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.
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.