HCA Healthcare, Inc. (HCA)

Summary

We focus on smaller companies with “Ft. Knox” balance sheets and large & sustainable free cash flow yields and we are typically seeking a double-digit FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reductions, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We generally focus on small and micro-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

A larger cap stock we have owned for the past year is HCA Healthcare, Inc. (HCA), the largest for-profit hospital company in the U.S.  HCA was written up by Rearden in March 2017 and we completely agree with and highly recommend that excellent writeup.  Since then, there have been increased M&A opportunities in HCA’s industry and we believe this makes the thesis even stronger, since HCA is likely to use its superior balance sheet to enhance its competitive position.  HCA has already acquired 7 hospitals in 2017 for about $1b.

We believe HCA is essentially a modestly leveraged LBO of a stable, non-discretionary business with strong cash flows and deeply entrenched competitive positions in some of the most attractive local markets in the U.S.

HCA has 177 hospitals located in some of the fastest growing and most attractive geographic markets in the U.S.  HCA has an average market share of about 25% in the local markets it competes in and has been gradually increasing market share over the last six years.  While concerns about ACA/Obamacare’s future have weighed on its stock price, only about 2% of HCA’s total admissions are exchange patients under the ACA.  HCA management estimates only about 5%-6% of total EBITDA is from the ACA.  Importantly, we believe HCA is one of the most efficient and lowest cost operators in the for-profit hospital industry, which should enable it to effectively deal with changes in government payment programs or reimbursement rates from government and/or commercial payors.  HCA has long been focused on delivering value-based healthcare services.  Further, healthcare is a less discretionary expenditure.  This was made clear by HCA’s strong results in the Great Recession of 2008-9, when HCA was more leveraged (net debt to adjusted EBITDA of about 6x versus 4x today).  It is also difficult to open new hospitals, which require a Certificate of Need (CON) from state regulatory authorities and this limits competition.  As Rearden’s write-up noted, the number of hospitals in the U.S. has declined over the past 20 years while the U.S. population has increased significantly, resulting in higher per capita per hospital bed today.  Moreover, almost 80% of all hospitals in the U.S. are either non-profit or government owned hospitals which are generally less competitive players.

HCA has a highly cash-generative business model with a strong return on invested capital (ROIC) and significant opportunities to deploy additional capital to make its moat stronger.  HCA also has one of the strongest balance sheets in the industry at net debt to adjusted EBITDA of about 4x which should enable it to increase its market share over time as more highly levered players are forced to sell assets to reduce debt.  In fact, this is already playing out at Tenet Healthcare (THC) and Community Health (CYH).  HCA is also aggressively repurchasing its shares to further drive shareholder value, with total shares outstanding being reduced from 496m at year end 2011 to about 360m as of Q3 2017, a 27% reduction.  HCA’s strong free cash flow generation has enabled it to reduce its shares by 27% and concurrently reduce its leverage ratio from about 6x net debt to EBITDA in 2008 to about 4x at Q3 2017.

HCA’s financial performance has been strong over the past six years, with total revenues growing at about 5% p.a. and adjusted EBITDA growth of about 6% p.a.  HCA has consistently grown in-patient volumes in the low single digit levels, which is significantly better than most competitors and its industry.  We believe these volume trends can continue due to the attractive demographics in its markets, an aging boomer population, increased diseases such as diabetes and cancer in an older population, as well as organic growth investments to improve its network of facilities and services.  In addition to share repurchases, HCA has also paid two special dividends to shareholders which total $5b. Over the past six years, HCA has generated about $25b in cumulative cash from operations or about 40% of today’s enterprise value or 80% of today’s market value.

