Value Investors Club / HCA HEALTHCARE INC (HCA)

Description

I. Pitch

HCA is a well-managed, competitively advantaged hospital operator that historically grows EPS L/MT but is trading at just ~14x

cons EPS despite having all-time low leverage. Lingering COVID noise and associated regulatory uncertainty is clouding near-term

visibility, but we believe HCA will compound earnings even faster than the historical rate for the foreseeable future as (i)

fundamentals are strong and (ii) NPPE matures. We see additional potential upside from utilizing the balance sheet – every 0.5x of

leverage represents ~8% of market cap, and HCA is ~0.7x below the high-end of its target range. We see EPS compounding at

~20% through occurrence; a modest dividend (~1%) is offset by a slight de-rate (14x→13.8x) for a ~20% IRR.

II. Business Overview

HCA is the largest for-profit hospital system in the US with 182 hospitals and 125 freestanding surgery centers across 20 states and

the UK. While most hospital systems have grown by acquiring assets over time, the present day HCA is the result of spinning or

selling ~65% of its hospitals over the past 25 years. This was part of HCA’s long-held strategy of operating exclusively in growing

urban markets, which has contributed to HCA’s best-in-class growth, market share, margins, and returns over the past decade.

We believe HCA’s margin and ROIC advantage versus peers can be approximately broken down into the followings buckets: (1)

Peer margins, (2) better commercial rates, (3) better operations, and (4) better acuity

Better commercial rates

HCA is able to negotiate favorable commercial rates due to high share in its local markets; HCA has ~30% market share or more

in approximately 25% of its MSAs, and ~20% market share or more in approximately 50% of is MSAs. When HCA represents a

significant portion of facilities in a given market, insurers are forced to include HCA’s hospitals in-network, or else their insured

populations will not be able to use the facilities that are most convenient for them. We believe this provides HCA with enormous

pricing power when negotiating contracts with commercial payers in its markets – we estimate HCA has been able to improve

commercial reimbursement by ~3-4%/yr over the past decade, and this has strengthened over time as HCA has continued to grow

in its markets (~28% share in 2021 vs ~26% in 2019).

A secondary reason for superior commercial rates is HCA’s ability to deliver quality care – insurers are willing to pay higher rates if

they get better outcomes for their insured population. The most common ‘quality’ metrics are defined by the Center for Medicare

and Medicaid (CMS) as hospital readmissions and hospital-based infections. HCA is a strong performer (the most important reason

that HCA is able to deliver high quality care is due to its use of data, discussed further in the next section).

Better operations

We believe HCA is a best-in-class operator – we did not have a single conversation (formers, peers, insurers) that was critical of

HCA’s operational abilities. We bucket HCA’s operational advantages into the following categories:

• Centralization. By operating 308 facilities, HCA is able to spread ‘centralizable’ functions (payroll, HR, billing, sourcing)

across its system. While hospital systems have been consolidating markets across the country, a significant number of

hospitals are still standalone – across HCA’s markets, about 35% of the beds are either unaffiliated with a system, or are

part of a system with less than 5% market share

• D

ata. HCA has developed proprietary systems over 20+ years and is relentlessly focused on tracking and monitoring

anything quantifiable. Conversations with formers have revealed several examples of the benefits of this data collection,

including: (i) detecting referral pattern changes from primary care docs (providing HCA the opportunity to address them),

(ii) analyzing patient indications to preemptively detect and treat in-hospital infections like sepsis, and (iii) ensuring staffing

is fully utilized by department. By having all clinicians and back-office employees trained on the same system, and by

running the same systems at all its hospitals, HCA is able to move resources around seamlessly

• H

iring. HCA owns and operates its own nursing school, and runs rigorous internal talent development programs to breed

its next generation hospital COOs and CFOs. Training nurses on how to optimize ‘coding’ (i.e. determining if a patient

qualifies for admission or other services) of a patient is complicated, but can be a significant competitive advantage – we

believe knowing how to code properly can drive 1-2% of margin advantage alone. HCA is also able to offer the best docs

the highest volumes given its referral network. The ability to move doctors around geographically when requested also

keeps them in the network. We believe this internal training apparatus allows HCA to spread its institutional knowledge

to all of its staff, and helps with recruiting and retaining talent.

