How to do Business Analysis of Hospitals

The current article aims to discuss the key features of the business model of hospitals. After reading the current article, an investor would know the factors that make any hospital a strong player. She would also know how the operating environment for Indian hospitals may evolve in the future to change their pricing power and competitive landscape.

The hospital industry is classified into multiple segments based on the level of specialized care and the size of the hospital represented by the number of beds e.g. primary care/daycare centres, secondary care/a few specialities and tertiary care/referral centres.

However, from a simplistic understanding perspective, an investor may divide hospitals into two groups. The first is large super-speciality hospitals providing complex healthcare that may also have medical colleges attached to them and the second group is smaller hospitals and daycare centres that provide simpler healthcare services.

During the current article, we would discuss the business characteristics of the hospital from the perspective of these two segments i.e. large super-speciality hospitals and other smaller hospitals because, in many aspects, these two groups have slightly different business strengths and challenges.

Key features impacting the business model of hospitals

1) Low cyclicity in the demand for healthcare services:

The demand for healthcare services is not linked to general economic cycles of boom and bust. This is because people get sick and therefore avail services of hospitals irrespective of the state of the economy. As a result, healthcare services providers face a low cyclicity in the demand for their services.

Rating methodology for hospitals, ICRA, September 2020 (click here), page 3:

ICRA considers the low cyclicality associated with the hospital business favourably as demand for healthcare services is largely insulated from macroeconomic cycles.

As per the credit rating agency, Standard & Poor’s (S&P), in the past recessions, the revenue of the healthcare services industry did not witness any decline whereas the profit margin declined only in the range of about 3% to 6%, which indicates a low level of cyclicity in the industry.

Key credit factors for the health care services industry, Standard & Poor’s, April 2014 (click here), pages 3-4:

Historical data supports this view, showing no cyclicality of revenues and low cyclicality of profitability, which are the two key measures used to derive an industry’s cyclicality assessment. Based on our analysis of global Compustat data, health care services companies experienced no peak-to-trough (PTT) decline in revenues during recessionary periods since 1968, including the severe 2007-2009 recession. The EBITDA margin of health care services companies experienced an average PTT decline of 6.2% during the longer period, and a smaller decline of 3.8% in the 2007-2009 recession.

Some segments of healthcare services, especially lifesaving and life-sustaining procedures do not face any cyclicity. It includes emergency services and procedures like kidney dialysis etc. In these segments, a person cannot postpone the treatment. Therefore, healthcare services have nearly stable demand irrespective of the stage of the economic cycle.

Some of the segments like dental services or other elective procedures may witness a decline in demand during an economic slowdown. This is especially true in countries where a large amount of healthcare expenditure is paid by insurers and during an economic slowdown, people lose insurance due to job losses.

Key credit factors for the health care services industry, Standard & Poor’s, April 2014, page 4:

Demand for health care services is somewhat shielded from general macroeconomic cycles because disease occurrence and prevalence (in developed countries) do not vary with the economy…overall demand is modestly sensitive to the employment rate, in part, because lack of a job may mean lack of health insurance…Routine check-ups and elective procedures may be deferred for economic reasons.

Therefore, even though during economic slow-downs, job losses may lead to a decline in elective and non-critical procedures; nevertheless, a major portion of healthcare services continues to see stable demand. As a result, the healthcare services sector has a low level of cyclicity.

India has sustained demand for almost healthcare service institutions because currently, the penetration of quality healthcare in India in terms of proportion of beds or healthcare spending by Govt. is very low than global standards.

Rating methodology for hospitals, ICRA, September 2020, page 2:

The country currently has 7 beds per 10,000 of the population compared to 38 beds per 10,000 in the US, 23 in China, 22 in Brazil and the global average of 27.

India spends about 3.6% of its GDP on healthcare, which is significantly lower than the US (16.9%), Brazil (9.2%), South Africa (8.1%), Russia (5.3%), China (5%) and the global average of 8%.

