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Trouble Ahead: Higher Interest Expense Strains 'B-' Rated U.S. Health Care Credits

Low Interest Rates Allowed Health Care Companies To Rack Up Debt

The U.S. for-profit health care industry, a traditionally defensive one, has evolved over the past 10 years, amid significant structural changes as public and private payers seek to control rising costs. Significant interest from private-equity investors, combined with very high valuations, has increased the concentration of highly-leveraged firms rated 'B' and below and increased adjusted leverage versus the corporate average. (See "Private Equity-Backed Investor Interest In Health Care Has Taken A Toll On Ratings", published March 2, 2020, for more regarding private-equity activity in health care.)

In addition to considerable consolidation in exceedingly fragmented markets, many service companies with private-equity sponsors attempted to take advantage of low interest rates to create new business models and address an ongoing shift to new payment methods, investing heavily upfront with the prospects of addressing the evolving market. Meanwhile, following the Health Information Technology for Economic and Clinical Health (HITECH) Act, hospitals, ambulatory centers, and physicians quickly adopted technology such as electronic health records (EHR) and revenue cycle management (RCM) software. This created another significant growth opportunity and attracted additional attention and investment.

These companies, especially health care information technology (HCIT) providers, also invest heavily upfront, expecting substantial EBITDA growth within 18-24 months of investments. As such, the health care sector has increased debt issuance over the past several years as firms sought to increase scale and gain market share, realize greater efficiencies, increase negotiating leverage with payers, and fund capital expenditures (capex) and strategic business initiatives. Some have supplemented organic revenue growth with debt-financed M&A while others have funded shareholder-friendly activities. Health care providers and services is now the second most represented sector in U.S. collateralized loan obligations (CLO), after software, due to continued CLO demand for loans from this subsector.

As investors hunted for increased yield in a prolonged low-interest-rate environment, the balance sheets of health care credits built up record leverage. This combined with lower-than-average EBITDA interest-coverage ratios among the speculative-grade health care credits has significantly deteriorated credit quality. Speculative-grade companies have been on the rise, with about 74% of health care issuers (162 of 218) rated 'B' or below as of Sept. 15, 2022, significantly more than the approximately 51% of U.S. nonfinancial corporate issuers. This is comparable to software, professional, and business services.

Chart 1

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Of those 218 health care sector issuers, about 59% are owned by private-equity sponsors, and we rate about 50% of them 'B-'. These firms are generally highly leveraged, with median S&P Global Ratings-adjusted leverage of 9.7x, FOCF to debt below 1%, and EBITDA interest coverage of 1.8x in 2021. Often owned by private-equity firms with short to medium time horizons to monetize investments, prioritizing shareholder returns over decreasing leverage, many focus on rapid growth. They often add significant leverage and generate modest cash flows, if any.

S&P Global Ratings uses two key measures of leverage: debt-to-EBITDA and funds-from-operations-to-debt ratios (refer to our ratios and adjustments criteria). As of December 2021, median adjusted debt to EBITDA for speculative-grade companies in health care was 7x, more than a turn higher than the nonfinancial corporate median of 5.6x. Narrowing to 'B-' credits alone, median adjusted leverage for health care companies was a historic high of 9.4x, about a turn higher than the North American corporates median of 8.3x. Meanwhile, EBITDA interest coverage has declined over the past 10 years to the corporate median from above that for nearly a decade. While debt-financed acquisitions and investments have strengthened the business propositions for some speculative-grade companies, we believe the added financial risks attributable to this debt are significant. Excessive leverage can leave a company more vulnerable to disruptive business conditions and liquidity problems due to rising financing costs, as in the current environment.

Chart 2

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Chart 3

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'B-' Rated Health Care Credits Will Add High Interest Expense To Their List Of Woes

Health care companies are already grappling with multiple operational challenges, including supply chain disruptions, a tight labor market, wage inflation, and reimbursement pressures, all of which have reduced profitability and increased leverage, heightening the risk of tightening liquidity cushions. The expanding supply-demand gap for medical workers has challenged providers' ability to staff at capacity to avoid paying surge-pricing for temporary nurses, increasing their cost structures 100-150 basis points (bps) and pressuring profitability. We view this as a structural shift and do not expect this pressure to subside, forcing providers to find innovative ways to maintain margins (see "U.S. Health Care Staffing Companies Benefit From Growing Labor Imbalances," Aug. 25, 2022). In addition, reimbursement is an ever-present risk for providers, with pressure from rate cuts and payers consistently affecting margins and cash flows.

Health care provider staffing shortages have also slowed the pace of implementation of new contracts for HCIT companies such as EHR and RCM firms. The latter tend to be highly leveraged and are coping with shortages of engineers while more labor-intensive companies with more manual processes compete for lower-skilled talent. HCIT software companies may also experience trickle-down pressure from reimbursement cuts, as they often price contracts with providers based on a percentage of collected patient service revenue. Finally, we believe it's likely hospitals will scrutinize their spending, prioritizing more immediate needs over technology investments, which may slow EBITDA growth expectations for HCIT providers.

