Description

Community Health Systems 6.125% Junior-Priority Notes due 2030: Debt-like Risk for Equity-like Returns

Summary / Situation Overview

Community Health Systems (NYSE: CYH) operates 81 hospitals & related facilities, including ambulatory service centers (ASCs), across the US.  CHS (the “Company”) is one of the larger hospital operators in the country and benefits from economies of scale (in both individual markets and throughout its greater operations).  CHS historically levered up to roll-up individual hospitals and smaller systems in the U.S., but over the past few years has divested a significant amount of assets that do not fit its strategic vision with new mgmt. focused on generating FCF and deleveraging. 

The 2029 2^nd lien notes (the “Notes”) at a price of 54.75 and a YTM of 19.7% represent an attractive opportunity with significant potential for capital appreciation, a strong CY of 12.6%, and downside potential stemming from a reasonable creation value on trough EBITDA.  The healthcare sector, and especially hospitals, have been ravaged by wage & labor inflation over the past few quarters which has substantially depressed margins and FCF generation.  Furthermore, US hospitals face a secular headwind as care continues to shift from inpatient to outpatient care for less acute cases in the which has depressed admissions.  With that said, the Notes, represent an interesting opportunity, given that CYH’s hospitals are primarily positioned in strong demographic markets, should recover a sizable amount of margin as temporary wage & staffing shortages subside, and benefit from a reasonable net creation value of 6.6x my 2022E Base Case Adj. EBITDA and 10.1x 2022E Base Case UFCF. 

Capital Structure

            CYH has a highly leveraged capital structure with net debt of 7.4x LTM Mgmt. Adj. EBITDA.  This becomes even more concerning with 2022 results expected to be significantly below 2021.  With that said, CYH benefits from no near-term maturities, $1,152 mm in liquidity, and the ability to quickly reduce growth CAPEX to maintain break-even to slightly positive FCF. 

Capitalization ($ in mms)

1L Debt: $8,231 (6 bonds, earliest maturity is 2026)

$1,775 of 6.875% 2L Notes due 2029, 19.7% YTM @ 54.75 (recommended security)

$1,440 of 6.125% 2L Notes due 2030 17.4% YTM @54.59

Total secured debt: 11,446 (7.0x LTM EBITDA); 2L creation multiple of 6.2x LTM EBITDA

$767 of 6.875% senior unsecured notes due 2028 21.7% YTM @ 50.00

Total debt: 12,213 (7.6x LTM EBITDA)

Less cash (300)

Net debt: 11,913 (7.4x LTM EBITDA)

Plus mkt cap of $670 & NCI of 582

EV: 13,165 (8.2x LTM EBITDA)

Liquidity: $300 mm in cash + $935 available under RCF = $1,152

Given the lack of near-term maturities, strong liquidity, and midterm FCF generation, I do not expect a restructuring transaction in the near-term.  As labor pressure eases and margins normalize, CYH seems to be in a solid position to naturally delever, especially given mgmt.’s focus on debt paydown and cash conservation.

Industry Overview

            Healthcare is known as an industry with a complex value chain, given the importance of insurance and the manner in which care is paid for and regulated.  CYH is primarily a hospital management company for urban and suburban areas with ancillary operations of ASCs and other care centers.  The healthcare value chain generally starts with the patients, who are facing some aliment or issue.  In a non-emergency, a patient will likely go to their primary care doctor, or the specialist they have historically worked with for that aliment.  If the patient needs to see a specialist or undergo more advanced care, its doctor will refer it to another doctor at a hospital or other service center.  Doctors’ ability to refer customers makes them essential for customer acquisition, which is why management companies compete to partner with or be their preferred company to refer patients to.  Management companies also employ doctors to provide care and pay especially high compensation for those who are devoted to lucrative specialties or who can attract many patients. 

            Payors generally have high bargaining power over providers of care, given their much larger size, and ability to deem certain providers in/out-of-network.  This is somewhat mitigated by larger providers (e.g., CYH) who build dense networks in certain locations, controlling a high amount of the infrastructure dedicated towards healthcare.  Payors and management companies negotiate contracts, generally annually, that set reimbursement rates; higher acuity procedures benefit from higher reimbursement rates.