Low investment in the healthcare sector in India has led to a high burden on the existing healthcare institutions, which also leads to a high-sustained demand and a low cyclicity.

2) Capital intensiveness:

Establishing a hospital is an expensive project. The company needs to find out a suitable land parcel at a prominent location, and invest a significant amount of money in buildings, and expensive medical instruments. This is especially true for large super-speciality hospitals that attempt to have the latest equipment including robots and employ highly qualified medical professionals.

Rating methodology for hospitals, ICRA, September 2020, page 2:

The capital investment required for setting up a hospital is high, due to requirement for land and building in an easily accessible location and need for expensive medical equipment and infrastructure

In addition, when a new hospital is set up, then for the initial period of operations called the gestation period, the earnings of the hospital are not sufficient to cover its investments and expenses; therefore, it suffers losses during the gestation period. During this phase, the investors need to put in more money to sustain the operations of the hospital, which adds to the capital intensiveness of a hospital.

Rating methodology – hospital industry, CARE, August 2020, page 2:

commitment of the promoters not only in the form of equity but also their ability to continuously support during the initial years of operations for loss funding

Moreover, a hospital needs a continuous investment of money to expand and upgrade its services, which puts a lot of strain on the financial strength of the company.

Rating methodology for hospitals, ICRA, September 2020, page 6:

Hospitals have significant re-investment requirements for expansion and upgradation of facilities

Investments in the continuous upgradation of facilities are essential for hospitals because an ability to provide complex healthcare services with the latest equipment leads to better profit margins for the hospital.

Rating methodology for hospitals, ICRA, September 2020, page 3:

complex medical service offerings improve a hospital’s pricing power and leads to better margins.

Therefore, establishing a hospital is a capital-intensive project, which creates a barrier to entry for new players.

Rating methodology for hospitals, ICRA, September 2020, page 2:

Due to high capex requirements and a multitude of approvals required to set up a hospital, the barriers to entry are considerable.

Further advised reading: How to do Business Analysis of a Company

3) In the hospital business, size matters the most; big gets bigger:

Large super-speciality hospitals have a significant competitive advantage over the smaller hospital with limited healthcare facilities.

3.1) Diversification:

Large hospitals are usually much diversified in terms of service offerings, patient profile as well as geographical coverage.

Large super-speciality hospitals are able to offer treatment under many different specialities as well as both basic and advanced level healthcare, which helps the hospital earn high margins as well as earn stable revenue. For example, cardiology and neurology provide high-margin whereas gynaecology & obstetrics, paediatrics and radiology provide a lot of stable revenue to the hospital.

Rating methodology – hospital industry, CARE, August 2020 (click here), page 3:

healthy mix of speciality-wise diversification is important for hospital entities, as while some specialities such as cardiology and neurology are high-margin contributors whereas others such as gynecology, pediatric, and radiology contribute most to the occupancy.

In addition, the presence of many specialities, as well as the ability to provide advanced-level complex healthcare, allows large super-speciality hospitals to prevent referral of patients outside their hospital and earn a higher share of the healthcare expenditure of the patients.

Rating methodology – hospital industry, CARE, July 2019 (click here), page 2:

A higher level hospital is able to keep more patients and not required to refer out patients for services not provided by it.

Similarly, large super-speciality hospitals are able to maintain a healthy mix of patients from insurance/institutional sources, self-paying domestic and international patients.

Institutional patients like govt. schemes (CGHS, EHS, ECHS etc.) as well as govt. departments (centre/state govt. employees /defence or PSUs) usually provide a lot of patient business to hospitals; however, these agencies usually negotiate lower/competitive prices of treatments with the hospitals. Therefore, this segment of patients is a high-volume low-margin business for the hospitals, which ensures increased utilization of hospital infrastructure. In addition, these agencies make payments after some time to the hospitals.

Rating methodology for hospitals, ICRA, September 2020, page 3:

institutional patients that are Government scheme-linked or institution-linked may provide lower pricing and longer payment cycles but may generate healthy volumes, which provide a cushion in absorbing the high fixed costs of running a facility.