• S

upplies. HCA is able to buy supplies cheaper given its high volume purchases. While approximately 50% of hospitals are

part of a GPO for commoditized items (swabs, masks, etc.), and therefore should get similar savings to HCA on these,

HCA saves its money on the larger, less commoditized purchases, such as knee replacement devices, which are big ticket.

We estimate that HCA saves ~20% on these big ticket items vs. the average US hospital.

Better acuity

A complex or high-risk procedure on a high-risk patient is said to have high ‘acuity’ – high acuity procedures generally have higher

reimbursement and higher margins. The best measure of acuity is Case Mix Index, a statistic compiled and reported by CMS. HCA’s

acuity spread (HCA CMI vs local peers CMI) has expanded from ~10% in the early 2010s to ~16% today.

HCA is able to create higher acuity across its base as the core requirement to serve higher acuity patients is the equipment and

expertise to perform the procedure. In order to justify spending capital on the associated equipment and hiring the associated

expertise, a minimum volume of these ‘higher-acuity’ patients is needed. HCA’s scale and market share means it can make these

investments and hire these doctors and ensure the volumes are there to justify the expense. As HCA performs more high acuity

procedures, it tends to attract both patients and doctors to the hospital, creating a flywheel effect.

III. Thesis Detail

i. HCA’s compounding algorithm will persist

Over the past 5 & 10 years, HCA has compounded normalized earnings at 13-15%.

HCA’s compounding algorithm is comprised of (1) organic growth of ~5% driven by admission growth and revenue per admission,

(2) M&A, though we assume no incremental M&A, (3) financial leverage and (4) share repurchases / yield

Volumes

HCA’s ~2.5% of admission growth has been roughly driven by ~140 bps of population growth, ~40 bps of procedures/capita

growth, and ~70 bps of organic market share gains. We believe all three are likely to equal or exceed these historical averages over

our investment time horizon.

We believe HCA’s markets’ population growth has outpaced the national average by about 60 bps, and will continue to outpace the

national average at the same pace through 2023. At the same time, we expect national procedures per capita to grow at an

approximately 40 bps CAGR, roughly in-line with the historical ~35 bps CAGR.

Over the past five years, HCA has hit the effective cap on licensed bed utilization – high 50%s utilization (on average) actually

implies 100% utilization during peak times (weekends). We believe that HCA’s ability to take share has partially been hampered by

fully utilized facilities – HCA has been aggressively adding capacity, which we believe will provide it with the capacity it to continue

to take share in its markets. This dynamic is discussed in further detail in Thesis iii

Rolling these pieces together, we expect HCA’s volumes to grow ~2.5% over the next 3 years.

Price

HCA’s ~2.5% of revenue/admission growth has been roughly driven by ~50 bps of government price increases, ~125 bps of

commercial price increases, and ~75 bps of mix. We believe all three are likely to equal or exceed these historical averages over our

investment time horizon.

Government rates. CMS rate increases are expected to modestly accelerate from historical levels. One subtle change that is also

benefiting HCA is the CMS’s push toward value-based care, which rewards providers who provide high quality care, and punishes

those that do not. HCA performs well on these metrics. Therefore, we expect the risk to be to the upside on government

reimbursement rates. CMS hospital spending growth has averaged 4.5-5%/yr over the past five years, but may increase from these

levels due to financial incentives for value-based care.

Commercial rates. HCA’s ability to increase commercial reimbursement rates is driven by scale and local market share. HCA’s local

market share has increased over time, which should enable it to have even more negotiating leverage with insurers going forward.