            There have been a few key trends affecting the primary care market, including a shift from inpatient to outpatient care coupled with the rise of ambulatory service centers and intense wage inflation / margin compression on the provider side.  The shift towards outpatient care has negatively affected hospitals which are primarily known for inpatient care and ER services.  Outpatient settings benefit from looser regulation, more flexibility, and a higher ability to turnover patients which results in higher margins; for example, ASCs are much more lightly regulated when compared with hospitals and have significantly higher margins.  This has resulted in hospitals wallet share of total patient spend decreasing with many traditional hospital companies, including CYH, seeing inpatient volumes decline.  This has also spurred investments into outpatient care settings, especially ASCs, by legacy hospital operators through both de novo builds and acquisitions.  This trend is a general headwind for hospitals but is relatively mild in impact, helping to keep inpatient admissions flat to down LSD. 

Rapid wage inflation, and as a result margin compression, has marked the primary care industry.   As a result of the COVID-19 pandemic, many nurses left the workforce or switched from being traditionally employed nurses to contract nurses.  Contract nurses are contracted to work for hospitals on short-term (weeks) agreements at much higher rates than traditional nurses but have a much less stable and usually travel-intensive work life.  As nurses have flocked to the contract labor force from traditional hospitals, the use of contract labor, at comparatively inflated rates, has caused labor expense to go up multiples.  Many primary care operators have called out contract labor as the primary reason behind compressed margins.  This has especially affected hospitals, given the stringent regulations around nurses per patient.  Furthermore, dating to pre-COVID, rural hospitals have been significantly less profitable than urban/suburban hospitals due to lower admission volumes; the makeup of an operator’s portfolio has a large impact on both their earnings power and the appropriate multiple it should be valued on.

Company Overview

            In 2014, CYH made a transformative, ~$7.6 BN acquisition of Health Management Associates (HMA), adding 62 hospitals to its portfolio.  This acquisition left CYH overlevered and with 206 hospitals with a bed count of 31,000+; this portfolio was geographically dispersed, of varied quality, and not particularly high margin.  To improve profitability and reduce leverage, CYH enacted a divestiture program cutting its hospital count to 81 as of 3Q22 with the majority of the reduction in 2016-2020.  The CEO, Wayne Smith, who oversaw the acquisition and rapid growth of CYH, along with its debt binge and subsequent deleveraging, was replaced by Tim Hingtgen in January 2021.  Hingigten has proven himself a capable leader with a focus on deleveraging, free cash flow generation, and smart capital allocation; guidance has not proven itself tremendously accurate over his tenor but much of this can be attributed to the macro environment, specifically wage inflation and lack of recoveries in admissions volumes / COVID variants. 

            Today, CYH is one of the largest hospital operators in the US with ~11,500 beds in service and TTM adjusted admissions of ~1,000,000; CYH is primarily focused on markets with strong underlying demographic trends.  The Company suffered during the COVID pandemic from a reduction in elective surgeries and overall hospital visits; furthermore, Medicare accelerated payments awarded to hospitals to help with cash flow timing during the pandemic clouded FCF generation over the 2020-2021 periods, primarily through dramatic changes in working capital. 

            CYH is underearning relative to its potential with the primary cause being wage inflation on the contract labor side; contract labor has been a ~$400 mm hit to EBITDA on an annualized basis.  The Company historically operates with EBITDA margins in the 13-15% range which has been impaired over the past few quarters due to this tremendous increase in contract labor expense with guidance implying 10-11% margins for FY22.  Although the 4^th quarter is always seasonally strong, the Company is guiding towards EBITDA margins improving to ~13% in Q4 as volumes continue to recover and wage pressures see greater easing.  Contract labor expense was $190 mm in 1Q22 and $170 mm in the 2nd quarter, over 3x the $50 mm expense in 2Q21.  This is pressure is beginning to moderate with contract labor dropping to $100 mm in the 3^rd quarter.  The Company is guiding towards long-term contract labor expense of $50-60 mm a quarter compared with $30mm pre-pandemic. 

Historically, CYH has been a resilient business that is known for best in-class cost management with margins nearing 16% in 2021.  Given Medicare price increases of ~3% for 2023 plus expected price increases from private payors, CYH should be able to claw back a significant amount of its lost margin throughout 2023.  Admissions are expected to increase in the LSD in the mid-term, driven by CYH’s positions in attractive growth markets (e.g., the sunbelt); inpatient admissions are likely to decline in the near-term, as many payors have moved procedures towards outpatient settings.  Growth in outpatient care should more than offset this, especially given CYH’s rapid expansion into ASCs (on pace to build 5 per year). 