Meanwhile, medical device manufacturers grapple with the availability of raw materials and intermediate goods, such as microchips, input costs inflation, and higher fuel and freight costs, sometimes exacerbated by understaffed factories. Lower or delayed volumes sometimes require them to purchase inputs at premium prices or pay premium shipping. Depending on the nature of their contracts and ability to negotiate with providers, these companies may be unable to pass all these costs through, deteriorating margins.

'B-' Rated Companies May Have Difficulty Covering Interest Expense And Will Watch Cash Flow Vanish

The Fed has lifted its benchmark overnight interest rate an additional 75 bps to a target range of 3%-3.25% and, maintaining its commitment to tamp inflation back to its 2% target, will likely continue to raise rates over the coming quarters. We expect the Fed to prioritize easing U.S. inflation pressures over economic growth, with Chair Jerome Powell's Sept. 21 comments that the Federal Open Market Committee's overarching focus right now is to bring inflation back down to its 2 percent goal guiding our expectations. The panel holds eight regularly scheduled meetings per year to determine the appropriate stance of monetary policy. It will meet twice more this year, in November and December.

Given high uncertainty in the current environment, we have developed several downside scenarios based on the assumption that persistent high inflation in the U.S. could require a continued aggressive Fed response. Assuming the Fed prioritizes addressing inflation, price pressures broadening further across the supply chain could place it in the difficult position of having to further accelerate tightening of monetary policy even as growth slows and maintain it for longer than originally expected.

We expect a plunge in economic activity and rising recession risk (see our most recent forecast, "Economic Outlook U.S. Q4 2022: Teeter Totter", published Sept. 26, 2022) would be less impactful on the defensive health care industry than for many others, especially since rising unemployment would be somewhat offset by severe labor shortages in the industry. Meanwhile, higher rates, especially if prolonged, could impair a significant portion of rated health care firms, about 74% of which we rate in the 'B' category and below. As such, while the creditworthiness of many corporate issuers rated in the 'B' category could be more sensitive to business weakness, health care companies may be more wary of interest hikes.

The impact of favorable credit conditions over the past several years allowed health care capital structures to become gradually more aggressive, with high debt-to-EBITDA ratios and very modest cash flow.   Companies have taken advantage of the low cost of debt to increase their M&A spending even at high multiples and investments in growth projects, often relying on stronger EBITDA growth in the next 18-24 months to lower leverage and produce operating cash flow. Financial sponsors have also paid high multiples for leveraged buyouts in health care and HCIT, further burdening balance sheets and sometimes taking large dividends to monetize their investments. (For more regarding HCIT trends, see "Ratings Upside Is Limited In The Burgeoning Health Care IT Industry", published March 10, 2022.)

On Sept. 21, Mr. Powell reiterated his Aug. 26 comments at Jackson Hole to affirm that "restoring price stability will likely require maintaining a restrictive policy stance for some time." To assess the effect of rising interest rates on low-rated speculative-grade companies, we calculated the interest costs of all 'B-' rated U.S. health care issuers should interest rates rise 350, 400, 450, and 500 bps versus interest paid in 2021. Most 'B-' credits are funded with floating-rate debt and thus more vulnerable to changes in interest rates. About 73% of the debt issued by 'B-' health care companies is variable rate. We found that if interest rates were to increase 400 bps from 2021, the group's median interest coverage ratio (EBITDA less capex, divided by interest) would drop to 1.42x in 2023 from our expected 1.59x.

Chart 4

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Some companies have entered into interest rate caps and swaps to hedge rising interest rates on their variable rate debt, providing some cushion under the current environment. However, for most other companies with no hedging instruments, a further rise in interest rates will tighten liquidity. Even for companies that entered into swaps/hedges to manage their exposure, many still face exposure to the lower yet elevated LIBOR rate increase of 350 bps, as caps only protect above a certain threshold. Many companies have protected only a portion of their variable debt or have instruments expiring within the next 24 months. Finally, companies that entered into these instruments in the past year are incurring higher costs for these protections.

With cash flows dwindling, some "belt-tightening" could soon take hold.  For many smaller health care issuers, cash flow after capex is very thin. Under our base-case forecast, we project about 50% of 'B-' rated health care companies will have FOCF to debt below 3% and 27% below 1% in 2023. A 400-bps increase over 2021 interest rates could severely cut into cash flow generation and increase the percentage of issuers with less than 3% FOCF to debt to 61% of companies and below 1% FOCF to debt to 39%. Dwindling cash flows due to rising interest rates may further deteriorate their credit quality. While some may curb growth capex to produce cash flow if needed, they may do so at the detriment of growth, especially high growth and highly competitive industries (such as HCIT) in which significant research and development and capitalized software may be required to remain competitive.