On the contrary, out-of-pocket paying patients, insured patients as well as international patients provide high margin business to hospitals.

Rating methodology for hospitals, ICRA, September 2020, page 3:

Non-institutional patients such as the out-of-pocket patients, insurance-paid patients and walk-in international patients provide hospitals with better pricing and collection cycles but these may or may not provide the requisite volumes to attain optimal occupancy.

An investor may note that until now in India, hospitals are able to earn a high-profit margin from insured patients; however, as we would discuss later in this article, the experience of the developed world indicates that, over time, as the insurance coverage increases, the negotiating/pricing power shifts from the hospitals to the insurance companies.

Nevertheless, a diversity of patient profiles help the hospital bring stability to its business.

Apart from a better diversification of speciality services and patient profiles, large super-speciality hospitals are also able to open a chain of hospitals across many different markets. It protects them from risks arising from the geographical concentration of revenue like calamities e.g. earthquakes, fire etc., labour strikes etc.

Rating methodology for hospitals, ICRA, September 2020, page 3:

A hospital with a large revenue base is more likely to have a diversified operational profile, thereby lending stability to operations. Further, large hospitals tend to exhibit stronger earnings profiles, providing necessary resources to expand and invest.

Smaller clinics/hospitals may not get such kind of diversification benefits, which increases their business risk as well as volatility/fluctuations in their financial performance.

Rating methodology for hospitals, ICRA, September 2020, page 3:

A larger revenue base is viewed as a positive factor, as smaller hospitals tend to exhibit higher revenue volatility due to their dependence on a few specialities or consultants, indicating high concentration risk.

Further advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

3.2) Pricing power:

Large super-speciality hospitals enjoy a high pricing power over their customers i.e. patients.

Rating methodology – hospital industry, CARE, August 2020, page 2:

hospitals with multi-speciality are better placed as compared to a single speciality in terms of pricing power.

The size of the hospital provides benefits in many other operational aspects as well. For example, a large hospital has better bargaining power with its suppliers as well as with highly-skilled medical professionals.

Hospital industry – key success factors, credit rating agency Pefindo, Indonesia, November 2021 (click here), page 1:

Strong market position will also lead the company to have favorable bargaining power in negotiation process with the doctors and its suppliers, and to become more flexible in pricing adjustment.

Skilled medical professionals prefer to work at established super-speciality hospitals because they get them more patients.

Rating methodology – hospital industry, CARE, July 2019, page 2:

Also specialists tend to prefer recruitment at such hospitals as they gain more patients.

Better pricing power with the patients, suppliers, as well as medical professionals, helps large multi-speciality hospitals earn a better profit margin than smaller hospitals.

3.3) Barriers to entry and competitive intensity:

The hospital segment is very fragmented where numerous small doctor-owned clinics form the major part of the industry. Therefore, the competition level in the industry is high.

Rating methodology for hospitals, ICRA, September 2020, page 1:

The industry is highly fragmented, with more than 80% of the hospitals being standalone, owned and operated by medical professionals or trusts.

However, the two segments of the hospital industry, large super-speciality hospitals and smaller hospitals face a very different levels of competitive intensity in their business.

Large super-speciality hospitals have high barriers to entry due to large capital requirements, first, to make the hospital and then to fund losses in the initial phase. On the contrary, small hospitals/clinics do not need a lot of capital to establish; therefore, have very low entry barriers.

Therefore, small clinics/hospitals see a frequent entry of new players whereas large super-speciality hospitals usually command a dominant position in an area.

Rating methodology for hospitals, ICRA, September 2020, page 3:

Smaller players can enter and cater primarily to low complexity cases, which also requires relatively low capital investment while larger players enjoy a dominant position in the complex and high value cases

Therefore, an investor would appreciate that large super-speciality hospitals have multiple advantages over small clinics like stable revenues backed by a diversified revenue base, a high pricing power as well as high entry barriers for new competitors.

