Wednesday, November 26, 2014

Tenet Healthcare Equity Thesis in Three Words

“Screw the bondholders”, Larry Robbins says.

Ok maybe not in those words.  But at a recent conference, Larry Robbins of Glenview Capital suggested that as Tenet Healthcare (THC), the hospital operator, digest its recent Vanguard acquisition, THC should take advantage of the credit markets to maintain 5x leverage. THC’s debt currently stands at 6x EBITDA (> 70% debt/enterprise value!), but instead of deleveraging, Robbins suggested the company can buy back stock.

Robbins is a power player in healthcare space and supposedly has so much influence on THC management that he actually drove Vanguard deal.

To be fair, THC has other things going for it. Synergies from Vanguard acquisition is one. ObamaCare is another. The company has a sensible strategy of teaming up with reputable non-profit players like the Yale New Haven system. Hospitals industry is ripe for consolidation and THC could be buyers (with more debt?). The conference notes link above noted more. There are concerns about the hospital industry as a whole, and I mentioned some in my HCA write up here, but nothing that can’t be overcome.

Valuation is ok -  ~8.5x EBITDA and 18x 2015 P/E (consensus is expecting some explosive EPS growth). P/E is less relevant here because THC is so highly leveraged (both financial and operating) that any little revenue growth juices earnings disproportionately. By 2016 P/E could easily be under < 15x.

So still, the equity story goes back to leverage. When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent. Tenet Healthcare’s 8% senior notes due 8/20 (rated B3/CCC+ by Moody’s/S&P respectively), are yielding a mere 4.4%. What can they do? The Fed started a QE orgy, the ECB is holding the bondholders down, and the BOJ is manning the door. It’s clear that “high yield” bond managers have nowhere else to go.  

Larry Robbins is enjoying this party and he’s inviting all equity investors to join in.

I’m in.­

4/22/2016.  Minor edit as I look back to this very old post. I sold this stock long time ago but this post could be clearer. Added "When a company has 6x debt/EBITDA and still want to buy back shares, there ought to be a creditor revolt. But the bond vigilantes are silent.

HCA’s Organic Growth Prospects

I established a combined 2.5% position in HCA Holdings (HCA) and Tenet Healthcare (THC) last week. I have been eyeing the hospital sector for a while mostly as a hedge against higher medical utilization rates for my managed care positions (now ~7.5% of my portfolio). So when they cratered recently I bought HCA at ~$66 and THC at ~$47.5.

I will focus more on HCA here because that’s the one I might add more to, while THC is more of a trade. Compared to Tenet Healthcare, HCA has better quality hospitals, higher margins, lower leverage and cheaper valuation multiples (at least for 2015E).

Valuations multiples are high by historical standards but still reasonable in absolute terms. HCA trades at 7.5x forward EBITDA and 13x 2015E earnings. The big discrepancy between EV/EBITDA vs P/E numbers hints at the high level of operating and financial leverage. This has several implications. First, it means margins and profitability could be distorted and you have to look further out for “normalized” results. Second, it also means top line growth should be the focus of my analysis.

I will start by putting the company in its industry context, then focus on organic growth.

HCA and Industry Context

HCA is the largest-profit hospital operator in the U.S., with 165 hospitals and 113 freestanding surgery centers. Traditionally physicians are not employees and they bill their services separately, while hospitals make money off bed utilization, medical resources and services, facility charges and other ancillary services. Think of physicians as athletes and hospitals like HCA as stadium operators. HCA has a high quality portfolio - ~70% of the hospitals are in The Joint Commissions list of “Top Performer on Key Quality Measures”, which recognizes top ~37% of U.S. hospitals. Roughly ~45%-50% of revenues came from Florida and Texas facilities. Private equity firms Bain and KKR still have stakes in the company.

The core hospital industry is nothing to get excited about. Volume growth, as represented by same facility admissions growth, fluctuated around -2% to 3% the past decade. As recently as 2013, same store admissions were flat to negative. This is due to a structural trend shifting away from inpatient hospital usage, toward outpatient services and other formats, such as ambulatory surgery centers (“ASC”), specialty hospitals, urgent care centers, diagnostic/imaging centers…etc. Together, these substitutes extend the competitive landscape beyond other hospitals.

