Description

Summary:

Buy QHC stock - Quorum Health.  170% upside. 

Investment type:  spin off + levered stub + operational turnaround story underway + deleveraging/refinancing + asset sales + cheap + uncorrelated.  There's something for everyone.  

Quorum Health is a rural hospital spin off from Community Health.  It only has a $260mm market cap and is a levered stub equity, so trade accordingly 

I think there's a lot of upside in the stock as they:

 1) continue to fix up, staff up, enhance, and improve operations;

 2) sell underperforming hospitals (there's a strong bid for individual hospitals);

 3) refinance their expensive debt;

 4) bring more operations in house. 

This is a classic case of neglected assets within a large company that could have done much better with focused management attention and some growth capex.  Now they're getting the attention and numbers are improving 

There is a lot of upside at QHC.  There aren't many short-term, possible multi-baggers left in these markets that you can honestly and conservatively outline a path to being up 100-200%.  This could be a $23-$24 stock potentially in a year,  up 170% from an $8.72 stock now.

My base case is $15-$20, up 100%+

My downside case is $6.10, down -33%  (although as a levered stub in what is admittedly a tough business, this can be all over the place)

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Valuation: 

They have $1.26bn debt, $6mm cash

$225mm of incremental hospital divestitures (guided range of $200-$250mm) that are doing negative EBITDA of around $20mm

So that’s $1.03bn of net debt pro forma for the divestitures

2018 pro forma EBITDA adjusted for divestitures is $170mm ($160-$180mm guidance).  i.e. that's what their 'core' hospitals can do.  They give a lot of good disclosure around their facilities and operations (which they have to do given how small and lumpy their business is) 

Base Case Upside:

I think they can continue to grow revs and get EBITDA margins inline with peers at 12% as they fix up the hospitals, hire physicians, gain local share, and improve the business in 2018/2019. 

So they can get to roughly $205mm of EBITDA.  It's more clear that they can get there (and possibly more) now that they got out of the CYH Transaction Services Agreement (CYH was overcharging and not doing a good job with collections), which is a $35mm boost in total (they've guided to a $15-$20mm reduction in costs, and $15-$20mm improved collections - collections is an issue & opportunity across the healthcare industry given poor billing and patient tracking).  

  At a 7x EV/EBITDA multiple, similar to other hospitals,  that $1.44bn EV,  $409mm market cap

 There are 28.3mm shares, so QHC could be worth $15

Currently, they're roughly at FCF breakeven ($65mm of capex and $120mm of interest).  But after they finish the hospital sales and delever and boost EBITDA,  they can refi out of their rather expensive debt

- I think they can lower interest expense to $62mm

- that would get them to around $63mm of FCF (after tax) assuming $205mm of EBITDA.  At 9x P/FCF after refinancing,  the stock is worth $18 

High Upside Case: 

If EBITDA gets to $220mm (as operations improve and the new Oregon expansion gets up and running, which adds $15mm of EBITDA to my $205mm base case), and they get $250mm of proceeds (high end), at 7.5x EBITDA (which is at the higher end but doable since they're outperforming peers) and 9x FCF, the stock could be $23-$24, up from $8.18 now

- coincidentally, that gets them to 4.6x net leverage,  which is their stated target leverage range.  

- in other words, getting to their target leverage implies the stock could be worth $23.  

- QHC's core operations have outperformed and done very well in the last few quarters.  Last quarter SS revs were up 7.6% and SS admits +3.7%.  They've been putting up numbers that far outshine all their peers including HCA and UHS (the best of breed hospitals) and they have a long run way for that to continue as they fix up their neglected hospitals.  So I think this should trade inline or higher than peers 

Downside Case: 

Assumptions (half assed):

- they only get EBITDA up to $195mm (only half the cost savings come through and the Oregon facility generates half the incremental EBITDA)

- Incremental asset sales only come in half of guidance  ($125mm)