3.4) In-house talent pool:

Large super-speciality hospitals that also have medical education institutions are at a much better competitive position because they are able to have easy access to medical professionals, which is otherwise a scarce resource.

The scarcity of medical professionals in India is one of the factors that has delayed full capacity utilization of hospitals and as a result, has led to subdued financial performance.

Rating methodology for hospitals, ICRA, July 2018 (click here), pages 1-2:

Concerns such as high real estate costs, increasing equipment and operating costs, and shortage of medical professionals have resulted in elongated payback periods.

As a result, those hospitals that have attached medical colleges, which are usually large super-speciality hospitals are at a big advantage over small clinics/hospitals.

Rating methodology for hospitals, ICRA, September 2020, page 4:

ICRA also favourably considers entities that have access to a captive source of talent pool through the operation of educational institutions, which also augments research capabilities.

Further advised reading: How to analyse New Companies in Unknown Industries?

4) Old-established and mature hospitals have a lot of competitive advantages:

Establishing hospitals is a capital-intensive business, which has a high proportion of fixed costs. Therefore, in the initial phase of operations, when the patient footfall is low, hospitals end up making losses. However, as their occupancy/utilization levels increase, then the fixed costs spread over a larger number of patients and the profit margins of the hospital improve significantly indicating a high level of operating leverage.

Therefore, mature hospitals have a high-profit margin than newly established hospitals.

Rating methodology for hospitals, ICRA, September 2020, page 6:

Hospitals have a high operating leverage due to significant fixed costs in the operating structure. Newly built facilities take time to ramp up and face pressure on profitability during the initial years of operations. On the other hand, a mature facility will have a stable and moderately growing revenue profile with an established track record of operations.

Rating methodology – hospital industry, CARE, August 2020, page 3:

CARE also looks at the mix of revenue from matured and recently established hospitals as matured hospitals tend to provide better profitability with stable revenue.

As a result, mature/old-established hospitals have strong competitive advantages over new players and while planning new hospitals, investors look for areas away from old-established hospitals.

Rating methodology for hospitals, ICRA, May 2016 (click here), page 2:

Healthy market share for incumbents also acts as a barrier to new entrants in the region, particularly given the considerable outlay required towards infrastructure, technology and marketing in the business.

A mature-established large super-speciality hospital combines the advantages of large size as well as operating leverage; therefore, it has strong competitive advantages over both new large entrants as well as other smaller hospitals.

Hospitals need large investments regularly for the upgradation and expansion of their facilities. However, most of the time, hospitals do not readily approach capital markets for money. Moreover, they face challenges in getting long term funding from banks. As a result, many hospitals end up using short-term loans for investing in facilities, which creates cash flow mismatches.

Rating methodology for hospitals, ICRA, September 2020, page 6:

hospital industry remains highly dependent on the banking system to meet its funding requirements, with limited access to capital markets, except for a few large corporate entities. Significant dependence on short-term borrowings to meet increasing investment in infrastructure exposes hospitals to funding mismatches and refinancing risks

Established large super-speciality hospitals, which have sustained strong earnings are able to generate free cash flow for expansion and upgradation of facilities. The matured status of an established super-speciality hospital helps it in meeting its investment requirements from both its own free cash flow as well as from financial institutions, which acts as a strong competitive advantage.

Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

5) Increasing insurance coverage is a double-edged sword for hospitals:

India still has a low penetration of health insurance even though the penetration is increasing steadily. In India, about 50% of healthcare spending is done by people from their pocket i.e. is not covered by insurers or employers (Source: Per capita out-of-pocket health expenditure declines from ₹2,336 to ₹2,097, says report: The Hindu, November 29, 2021)

As a share of total health expenditure, OOPE has come down to 48.8% in 2017-18 from 64.2% in 2013-14.

In comparison, in developed countries like the USA, only about 12% of total healthcare expenditure is done by the patients from their own pocket.