HCA trades at modest multiples of about 7.8x adjusted EBITDA and 13x EPS.  We expect HCA to repurchase at least 20m shares per year in 2018, 2019, and 2020 and end 2020 with total shares outstanding of about 300m (versus 360m shares today).  We believe HCA could continue to grow total revenues at about 4%-5% per year based on growth of about 1%-2% per year in patient volumes with the remainder from pricing increases and strategic hospital acquisitions.  HCA has grown adjusted EBITDA at close to 6% p.a. from 2011 to 2016, from $6.1b to $8.2b.  While adjusted EBITDA for 2017 will likely be flattish at about $8.1b, we believe it would have grown to about $8.4b for 2017 with certain one-time items added back (i.e., the hurricanes in Texas and Florida and a $50m Medicare adverse ruling in Texas).  We believe HCA can achieve adjusted EBITDA of about $8.5b in 2018, $9b in 2019, and $9.5b in 2020.  HCA has recently completed acquisitions in 2017 of 7 hospitals for about $1b which further strengthens its existing network.  Management has noted its pipeline of acquisitions is the strongest in 20 years.  Hospital acquisitions in 2017 were primarily from Tenet Healthcare (THC) and Community Health (CYH), which are more highly leveraged players who are disposing of assets to reduce debt and improve liquidity.  We believe HCA will be able to enlarge and strengthen its hospital network over the next few years.  We believe HCA is an important part of the U.S. healthcare industry, with roughly 5% of U.S. healthcare patients serviced in HCA’s extensive network of hospitals and outpatient facilities.

We believe HCA shares could trade higher over the next three years if it continues its solid performance.  Based on 8x our estimated adjusted EBITDA of $9.5b for 2020 with net debt of about $31b outstanding at year-end 2020, we believe HCA could trade for an EV of close to $76b or a market cap of about $45b.  Based on 300m shares outstanding estimated by year end 2020, this would imply a share price of about $150 per share or 60% higher than today’s price of about $93 per share.  If HCA continues to execute and its acute care hospitals perform as we expect, we think our target price can be achieved.

Geographic Markets

HCA market share ranks first or second in 27 of its 38 markets, as shown below.  We believe this gives HCA a very strong competitive position in its markets.  HCA is in some of the fastest growing markets in the U.S. including several urban markets which are growing due to the trend of population shifts back toward urban environments.

Valuation

We believe HCA is attractive at current prices trading at 7.8x adjusted EBITDA and 13x adjusted EPS.

HCA has grown adjusted EBITDA from $5.8b in 2010 to $8.2b in 2016 or about 6% p.a. compounded over the past six years.  Adjusted EBITDA grew from $6.6b in 2013 to $7.4b in 2014 (12% growth) to $7.9b in 2015 (7% growth) to $8.2b in 2016 (4% growth).  We believe HCA can grow adjusted EBITDA by at least5% p.a. from 2017 to 2020 to about $9.5b in 2020. 

Revenues by Payors

The approximate percentages of inpatient revenues, before provisions for doubtful accounts, related to Medicare, managed Medicare, Medicaid, managed Medicaid, managed care plans and other insurers, and uninsured are shown below:

Seasonality

The Company’s seasonality is shown below, which shows quarterly revenues and adjusted EBITDA, and indicates limited seasonality.

Attractive Industry Structure / Acute Care Hospital Has Significant Barriers to Entry

HCA operates in an industry with significant barriers to entry.  New hospital construction is regulated by states and requires a certificate of need (CON) to be approved.  There has been a decline in total hospitals in the U.S. over the past twenty years despite a significant increase in the population.  Furthermore, almost 80% of all hospitals are either non-profit or government-owned and a large percentage of total hospitals in the U.S. lose money.  We do not believe there is significant room to reduce reimbursement rates to hospitals in the U.S. without impacting quality of care.  HCA is among the most efficient hospital operators and we believe this gives it a significant competitive advantage which results in HCA being one of the most profitable hospital operators. 

Strong Local Market Positions in Attractive Acute Care Hospital Industry

We believe the acute care hospital industry has attractive characteristics over the long-term and HCA has strong market shares in some of the most attractive geographies of the acute care hospital industry, with an average market share of about 25% in its local markets.  There is a trend towards servicing patients in lower cost outpatient facilities and significant growth in these outpatient facilities.  However, the large hospital networks like HCA have established their own outpatient facilities to service lower acuity requirements and be a point of initial contact for patients.  Higher acuity services continue to be handled at acute care hospitals.  HCA has built a strong network of hospital and related facilities and services in its geographic markets which well positioned.

Strong Cash Generative Business Model

HCA has a highly cash-generative business model with a solid return on invested capital (ROIC).  HCA has consistently generated strong cash from operations year after year.  HCA has also consistently converted a high percentage of adjusted EBITDA into cash from operations.  Over the past six years, cumulative cash from operations is about $27b or close to 40% of the current enterprise value (EV) and close to 80% the current market cap.  In 2016, HCA generated about $5.6b of cash from operations with $2.7b of capital expenditures, which we believe includes significant growth expenditures.  We estimate FCF at close to $4b. We believe the Company has excellent prospects for growth in revenues, adjusted EBITDA, FCF, and adjusted EPS over the next three years. We estimate maintenance capital expenditures at about $1.5b per year or about 3% of revenues, which is about the amount spent in 2009 and 2010, when HCA was conserving capital in a tough economic environment.

Recession-Resistant and Resilient Business Model

HCA operates in a recession-resistant industry and HCA produced very solid results in 2008 and 2009 during the Great Recession.  HCA completed a leveraged buyout in 2007 immediately before one of the most difficult economic climates in the last 60 years.  Despite carrying leverage of close to 6x net debt to adjusted EBITDA, HCA successfully worked through this difficult period and grew adjusted EBITDA in 2008 and 2009 and completed a highly successful IPO in 2011.  Today, HCA has a stronger balance sheet, with net debt to adjusted EBITDA of about 4x and a stronger, more diversified business model.  We believe HCA is well positioned to handle difficulties in either the general economic environment or the specific healthcare environment.  We believe management has continued to strengthen HCA’s network in its key markets through additional facilities like freestanding ER’s and surgery centers as well as additional services provided that are in demand.  We believe HCA is a essential part of the local economies where it operates, with an average market share of about 25%.

Aggressive Share Repurchase / Capital Return Program

HCA has returned close to $13b to shareholders in the form of share repurchases and special dividends since going public in 2011.  HCA has been able to return this capital while concurrently significantly improving its leverage ratio from 6x in 2008 to 4x at present due to its highly cash-generative business model.  We believe the Company will continue to aggressively repurchase shares and spend close to $2b per year for share repurchases going forward.  Consequently, we expect HCA’s total diluted shares outstanding to continue to decline from the present level of about 360m shares to close to 300m by year end 2020.  Since starting its capital return program in 2012, HCA has reduced total shares outstanding by about 27% from about 496m at year end 2011 to about 360m at present.  The aggressive reduction in total shares outstanding should contribute to much stronger growth in adjusted EPS.

Solid growth in adjusted EBITDA from 2011 to2016 - Good Growth Prospects for 2018 to 2020

HCA is focused on continued growth in adjusted EBITDA in 2018, 2019, and 2020.  HCA has averaged about 6% p.a. growth in adjusted EBITDA over the past five years, from 2012 to 2016.  While adjusted EBITDA will likely be flattish in 2017 at about $8.2b, this is primarily due to one-time events such as the hurricanes in Texas and Florida and a Medicare ruling in Texas.  We believe HCA would have generated approximately $8.4b in adjusted EBITDA in 2017 without these events.  We conservatively estimate HCA can achieve $8.5b in adjusted EBITDA in 2018, $9b in 2019, and $9.5b in 2020.  This would be consistent with its historical growth rate.  Management has confirmed a long-term growth rate for adjusted EBITDA of about 4% to 6% per year.  HCA has consistently grown equivalent admissions by close to 2% per annum over the past five years, outperforming the hospital industry.  We believe HCA is making significant organic investments to strengthen its market position in existing markets.  We also expect HCA to make more hospital acquisitions in existing or adjacent markets, like the 7 hospitals acquired in 2017.  This should also help grow adjusted EBITDA.

Excellent Management Team

We believe HCA has the strongest management team in the for-profit acute care hospital industry.  Milton Johnson is a strong CEO with an excellent track record.  We believe HCA is very adept at cost-cutting, rationalizing operations, and exiting weaker businesses and growing stronger businesses both organically and through acquisitions.  HCA has a very sharp pencil in terms of evaluating both capital expenditures and working capital investments. 

High Performing / High Quality Hospitals

Over 75% of HCA’s hospitals were recently given the top-quality ranking in the recent survey, compared to about 35% of all hospitals in the U.S. which received the highest rating.  These high-quality rating are likely to help patient admission trends continue to be positive and outperform industry averages.  These high-quality ratings also help strengthen HCA’s leverage with payors who want high rated hospitals in their networks.