            CYH has high free cash flow conversion (pre growth CAPEX) with management’s metric of maintenance capex ~1% of revenue; this has been obscured by substantial investments in growth opportunities, especially in opening new urgent cares and ASCs, bringing capex to ~4% of revenue.  This growth capex can be quickly scaled back in hard times, as evidenced by the Company shifting its planned capex from $1 bn to ~$500 mm this year to offset higher contract labor expenses.  Conservatively assuming 13-14% steady state EBITDA margins, which are substantially below long-term guidance and historical performance, and a return to historical total capex spend (maintenance + growth) the Company should generate UFCF margins in the ~9% range, which amounts to about ~$1 bn of UFCF compared with cash interest of ~$800 mm. 

Investment Thesis

            As previously mentioned, CYH is severely underearning compared to its “normalized” state.  EBITDA and FCF are being hit by ~$400 mm of additional expenses this year that are beginning to normalize; however, the market is treating this temporary earnings impairment as permanent.  The market is failing to recognize the temporary nature of elevated contract labor expense that arose as a byproduct of the COVID-19 pandemic and is beginning to normalize on both a price and usage basis.  As nurses fled hospitals and quit in record numbers during the pandemic, hospitals were forced to rely on contract labor, resulting in a substantial increase in its cost; in recent months, the cost has begun to come down significantly with usage also beginning to moderate, as hospitals are able to staff up their labor forces.  Going forward, CYH will benefit from the maturity of its recent growth investments, especially in ASCs which have the potential to generate very attractive margins (20%+) compared with the legacy biz, and price increases in the LSD-MSD; these will help offset some of the shift away from inpatient care that will cause admissions to decrease in the LSD in the mid-term.  

Even on these depressed EBITDA figures, the Notes benefit from a 6.2x gross and 6.0x net creation multiples on LTM EBITDA, which is reasonable compared to comps (HCA Healthcare, Tenet Healthcare) which trade in the 7.5-9.0x range and historical multiples.  As contract labor expense begins to normalize, the 2^nd lien notes should be more than covered by enterprise value, even if EBITDA remains depressed.  If the business never truly returns to its former economics and EBITDA margins remain in the ~12% range with revenue in the $12.3 bn range (no growth), the Notes are worth ~55-60 cents on the dollar, based on a 7x EV/EBITDA multiple on 2024E EBITDA of ~$1,500 mm discounted to today. 

            On a FCF basis, CYH remains able to support its highly levered capital structure through stable revenue numbers and strong FCF conversion.  Since CYH’s core business requires little maintenance capex (~1% of rev), the Company can quicky scale back capex in lean times, as shown through mgmt. cutting capex guidance in ½ this year. Even in a year where FCF is down ~$400 mm due to the rise in contract labor expense, CYH is able to remain LFCF neutral, as revenues remain resilient and CYH’s management limited other operating costs.  This demonstrates the sustainability of CYH’s capital structure and its ability to naturally deleverage; on a normalized basis, CYH should generate a UFCF yield of ~7% on its net debt of $11.9 bn.  

            The notes offer an attractive current yield of 12.6% and a YTM of 19.7%.  The current yield, which is supported by CYH’s strong liquidity (over $1 bn) and FCF generation, along with the attractive creation multiple (6.0x net on LTM EBITDA) provide significant downside protection.  Furthermore, the CY of 12.6% provides a strong source of return while one waits for the market to credit CYH for the resiliency of its business and its contract labor expenses continues to come down.

            The major risk is that contract labor expense does not normalize; this is mitigated by contract labor expense already beginning to inflect downwards, a reasonable creation value on trough earnings, and CYH’s ability to support its capital structure even with this reduced earnings power (LFCF neutral). 

Catalysts

The main catalyst is CYH continuing to report reduced contract labor expense in its FY22 earnings and into 2023 earnings, as the healthcare labor market continues to normalize.

Long-term, another catalyst is CYH beginning to build cash on its BS, as earnings realign back to historical levels, and taking advantage of attractive debt prices to buyback its debt at accretive prices. 

Catalyst

The main catalyst is CYH continuing to report reduced contract labor expense in its FY22 earnings and into 2023 earnings, as the healthcare labor market continues to normalize.

Long-term, another catalyst is CYH beginning to build cash on its BS, as earnings realign back to historical levels, and taking advantage of attractive debt prices to buyback its debt at accretive prices.