Key credit factors for the health care services industry, Standard & Poor’s, April 2014, page 3:

in the U.S. in 2012, patients or a family member paid for only 12% of health care services

Therefore, India has a lot of scope for further health insurance penetration. From the above discussion, an investor would remember that insured and institutional patients constitute the major business for large-super-speciality hospitals. Therefore, it may seem that increasing insurance penetration would be a boon for the hospitals.

However, an analysis of developed countries with a high insurance penetration shows that as insurance penetration increases, the pricing power shifts from hospitals to insurers. As a result, the hospitals become price-takers.

Key credit factors for the health care services industry, Standard & Poor’s, April 2014, pages 5 & 6:

Health care services providers have limited, if any, price flexibility because of powerful third-party payors. This is sometimes called “reimbursement risk.”

Providers are truly price-takers from government payors for some services in some countries…Third-party payment or reimbursement rates are not a function of supply and demand.

When insurance penetration in society increases, then insurance companies (payors) control where patients undergo treatment. Insurers force hospitals to accept lower rates of treatment to enter into their network-hospital list. If any insured patient undergoes treatment at an out-of-network hospital, then the insurers put a penalty on the patient.

Key credit factors for the health care services industry, Standard & Poor’s, April 2014, page 6:

In the U.S., an insured patient often bears an economic penalty if he chooses an out-of-network provider (which has not agreed to accept a discounted price from the insurer)…Providers choose to accept lower payment rates in the expectation of higher volume.

In the developed countries with a high insurance penetration, the insurers hold such a high bargaining power that even well-established mature hospitals, which can perform complex procedures do not enjoy any superior pricing power.

Key credit factors for the health care services industry, Standard & Poor’s, April 2014, page 8:

little weight to competitive advantage, which is appropriate because competitive advantages often don’t confer premium pricing in this industry.

Apart from pushing down the reimbursement rates for the medical procedures, insurers also delay the payment to the hospitals. In the case of walk-in patients who pay from their pocket, the hospital gets advance or immediate payment. Therefore, hospitals used to have a very low working capital requirement. However, as the share of insured/institutional patients is increasing, the hospitals are witnessing delays in collecting their receivables.

Rating methodology for hospitals, ICRA, September 2020, page 7:

The working capital cycle in general is getting longer for the sector as the share of cash paying patients is reducing and that of insurance-paid patients is rising, leading to longer receivable cycle. The Central Government, state governments, armed forces and the PSUs operate various healthcare schemes for their employees (along with their dependents) and empanelment with these public-sector schemes enables a hospital in attaining reasonable volumes…However, the payment cycle of these public-sector schemes is long and in some instances in the past has become significantly stretched, which leads to cash flow mismatches, high working capital intensity of operations and in some cases, stretched liquidity position.

Therefore, while analysing the future of the Indian hospital industry, an investor should note that with increasing health insurance penetration, the pricing power of the hospitals will decline, which may impact their profit margins and revenue and elongate their receivables days leading to a stretched working capital position.

Further advised reading: Receivable Days: A Complete Guide

6) Regulatory risks on pricing power, anti-competitive practices, aftermarket abuse of patients:

The hospitals/healthcare services sector is highly regulated because it directly affects the health and lives of people. Therefore, almost all governments control every aspect of the healthcare industry including operations standards as well as prices of products and services. One of the aims of such pricing interventions is to reduce the spending done by people on healthcare. Therefore, hospitals face a risk of a sharp decline in profits due to changes in regulations (“stroke of a pen” risk).

Let us see some examples of how govt. is attempting to reduce the cost of healthcare services by regulations.

6.1) Direct control of prices:

In 2017, the Indian govt. put a limit on the pricing for cardiac stents and knee transplants by reducing their prices by about 70%. It impacted the revenues and profit margins of hospitals. (Source: After cardiac stents, government now caps knee implants price, cuts prices by up to 69%: Economic Times, August 17, 2017)

Out of 1.5-2 crore patients who require arthroplasty interventions, only around a lakh are in a position to pay for the procedure every year, NPPA stated

This decision is expected to lead to a saving of Rs 1,500 crore per year for the people of India

NPPA’s order comes around six months after it slashed the prices of coronary stents by up to 85%.

