Description

Health Management Associates

Overview

Despite substantial erosion in its share price following a disastrous February 2007 dividend recapitalization, Health Management Associates remains an excellent short opportunity as the poor patient economics and bad debt issues currently plaguing the Company are likely to yield financial distress during the first two quarters of 2008 and new management efforts at an operational turnaround remain in a trial stage.  With bad debt issues likely to deteriorate further (rather than improve per management guidance) over the next four quarters, HMA is very likely to face financial covenant issues in Q1 2008 and liquidity issues in Q2 2008 due to the forced redemption of its convertible bonds.  Moreover, HMA’s asset base of chronically under-managed acute care hospitals provides few opportunities to delver through asset sales in a market replete with more attractive opportunities for strategic and financial buyers.

Company Overview & History

HMA owns and operates 57 general acute care centers located in rural and suburban markets predominantly in the Southeastern and Southwestern United States.  The Company’s facilities are located in 16 states and house approximately 8,350 licensed beds.  Following divestitures / closure of much of its outpatient diagnostic and ambulatory surgery services assets in 2005-2006, a substantial majority of its outpatient revenues are now generated from emergency room services. 

HMA was a stellar performer in the mid-1990s, enjoying some of the highest operating margins in the hospital sector due to the favorable pricing it was able to obtain from Medicare and managed care organizations given lack of competition in its rural markets.  In the early 2000s, HMA benefited (along with other acute care hospitals) from generally higher managed care pricing and the Company sank free cash flow into $3.8 billion in new facility capex and facility acquisitions between 1999-2003, predominantly in suburban markets.  Expansion into suburban markets in the early 2000s proved challenging as the Company lacked the pricing and cost management practices necessary to compete in better-penetrated suburban markets.  

In particular, HMA’s suburban facilities have been squeezed by (i) poor margins on managed care revenues, (ii) poor surgical volumes referral admissions driven by low physician satisfaction/retention rates and (iii) high bad debt expense driven by uninsured patients.   Much of the Company’s suburban acquisition strategy in the early 2000s was premised on the faulty assumption that it could replicate the insulated pricing it received in rural markets in more competitive suburban markets.  Aside from lacking leverage in pricing negotiations, HMA management simply failed to keep up with the need to renegotiate discount-based contracts on an annual basis with MCOs or meaningfully improve the cost structure of acquired hospitals. 

In addition, both HMA’s traditional rural and acquired hospitals have suffered from a more gradual trend in recruiting and retaining physicians in coveted specialties (e.g., anesthesia, radiology). Aside from the general challenge of recruiting physicians to less central geographies, this has been driven by the cost to physicians of treating uninsured patients brought in through emergency departments – a cost center more difficult to avoid in rural/suburban markets than in urban markets where specialists can more easily avoid ER referrals.  Difficulties in recruitment/retention have been self-perpetuating, with well-publicized complaints of physicians centered on chronic ED under-staffing, and impacted HMA hospitals in two distinct ways.  First, without a motivated base of referring physicians, a growing share of HMA’s admission revenues have been generated from emergency room volumes with a substantially higher share of uninsured patients.  Second, for similar reasons, the share of higher-margins surgical admissions (to general admissions) has appreciably declined.  While HMA does not disclose the share of revenues it derives from surgery, surgical admissions have declined approximately 7% (from 95% to 88% of total inpatient admissions) since 2002.  Patient mix and surgical volumes were further harmed by generally poor facility-level management that has led to underinvestment in high-end medical equipment, poor physician utilization and, in a few instances, questionable sanitary conditions.

Finally, it is difficult to overstate the degradation in HMA’s own collections due to the increase in (and increasing delinquency of uninsured patients) coming in through its emergency rooms.  As a result, despite the Street’s heavy focus on healthy EPS improvement (43 cents in 2007 to $1.42 in 2005), HMA’s return on assets steadily declined from 16% in 1997 to 2-4% in 2006/2007 YTD.  Despite the step-up in provisionsing described below, self-pay receivables have come to represent over 40% of HMA’s total AR with DSOs that, on average, three times that of third-party payor receivables.  Traditionally 60-70% of these obligations become delinquent.  While a national problem for all acute care hospitals (and a more pressing one for other non-urban providers), uncompensated care remains a particular challenge for HMA because of the reputation its hospitals have accrued for lax collection practices.  Under former management, HMA hospitals became reputed amid indigent populations in its markets for slothful delinquency management (e.g., moving receivables to contingency collections, legal enforcement) – a factor openly admitted by new management as driving its disproportional share of uncompensated care.

