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Operating Room

Rising hospital costs, a plague to most companies, have helped some finance chiefs nurse profits back to health.

1Jan

The mid-1990s were promising years for most corporate finance chiefs trying to hold down health-care costs, but painful ones for hospital companies such as Tenet Healthcare. Like other hospital operators, Tenet was no match for the rapidly growing health maintenance organizations that were signing up cost-conscious employers by the thousands. Even in the Southern California market, where Tenet operated 12 facilities, it was in no position to argue with the HMOs during annual contract negotiations. If Tenet didn't agree to lower reimbursement rates, the HMOs would simply look elsewhere.


"We had to accept it," says David Dennis, who became Tenet's CFO in March 2000. "The managed-care companies were competing on price, and we had to share the pain."


To the dismay of companies that pay health-insurance premiums — and the relief of health-care providers like Tenet — the balance of power has changed dramatically. While consumers were rebelling against restrictive managed-care plans, hospital companies were acquiring their way to lower cost structures and improved bargaining positions with insurers. Now the nation's second-largest investor-owned hospital chain, Tenet bought 18 more Southern California hospitals over the past five years, and today wields far greater leverage with the health plans. "The days when [HMOs] get 10 to 20 percent premium increases and capitate their costs with us are over," says Dennis.


This hardly comes as a surprise to most finance chiefs. It's one reason that commercial health-insurance premiums increased by an average of 10.2 percent in 2001, according to the Kaiser Family Foundation's annual survey of employer-sponsored health benefits. The largest increase since 1992, it follows an almost 8 percent rise in 2000. And early indications from this year's insurance renewals suggest that rate hikes will continue higher for 2002.


For health-care providers, the trend is most noticeable in markets with high levels of managed-care penetration, like Southern California. But it's felt everywhere in the United States to some degree. At the same time, the government side of the hospital operators' business has also improved, at least marginally. In 1999, Congress passed legislation to restore some $8 billion of the estimated $97 billion of cutbacks in Medicare reimbursements through 2004 resulting from the Balanced Budget Act of 1997.


"The pendulum has shifted in our favor over the last few years," says Burke Whitman, CFO of Dallas-based Triad Hospitals. The chain of 47 middle-market hospitals, spun off in 1999 by HCA Corp., posted third- quarter earnings of $6.5 million, compared with a net loss of $1 million in the prior year, and its stock has more than tripled since the spin-off. Earnings at other investor-owned hospital chains — including HCA, Tenet, and small-market and rural providers like Health Management Associates and Lifepoint Hospitals — have also done well, making hospital stocks a favorite haven for investors in this tumultuous market. Indeed, the Morgan Stanley Capital International USA Healthcare Providers Index was up 74 percent in 2000, and was flat through December 3 of last year.


The sharply improved financial outlook for health-care providers, however, is far from universal, especially among the large majority of U.S. hospitals that operate on a not-for-profit basis. While the number of investor-owned hospitals has been growing in recent years, more than 8 of every 10 institutions are still nonprofit. And many of these cater to the population's most vulnerable, and least profitable, patients.


Among the 4,800 hospitals registered with the American Hospital Association (AHA), one third earn a profit, while another third break even, and the remaining third operate in the red, says AHA senior vice president Rick Wade. For most health-care providers, "the bottom line is not the driving force," he says. "Their first mission is to do good works and to organize the limited resources they have to meet that mission."


All CFOs have to consider parties with interests other than profits, of course, but hospital finance chiefs deal with an unusually broad range of powerful stakeholders, including doctors, patients, community leaders, and public health officials. Their jobs are a balancing act between what their community needs and what is financially feasible to provide. In fact, in many ways "the rules of the marketplace don't apply to hospitals and health care," says Wade.



