Description
Hospital stocks have sold off across the board due to the broad-based deferral of elective procedures brought on by COVID-19. This backdrop has provided an attractive entry point into HCA, a high-quality company with a positive long-term outlook.
Company description:
HCA is a large health care system anchored by 179 acute care hospitals with ~48k beds and 123 freestanding surgery centers. The company also operates psychiatric hospitals, emergency care facilities, urgent care facilities, walk-in clinics, diagnostic and imaging centers, rehab and physical therapy centers, radiation and oncology therapy centers, and physician practices. Facilities are in 21 states and England.
Favorable attributes:
- High local market share:
o HCA’s average market share in its various regions is 26%. This high share gives HCA increased bargaining power with commercial payors when negotiating reimbursement rates since commercial payors are loath to exclude a large system from their network.
o This pricing power allows HCA to earn higher reimbursement rates on a like-for-like basis vs. subscale competitors.
- Better operating efficiency:
o HCA is an extremely well-run company. Most of its competitors are non-profits (nationwide only ~20% of hospitals are for-profit). As you may imagine, many non-profit hospitals are inefficient and often lose money.
o Hospitals provide a critical service and are large employers with powerful lobbies. Therefore, the government generally sets reimbursement rates at a level that allows the marginal, sub-scale hospitals to stay in business. This provides a price umbrella for HCA.
- Virtuous cycle:
o Superior commercial reimbursement rates, better operating efficiency, and general economies of scale (procurement, staffing, etc.) leads to higher operating margins and robust free cash flow.
o This prodigious free cash flow has allowed HCA to reinvest in its assets much better than its cash-starved peers that are limping along.
o Since doctors want to practice at hospitals with the latest equipment, best throughput, and best patient outcomes, it is not overly surprising that HCA has been able to consistently take market share over the past decade.
- Growth initiatives
o HCA has historically reinvested a material portion of its excess cash flow in growth initiatives.
o For example, HCA has prioritized expanding into higher acuity service lines which improves complexity mix.
o HCA also frequently invests in standalone outpatient practices, which adds touch points in the market and further densifies its footprint.
o More recently, HCA has opportunistically acquired struggling hospitals from cash-starved competitors. HCA can generally improve margins to company averages since HCA has superior scale and higher commercial reimbursement rates.
- Attractive geographic footprint
o HCA has focused on growing, urban markets in business-friendly states. This demographic tailwind has allowed HCA to outgrow the industry year-after-year. Texas and Florida are HCA’s two biggest markets.
- Owner-operator mentality
o The Frist family owns 20% of the company. The family has a long track record of creating value for shareholders.
o Thomas Frist III is Chairman of the board. His father (Thomas Frist II) co-founded the company with his father (Thomas Frist I) in 1968.
- Strong financial track record
o In the past decade, HCA’s operating EBIT has grown by ~$3.2b and its invested capital has grown by ~$16.5b. This implies a 19.5% pretax return on incremental invested capital.
Valuation:
- HCA earned $10.50/shr of adj. EPS in 2019. On 1/28/20, the company guided to a midpoint of $11.70/shr. This has since been withdrawn for obvious reasons.
- Therefore, at $109, HCA is trading at 10.4x ’19 and 9.3x pre-COVID ’20 EPS.
- Analytically, I have thrown up my hands on what 2020 EPS will be. 2Q is going to be extremely ugly given the lockdown. I roughly estimate that inpatient admissions will be down ~15%, inpatient surgeries will be down ~20%, and outpatient surgeries will be down ~25%. However, a lot of the deferred elective procedures should be made up in the second half of the year as most the underlying health issues of patients are still a problem.
- Despite this uncertainty, I am confident that HCA will survive (ample liquidity) and emerge stronger (vs. weaker peers) on the other side of the crisis.
- HCA went into the pandemic at 3.4x net debt/EBITDA, below the low end of its target leverage range. The company has a staggered, termed-out maturity schedule and its debt trades well above par.
Key risks:
- Policy risk:
o We are in an election year so headline risk is elevated. However, Trump is a known quantity and Democrats have historically been good for providers (they tend to push for expanded coverage).
o Biden’s policy platform is to build on the ACA which was a windfall for hospitals the first time around.
- Sustained high unemployment:
o Would hurt commercial mix. As a mitigant, EBITDA held up well in ’08-’09 demonstrating the resiliency of the model.
- Reimbursement cuts:
o I doubt this is on the agenda given how critical hospitals have been (and how much financial pain they have endured) dealing with this public health crisis.
- Reimbursement fraud:
o Occasionally providers get caught being overly aggressive with reimbursement coding.
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
business stabilizes in 2H'20