Beginning in 2006, sector-wide market concerns over flat same-site patient volumes, continued payor price discipline and escalating bad debt from uncompensated care held the stock range bound despite management’s drumbeat of strong and durable earnings growth, leading to heavy takeover / LBO speculation (e.g., Private Capital Management) that never materialized.   In February, former management – large owners of the stock and frustrated by its stagnant trading in a bull market, consummated a roughly 50% dividend recap of the Company by paying a $10/share special dividend funded predominantly through an incremental $2.4 billion bank debt refinancing.  The recap raised LTM net leverage from 1.9x to 4.8x (currently 5.5x). 

Almost immediately following the recapitalization, HMAs bad debt issues came to a head.  In conjunction with the closing of the recapitalization, HMA announced a massive $200 million write-down of its receivables in conjunction with the third of four changed to its accounting policies for self-pay receivables.    The write-down evicerated the Company’s prior 5 years of EPS growth and exposed the folly of the recapitalization.  In April, HMA’s longtime CEO, Joe Vumbacco, stepped down and was replaced by COO Burke Whitman; Whitman subsequently brought back COO Kelly Curry from retirement to address HMA’s numerous operational issues.  In addition to new operating initiatives (discussed below), the new management team has begun to divest non-core facilities.  In Q3 2007, HMA completed the sale of two Virginia facilities for $70mm and designated two Arkansas facilities for sale.  Management expects to sell 2-4 additional facilities over the next 12 months.

Current Operations

Patient Care Margins

Like many other companies in the non-urban hospital segment, HMA has suffered a steady decline in margins since 2002 due to a weighted average increase in competition in its hospital markets (reducing reimbursement rates by 3^rd party payors) while incurring patient care cost inflation at the high end of the sector (6-8%) due to poorer than average cost control.   As a result, while per patient margins have generally been flat for the sector as a whole, HMA has experienced a 566bp decline in operating margins over this period:

While HMA, like other ACH providers, does not disaggregate inpatient and outpatient costs of service, this is largely a function of the Company’s shift in patient mix to outpatient services.   In Q2 and Q3 2007, admissions volume to emergency rooms increased 2% and 3%, respectively, while inpatient admission declined 1.6% and 0.4%.

To its credit, the new management team has tried to be transparently address HMA’s operational difficulties but initiatives to date are in early stages (e.g., physician and customer surveys, personnel replacement) and no genuine strategy has been elucidated to turn the Company’s exposure to industry secular trends around.  Management’s primary focus has been on (i) improving the renegotiation rate of discount-based managed care contracts, (ii) improving physician and customer satisfaction rates, (iii) moving physicians to productivity-based contracts and (iv) improving collections management.  On (i), despite the Company’s August announcement that it had renegotiated over 200 of the roughly 600 such contracts to date (versus 76 renegotiations in August 2006), Q3 2007 revenue per adjusted admission increased 4.6% YOY – precisely the same growth as Q3 2006 and below the nearly 11% YOY growth in opex/adjusted admissions.  On (ii), the Company just completed its first physician satisfaction surveys in over 5 years but has yet to disclose any concrete approaches developed from them.  On (iii), the Company let go 132 doctors in Q3 that refused to move to production-based contracts but released no other information on this initiative – suggesting progress has been difficult, particularly at a time when HMA is struggling to improve relations with the overall physician base.

