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Will The Next Phase Of Seismic Compliance Spending Shake California Hospital Ratings?

In the past 20 years, many California acute care providers have absorbed significant capital spending and operating expenses related to achieving seismic compliance as mandated by state law. Meeting compliance milestones occurred while the industry underwent significant changes and the economy experienced a major recession. Through this extended period, many of the providers we rate met their seismic compliance goals and absorbed the high levels of capital spending during a time of heightened operating pressures. Our ratings on most California hospitals are unchanged or close to their initial rating, but the rating distribution widened slightly over a 15-year period (2003-2018), suggesting a growing gap between the strongest and weakest entities.

Most of the organizations that we rate have met the first seismic compliance deadline of Jan. 1, 2020 (initial deadlines were much earlier than 2020 but many providers received extensions). However, to remain operational, California hospitals must achieve full seismic compliance by Jan. 1, 2030; this includes addressing structural and nonstructural components, particularly for those hospitals that have not undergone a full replacement. (Structural compliance ensures that the physical building has been built so it does not collapse or fail after a certain level of an earthquake while nonstructural compliance ensures that the building systems, technology, etc. can operate after an earthquake.) As many rated California providers invest in the next round of compliance, they will have ongoing capital expenditures, although for some organizations it will likely be less than the updates leading up to the 2020 deadline. Nevertheless, many will face mandated capital spending that will compete with other strategic priorities and many will face potential operating challenges related to making nonstructural updates while minimizing patient care disruption.

S&P Global Ratings believes that most rated hospitals and health systems in California that need to spend on final seismic compliance will likely be able to manage, particularly those with higher ratings. These additional capital expenditures and nonstructural updates, however, could be difficult for organizations at the lower end of the rating spectrum that are already struggling to access capital at a reasonable cost and manage expenses. Moreover, the additional potentially prohibitive costs for this next round of compliance needs, combined with ongoing industry pressures, could contribute to some shifting strategies such as mergers and acquisitions, rebalancing of strategic priorities, and potentially closures for those hospitals without the means to finance the project and absorb increased expenses. And for many acute care hospitals and systems, we believe there will be a re-evaluation of what a particular community needs from an inpatient acute care perspective as the delivery of care continues to evolve toward more outpatient care.

Our analysis is based on the 41 rated acute care hospitals and health systems in California as of Dec. 31, 2018, and one health system that is not headquartered in California, but has a significant number of facilities in the state. These 41 entities often include more than one inpatient facility. In fact, this sample of organizations includes close to 200 inpatient hospital facilities in the state. We reviewed audited data from 2003 to 2017 and rating history from 2003 to 2018 for both our subset of California issuers only and then more broadly, all of the not-for-profit acute care providers that we rate. Although the seismic legislation went into effect before 2003, we chose to focus on the 2003-2018 period given data availability. The universe of rated providers in 2003 was not the same as in 2018 and, in fact, the number of rated entities in California almost doubled over that period. For financial and rating history analysis, we compared the California acute care providers with the general universe of U.S. not-for-profit acute care entities--ranging from 450 to 500 health care organizations, depending on the year.

Background: Seismic Requirements Include Both Structural And Nonstructural Performance Standards

Following the 1971 earthquake in the San Fernando Valley of California, the state legislature passed the Alfred E. Alquist Hospital Facility Seismic Safety Act to ensure hospital facilities met certain seismic standards. The act was further expanded and strengthened with California State Bill (SB) 1953 (introduced in 1994), which provided specific guidelines around earthquake performance categories for inpatient hospitals. The Office of Statewide Health Planning and Development (OSHPD) provided the guidelines for both structural and nonstructural areas. SB 1953 established a first deadline to ensure that an inpatient hospital could withstand a certain magnitude of earthquake, and established a second deadline to ensure that it could remain operational following an earthquake. Consequently, acute care hospitals in California must ensure that they meet certain structural and nonstructural performance levels by the second deadline of Jan. 1, 2030, or be ineligible to provide inpatient care in the non-compliant structures.

Structural performance

On the structural side, SB 1953 required that an inpatient hospital and its related buildings for inpatient services remain standing after an earthquake of a certain magnitude, and hospitals had to meet this by 2008. However, most hospitals received extensions through 2013 and some even received extensions through 2020. Based on OSHPD data and discussions with entities we rate, most California acute care providers in our sample have met this requirement or are close to meeting it in 2019, with one or two having received extensions just beyond the 2020 date for specific circumstances.

Since SB 1953 took effect, many hospitals built full or partial replacement facilities to meet the initial deadline; they have likely also met the 2030 deadline for all or components of their inpatient buildings. However, acute care hospitals and systems that may have retrofitted certain hospital buildings, or did not replace facilities in full, likely will require in some cases very significant upgrades to meet 2030 compliance. According to OSHPD data as of May 2, 2019, a little under half of all California acute care buildings have met the 2030 deadline for structural compliance. Although many of our rated providers have addressed certain seismic needs, several hospitals and systems that we rate still require sizable spending to achieve full seismic compliance. The number of buildings is an estimate, as some providers may choose to completely decommission certain buildings (or even hospitals) or repurpose them for non-acute care activities as part of the overall facilities plan.