In addition, we asked VAR to opine on whether HCA’s commercial rate increases would be higher in the future than the past –

only one of seven respondents thought rate growth would decelerate (an insurer), two of seven thought it would remain the same,

and four thought it would accelerate. We assume commercial rates expand in line with historical, but believe the risk is the upside

given the higher local market share versus the past.

Mix. There are two key drivers of mix – procedure mix (i.e. high acuity) and payer mix (i.e. high commercial payers). HCA’s

procedure mix (generally interchangeable with acuity) has been on a steady upward trend, which we would expect to continue as

HCA continues to take share in the more complex cases. Payer mix is primarily a function of employment in HCA’s markets –

while employment stats are backward looking, we believe they should be a modest tailwind going forward.

Rolling these pieces together, we expect HCA’s revenue/admission to grow ~2.75% over the next 3 years.

ii. Upside from unproductive PP&E

HCA has grown FCF/bed at a ~7% CAGR over the past 10 years, and has been aggressively reinvesting that cash flow back into

the business – HCA has increased capex per bed from ~$35-40K/yr in 2005-2010 to ~$85K in 2019.

HCA’s ROIIC has consistently exceeded ROIC, driving ROICs up more or less every year over the past decade. HCA’s newly built

facilities do not generate a profit until year three on average. Over the past 3-5 years, HCA has ramped investments such that

unproductive PP&E has become a larger share of the invested capital base (~20% today up from 5% trough in 2009).

While this unproductive capital sits on the books, it depresses reported ROIC. If we simply strip out unproductive ROIC, we can

calculate a more precise “return on productive capital”. The widening gap between ROIC and ROPC has been driven by an outsized

share of unproductive capital. The two metrics were roughly on top of each in the early 2010s, but are now ~500 bps apart.

The failure to appreciate this subtle yet important dynamic has led to an underappreciation of HCA’s future earnings power. While

consensus models ROICs roughly reverting to the ~23% earned in 2018/2019 by 2022, they are implicitly modeling ROPC well

below 2018/2019 levels.

Simply put – HCA has ~$5.2B of unproductive capital in the ground today. In three years’ time, that capital could earn 5.2B * 29%

ROIC = $1.5B of NOPAT, or ~25% of FY21 net income.

iii. Misunderstood risks to provider profit pools

Despite HCA’s ability to generate increasingly higher returns on capital, the stock trades at a discount due to what we believe are

misplaced concerns. We discuss the important ones below.

Adverse regulatory change(s)

We believe the worst-case scenario for HCA is socialized medicine. While hospitals would of course still exist under Medicare for

All, HCA would arguably lose a crucial competitive advantage – its ability to leverage its scale for favorable commercial rates. Our

best guess is that commercial rates contribute ~400 bps to HCA’s margins – simply eliminating this implies a PF margin of ~12.5%,

or a ~35% reduction to EPS.

However, we believe this fear is misunderstood for two reasons. First, we believe the odds of Medicare for All passing are extremely

low, particularly under a moderate Democrat like Joe Biden. We also believe that even the most liberal Democrats (i.e. Elizabeth

Warren) do not really believe that M4A is realistic policy, but more of a negotiating tactic.

Second, and more importantly, we come back to the argument that underpins our conviction in the sustainability of HCA’s ROIC

– most hospitals in the US simply cannot sustain a dramatic cut to reimbursement.

In other words, if M4A were to somehow pass, the government would have to increase rates (or make some other change(s)) to

ensure the most important providers of care in the country didn’t disappear overnight. We incorporate a 3% node in our analysis

to reflect the downside risk from the most draconian outcome (HCA’s commercial rate advantage disappearing completely without

any offset), which we feel is conservative.

While the share of total national healthcare expenditures consumed by hospitals is significant (~35% of total) and headline grabbing,

we believe this is a red herring, because it fails to consider the cost of providing care – aka provider margin. If we overlay our margin

assumptions by provider type, the profit pools in the US system look very different

If the government wants to attack profit pools through a tax or regulation, hospitals should not be first on the list. Of course the

government can try to reduce spend at hospitals by reducing utilization, which is discussed in the next section – the punchline is

that it is much easier for regulation to attack excess profits than to enforce a sea change in the delivery of care.