This decision (a stroke of a pen) led to a reduction of the revenue of the hospital by about ₹1,500 cr.

6.2) Controlling anti-competitive and exploitative practices by hospitals:

The govt. /policymakers recognise that when a customer/patient approaches a hospital for treatment, then due to the specialized-life-saving nature of services, the customer does not have a strong negotiating power over the hospital. The govt. has acknowledged that some hospitals take advantage of such a position by forcing the customer to buy products and services from them at very high prices.

For example, hospitals force patients to buy medicines at high prices from in-house pharmacies despite these medicines being available at a cheaper price in outside shops. Also, hospitals reject the diagnostics test done at outside laboratories and force patients to repeat all tests at in-house laboratories.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018 (click here), page 6:

There are instances where the patient is forced to purchase consumables such as medicines, syringes etc. at printed MRP from the in-house pharmacy of the hospital when the same is available at significantly lower prices outside the hospital premises.

It has also been observed that hospitals commonly reject even recent reports of diagnostic tests conducted outside the hospital and mandates repeat tests from their in-house diagnostic labs.

Further advised reading: How to do Business Analysis of Diagnostic Labs

Hospitals are able to force such anticompetitive practices on patients because the switching costs for a patient from one hospital to another can be very high.

Making markets work for affordable healthcare, a policy note by the Competition Commission of India (CCI), October 2018 (click here), page 6:

Further with no regulatory framework that ensures and governs portability of patient data, the switching cost for a patient becomes high.

Govt. authorities have taken action against anti-competitive practices of hospitals.

For example, in one case against Dr. L.H. Hiranandani Hospital, Powai, Mumbai, the CCI penalized the hospital (referred to as OP hospital in the order) with a ₹3.8 cr penalty and cancelled its exclusive agreement with a stem-cell storage company. The CCI found that hospitals enter into such exclusive agreements only to earn a high commission, which increases the cost for the patients.

CCI order against Hiranandani Hospital, February 2014 (click here), pages 8 & 11:

A collective reading of the successive tie-up agreements (between Life Cell and OP hospital from 2009-2011 and between Cryobanks and OP hospital from 2011 onwards) shows that commission paid by the stem cell banking company to OP hospital was the sole and important criteria in selecting the stem cell banking company. Though Life Cell was paying Rs. 8000/- per enrolment for 2009-10 and Rs. 10,000/- per enrolment in 2010-11, Cryobank offered Rs.18000/- per enrolment in 2011-12 and Rs.20,000/- in 2012-13.

Such exclusive arrangements do not accrue any benefit to the consumer and are rather at the cost of consumer… This actually kills all competition replacing competition culture by commission culture.

The hospital argued that the patient was free to leave at any time and take treatment from another hospital. The CCI rejected this argument by terming it as “flimsy” stating that once patients develop trust in a doctor, then they do not change doctors for saving a few rupees and therefore resign to their fate of exploitation by the hospital.

CCI order against Hiranandani Hospital, February 2014, page 12:

When at the last stage of pregnancy, the woman is told, if she wants stem cell banking of her choice, she has either to change the hospital or to engage the Cryobank with whom OP hospital had agreement, no woman admitted in a super speciality hospital, to save few rupees will change the hospital….Thus, the argument of OP hospital that the patients were free to leave the hospital is a flimsy argument, not worth any weight.

As a result, the CCI cancelled the exclusive agreement of Hiranandani hospital with Cryobank and put a penalty of ₹3.8 cr on it.

6.3) Acknowledging after-market abuse of patients by hospitals:

The CCI is currently investigating the use of anti-competitive practices by large-super speciality hospitals in Delhi. In a case against Max Super Speciality Hospital, the CCI found that the hospital (OP-2) had forced its admitted patients to purchase medicines at exorbitant prices.