Chart 5

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High interest expense and resulting low cash flow expectations may lead companies with more variable costs to revisit their operating expenses. Although companies with more variable cost structures may contract some of their costs as needed, this may be a harder lever to pull if demand remains stable despite macroeconomic pressures--as expected for many health care companies.

Refinancing risk remains a concern for weaker issuers with upcoming maturities.  High leverage ratios and deterioration of interest-coverage ratios leave the sector exposed to potential cash flow and liquidity issues. 'B-' rated health care companies will need to rely on capital markets access to meet upcoming maturities and, potentially, new debt issuance to cover capex and permanent working capital. 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. Nevertheless, many issuers have taken advantage of the low interest rate environment over the last few years to refinance and push off maturities.

Chart 6

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Table 1

Health Care Companies With Debt Maturities In The Next Two Years
Issuer Rating Debt type Date Downside trigger

AG Parent Holdings LLC

B-/Positive Revolver July 2024 We could revise our outlook if we expect FOCF to debt to be below 3% (excluding net working capital sources of cash) or anticipate its leverage will generally remain above 7x. This could occur due to a more aggressive financial policy involving debt-financed acquisitions or dividends. Alternatively, we could revise the outlook to stable if we expect EBITDA margins to continue contracting beyond 2022. This could occur due to operational headwinds such as those stemming from intensified competition, an unexpected loss of clients, operational disruptions that undermine the company's reputation, and/or changes to regulatory requirements that simplify the safety reporting process (e.g., the international harmonization of data requirements).

Air Methods Corp.

B-/Stable Revolver Term loan April 2024 April 2024 We could lower our rating within the next 12 months if the company's performance significantly underperforms our base-case assumptions. This could result from a substantial increase in bad debt, a large resurgence of COVID-19 hospitalizations, unfavorable weather conditions, or a larger-than-anticipated reduction in earnings attributable to the implementation of the No Surprise Billing Act. These factors could constrain liquidity and lead us to conclude that the capital structure is unsustainable.

Alvogen Pharma US Inc.

B-/Negative Asset-based lending facility Term loan Dec 2024 Dec 2023 We could lower our rating within the next 12 months if the company cannot address its upcoming debt maturities or expected improvement in profitability and operating cash flow doesn't materialize due to poor execution of recently launched products or further delays to upcoming products. This could lead to liquidity constraints and us to conclude that the company's capital structure is unsustainable.

Azalea TopCo Inc.

B-/Stable Revolver July 2024 We could lower our rating if the company's free cash flow cannot cover fixed charges, including debt amortization. This could happen as a result of significant client loss and market share or an unexpected setback in integrating recent large acquisitions.

Buccaneer Intermediate Holdco Ltd.

B-/Stable Revolver Sept 2023 We could consider lowering the rating if cash flow generation is persistently negative. This could occur if market activity slows or operational issues reduce revenue or EBITDA, at which point we could consider the capital structure unsustainable.

Covenant Surgical Partners Inc.

B-/Stable Revolver July 2024 We could consider a downgrade on discretionary cash flow deficits over an extended period, leading us to view the capital structure as unsustainable. Cash flows could turn increasingly negative due to a reduction in reimbursement, higher-than-expected costs due to staffing shortages of skilled personnel, or poorly performing acquisitions and integration problems. We could also consider a downgrade if the company aggressively completes too many acquisitions, requiring additional debt, potentially further constraining cash flow.

Golden State Buyer Inc.

B-/Stable Revolver June 2024 We could lower our rating if operating performance is affected by a significant event leading to sustained, persistent cash flow deficits without prospects for improvement. A change in the government's procurement process that substantially impairs the company's ability to compete on contracts, significant U.S. Veterans Affairs or Department of Defense budget cuts for generic drugs, or persistent aggressive pricing from competitors. We could also lower our rating if the attractive discounts it receives from its primary distributor are adversely revised, materially contracting margins, sustaining cash flow deficits, and leading us to believe the company's capital structure is unsustainable.

*Greenway Health LLC

B-/Negative Revolver Term loan Nov 2023 Feb 2024 We could lower the rating within the next 12 months if we believe the capital structure is likely unsustainable or the company cannot refinance debt. In this scenario, we would expect sustained cash flow deficits resulting from the company underperforming our expectations. We think this could occur if customer retention rates are worse than expected (with lower revenue expectations) or the company does not capture cost reductions as much as projected.

LifeScan Global Corp.