Pressure on inpatient volumes

A trend that the market and industry talk a lot about is the pressure to move inpatient procedures to outpatient settings. We analyzed

this threat in several different ways, and our high-level conclusion is that this is a manageable risk for HCA, and could actually

present an opportunity to improve share and profitability.

Headline Risk

Mitigant

The average hospital approximates that ~15% of current

inpatient procedures can be reasonably and safely

performed in an outpatient setting, and that ~4% of these

procedures will leave the hospital per year over the next 5

years

In spite of this, the average hospital estimates that same-facility

inpatient procedures will accelerate to ~2.3% over the next three

years, compared to ~1.8% over the prior three. The offsetting

factors to the inpatient->outpatient shift are: (i) population

growth, (ii) increasing procedures/capita, (iii) novel inpatient

procedures, and (for the larger systems) (iv) market share gain

When a procedure moves from inpatient to outpatient, the

average operating profit dollars for that procedure decline

by ~9%; combining this with the fact that ~4% will shift

per year implies a ~35 bps headwind to consolidated

EBIT

If we only include hospitals with a 40% or better commercial

payer mix, the average operating profit dollars are equivalent in

an inpatient and outpatient setting

While there will inevitably be leakage from inpatient to outpatient, there are several offsets that will allow hospitals to maintain

inpatient procedure growth, including population growth and novel inpatient procedures. Notably, this ‘concern’ around inpatient

volumes shifting to outpatient has been around for nearly a decade and the impact on the business has not been noticeable. Finally,

Life Science Intelligence, a medtech market analysis provider, estimates that inpatient procedures will grow ~1.2% through 2023

(ex-COVID impacts), which is in fact a modest acceleration from the past 3 years (~60 bps 2017-2019 vs ~1.1-1.3% expected 2020-

2023).

IV.Risks

i. Government changes the game. While we believe that HCA is protected by the ‘backboard’ of the government being unable to

lower rates without disrupting providers of care, we cannot discount the possibility that the government simply does something

foolish. We struggle to quantify both the magnitude and probability that this happens, but believe our 3% disaster node in our

analysis is sufficiently conservative to capture such an outcome. Our sizing recommendation is smaller than it otherwise would be

if this permanent capital impairment scenario was not on the table.

ii. Low visibility / M2M. It is difficult to forecast hospital volumes/mix over the short-term, and given the fixed cost nature of the

business, small changes in the topline can have outsized impacts on the bottom line. In addition, the market is well aware of the

risks facing hospitals, and thus tends to punish poor earnings more severely than the average stock. That said, our confidence in

HCA’s secular tailwinds and structural advantages provides us with the confidence to hold (and potentially size up) during these

temporary drawdowns.

iii. Domestic tax payer. HCA is a profitable, US domiciled business (foreign taxes represent ~2% of total provision), making us

exposed to any increase in domestic tax rates.

V.Valuation

HCA is trading roughly in-line with its historical discount to the S&P (~25% below). While we believe a business of this quality and

defensiveness deserves a higher multiple than 14x, we assume a ~14x weighted average multiple at occurrence. Putting this on $26

of FY24 EPS gets you a ~$365 stock, representing ~40% upside or a ~20% 2yr IRR.

Disclosure:

We and our affiliates are long HCA Healthcare (HCA US) and may buy additional shares or sell some or all of our securities, at any

time. We have no obligation to inform anybody of any changes in our views of HCA. This is not a recommendation to buy or sell

securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Earnings and easing of regulatory uncertainties

show sort by

			2022	2023
Price:	267.00	EPS	18.63	21.82
Shares Out. (in M):	302	P/E	14.3x	12.2x
Market Cap (in $M):	80	P/FCF	17.6x	15.5x
Net Debt (in $M):	35	EBIT	9,905	10,538
TEV (in $M):	118	TEV/EBIT	12.0x	11.3x