CCI order against Max Super Speciality Hospital, August 31, 2018 (click here), pages 4, 5 & 6:

OP-2 had earned huge profit margins ranging from 269.84% to 527% in the financial year 2014-15…Further, it has been found by the DG that OP-2 has been compelling its in-patients to purchase products only from its in-house pharmacy once they are admitted to OP-2…there is a reference to OP-2’s alleged conduct as being akin to ‘aftermarket abuse’

In such a situation, the patients do not hold any countervailing buying power and they are completely dependent on OP-2.

It is common knowledge that this practice of exploitative pricing from the locked-in patients is followed with impunity by most of the hospitals.

As a result, the CCI directed an investigation into the aftermarket practices of all super-speciality hospitals in Delhi, which is currently in progress.

An investor may appreciate that in many other cases like the cement industry, paper industry, tyre industry etc., the CCI has taken a strong view against anti-competitive practices and in some cases put very heavy penalties.

An investor should closely monitor the developments in the said investigation into aftermarket practices of hospitals because it may have a significant impact on the way hospitals charge their admitted patients. It may have a significant impact on the revenue and profit margins of the hospitals.

7) Key man risk/manpower costs:

Employee costs including super-specialist consultants’ costs are the main expense for any hospital. They are the main pull factor to the patients for any established mature hospital. A hospital needs to maintain a fine balance of its expenditure on its consultants/doctors.

A large expense on the consultants/doctors may impact profit margins whereas a low expense on consultants/doctors would deteriorate patient experience and the hospital’s reputation.

Having many doctors on the hospital’s payroll improves patients’ experience due to easy doctors’ availability, but it increases the fixed expenses and deteriorates the hospital’s profitability. On the contrary, having many visiting consultants reduces the fixed costs for the hospital but dilutes the brand of the hospital because doctors are not readily available.

Therefore, many hospitals go for revenue-sharing agreements with key consultants, which protects the hospital during phases of low demand and rewards the consultants during periods of high demand.

Rating methodology for hospitals, ICRA, September 2020, page 4:

Key consultants typically tend to have higher revenue share as remuneration along with a minimum monthly guaranteed payment…A variable remuneration structure makes the interest of the key consultants better aligned with that of the entity and it also reduces cost pressure in case of a fall in revenues/volumes.

Therefore, managing manpower costs is one of the key challenges for the hospitals due to the scarcity of experienced super-speciality consultants and the trade-off between saving costs and the hospital’s reputation.

Further advised reading: How to do Business Analysis of a Company

8) Criteria specific to the hospital industry for measuring performance:

Some key parameters are unique to measuring the performance of the hospital industry. Let us understand some of them.

8.1) Average revenue per occupied bed (ARPOB):

ARPOB is a parameter similar to the average revenue per occupied room for a hotel. Large super-speciality hospitals providing complex medical care usually have a higher ARPOB than smaller clinics/hospitals. A higher ARPOB usually represents a higher pricing power for the hospital.

Rating methodology for hospitals, ICRA, September 2020, page 4:

The average revenue per occupied bed day (ARPOB) is the metric used by ICRA for understanding the pricing power and complexity of the speciality mix

8.2) Average length of stay (ALOS):

ALOS measures the average duration of stay for an admitted patient in the hospital. Hospitals try to keep ALOS short because most of the revenue from any patient is earned during the initial period of stay when the patient undergoes multiple tests for diagnosis and the surgical procedures for treatment. Thereafter, the patient enters the recovery/monitoring phase when the earnings of the hospital from the patient decline.

Rating methodology – hospital industry, CARE, August 2020, page 4:

lower ALOS helps in faster turnaround of beds which results in more patients being treated from the current facilities. In addition to this, it also helps the hospitals to increase their income as most of the revenues are made by hospitals in the initial few days of the patients’ treatment.

Moreover, if any hospital has a higher average length of stay (ALOS) even in cases when the treatment/procedures are simple, then it indicates weaker operating efficiency.

Rating methodology for hospitals, ICRA, May 2016, page 3:

ALOS management also plays a role in asset utilization, where lengthening ALOS not backed by corresponding increase in complexity of service rendered indicates weak operating efficiency.

