Community Health Systems - CYH
CYH presents a highly skewed return opportunity, with over 200% upside if the company can get a handle on a recent spike in labor costs in the next few years before running into funding issues, or 100% downside should they fail at this, and slide into bankruptcy, with the company’s heavy debt burden. There are reasons to believe that the odds of the former are greater than the latter, and hence I find it an attractive, option-like investment opportunity.
CYH runs the 9th largest hospital system in America, with 83 hospitals, 13,000 beds, and 1,000 outpatient facilities in 16 states, and is the 3rd largest publicly traded hospital company, after industry leader HCA Healthcare (also long, but not the extreme deep value turnaround that CYH is) and Universal Health Services.
CYH’s strategy (like HCA’s) is to develop strong local market shares and dense networks in the markets it operates, which gives greater negotiating leverage with the primary healthcare payors, and thus better returns. In addition, it has focused its footprint in regions in the Southeast and Southwest with attractive demographic growth characteristics versus the rest of the United States. This approach has delivered reasonably consistent EBITDA margins that have averaged 15% over the past 20 years (about 5 percentage points lower than HCA, which is a much higher quality company with significantly greater advantages to scale). Consistency in margins for the large public hospital systems is largely structural and driven by payer mix. With over 60% of revenues coming from managed care organizations (vs. 35% from Medicaid or Medicare), CYH is able to pass on changes in healthcare cost on a frequent basis when its contracts renew, or it can seek to renegotiate these contracts before renewal, when necessary. This only works when the hospital company has sufficient local density to give it leverage with the large managed care payers.
Year-to-date, CYH’s stock is down nearly 80%, with the biggest drop coming after its Q2 results, when the company missed sales by 6%, and EBITDA by 43%, and cut 2022 sales 4%, and EBITDA guidance by 27% (implying EBITDA margins of 10.9% vs. 14.4% previously).
The primary reason for the disappointment and guidance cut is wage inflation and elevated contract labor costs which have impacted all the major hospital chains to varying degrees. Typically contract labor is 2-3% of CYH’s total labor cost, but in Q1 it reached 13% before falling to 10% in Q2 (while a sequential improvement, this was not as much of an improvement as expected).
CYH carries a heavy debt burden, with leverage of 7.1x net-debt-to-EBITDA. After the Q2 results, credit spreads blew out and the company’s senior secured now trades around 10% yield, with a B2 rating. With this leverage, if the company is *unable* to improve its cost situation or it can’t raise capital, it could easily default in the next 2-3 years.
Why I’m optimistic:
Despite the massive disappointment in Q2, trends are moving in the right direction. As noted above, contract labor fell from 13% to 10% of total labor costs from Q1, though the company was expecting an even greater improvement. The company also reported significant improvements in retention rates for its nurses, where turnover has been cut in half since the peak at the end of last year. Additionally, the company reiterated its view that total labor cost inflation will still be in the 4% range for full year 2022, a moderation from 8.5% last quarter. Longer term, the company has numerous initiatives to ameliorate its labor situation, including its partnership with a nursing college which is on track to graduate more than 1,000 nurses per year by 2023.
CYS is not alone in reporting improvements in the labor situation. HCA saw improvements in each month of Q2, with contract labor falling 22% from April to June. It also reported improvements in hiring and retention. UHS reported a similar drop in contract labor expense last quarter, and indicated it believes the trend will continue through the end of the year. More broadly, the KaufmanHall National Hospital Flash Report indicated similar, elevated but slightly improving cost trends.
While CYS’s leverage is high, its debt is covenant-light, and its nearest maturity is in 2026, giving it significant breathing room to reduce its elevated costs and pass on the costs it can’t cut to its primary payers. In addition to cash of $346 mm, the company has an untapped ABL facility of ~$900 mm, giving it about $1.2 bn in liquidity.
And despite the cut in guidance for the year, the company still expects to be slightly cash flow positive:
Longer-term, the company retains confidence in its targets, which are buoyed by solid demographic trends in its markets and sustained expected growth in national healthcare spending: