HCA is the largest public hospital and health care services company in the US.  The Company went public in March and currently has an $19bn market capitalization.  HCA is a great franchise, with best in class management, assets, operations and organic growth prospects.  Over the last 10 years HCA has grown EBITDA at a 7% CAGR and has never had a year in distant memory where EBITDA declined materially (i.e., more than 1%).  The Company generates an attractive return on assets and significant free cash flow in an industry where few operators do.  

The incremental thesis for investing in HCA is simple.  Sell-side analysts and market participants seem to be materially underestimating 2012 EPS, primarily by overestimating interest expense.  The current weighted average interest rate on the Company’s ~$25bn of debt is ~8%.  This average rate is inconsistent with HCA’s high credit quality and current leverage ratio of 4.2x net debt / EBITDA.  HCA will take advantage of accommodating covenants and historically low market borrowing rates to bring down HCA’s cost of debt.  

The consensus sell-side 2012 EPS estimate is $3.  My estimate is 50 cents higher, or $3.50.  At $34.50, HCA trades for 10x my 2012 EPS estimate, 7x my 2012 EBITDA estimate (minority interest capitalized at 10x), and a ~10% FCF yield (after payments to minority interests).  HCA is cheap, especially on P/E and FCF metrics.  At $45, HCA would trade for 8x 2012 EBITDA, 13x 2012 EPS, and an 8% FCF yield.  These valuation multiples are appropriate on a fundamental basis and relative to current peer multiples.  

I think the market should bring up expectations for 2012 EPS over the next six months as the Company’s capital structure plan gets communicated and executed on.  HCA should continue to deliver strong operating results in the meantime.  The high potential return over a short holding period seems attractive and the downside at the current valuation seems limited.  This thesis does not require a rebound in commercial volumes and/or utilization, which are possible upsides.


Company Background

From the HCA website: “Today, we are the nation's leading provider of healthcare services, a company comprised of locally managed facilities that includes about 164 hospitals and 106 freestanding surgery centers in 20 states and Great Britain and employing approximately 183,000 people. Nearly five percent of all inpatient care delivered in the country today is provided by HCA facilities.”

HCA’s hospitals are located in markets with attractive demographics.  The Company’s 10 largest markets include: Miami/Fort Lauderdale, Tampa, Nashville, San Antonio, Houston, Austin, Dallas, Kansas City, Denver, and Salt Lake City.  In most of their markets HCA has 20%-40% market share.  This high level of market share creates negotiating leverage when contracting with insurance companies.  This combination of exposure to fast growing markets and high local market share allows HCA to deliver strong admissions, revenue, and earnings growth.  Finally, it is important to note that the Company has historically had best in class quality scores as measured by CMS.

KKR, Bain Capital, Bank of America, and Tommy Frist sit on the Board and have meaningful equity ownership.   In addition, a large number of HCA executives have meaningful equity value in the company.  This is a team that can be counted on to maximize shareholder value, whether it is through operations, use of capital, monetizing assets or optimizing the capital structure.  Certainly the godfathers of the “LBO” wont miss opportunities to reduce the cost of capital.


What the Market is Missing

The Street is modeling 2012 interest expense at levels that are only down marginally from current run-rate levels.  There are 4 main sources of potential interest savings.  These sources of interest savings should total $500mm and may be larger.

1) Interest rate swaps.  HCA has a $7.1bn fixed-to-floating swap that is maturing in November 2011.  The current swap rate is at ~4.8%.  While a new $3bn swap will come on in November, the Company plans to leave $4.1bn floating rate.  The new $3bn swap is set at ~3.7% and current LIBOR is at ~20bps.  Note that the company has limited floating rate debt in the capital structure today.  The potential interest expense savings from the swap maturity is ~$220mm annually.

2) 2nd lien notes.  HCA has $6.1bn of 2nd lien debt at a weighted average effective interest rate close to 10%.  $5.8bn of this debt is callable in 2011.  HCA recently called $1.1bn, and should call the remaining $4.7bn of debt on November 15th, 2011.  HCA recently amended their credit facilities to allow 1st lien leverage up to 3.75x EBITDA.  This amendment gives HCA ~$8bn-$9bn of additional 1st lien capacity.  I believe HCA is very likely to issue term loans or 1st lien notes to fund the retirement of the 2nd lien notes.  HCA’s current 1st lien notes trade to yield 5%-5.5%.  The potential interest expense savings from retirement of all the callable 2nd lien debt is ~$200mm annually.

3) FCF.  HCA should generate ~$3bn of FCF over 2011 and 2012 after accounting for distributions to minority interest holders.  Some of this cash could be used for accretive hospital acquisitions.  However, I have made the conservative assumption that the capital is used to paydown debt.  Potential interest expense savings from using FCF to paydown or retire debt is >$50mm annually.

4) Other.  As noted above, HCA has significant capacity to issue 1st lien debt.  Given this capacity and a management and Board focused on maximizing returns to equity holders, it would be reasonable to assume that the Company looks to take out other higher cost debt through open market purchases, tenders, or other mechanisms available to them.

Note that in addition to very conservative sell-side interest expense assumptions, sell-side estimates for D&A and tax rate are also somewhat conservative.  My 2012 estimates are shown below.


2012E Summary P&L ($s in millions)

2012 EBITDA             6,525
               
D&A                         (1,450)
Interest Expense    (1,575)
EBIT                         3,500
               
Taxes                     (1,155)
Minority Interest        (400)
Net Income              1,945
               
2012 EPS                 $3.50
Sharecount                 555


Risks

Reimbursement from government payers appears to be the most relevant risk.  What cushions HCA and other for-profit hospital chains from material reimbursement cuts is the fact that a large percentage of non-for-profit hospitals in this country are losing money.  Estimates suggest that between 1/4 and 1/3 of U.S. hospitals are unprofitable.  There is a history in the health care services industry of large reimbursement cuts being reversed soon after implementation due to financial distress among operators.  Patients and the industry lobby have a loud voice in Washington D.C..  Note that large reimbursement cuts in various state Medicaid programs are factored into HCA’s guidance of mid-single digit EBITDA growth for 2011.  The Company has not formally guided on 2012 EBITDA growth but seems comfortable leading investors to a mid-single digit organic EBITDA growth assumption.  To the extent that Medicaid and Medicare reimbursement is lower than expected, HCA can lean on commercial insurers for higher reimbursement and can also pursue operating efficiencies such as reducing supply costs.  

Fraud is also a risk that should be considered, especially given the alleged fraud at CYH.  While HCA did have problems in the late 90s under prior management, there is far less risk of that type of behavior today.