Further advised reading: Operating Performance Analysis: A Simple & Complete Guide

8.3) Hospital construction expense: Investment per bed:

While assessing the construction cost of a hospital, usually, its construction cost per bed is measured and compared with similar other hospitals. It forms a key parameter to assess whether the hospital construction is cost-efficient or has suffered from cost overruns.

Summary

The hospital industry in India faces a high demand because due to low public investment in healthcare, it has a lower proportion of beds than the global average. As a result, the industry has a low cyclicity and performs independently of general economic phases of boom and bust.

It is a capital-intensive industry where companies need to spend a large amount of money on building, infrastructure, medical equipment etc. and then fund losses during the initial long-gestation period. As a result, large super-speciality hospitals have a strong barrier to entry.

In addition, large super-speciality hospitals enjoy other competitive advantages like diversification in terms of specialities/branches of healthcare, patient profile as well as geographical diversification, which protects them from many risk factors. Large hospitals also enjoy better bargaining and pricing power over their customers/patients, suppliers, insurers as well as consultant doctors who prefer to work in these hospitals because they give them access to a large number of patients.

Large hospitals, usually, also have attached medical education facilities, which give them easy access to in-house medical professionals. All these factors put large super-speciality hospitals at a higher competitive advantage than smaller clinics/hospitals, which are very fragmented and see a large churn in terms of opening and closing of clinics.

The capital-intensive nature of large hospitals makes their operations fixed-cost intensive. As a result, they have large operating leverage where the profit margins of the hospital increase significantly as its capacity utilization increases. Therefore, old-established & mature large hospitals have strong competitive advantages over new entrants.

Hospitals like other segments of healthcare services like pharmaceuticals face strong regulatory challenges. Govt. controls many aspects of operational standards as well as pricing of key products and services to make healthcare affordable to citizens. In the past, govt. has ordered a sharp reduction in the prices of stents and knee replacement implants. In addition, the govt. has been looking into the anti-competitive practices and exorbitant pricing charged by hospitals from its admitted patients.

Increasing health insurance coverage helps hospitals because it brings more patients to hospitals and increases their capacity utilization. However, as insurance coverage increases in society, the pricing & bargaining power shifts from hospitals to insurers. Insurers force patients to take treatment in their network hospitals that have agreed to a lower price for treatments. In addition, insurers delay payments to hospitals, which increases the working capital requirement of hospitals.

Senior medical consultants are the key resource of any hospital, which act as the major pull factor for patients to the hospital. As a result, they are one of the biggest costs for the hospitals. A hospital has to maintain a fine balance between the manpower cost and the profitability because a higher number of payroll doctors reduces profit margins but improves the hospital’s reputation due to better patient experience. On the other hand, a lower number of doctors on payroll and a higher number of visiting doctors reduce costs but impact the hospital’s reputation because doctors are not readily available.

While analysing a hospital an investor needs to focus on multiple aspects including average revenue per occupied bed, the average length of stay, construction expense per bed etc. to assess whether a hospital has pricing power or is working efficiently or not.

Therefore, in the hospital industry, usually, old-established & mature large super-speciality hospitals have a very strong competitive advantage over new entrants. However, going ahead, an investor needs to closely monitor development related to CCI investigation and policy measures about anti-competitive practices by hospitals because any adverse policy decision against the industry may significantly impact the revenue and profit margin of hospitals. The investor should be well prepared to witness moderation in profit margins of hospitals as insurance penetration in society increases.

The following key factors determine the key business characteristics of hospital companies.

• Low cyclicity of demand
• Capital-intensive business
• Big becomes bigger: economies of scale and size matter a lot
• Old-established and mature large-super speciality hospitals have strong competitive advantages
• Increasing insurance coverage would reduce the pricing power of hospitals
• A large regulatory risk. Profits for hospitals can decline on the stroke-of-a-pen by regulators
• Managing scarce senior medical consultants is a key challenge

We believe that if an investor keeps the following factors in her mind while analysing any hospital, then she would be able to assess the true business strengths of the company.

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.