- Although I do give them credit for generating $30mm of FCF after they refi debt, which is half of what I expect over 1 year after they refi their expensive debt.  I look at their potential FCF generation in a downside case because it could likely be a very meaningful % of their market cap 

EBITDA stays around these levels

6.5x EV/EBITDA multiple (inline with undperperforming rural hospital Lifepoint - LPNT)

I get to $6.10 stock, down 33% from here 

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NOLs

- they have $125mm of Federal NOLs as of 12/31 (up $55mm YoY), which will shield taxes for a few years.  I expect the NOLs to build substantially again over 2018 until they  refi

- also they have $668mm of state tax loss carry forwards 

- I don't give them credit for this, but it's something to keep in mind 

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Catalyst / Event Path

- Over the next few quarters, their core hospital operations should continue to improve as new physicians and service lines ramp up

- The CYH agreement officially terminates in Sept 2018, after which they should have $15-$20mm in cost savings (e.g. IT savings), and $15-20mm in improved collections.  Given CYH is by far the worst operator, I think it's easy to improve after they stop relying on CYH for basic operational items

- the new Oregon patient tower (which expands surgical and ER capacity) gets up and running.  It will be completed late 2018 and start contributing over 2019.  Total estimated cost is $105mm (they've spent $83mm on it so far over the last 3 years) and expect a 12-18% return on the capex. 

- refinancing the debt:  I think they'll refi the debt within a year

  - they have $831mm of a L+675 (1% LIBOR floor) Term loan (and no interest rate swaps) trading at 102, but is prepayable at par

  - and they have a $400mm 11.625% bond (trading at 107) for a 9.5% yield.   They have to pay a make whole if they want to call it now.  But this is callable on 4/15/2019 at 108.7, a year later at 105.8, a year after at 103.   

I think they'll try to call in April 2019.

  - the credit markets are clearly positive on the company with the securities trading comrotably above par 

  - I think they can refi it all at a 6% blended rate with a new term loan (the new issue term loan market is hot)

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Hospitals background (for beginners):

- Hospitals are a tough business with fairly low margins (EBITDA margins are generally in the low teens for acute care hospitals), a lot of capex requirements, high bad debt / charity care

Secular shifts 

   - there's a shift by payers and consumers to seek lower cost of care.  Traditionally, people look at a stereotypical hospital admission (inpatient admit) as what you should expect when you go in for a surgery or for something serious. 

   - increasingly, payers are trying to keep people out of hospitals (which are generally expensive sites of care given the infrastructure and need to have so many expensive pieces of equipment and doctors) and move them towards easier, simpler, cheaper, and hopefully better sites of care (e.g. doctors offices, outpatient setting, ambulatory surgery centers, freestanding ERs, etc.  

   - so higher profit inpatient admissions have been muted/weak, while lower margin outpatient admissions continue to take share 

    - hospitals hence are expanding into outpatient services and trying to ramp up higher acuity services (ortho, cardio, oncology, etc.) 

   - but overall overall hospital industry admissions for the publicly traded peers are up 0-1% over the last few years, and +1% over the long term  

- the vast majority of hospitals in the US are non-profit hospitals, which generally  don't make much money.  This is good and bad.  

  - this means that publicly traded hospitals have competition that generally aren't as focused on profit (so it's easy to outperform peers)

  - however, given their lack of profit, reimbursement from the government and other payers for the industry is generally favorable and supportive (because if they cut reimbursement, many hospitals would close and many communities would have serious issues, since hospitals are as important as any utility and a basic common good). 

- Rural vs. Urban

  - rural hospitals (LPNT and QHC) usually suffer from poor demographics as people move to urban/subrban areas.  Hence it's hard to grow admissions.  On the plus side, reimbursement rates and pricing generally go up since they have pricing power because there usually aren't as many competitors in the rural locations.  Also, they typically have fewer labor cost pressure (again because of less competition) 

  - urban hospitals (THC, HCA, UHS, CYH) generally have better demographic tailwinds, but also much more competition for patients, insurance, and medical staff

- Labor cost inflation 

   - there's a shortage of nurses and doctors from an aging workforce, muted new medical/nurse enrollment, and the proliferation of other sites of care which increase the demand for medical staff.   Hence hospitals are feeling the pinch.  

