over the past decade sought to increase their exposure to smaller biotech clients (which are doing more R&D in pharmaceuticals). Also, a number of CROs offer outsourced marketing services that may, like advertising and marketing in general, hit volatility in a down market, though pharmaceutical promotion expenditures are more linked to new product launches.

Health care IT: Change Healthcare Holdings LLC

This is a relatively new industry that significantly expanded after the U.S. federal government enacted the Health Information Technology for Economic and Clinical Health Act (HITECH) as part of the American Recovery and Reinvestment Act. It provides services and software, mainly to health care providers to upgrade their systems for collecting and managing medical records, coding, and billing. It's now an essential service as hospitals and other care centers seek to increase efficiency. The electronic health record (EHR) industry for hospitals and physician offices is largely saturated, but EHR software providers turned to add-on services and the replacement market. In a recession, however, funding relies on provider budgets (see the next group), and it is likely health care providers will be in no rush to update their EHR systems.

Meanwhile, revenue cycle management (RCM) software and services could become more crucial during an economic downturn, as health care providers attempt to increase collection rates. Additionally, providers may opt to outsource RCM software they view as outside their expertise as well as labor-intensive services that are still done in-house.

Hospital services: Tenet Healthcare Corp, Prospect Medical Holdings Inc., HCA Healthcare Inc.

The hospital emergency room is not the most cost-efficient way to treat patients. The ongoing trend of patients being directed to lower-cost alternative sites steadily decrease patient volumes at the high-cost, high-overhead hospital setting. Although patient volumes and admissions may increase in a recession, insurance coverage tends to decline as unemployment rates increase, potentially increasing uncompensated care for hospitals.

Health care services: Acadia Healthcare Co. Inc., WP CityMD Bidco LLC

While some players benefit from favorable trends of patients being directed to lower-cost alternate sites and away from more expensive hospitals, this is a very diverse group. Depending on the service, a company can be highly exposed to reimbursement rates. We are concerned about what happens to Medicaid and Medicare rates in the event of squeezed state and federal budgets in a downturn.

There are 50 state Medicaid programs that all could have different funding situations. We typically assume a 0%-2% Medicaid rate increase, most at the higher end of range, given the favorable economic environment. But Medicaid funding could differ from service to service. During an economic downturn, demand for Medicaid services increases, but state revenues decline, increasing pressure for cost controls and rate cuts. Potential rate cuts could have a significant impact on issuers, given that health care services is already one of the lowest-rated subsectors and has little financial flexibility.

Hospital staffing: AMN Healthcare Services Inc., CHG Healthcare Services Inc., Sound Inpatient Physicians Holdings LLC, Team Health Holdings Inc.

This industry provides outsourced temporary and permanent staffing, such as doctors and nurses, to hospitals and other providers. We rank this subsector high for exposure to a downturn, given its client base. Squeezed hospital budgets will have a direct impact on rates. However, we also find that the strength of the economy affects the demand for temporary staff (for example, travel nurses).

The segment most vulnerable in downturns is temporary nurse staffing, which is more sensitive to cyclicality than part-time physician staffing and full-time employment. Some specific physician concentrations more prone to discretionary spending--such as plastic surgeons--may be highly sensitive as well. As economic activity slows, attrition decreases for hospitals and other health care providers. They reduce their use of temporary employees before laying off regular employees. Additionally, permanent full- and part-time health care facility staff may be inclined to work more hours and overtime, creating fewer available vacancies and less temporary staffing demand.

Finally, temporary staffing is often used to accommodate increased hospital admissions. During economic downturns, however, hospital admissions may decline due to reduced consumer spending and higher unemployment, increasing under- and uninsured patients.

While this industry may contract significantly during a downturn, it has a distinct competitive advantage of low fixed costs and minimal capital expenditures. It can also rebound relatively quickly in a recovery, as unemployment decreases, hospital admissions increase again, and full- and part-time staff work fewer hours.

This report does not constitute a rating action.

Primary Credit Analyst:Arthur C Wong, Toronto (1) 416-507-2561;
Secondary Contacts:Sarah Kahn, New York (1) 212-438-5448;
David P Peknay, New York (1) 212-438-7852;
Tulip Lim, New York (1) 212-438-4061;
David A Kaplan, CFA, New York (1) 212-438-5649;
Maryna Kandrukhin, New York + 1 (212) 438 2411;

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