This has been going on for years. Hospitals wised up and decided on an “if you can’t beat them, buy them” strategy. Hospitals have been buying ASC, physician groups…etc. Since acquisitions serve to both defend and expand market share, hospitals with strong financial flexibility have clear advantages.

Analyzing Organic Growth

After 2Q14 it became clear that the Affordable Care Act (ACA) is a home run for the hospitals. Same store revenue growth spiked. With Medicaid expansion and insurance exchanges, hospitals got more insured patients, which not only added volume but also lowered bad debt expenses. HCA guided to a strong 2014E revenue and EBITDA growth of 7.5% and 11%.

The question is how much of that growth is organic and sustainable? There will be a day when all the uninsured already have insurance, and ACA as a source of growth goes away. Also, growth by building and buying hospitals cost money. We need to break down revenue growth between ACA, new hospital contributions, true organic/”same store” volume growth, as well as price increases.

This is harder than it sounds and I had to piece together various data points, and made some reasonable assumptions*. I attributed 2014E revenue growth into the various sources (see table below). Volume gains can be broken down as follows:  ~1 % from Obamacare, 1 – 1.5% gain from new facilities, and ~1% organic. Price gains are in terms of net revenue per adjusted admission, which would account for lower bad debt expenses.

HCA:  Breaking down 2014E Revenue Growth

This 1% core volume growth is an improvement compared to near 0% in 2013. So it appears that HCA has found a way to mitigate the shift out of hospital into outpatient and free standing facilities. The real organic growth number could be slightly lower as there could be some other sources of growth that’s not sustainable. I can imagine a few below:  

·         Whenever the rules change there will be some distortions of the system. While I have no reason to believe HCA management is anything less than ethical, doctors on the ground could be doing some unnecessary test, exams, or surgeries.
·         Some volumes could be from under-education. As high deductible plans and bronze plans are still relatively new, some people go to hospitals and don’t realize they have to pay. Sooner or later they will learn.
·         As this NY Times article highlighted, buying out physicians groups allow facilities to charge higher price for the exact same service. While legal, this is contentious and could come under challenges.

As outside investors, there is no way we could know or quantify how much these contributed to growth. But it's something to keep in the back of our minds.

Outlook for Next Few Years and Upside

HCA’s top line is in decent shape. An 1% organic volume growth is not much. However, with a moderate 1-2% price increase and new facilities contributing 1-1.5%, HCA can expect 3-5% revenue CAGR in the next few years. EBITDA and earnings should grow faster than that due to operating and financial leverage. This is without further growth from Obamacare so 2015E consensus expectations of 5% revenue and EBITDA growth appear very reasonable.

Ultimately, the success of this company will depend on returns on incremental invested capital. HCA certainly has opportunities here. According to the American Hospital Associations, some 20-30% of hospitals operated at negative margins as of 2012. HCA is a proven consolidator with a track record of improving hospital efficiency. It also has strong capital resources in terms of free cash flows and debt capacity. HCA also just authorized $1bn of stock repurchase program. 

As with all things healthcare, the key risk is reimbursement changes.

* We have some useful data points. HCA said 4% out of the expected 11% EBITDA growth came from ACA. This is consistent what other hospitals have said (roughly 1/3 of their gains came from ACA). We also have % growth vs same store growth %, which allows us to back into contribution from new facilities. The remaining is same store organic growth. Finally, we also know what proportion of revenue comes from price versus volume, since HCA give us equivalent admissions and revenue per equivalent admission.

* Back of the envelope way:  Total volume growth is 3.3%. Assume ~1/3 new admissions are from ACA (just pro-rate as EBITDA growth contribution) that means ~1% came from ACA.  SS admission of 2% minus 1% from ACA leaves ~ only 1% organic/“same store” volume growth.