Thinking Big in Texas
Whether a hospital is managed for profit or not, the first mandate for its CFO is the same as for any enterprise: ensuring the institution's financial viability. "No margin, no mission. All CFOs have to live by that," says Sally Nelson, CFO of the not-for-profit Texas Children's Hospital in Houston. "If I don't generate cash flow, I'm out of business." Few CFOs have expanded the mission as successfully as Nelson. When she joined the hospital in 1987, it had an operating loss of $17 million. An awkward separation from another hospital, St. Luke's, left Texas Children's with a broken billing system and a lack of administrative staff. Nelson says she was only days from missing payroll at one point. It took two years to bring the hospital back to break-even. Last year, Texas Children's recorded income of $37 million, for an operating margin of 4 percent, which was all plowed back into facilities, staff, new technologies, research, and education.


Texas Children's has the luxury of a $650 million endowment, though, and a matchless brand identity as one of the premier pediatric hospitals in the world. Still, Nelson watches the cost side of the equation carefully. In fact, she credits the managed-care companies for forcing her, and all hospital CFOs, to manage expenses more aggressively. With 40 percent of the patients at Texas Children's now insured by managed-care companies, Nelson has squeezed costs from both administrative and clinical processes to preserve margins.


On the mission side, Nelson recently spearheaded the hospital's largest capital-investment project since it opened in 1954: a 1.5 million-square-foot, 15-story addition to the original 4-story building, along with a 16-story outpatient clinical-care center. To manage the expansion, she brought hospital trustees, community leaders, and physicians on board early, along with the Baylor College of Medicine, which uses the hospital as a teaching facility. She also sold the plan to credit analysts, securing a AA/Aa2 Standard & Poor's Corp. rating — the highest for any Texas hospital.



What the Community Needs

For other nonprofits, like Boston Medical Center (BMC), the pressure to contain costs is far more intense. The 547-bed acute-care facility, formed by the 1996 merger of two money-losing nonprofits, originally was given long odds in its overcrowded market. But despite continued operating deficits, BMC still serves as a safety-net hospital for many of Boston's poorest residents.


"About 75 percent of our patients are still either insured by the government or underinsured," says CFO Ron Bartlett proudly. Last year, BMC provided $166 million in charitable care, most of which went unreimbursed. One of Bartlett's jobs is to find ways to continue funding services like neonatal intensive care, which will never be profitable for the hospital. "We wouldn't do it from a profit perspective," says Bartlett, "but our community requires it."


Those services get funded, in large part, by cutting costs elsewhere. Since the merger in 1996 (Bartlett arrived two years later), BMC has reduced the number of beds by about 20 percent, and has consolidated back-office functions like billing and payroll, and lab services for physicians. Bartlett also instituted a just-in-time inventory system, using outside vendors to supply logistical support, and hired pharmacy benefit managers to help control costs for prescription drugs not covered by government insurance.


The number of full-time equivalent workers at BMC has remained flat, despite increased hospital admissions. Labor accounts for more than 60 percent of a typical hospital's expenses, and virtually all hospitals have been increasing the workloads of their existing staffs. (Indeed, the war on costs over the last decade has had the unintended effect of driving nurses, pharmacists, and other lower-paid technical workers out of the industry. Many analysts believe that the resulting shortage of nurses, especially, will continue to hurt hospitals financially.)


Bartlett and BMC are not yet out of the woods. "I spend 20 percent of my day thinking about how we're going to survive," he says. Without a bond rating, because of its continued operating deficits, BMC hasn't issued any debt since 1998. And private donations, which amounted to $10 million last year, aren't enough to fund future investments. "We're going to have to spend between $150 million and $200 million over the next eight years," says Bartlett, "and I don't know where the money will come from."


This kind of financial pressure has in part encouraged some fundamental changes in the way hospitals provide services. Thanks to more-effective drug therapies and less-invasive treatment options, for example, 60 percent of surgical procedures are now performed on an outpatient basis, with little or no hospitalization, according to the AHA. At New York Health and Hospitals Corp., the largest municipally owned health system in the country, the average length of stay per admission has dropped by 35 percent over the past seven years, to 5.3 days, says CFO Rick Langfelder. "Prior to 1994, AIDS and tuberculosis were inpatient conditions for us," he says. "Now we treat them on an outpatient basis."