B-/Stable Revolver Term loan Oct 2023 Oct 2024 We could lower the rating in the short term if the company fails to extend the revolver maturity due in October 2023. We could also lower the rating if the refinancing prospects of the company's first- and second-lien debt (due October 2024 and October 2025, respectively) become less certain due to further deterioration in the BGM segment (including acceleration in rebates outflows) or further delay in the CGM launch.

Mercury Parent LLC

B-/Stable Revolver Feb 2023 We could lower the rating over the next 12 months if free cash flow deficits in 2022 are larger than expected or increased uncertainty in the company's ability to return to positive free cash flow. This could occur if the clinical solutions business struggles to expand its non-COVID-19 business. This scenario is also possible if the company pursues significant debt-financed acquisitions or due to a disruption in the health-assessment business.

NMN Holdings III Corp.

B-/Stable Revolver Nov 2023 We could lower our rating in the next 12 months if cash flow generation weakens such that it is insufficient to cover fixed charges on a sustained basis, leading us to consider the capital structure unsustainable. This could occur on significant supply chain disruptions, greater-than-expected pricing pressures from its wheelchair suppliers, a reimbursement cut from government payers, or billing-related complications. We also believe refinancing risk could rise because the company's primary source of liquidity, a $50 million revolver, matures in November 2023.

Quincy Health LLC

B-/Stable Asset-based lending facility July 2024 We could lower the rating if the company underperforms relative to our base-case scenario. This could occur if operating performance at hospitals deteriorates, likely involving persistent cash flow deficits. We would therefore believe the capital structure is unsustainable and that Quincy could not support its debt burden over the long term.

ScribeAmerica Intermediate Holdco LLC

B-/Stable Revolver April 2023 We could consider a lower rating if we do not expect sustained revenue growth (e.g., sequential revenue declines) or the company has difficulty maintaining margins and producing cash flow, leading us to believe it faces increasing refinancing risk ahead of the 2025 maturity.

Spectrum Holdings III Corp.

B-/Stable Revolver Jan 2023 We could lower our rating on Spectrum if it faces persistent free cash flow deficits, which may suggest its capital structure is unsustainable. This scenario would entail little to no organic growth, no margin expansion, or margin declines potentially from cost pressures, supply shortages, or significant integration challenges with acquisitions.

Team Health Holdings Inc.

B-/Stable Revolver Nov 2023 We could lower our rating within the next 12 months if we consider its capital structure unsustainable over the long term. Under this scenario, we believe adjusted FOCF to debt would likely be below 1.5% for a prolonged period. This could occur if higher costs result in weaker-than-expected EBITDA margins or patient volumes are lower than we anticipate, potentially due to the spread of a new COVID-19 variant, increased competition, or a contract loss. This could also occur if liquidity significantly deteriorates and we believe the company's sources are insufficient to cover its fixed charges.

Waystar Technologies Inc.

B-/Stable Revolver Oct 2024 We could lower the ratings if growth far underperforms our base case. We believe competitive forces are the most likely factors that could hurt its bookings or ability to raise prices. We would need to see a sustainable erosion of EBITDA margin of at least 300 basis points, which we believe could result in leverage above 11.5x and nearly zero free cash flow. Another path to a lower rating includes large debt-financed acquisitions or dividend recapitalization that meaningfully raises interest payments and erases cash flow.

WellPath Holdings Inc.

B-/Stable Revolver Oct 2023 We could lower the rating on further EBITDA margin compression and sustained cash flow deficits due to higher-than-expected expenses if the COVID-19 pandemic extends longer than we expect. Another scenario might include difficulties with business integration or those that could lead to damage to its brand, loss of customers, or fewer synergies. We believe this scenario could lead to covenant tightness and liquidity constraints, keeping leverage above 10x, and us to view the capital structure as unsustainable.

YI Group Holdings LLC

B-/Stable Revolver Term loan Nov 2023 Nov 2024 We would consider a downgrade if performance deteriorates such that it sustains leverage of more than 10x and FOCF remains negative. We believe this could occur if its EBITDA margin contracts by about 150 basis points from our projections.

*Zotec Partners LLC

B-/Stable Revolver Term loan Feb 2023 Feb 2024 We could lower the rating if the company falls short of organic growth and cash flow expectations, leading us to expect cash flow deficits over an extended period and lowering our confidence that it will refinance debt.
*Weighted-average maturities within two years.

This report does not constitute a rating action.

Primary Credit Analysts:Sarah Kahn, Washington D.C. + 1 (212) 438 5448;
sarah.kahn@spglobal.com
Richa Deval, Toronto + 1 (416) 507 2585;
richa.deval@spglobal.com
Secondary Contact:Arthur C Wong, Toronto + 1 (416) 507 2561;
arthur.wong@spglobal.com
Research Contributors:Michael Fedorko, New York +1 2124380955;
michael.fedorko@spglobal.com
Nicholas Carino, New York +1 2124380956;
nick.carino@spglobal.com

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