Tuesday, November 11, 2014

Genworth Valuation and Restructuring Considerations

Background & Summary
Genworth (GNW) took a dive last week due to long term care (LTC) concerns. The valuation looks absurdly low from a book value perspective. Is it a bargain? Here’s my take on it.
  • Sum of the parts analysis shows that GNW is trading within a range of fair value depending on where LTC comes out.
  • To realize the value here, GNW should restructure and cleanly separate the various mortgage insurance (MI) subsidiaries from the life insurance businesses (life insurance, annuities, and LTC).
  • However, GNW’s unique corporate and capital structure means that any restructuring would require paying down debt – the difficulties of doing so reduces upside from restructuring.

What Is It Worth

Here I did a sum of the part approach. I will intentionally leave LTC blank for now and come back later.  I get to about $9.5 per share excluding LTC. If we say US MI is probably worth more than I assigned here this thing could be worth $10-11+ excluding LTC.

·         Canada (MIC.TO) and Australia MI (GMA.AX) are valued using their respective stock prices and exchange rates.

·         Segments that do not earn its cost of capital (judged by ROE against tangible book) would certainly not deserve book value, so I used a normalized earning x multiple approach. This is unfortunately most of the businesses (US MI, Life insurance, fixed annuities, international protection)
·         “Normalized earnings” are basically taking average earnings for last 3-7 quarters and annualized. 
·         I’m probably underestimating US MI here. Earnings here should be growing due to legacy vintage losses running off. On the other hand, US MI will have to raise about $500-700mm of capital due to new regulations. Management plans to use reinsurance to meet that requirement and that would decrease earnings. The $1.2bn I assigned here is equivalent to 75% of tangible book value (ex AOCI and DAC)
·         Life insurance and fixed annuities earnings could be at risk. Genworth just got downgraded so that could hurt sales.
·         Use book value for runoff segment.
·         Corporate is basically net debt.  Netting $2.2bn of cash/investment against $500mm deferred tax liabilities and ~4.2bn of debt leaves ~- 2450mm of book value at corporate.
·         Why only ~$4.2mm of total debt vs $6.7bn total?  In segments that are valued using earnings, we implicitly netted out the debt already so we have to be careful not to double count. Interest expenses are already accounted for in Australia, Canada MI, Life Insurance (not including LTC), so those related debt are excluded here. 
·         I noticed that international protection segment has interest expenses allocated to it but I’m not sure which piece of debt that should be attributed to. So maybe I’m overestimating the debt in corporate segment, if that’s the case value would be even higher

An Ideal Restructuring

Let’s say LTC is not totally negative (a big assumption). At $8.5 / share GNW would seem undervalued. But how do we unlock this value? I attempted a stub trade: buy GNW, short Australia and Canada MI. Unfortunately my broker is telling me Australia MI is not available to short. (I’m just an individual investor and I bet a big time hedgie can get those share to short but even then international shorting surely have its own complications).

For shareholders to realize value, GNW should cleanly separate out the MI segments from Life insurance businesses. These businesses have little synergies between them (aside from financial ones which I will discuss next section). At this point, a highly specialized headache such as LTC would be better served by dedicated management and analyst attention.

On the other hand I’m not sure it’s possible to separate out life insurance between life, LTC, and annuities, as LTC is a capital hog. Those 3 will have to remain together in the near future.

Problem with Restructuring

A barrier to restructuring is the ~$4.2bn of debt at Genworth Holdings, Inc.  As seen in the corporate structure below, Genworth Holdings Inc is just a holding company and services its debt by 1) hoarding cash on hand, 2) subsidiaries to dividend upward. With life insurance subsidiaries not planning for dividends in the near future, Genworth will be even more dependent the various MI subs.

It’s fair to say any corporate break up would require paying down debt due to 1) rating concerns, 2) current reliance on mortgage subsidiaries for holdco debt service. 

However, companies don’t just get to pay down debt whenever they want. The bonds I looked at are all non-callable and make-whole premiums at T+30 would be very expensive. Tender-offers would also be tough as most bonds are still trading above par.