Limited Exposure to ACA / Strong Competitive Position Provides “Umbrella”

Only 2.5% of HCA admissions are related to ACA.  HCA estimates it gets about 6% of total adjusted EBITDA from ACA related revenues.  We believe that HCA is well positioned regardless of how the debate about ACA plays out.  We believe HCA could take mitigating actions if the ACA is somehow repealed.  Management is focused on delivering the best value in its markets for patients and payors, including the best care at the best possible pricing.  We believe strong positioning in attractive local markets and HCA’s superior cost structure, efficiency, and profit margins will enable it to continue to enjoy strong profitability despite efforts by government and commercial payors to reduce reimbursement rates.  We believe there is a limit to how much reimbursement rates can be reduced without impacting quality of care and risk of life at hospitals and that less profitable and efficient hospitals, which represent about 80% of the hospital industry, will be impacted first.  HCA’s superior competitive position likely provides an “umbrella” for its long-term profitability.

Recent Acquisitions Should Help Grow Profitability

HCA has one of the strongest balance sheets and liquidity positions in the acute hospital industry.  Consequently, it is strongly positioned to grow market share and improve its competitive position as weaker hospital systems are forced to sell assets.  We believe this dynamic has started to play out in 2017 as HCA has announced acquisitions covering 7 hospitals from weaker industry players who are seeking to strengthen their balance sheets.  These hospitals have total revenues of close to $1.6b.  HCA has indicated it believe it can improve the margins on these hospitals from mid to low single digits to mid-teens over time.  We expect additional transactions like these to occur in the future.

Consistently Improving Operational Metrics and Profitability Over Past Six Years

Since 2007, HCA has consistently grown its number of hospitals, equivalent admissions, weighted average licensed beds, emergency room visits, and outpatient and inpatient surgeries – almost every metric of its underlying operating business has grown significantly. Similarly, total revenues, adjusted EBITDA, and adjusted net income have also grown.  Revenues before provisions grew from $30.7b to $44.8b from 2010 to 2016 or about 7% p.a.  Adjusted EBITDA grew from $5.8b to $8.5b or about 6% p.a.  While equivalent admissions and total revenue growth have been modest, growth in adjusted EPS has been significantly higher due to the reduction in total shares outstanding.

Opportunity for Higher Multiple as Business Model Recognized

We believe HCA’s strong, recession-resistant business model and unique competitive position will eventually be recognized with a higher multiple if it continues to execute its organic and inorganic growth programs successfully.  HCA has shown industry-leading growth in equivalent admissions for the hospital industry.  We believe its strong local market shares in attractive, high growth urban markets and its capital investments in new facilities and services that are in demand are key factors in driving these above average growth characteristics.  We believe HCA can continue to grow its revenues and adjusted EBITDA in a mid-single digit range and that adjusted EPS can grow at even higher rates.  Further, we believe HCA can grow through strategic acquisitions of hospitals and other key facilities in existing and adjacent geographic markets, such as the seven hospitals in 2017.

Solid Balance Sheet Enables Value Creation

HCA has a solid balance sheet with a net debt of about 4x net debt adjusted EBITDA.  While we typically do not like any debt in our investments, HCA has significantly reduced leverage over the past several years, from close to 6x in 2008 and 2009 to about 4x currently.  HCA owns a substantial amount of real estate which likely has great value.  HCA has a stable group of acute care hospital and related services that we believe can generate strong cash flows to pay down debt, even in a weak economic climate.  HCA’s debt is rated B+ and management is very focused on maintaining a strong credit rating.  HCA is significantly less levered compared to other major players in the acute care hospital industry and we expect this will enable HCA to acquire adjacent facilities and services and new markets and further strengthen its healthcare network over time.  The acquisitions of seven hospitals in 2017 are examples of this opportunity as these assets were in existing HCA markets and were acquired from more highly levered players seeking to reduce their debt positions.

Conclusion and Target Price

Based on 8x our estimated adjusted EBITDA of $9.5b for 2020 with net debt of about $31b outstanding at year-end 2020, we believe HCA could trade for an EV of close to $76b or a market cap of about $45b.  Based on 300m shares outstanding estimated by year end 2019, this would imply a share price of about $150 per share or 60% higher than today’s price of about $93 per share.  If HCA continues to execute and its acute care hospitals and outpatient facilities perform as we expect, we think our target price can be achieved.