Outstanding nonstructural performance

Buildings must also meet nonstructural performance category requirements. These components consist of bracing and anchoring equipment and IT systems as well as ensuring that utility systems (power, gas, water, fire alarms, and emergency lighting), among others can work properly following an earthquake. As it did for the structural performance standards, OSHPD has outlined nonstructural performance categories of what's required for an inpatient hospital to be operating after 2030. While many buildings have reached NPC-2 (nonstructural performance category), the buildings need to reach higher performance category ratings, per OSHPD, to be operational after a large earthquake. Specifically, acute care hospitals must complete other nonstructural upgrades to operate beyond 2030. The higher NPC ratings of NPC-4 and NPC-5 ensure that acute care providers can remain operational after a significant earthquake. If hospitals made full or partial replacements, the new construction and related systems likely incorporated the higher specifications required to operate past 2030. Unfortunately, per OSHPD data, only about 20% of California inpatient buildings are rated NPC-4 or NPC-5. Therefore, buildings could require significant work on nonstructural compliance over the next 10 years or require another plan to remove the space from inpatient care.

Seismic Upgrades' Effect On Capital Spending

We studied audited financial data from 2003 to 2017, as we believe a significant majority of seismic compliance-related capital spending likely occurred in that timeframe. Available data do not explicitly earmark the exact proportion of total capital expenditures for seismic purposes only; however, capital spending in California during the past 20 years was significantly higher than for the total universe of U.S. acute care issuers that we rate (see chart 1). In particular, in the mid-to-late 2000s, capital spending considerably increased for rated California health care organizations; this aligns with one of the initial seismic deadlines in 2008 (though that was extended to 2013 for some and then again to early 2020 for others). Because California's population has grown more than the nation's as a whole, demographics could have also contributed to capital expansions and spending. Regardless, any new construction for growth (or replacement) would have had to incorporate the tighter, and likely more expensive, seismic guidelines (compared with construction in non-earthquake-prone states) and thus, would have also contributed to the higher capital spending at California hospitals than at rated organizations across the country.

Chart 1

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We expect that capital spending could rise again as providers prepare for the 2030 deadline if they haven't yet fully addressed those compliance needs. While many providers addressed some or all of their buildings' structural and nonstructural seismic needs for the 2030 deadline, we understand from our rated providers that there are still some buildings and hospitals that need significant upgrades related to seismic compliance. In addition, capital costs for many providers will likely be oriented toward achieving nonstructural compliance, which probably will need some capital dollars albeit fewer than required to ready their facilities for structural compliance. That said, we believe that hospitals or health systems that haven't fully addressed all of their seismic needs might also strategize about the best way to manage care in those service areas as the health care industry focuses more on outpatient care delivery. We expect that there will be competing needs for those capital dollars that will require management and their boards to make difficult decisions about mandated capital spending versus other strategic priorities. While some inpatient providers might need or choose to spend the necessary capital to meet the 2030 deadline, others could end up closing a facility or transferring acute care services to another acute care hospital or partner facility and thereby be able to allocate capital for other strategic needs.

Balance-Sheet Strength Is Slightly Weaker For California Hospitals

Hospitals have had a long time to plan for the final 2030 deadline and so we've generally seen most providers manage their balance sheets effectively and with broad stability through what has been a complex and expensive endeavor. That's not to say that some sizable projects haven't led to balance-sheet deterioration or downgrades, but for most California organizations we rate as of May 9, 2019, we either affirmed the ratings, were within one notch of the original rating, or took positive rating actions of more than one notch since 2003 or since we assigned the initial rating.

Rated organizations, including those in California, tend to maintain healthy balance sheets but, not surprisingly, with higher capital spending, certain key ratios trend slightly less favorably than overall not-for-profit acute care medians. Providers have used both debt and cash flow and investments as they made seismic and general capital updates to their facilities for the initial 2020 deadline with minimal long-term diminution of the balance sheet. In addition, grants and California state bond issuances for children's hospitals have helped fund projects to minimize balance-sheet deterioration in some instances. Over the period analyzed (2003-2018), the median for days' cash on hand generally increased, dipping slightly in 2008 before increasing again (see chart 2), with leverage generally decreasing after a peak in 2009 perhaps indicating an increase in debt issuance as initial structural seismic deadlines approached.