The valuation above already needs to be way above stock price for an activist to take on the black hole that is LTC, having the additional cost of retiring debt just makes it that much tougher.


That’s not to say a restructuring can’t be done. GNW can selectively retire some but not all of the bonds and optimize between debt service coverage, ratings, and costs.

Genworth has plenty of assets that can be converted into cash. Australia and Canada MI are already publicly traded so Genworth can sell more stakes. US MI should have plenty of bidders. Upstarts like ESNT and NMIH are better buyers than RDN/MTG due to their lack of legacy issues and thus capital needs. Also, I’m sure some banker is pitching AIG to combine United Guaranty with Genworth’s US MI and be spun off into its own company. Because GNW holds some cash cushion for debt service, deleveraging would itself free up some of that cash on hand.

Maybe if 4Q reserve reviews leaves capital in a good position and thus more visibility on the LTC end, management can start deleveraging and set the stage for restructuring. I'm not counting on it.

Simplified Corporate Structure


Capital Structure

Wednesday, November 5, 2014

Santander Consumer USA (SC) – Update on Normalized Losses and Volume

A few months ago I wrote about Santander Consumer USA ("SC", "SCUSA") in an article. My long thesis was twofold. First, losses will get worse but still be manageable, so eventually reserve releases will serve as a positive catalyst. Second, volume growth will lead to steady earnings. After the 3Q14 results yesterday, my views have shifted. I now see little upside from both credit and volume, while management credibility is getting questioned. Accordingly I exited my already small positions.

Normalized Losses

In my old write up, I estimated normalized net charge-offs to be around 7.5% or 8%. Now it looks like charge offs for 2014E will be at higher end of that, meaning normalized levels could be higher depend on competition. The core auto installment loan business is actually still running within my expectations. What I completely missed was the deterioration in SC’s unsecured loans business.

SC missed its 3Q14 earnings due to a larger than expected credit provision, and that was mostly driven by unsecured consumer loans. Of the $770mm in total provision, consumer loan provisions contributed $167mm, a big jump from $70mm and $62mm in 2Q and 1Q, respectively. This is despite net charge-offs for that business being ~$80mm for the quarter. So management is either being super conservative or they see consumer loans getting destroyed in the future, perhaps both. The earning call offered little visibility, but management did explain that they see the consumer business making money from both fees and interest, so they’re ok with high charge-offs levels.

Regarding the auto loans portfolio, I now see average net charge-offs for 2014E to come in at low 7%s – a fairly comfortable level. We’re looking at 2 year average life so the worse 2013 vintage should be worked off sometime 2015 and there’s actually some credit upside there.

However the lack of visibility in unsecured loans is a big issue and I can no longer count on credit stabilization as a positive catalyst.


The company is running below target penetration of Chrysler’s originations. Management says this is due to lack of subvention support from Chrysler so they won’t be held accountable for that: 
“And I think at this moment, the amount of subvention that we have access to is not very similar to some of the other OEM captives and therefore these penetration rates for the contract would not be something we would held to. ... the actually penetration rates for the contract are tied to us being treated like other captives and I think today it's clear that we are not.”

That may be true, but it also means we can no longer assume that volumes will grow due to the Chrysler relationship, removing some of the upside. I also see SC’s value proposition to Chrysler diminishing. During the summer SC changed their strategy to selling most of the prime Chrysler loans, so at the end SC is no longer providing the financing but is more as a servicer.

Management credibility

Management continues to lose credibility in my eyes. For example, back in June SCUSA put out a press release saying that reserves are expected to come down slightly and expenses to increase due to higher compliance cost. Now the opposite has happened - reserves are actually increasing and expenses decreasing. Another example - in the 3Q14 call Dundon said that unsecured loans were not a big part of variability, when the 10Q clearly showed that it was in fact the key driver this quarter (it was even cited as a factor in the earning slides). Reading through the transcript, it appears that sell-side is also increasingly skeptical of anything management says.

The stock still looks cheap and I may get back in at some point. But I need to see of the drivers above improving first.