Uncompensated Care Problems Bad and Getting Worse

As the Company’s uncompensated care issues have mounted, HMA has repeatedly found itself behind the curve in provisioning for bad debt expense.  In addition to its generally high share of uninsured ER patients, HMA’s emergency departments have been particularly hard hit my “out-migration” – urban uninsured patients seeking ER services in the suburbs and, more recently, by higher uninsured rates in areas disproportionately affected by the housing market.  In mid-2005 through Q2 2007, HMA made a series of revisions to its charity care and bad debt provisioning methods in response to poor collection rates that resulted in substantial write-downs to its accounts receivable:

In Q1 2007, in order to settle a class action lawsuit against it brought by uninsured patients over alleged “abusive billing practices”, HMA agreed to offer self-pay patients discounts of 40-60% off of its “list” prices for services (similar to those provided to MCOs and Medicare).    However, the Company contemporaneously lowered to income levels for provision of charity care, such that the collective net revenue impact in Q1 was negligible (see table below).  In addition, the Company announced in its Q2 earnings release that it was increasing its guidance on bad debt provisioning from 7.5-8.5% to 11.5-12% based on “recent collections experience”.  While at first blush this may appear to be newfound conservatism, this new provisioning guidance is actually slightly less than HMA’s 12.2% average bad debt expense over the preceding two years (inclusive of writedowns):

 In its recently announced Q3 2007 results, HMA reported bad debt expense 11.8% ($126.5mm), which included $16mm from the sale from the sale of charged-off receivables (more than 200 days old).  While management struggled to characterize this as a recurring revenue stream on its earnings call while remaining cryptic on the particulars of the transaction, they strongly suggested that the sale (consistent with low-single digit purchase prices for charged-off healthcare receivables) represented a substantial majority of charged-off receivables outstanding with contingency firms.   As such, while the Company may, indeed, liquidate charged-off receivables more promptly on a go forward basis, such sales are extremely unlikely to be a materials source of funds in future quarters.  On an adjusted basis, Q3 bad debt expense was 13.3% -- substantially in excess of historical rates and guidance.  The Street’s modestly negative reaction to otherwise in-line results suggest that  it saw through this modest accounting chicanery.

In fact, there are two reasons to believe that HMA’s bad debt experience are likely to deteriorate further and the Company may need to further boost its provisioning policy to maintain acceptable receivables.

The first is a simple but (apparently) universally overlooked feature of the shift in its policy towards charity care and self-pay discounting adopted last quarter.  Recall that the impact of the two policy changes – implementing 40-60% discounts for self-paying customers and limiting charity care to patients below the Federal poverty line – approximately offset each other such that net revenues were unaffected (see page 5).  However, this policy shift has a predictable negative impact on the quality of receivables going forward because it leads net receivables to include a significant amount of debt owed by patients previously assessed as “indigent” (those with incomes 2-3x the poverty line) whose charges were previously forgiven under the more liberal charity care policy (and, thus, never booked as revenue).  By contrast, the current policy discounts these revenues by 40-60% and then provisions the remaining receivables (at 60%), resulting in 20% of such indigent self-pay charges being included in net receivables.  With the average patient in this cohort having a family income of under $25,000 per year, collection of these receivables is likely to be negligible.  As a result, this shift in policy should predictably yield to an increase in bad debt expense of approximately 2% of net revenues as it anniversaries.

In addition, HMA’s new discounting policy should lead to an overall 4-5% decline in net revenues because it applies to all self-pay non-elective charges (including non-indigent patients).

The second reason for prospective deterioration in receivables credit quality is the general trends contributing to as increasing volume of self-paying patients.  While self-paying patients represent approximately 9% of total patient admissions, they represent over 60% of outpatient volume (almost entirely due to ER admissions).  The mix of outpatient equivalent[1] to inpatient admissions has steadily increased from approximately 0.61:1 to 0.68:1 since 2002.  As previously noted, this mix shift is driven by a host of national and regional trends – none of which are expected to abate.  Assuming these trends continue, self-pay % could increase by as much as 3-4% over the next 5 years.

Taken together, the increase in HMA’s bad debt guidance (to 11.5-12% of net revenues) appears light in the face of its change in indigent care policies and growth in outpatient services and, going forward, stable bad debt reserve of 14-15% are likely to be necessary to adequately reserve self-pay receivables.

Financial Distress in 1H 2008 due to Covenant Issues and Convertible Redemption

HMA faces both exceptionally tight covenant compliance and the specter of a difficult-to-finance redemption of its convertible notes – with either credit event effectively forcing it to renegotiate with its bank group amid a much less amiable backdrop than was present during the recap. 

