Description

Investment Summary:

HCA is the leading hospital management company based in Nashville, TN. The company operates 173 hospitals and 74 freestanding surgery centers primarily located in urban areas throughout the southern and western states, and generated $19.7 billion in revenues in 2002. Currently the company manages about 41,000 beds, providing medical care to 1.6 million hospital patients while also providing substantial outpatient services (in 2002, outpatient revenue was 37% of total revenue).

HCA’s shares have declined from a 52-week high of $52/share in November, 2002, based on significant negative news from a competitor (and the resulting change in Medicare billing practices), weaker than expected patient volumes in the first quarter, and concerns over the impact of the new drug-eluding stents on hospital revenues. Looking beyond the near-term concerns, HCA possesses a tremendous franchise with terrific assets that are vital to local communities, strong free cash flow generation, terrific returns on capital, favorable long-term growth prospects in an industry with terrific demographic trends for years to come.

Business Description:

For-profit hospital companies account for roughly 15% of the total U.S. hospital beds. HCA, as the market leader, operates about 50% more beds than their nearest competitor, Tenet Healthcare. Obviously, the industry is highly regulated with the U.S. government accounting for about 1/3 of total revenues to HCA.

HCA’s strategy has been to locate their facilities in urban areas where population growth is expected to exceed the national average over time. The company has also chosen to cluster multiple facilities within the same market such that scale benefits can be achieved through staffing, purchasing, billing, and capital spending. Another benefit of having a leading market share in a particular city is the ability to negotiate more favorably with the HMOs serving that area. Sharing services, gaining leverage in negotiations with HMOs, and understanding specific market issues are major advantages in favor of HCA in the future.

Recently, HCA’s chief competitor, Tenet Healthcare has been in the news for Medicare billing issues, management turmoil, and most recently for a major earnings warning. Tenet’s troubles began as they attempted to take advantage of a Medicare billing system called “outlier” payments that were designed to provide higher reimbursements to hospitals for severely ill patients. As a result of Tenet’s actions, Medicare has proposed some rule changes that will impact the ability for hospitals to collect outlier payments (not a terribly severe impact for everyone besides Tenet).

A secondary issue affecting the industry this year (at least through Q1) has been lower than expected patient volumes. Over the past 20 years, and through a number of cycles, industry revenue has grown roughly 7.5% each year. Through the first quarter, patient volumes were weaker than expected and short-term investors severely punished the stocks. It is impossible to precisely predict when volumes will pick up, but we know there is a tremendous demographic tailwind behind the industry over the next 25 years (hospital utilization among the baby boomer generation will begin to increase dramatically over the next decade). Once again, short-term investors have focused on this quarter’s volume numbers and fail to see the value in HCA’s franchise.

Importantly, HCA has an experienced, proven management team that is capable of creating significant shareholder value for investors. They also possess the scale and asset quality that will allow them to benefit from many years of future patient volume growth. These qualities may not exist inside the nearest competitor, so the risk associated with an HCA investment is substantially lower than the risk of investing in Tenet.

Valuation:

Currently, there are about 525 million shares outstanding at $31.65 each. The company also has just over $8 billion in debt assuming the entire Health Midwest acquisition was financed with debt. As a result, the enterprise value for the company is roughly $24.7 billion.

Despite my misgivings in using EBITDA as a measure to evaluate a business, it is commonly used within the hospital industry. Based on my model, HCA will generate approximately $4.2 billion of EBITDA this year. That would suggest that the company is currently trading for just under 6x EBITDA. Over the past 5 years, this valuation represents the lowest multiple of EV/EBITDA for the company. In comparison, HCA has traded for as high as 14x EBITDA.

Clearly, the capital expenditures within the hospital industry are real and necessary. As a result, the most interesting way to evaluate this business is to look at earnings after necessary capital expenditures. In this case, I chose to value the current business at HCA without giving any benefit to future potential acquisitions that may represent terrific opportunities for growth at the company. Without growing the number of beds, it is very reasonable to use depreciation as a proxy for maintenance capex within the industry.

Recently, the company authorized a significant share buyback of $1.5 billion. After completing this buyback, it is likely that the company will use their free cash for both share buybacks and debt reduction. However, with high quality assets, it isn’t necessary to de-lever this balance sheet significantly.

If we are indeed in a trough cycle for volume growth, and that cycle lasts for several more years, then we still have a compelling buying opportunity at this price. Consider a scenario where the existing business achieves only 1.5% admission growth, and 4% pricing increases (very low compared to recent history). Under that scenario, and with no change in existing margins, HCA is poised to earn about $4.50/share in 2007 (up from an expected $2.90/share this year). Based on historic multiples of earnings, HCA should trade anywhere from 11x – 25x trailing earnings in the future. Right now, HCA is trading at 11x 2003 earnings estimates. For the patient investor, it is very likely that returns could range from 15% - 30% annually over the next 4 years.


Investment Thesis:

Investors are worried about a handful of issues related to the hospital industry: 1) the long-term ramifications of the changing outlier payment rules (primarily a worry for Tenet investors), 2) patient volume trends (this one is much easier to predict over an entire cycle, but impossible to forecast for the next quarter or two), 3) the impact of the new drug eluding stents and their impact on hospital revenues in the profitable cardiac surgery area (again, another short-term issue), and 4) the regulatory environment under which hospitals operate. The Tenet issues are primarily related to that hospital company, and have no bearing on the longer-term prospects for HCA or the other hospital companies. Patient volume trends will eventually be favorable, though I expect them to be permanently cyclical with a higher than GDP long-term growth rate. New technologies will always come along and impact the delivery of medical treatment, but there is no question that treatments must be delivered and hospitals are one of the only mechanisms to deliver necessary health care on a large-scale basis. The regulatory environment is impossible to predict, but it is important that the government act in such a manner as to not jeopardize the health of the enormous non-profit hospital industry.

In my opinion, the market is underestimating HCA’s long-term earnings power, and overestimating the short-term issues facing the industry. Again, I have no idea what patient volumes will look like this quarter or next, but I am convinced that HCA will continue to gain market share over time, and provide medical care to their patients at a margin attractive to investors.

With extremely high quality assets, a terrific management team, and significant underlying earnings power, HCA clearly has potential to generate outstanding returns for patient, long-term investors. Once historically normal volumes return for the industry, it is very likely that mid-teens earnings growth can be expected. That future is now for sale at a multi-year low of 11x earnings, providing investors with a terrific risk-adjusted return opportunity.

Catalyst

- $1.5 billion share repurchase authorization
- resolution of Tenet problems will favorably impact all hospital companies
- return by investors to a more defensive area of the market after the current technology stock rally fizzles