Chart 2

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For smaller hospitals that were cash strapped and without easy access (or with more expensive access) to the capital markets, keeping up with facility retrofits and construction to meet seismic requirements has been more difficult. Some organizations have turned to alternative financing options including the California Mortgage Loan Insurance Program (Cal-Mortgage). In fact, S&P Global Ratings rates more than 70 organizations insured by the program. As of February 2019, the Cal-Mortgage program had insured $1.7 billion in loans, with the ability to insure up to $3 billion as allowed by the state. Granted, not all of the loans relate to seismic projects, but we believe this program has been essential to some hospitals' ability to meet deadlines by allowing them access to the capital markets at a cheaper cost than they could achieve independently. We rate debt insured by the Cal-Mortgage program 'AA-' as of May 9, 2019.

Balancing Operating Expenses In An Increasingly Challenging Health Care Environment

Over the next seven to 10 years, there could be some additional debt needs as hospitals achieve the necessary structural and nonstructural compliance. In addition, general operating expenses might increase for the nonstructural work to meet the 2030 deadline, creating additional margin pressure for California hospitals as compared with hospitals in other states. Likely all of these projects will occur over multiple years, resulting in increased management focus on mitigation strategies and multiple years of related expenses and spending.

Achieving full nonstructural compliance could result in operating difficulties as facilities have to work around complex operational logistics to minimize patient care disruption while ensuring that the hospital's internal systems, utilities, and other structural elements can remain functional after an earthquake. That said, operating margins for rated California providers tend to be a bit higher than those for our larger universe of rated U.S. acute care providers, indicating some, though not significant, flexibility to absorb these costs (see chart 3). However, depending on the operating and potentially increased capital costs, coupled with the ongoing industry headwinds, these combined factors could be a hurdle for certain issuers.

Chart 3

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The Ratings Gap Is Widening Between California Health Care Issuers

From 2003-2018, we took rating actions on many providers but generally only by one notch (we included just the 32 issuers that had at least a 10-year rating history). As of March 5, 2019, slightly less than half of California providers remained at, or within one notch of, the original rating or the rating they had in 2003. As of Dec. 31, 2018, we upgraded about 12 organizations by more than one notch (from the initial rating). Based on this history, we believe most California rated acute care providers weathered the seismic compliance spending fairly well in the past 15 years.

The overall rating distribution changed from 2003 to 2018; however, it's difficult to draw many conclusions because the ratings universe isn't the same now as it was in 2003 and our sample size of rated California providers is smaller overall (41) versus the approximately 450 total acute care entities that we rate, which creates sample size limitations. Nevertheless, over 15 years (and looking every five years), the number of 'AA' rated providers increased while the non-investment-grade categories also increased--thus indicating a widening gap that is consistent with the national trend but more pronounced for California entities (see charts 4a and 4b).

California Versus U.S. Ratings Distributions

Chart 4a

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Chart 4b

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Partly affecting the ratings distribution and volatility is that rated California providers haven't remained static: Mergers, new issuers, and ratings withdrawals all added to the fluctuation. Furthermore, the number of rated California entities increased from 22 in 2003 (up from only 16 in 2000) to 41 as of December 2018. Some, though not all, of this increase could stem from the need for rated debt issuance to finance seismic compliance capital projects.

Hospitals Are Balancing Priorities So Far

We don't expect credit pressures across the board in the near term for rated California hospitals and health systems, but they all have, to different extents, a major, additional obstacle to navigate with seismic compliance mandates that hospitals in other states need not confront. That said, about 15% of California ratings have negative outlooks as of the date of this report, which indicates slightly increased pressure on issuers relative to the universe of rated acute care providers nationwide. We understand that structural and nonstructural performance-related projects might differ in size and scale for each organization depending on age and size of facilities, making it tricky to gauge the full impact. Many questions remain: Will seismic compliance legislation change or will deadlines be extended again? How much will actual structural and nonstructural upgrades cost and for how many years will they extend? Will seismic investment hamper a provider's ability to invest in other strategically important areas to remain competitive in a very dynamic health care operating environment? Lastly, there are unrated hospitals in California that are not part of our sample. How will the decisions of those organizations affect those in our sample? If unrated hospitals close, will it create additional demand for other hospitals? Will it compel health systems to step in and save hospitals from closure?

Our outlook on the health care sector is stable over the next year and although we cannot predict rating actions on California providers over the next 10 years, we know that many hospitals will choose to allocate their resources related to both operating needs and initiatives as well as capital dollars to maintain both financial and enterprise strength. We anticipate larger and higher-rated organizations will have more options and flexibility to manage both the seismic investments and other strategic priorities, while lower-rated entities (or those that are unrated and have limited financial flexibility) could find it difficult to fund and execute on seismic projects that could affect both the balance sheet and operating profile and widen the rating distribution further.

This report does not constitute a rating action.

Primary Credit Analyst:Suzie R Desai, Chicago (1) 312-233-7046;
suzie.desai@spglobal.com
Secondary Contacts:Martin D Arrick, San Francisco (1) 415-371-5078;
martin.arrick@spglobal.com
Kenneth T Gacka, San Francisco (1) 415-371-5036;
kenneth.gacka@spglobal.com

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