The financial covenants under HMA’s new credit facility with BofA are fairly tight and, while they clearly envisioned the prospect of bad debt issues for the Company (e.g., the specifically include changes in provisioning accounting in the definition of bank EBITDA), they also did not appear to anticipate the nearly 50% increase in normal provisioning (to 12%) much less the likelihood that it will prove inadequate (discussed above).  In fact, projecting covenant compliance into 2008 – assuming stable unit revenues and operating margins exclusive of bad debt expense and adjusting for planned facility divestitures at an average net sale price of $35mm per facility – suggested that HMA will violate covenants by the second quarter of 2008:

Given HMA’s high leverage and limited options, the outcome of any waiver negotiation with the Company’s bank lenders is likely to substantially impact its equity value.  With consensus 2008 earnings (52 cents) equivalent to less than 5% of the balance of the Company’s credit facility, the impact of virtually any typical amendment fee or impact on rate will dominate 2008 results – assuming this is sufficient to pacify HMA’s bank group.  Asset sales, the only other feasible band-aid measure are already being undertaken by the Company in an extremely unfavorable sale environment for ACHs and fixed commitments to accelerate this programs are only likely to depress sale values.

In addition the Company’s 1.5% convertible subordinated notes due 2023 become put-able at par to the Company by holders in June 2008.  Following adjustments for the February recapitalization, these notes are currently convertible at $13.93 cents per share – so far out of the money that it is almost certain that they will be put to the Company.  The Company may satisfy this obligation in either cash or common shares (in whole or part, shares valued based on preceding 30 days trading volume). 

Either form of redemptions will prove exceptionally difficult for HMA.  While the Company ostensibly has sufficient liquidity to fund the redemption in cash ($500mm available under the revolver + $114mm in cash at Sept 30), the covenants under its credit facility specifically limit it in doing so in favor of a subordinated debt offering.  HMA cannot fund the redemption out of its revolver unless it maintains 1^st lien secured leverage of 4.25x (currently 4.1x and expected to be over 5.0x by Q2 2008 absent any need to draw on the revolver) and $100mm of minimum availability under the revolver.  By contrast, a subordinated debt offering, while probably preferable given the Company’s modest liquidity at any reasonable cost and feasible back at the time of the recapitalization, would extremely challenging in the current credit environment.  While pro leverage would be unchanged, the credit facility restricts a new senior note issuance unless pro forma leverage would remain below 5.5x (which it would not) and the current trading prices of the Company’s 2016 senior notes (low 80s) suggest a sub note offering would be infeasible. Even assuming the Company was able to fund the redemption through its current borrowing capacity (i.e., met the covenant), HMA would be swapping  $575mm in 1.5% coupon debt for bank debt with a current yield of approximately 7.3% -- adding approximately $33mm in annual cash interest expense (about 25% of consensus 2008E EPS, not factored into most analyst models).

Conversely, satisfying the redemption in shares or funding cash redemption through a new preferred or common share issuance would be extremely dilutive.  If redeemed in shares, aside from mechanical dilution of approximately 35%, such issuance is likely to create a sustained overhang on the stock as shares held by institutional bondholders are monetized in the market.  Conversely, cash redemption funded by an equity offering (assuming one where feasible) would likely impose cash transaction costs of 4-6%.  In either case, even without such costs, the impact on EPS would be to undercut any EPS growth through at least 2009.

Valuation

Financial distress by HMA in 1H 2008 is likely to, at the very least, force market valuations based on current run-rate operating results (e.g., 25-31 cents EPS based on annualized Q2/Q3 results excluding unusual items) rather than the glossy current 2008/9 estimates (52 cents and 61 cents consensus, respectively) that assume growth in sales (despite contraction of HMA’s facility base), growth in operating margin per admission (despite consistent and long-term degradation as unit revenues have failed to keep pace with costs) and stabilization of bad debt expense (despite the addition of indigent receivables through the Company’s new discounting policy). 

At current market valuation multiples, such a discounted metric yields value of approximately $4/share. Of course, given the actual deterioration in fundamentals (admission margins and bad debt expense) and balance sheet instability, such valuation is actually pretty optimistic.  At projections that incorporate such degradation, HMA is simply insolvent.

Catalyst