While hospitals generally receive lower reimbursements for outpatient care from Medicare and managed-care payers, their costs to provide such services are much lower. At New York Health and Hospitals, for example, revenues have fallen from $4.5 billion in 1996 to $4.2 billion last year, but lower costs have enabled it to post operating gains in all five years. The huge health- care system has cut its full-time workforce by 11,000 people over the past six years, and has reduced the number of hospital beds in its 11 acute-care facilities by more than 3,200.


The trend toward less-expensive outpatient care doesn't reduce the overall demand for hospital services, though. The number of hospital visits connected with outpatient care has more than doubled since 1980, and after 15 years of declines reflecting the outpatient trend, hospital admissions have been rising again since 1994.



The Power of Flexibility

For investor-owned hospitals, those trends, combined with the aging of the baby boomers, have created a profit environment that analysts say could hardly be healthier. "Commercial and Medicare reimbursement rates are both going up, and demand for services is increasing," says Kemp Dolliver of S.G. Cowen Securities, who has strong buy recommendations on the shares of Tenet, Triad, and Lifepoint.


At Tenet, market share increases via acquisitions in urban markets are producing impressive results. Same-facility admissions rose 3.5 percent and operating margins, based on earnings before interest, taxes, depreciation, and amortization (EBITDA), expanded by more than a point, to 19 percent, thanks in part to price increases of more than 6 percent from managed-care companies. "We've got the right amount of capacity, and we're offering the right services," says CFO Dennis, who expects Tenet to post at least 25 percent higher earnings for fiscal 2002.


Tenet's experience building its urban hospital base illustrates an advantage publicly traded chains have over nonprofits: the ability to choose the markets they serve. Nashville-based HCA has been able to sell or spin off many of the acquisitions it made in the mid-1990s, refocusing on large urban markets.


At Triad — one of HCA's spin-offs — the senior management team determined that a third of the 47 selected urban and midmarket facilities were either too small or too financially weak to fit into the new company's business strategy. Those facilities that required a significant capital infusion were especially unattractive to Triad. It began life as a public company with a debt-to- equity ratio of 5.5-to-1. The sale of 17 hospitals brought leverage down to about 3-to-1, and enabled Triad to buy competitor Quorum Health Group last April.


Triad's success, says CFO Whitman, depends on its good relations with doctors--the biggest driver behind the company's industry-leading, same- facility admissions growth of 8 percent. "We provide services for patients on the recommendations of doctors," he says. "They are our customers, and we have to earn their respect and referrals."


Doctors get strong representation on local hospital boards, and the resources they need for their practices. If that cuts into hospital profits, so be it, says Whitman. Triad's EBITDA margin of just under 15 percent last year is one of the lowest in the industry. "We made a deliberate decision to move slowly so we wouldn't disrupt the relationships we're developing," the CFO explains. A good strategy, if you can afford it.



Andrew Osterland is a senior editor at CFO.



The Medicare Millstone


The average hospital derives 39 percent of its revenues from Medicare patients. For hospital CFOs, though, getting paid under the federal system for Americans 65 and older and the disabled can be frustrating.


Launched in 1965, Medicare first reimbursed on a cost basis. Good for providers; not so good for taxpayers. Since 1970, fees have been fixed for health-care services — leading to different billing codes for everything from tongue depressors to open-heart surgery. "The system is incredibly complicated," says CFO Rick Langfelder of New York Health and Hospitals Corp.


And underfunded. The system was headed for insolvency until 1997, when Congress passed the Balanced Budget Act and cut expected payments to hospitals by nearly 12 percent through 2004. The American Hospital Association now expects the cuts will create an average 4 percent operating deficit on Medicare patients by 2004.


Already 60 percent of hospitals lost money on Medicare in 2000, according to the association. "We get paid about 70 cents on the dollar treating Medicare patients," says Tom Lenkowski, CFO of Southwestern Vermont Health Care Center, in Bennington. Small-market providers say they are shortchanged by reimbursement formulas factoring in regional wage costs. Like many CFOs, Lenkowski shifts uncompensated costs to commercial insurance payers. "It plays havoc with premiums for companies in our region," he says, "but somebody has to make up the shortfall." —A.O.

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