Description

LPNT is a compelling idea relative to the company's underlying value and 2008 earnings power. LPNT will give earnings guidance during the first week of Jan. I actually expect that guidance to be negative vs. current 2006 expectations. However, once we get this disappointment out of the way, it will clear the way for the underlying value of LPNT's franchise to be recognized.

Ex. options, which compares with current consensus, I expect LPNT to earn $2.70 in 06, $3.21 in 07, and $3.77 in 08. With options, EPS with $2.50 in 06, and $3.01, and $3.57 in 08. Growth will be 11.4% in 06, 18.8% in 07, and 17.4% in 08. If you use 15x my 2008 EPS figure you get a $54 price target, which represents a solid return from the current price.

The key thing about LPNT is that they operate rural hospitals. Rural hospitals are much better than urban ones because they have local monopoplies and face much less competition. To put it simply, rural hospitals: good, urban hospitals: bad. Rural hospitals are worth 15x, urban hospitals probably should trade more like 13-14x.

LPNT is known as being a good operator of hospitals, but they can be criticized for the corporate acquisition strategy. It is not that their acquisitions have destroyed value, it is just that the $1.6bn that they spent on Province would have probably been better spent on a series of smaller, rural not-for-profit acquisitions. Community Healthcare has the best corporate acquisition strategy in the rural hospital space, and they get a 17-18x fwd EPS multiple as a result. I think the in two years, LPNT’s strategy is going to move towards CYH’s, and thus there may be more upside to LPNT as the company goes from a “bad strategy discoint” to a “good strategy premium.”

LPNT has a core set of mature hospitals and a set of recently acquired hospitals that will drive the growth. LPNT has been very busy with their acquisitions over the past year, so I expect the company to digest the announced deals for the next 18 months. However, ultimately LPNT should be able to do 3-4 small acquistions per year which will propel growth beyond what you can get from the same-store portfolio.

Three recent acquisitions are going to drive the robust 2007 & 2008 growth that I see: Province, HCA, and Danville. In 2005, PRV did $772mm in revenue, HCA $381mm, and Danville $181mm. I expect EBITDA for these three to go from $192mm, $31mm, and $22mm in 2005 to $219mm, $38mm to $240mm, $47mm, and $40mm in 2008. Margins will go from 24.8%, 8.3%, and 12.0% in 2005 to 26.7%, 10.8%, and 18.5% in 2008. Overall EBITDA will go from $496mm in 2005 to $650mm in 2008. $58mm of this increase will come from growth in the legacy LPNT same-store portfolio (assumes annual 6% same-facility revenue growth and modest margin expansion). The bulk of the rest of the growth will come form the acquisitons I highlighted above.

For Danville, margin expansion will be driven by improved productivity as their current 150 man-hours per adjusted admission gets worked down to a more typical 98-100 and as their 19% supply cost/rev gets to a more normal 14%. The HCA acquisition has an opportunity to get volume leverage as HCA's under-investment in this orphan division is rectified. Province is a little more complicated. The two key opportunities on PRV are to improve physician recruiting (which then drives volumes and then creates strong operating leverage and margin expansion) and to improve bad debt (but before this happens, a 2-year conversion of the PRV IT systems to LPNT has to happen). Thus, I expect a digestion period in 2006 (which is why I have a lower # than current consensus) to be followed by accelerating growth in 2007 and 2008.

At the end of the day, LPNT has a solid franchise that you can treat as a growing perpetuity in a stable business with few competitive threats. There are pressures on the hospital space: Medicaide cutbacks and the bad debt that can create, potential for less robust Medicare rate growth in the future (OK for now), and a growing population of uninsured/underinsured people and the bad debt it can create. However, LPNT is better positioned than most hospitals with industry leading 19% EBITDA margins. LPNT also has a company-specific opportunity to expand margins at Province, HCA, and Danville which gives them a nice boost to underlying growth. I think LPNT is a solid investment opportunity.

Catalyst

None, other than a realization of underlying value on long-term EPS power. Actually expect guidance call during 1st week of Jan to be disapppointing!