Becoming a (Financially Stable) System

The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.

Before Watauga Medical Center merged with two other hospitals to form the Appalachian Regional Healthcare System, the 117-bed rural North Carolina facility had historically maintained a strong 5 percent operating margin and a comfortable amount of cash on hand.

But soon after, the system ended a year $10 million in the red with a bank’s noose tight around its neck and the collapsing credit markets pulling it tighter.

To thrive in its newly systemic configuration, ARHS would have to improve its internal operations and convince an increasingly skeptical external market of its rediscovered strength and stability. The efforts resulted in an investment-grade rating for the rural system and a more affordable new debt structure designed to be easily adaptable to future system needs.

Relearning to thrive
As part of its strategic plan, Watauga joined with Cannon Memorial Hospital and Blowing Rock Hospital, two nearby critical access hospitals, to become Appalachian Regional Healthcare System. Neither critical access hospital was profitable on its own, and ARHS slid quickly into an operational downturn. It didn’t immediately create efficiencies to reduce operating costs among the three hospitals, and Watauga’s cash position wasn’t strong enough to support all three without changes.

“When you change the whole complexion of operations, you can’t keep doing the same thing and expect different results,” said Kevin May, who became chief financial officer of Appalachian Regional Healthcare System after the merge.

Because the hospitals lacked true competitors in their region, gaining market share was not a reasonable route to improve operations. With no opportunity to add patients, they would have to cut expenses and improve revenue cycle operations.

Turning the financials around took about two years, and while the hospitals continued to work through their cultural and service line evolution, the fiscal impact has been dramatic. Revenue cycle automation improvements mean that only 5 percent of bills must be touched by a person, down from nearly 100 percent. The system's days in accounts receivable financial ratio dropped from 75 to 40 with better payment collection methods. And in reopening cost reports, the system identified $1 million in missed reimbursement opportunities.

Considerable attention has also been given to IT: In the past, top-of-the-line software products purchased for the radiology, pharmacy, lab and other areas were highly functional in their own spheres, but didn’t integrate well. Now, new, integrated software is being deployed to improve communication among departments. Improved financial reporting and greater accountability has reduced the number of audit adjustments from 110 to 0, and senior leadership and the board have access to more accurate financial information to better inform decisions.

Watauga also applied for, and received, sole community provider status in 2009. "That brought the appropriate amount of Medicare reimbursement to Watauga, and it was significant," May said.

The new system went from losing $10 million in operations one year, to losing $500,000 from operations the next, to earning about $7 million — an $18 million turnaround in two years on a $140 million system-wide budget, May said.

With their financials turned around, ARHS had the perfect opportunity to present its new face to the capital markets and revamp its entire debt structure.

Approaching the markets
Before its turnaround, ARHS had a 12-month letter of credit enhancing $31.4 million in bonds, and the same bank that issued it was also the counterparty on an interest rate swap on the hospital’s variable-rate debt. The system had to renew its credit facility every year with a bank that held all the leverage.

Almost simultaneous with ARHS' internal growing pains came the credit collapse of 2008. Banks nationwide became more cautious about extending credit to all but the strongest borrowers, and many hospitals’ banking relationships soured. ARHS, already under scrutiny for violating debt covenants, was put on a tight leash: the term of their letter of credit facility was cut to 10 months, the fee charged by the bank went up, and costly modifications to legal documents were required. The hospitals fortunately had already created a workout plan to address deficiencies.

"We accomplished what we said we were going to accomplish, but it certainly didn’t come without pain," May said.

Besides being tied to a constantly-expiring letter of credit, Watauga Medical Center was the sole obligor on the existing debt, a setup that had become increasingly burdensome. It was also providing financial support to Cannon Memorial and Blowing Rock hospitals, necessitating a debt structure that would allow for undisturbed flow of funds throughout the system.

Lancaster Pollard walked ARHS through obtaining a credit rating, using the credit writeup to articulate the hospitals’ impressive turnaround, efficient operations and Watauga’s commitment to provide ongoing support to Cannon and Blowing Rock. The obligated group structure, combined with the system’s continued operational improvements, provided Standard & Poor’s rating agency the assurance it needed to offer an investment-grade BBB+ credit rating.

The $35.5 million refinance was structured with fixed-rate, tax-exempt bonds. With no renewal risk, ARHS now has a stable debt structure that includes the flexibility to easily issue additional debt in the future.

A Common future, an uncommon task
Watauga, Blowing Rock and Cannon merged together to create an entirely new system and then worked together to get the new obligated group on strong financial footing. Nationwide, many other hospitals find themselves seeking ways to create formal affiliations with other facilities to improve operations and care delivery. A July 2011 report by Irving Levin Associates suggested 2011 might be a record year for health care mergers and acquisitions. Preliminary figures showed 32 hospital M&A transactions completed in the second quarter of 2011, compared to 24 in the first quarter and 18 in the second quarter of 2010.

"Hospitals continue to digest the new health care reform law and to wrestle with its implications. One conclusion they have drawn is, come what may, there is strength in numbers. Accordingly, they are buying other hospitals and physician medical groups to build up local and regional systems, implement ACOs—accountable care organizations—and share financial risk and reward through a more diversified provider network," noted Stephen M. Monroe, managing editor at Irving Levin Associates, Inc., which publishes "The Health Care M&A Report."

Bringing new hospitals into a system or affiliate agreement, or creating a system as ARHS did, isn’t like becoming brothers, May said. It’s more like becoming conjoined twins. And it’s not something hospital leaders do every day, every year, or even every decade. Financial downturns should be expected, according to health care consultants, but hospitals can prepare for them.

ARHS is still adjusting to its new form, but May offers several suggestions for hospitals that are considering forming or becoming part of a system:

  • Have a solid business plan.
  • Be conservative in borrowing and realistic about how much the system can afford to pay back.
  • Make sure the hospitals involved get to know one another’s cultures, including medical staff, operations and how they operate.
  • Engage outside experts to help integrate systems and services.
  • Use debt rather than liquidity to finance projects, at least until the hospital has built a comfortable financial cushion.

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