- Consolidation / portfolio pruning

   - hospitals have been going through a period (years) of portfolio optimization as they sell underperforming hospitals where they have limited share and poor payer relationships to the operators in the region who have dominant market positions.  e.g. if you're the 4th or 5th hospital in a regions and aren't in-network with many of the local plans, you struggle to keep the beds filled.  However, the #1 or #2 hospital is probably packed and has great relationships with all the insurance companies in the region.  So the #1 hospital can buy the underperforming hospitals, and immediately put it in-network, get cost/procurement synergies, and increase utilization, etc.   So it's a win-win and hence why many unprofitable / low margin hospitals are getting sold for good prices (usually around 0.3-0.5x EV/Revs,  or low teens LTM EBITDA multiples), since the acquirers think they can immediately/quickly improve margins and get those effective purchase prices down to 5-6x EBITDA.  e.g. they think they can get those LSD % EBITDA margins up to low teens %. 

- Industry rank

  - HCA is best of breed (good capital allocation, margins, execution, etc.).  They're spending a lot on outpatient and positioning themselves well

  - UHS is 2nd with very strong acute care hospitals (partly driven by strong local economies around Vegas).  Their behavioral side has good long term demand/supply, but is suffering from length-of-stay issues and regulatory overhang

  - THC is 3rd with a good turnaround underway.  They've spent a lot to expand into ambulatory surgery centers (good secular growth). 

  - I'd rank QHC a bit below THC.  Also a solid turnaround story

  - LPNT is a rural hospital with a roll-up strategy, but it hasn't worked out well.  They hope to buy LSD/MSD EBITDA margin hospitals, and fix them up to low teens.  It's been easier said than done and their capital allocation hasn't worked too well. 

  - CYH is worst after the disasterous HMA acquisition and just poor operations in general

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History (the below is from memory, I could be off a bit, but you get the gist):

- QHC first spun-off from CYH back in April 2016.  The stock was trading around $10-$14.  People thought that QHC could do $250-$260mm of EBITDA on a standalone basis and that's what CYH / QHC had guided towards

  - CYH had been underperforming for a while (they're just horrible operators), Obacamare/ACA tailwinds had been abating and the industry headwinds continue

    - CYH has been selling off hospitals in order to paydown debt and trying to focus on their core locations (where they have good payer relationships) and urban locations (with better demographics).  QHC's locations are all over the map and small, so CYH just wasn't focused on them

- So they divested QHC and did a levered dividend recap (issued debt at QHC, and the money was sent right to CYH)

    - As an aside, I think CYH goes bankrupt in a few years, and is already having trouble refinancing/extending near term debt.  They have to do some exchange offer (offering 1st and 2nd debt to refi unsecured)

 - Right off the bat (the first quarter out of the gate in Aug 2016) QHC was a disaster.  EBITDA missed by a lot and annual EBITDA expectations were ratched down to ~$150-$160mm.   This was due to all the turmoil / disruption during the spin (which took a year to finish) and doctors fled and went elsewhere.  Operations suffered.  Plus the company hadn't really set up their own  systems and administration as a standalone company yet either.  

  - It was a debacle and the stock fell from $10 to $4 immediately

  - The overly optimistic disclosures and spin + debt looked fraudulent, which is still being litigated against CYH.  However it's generally hard to prove any wrongdoing by CYH.   It looked like this company was insolvent right out of the gate.   

- The stock rallied to $6 after the dust settled, but fell back to $4 after Trump won in Nov 2016 and CYH had a really ugly quarter (given thet ties between CYH and QHC, people lump them together - although QHC has outperformed CYH by a lot recently).  Investors thought Republicans would dismantle Obamacare/ACA and bad debt and admissions would fall

  - the bonds went to the $60s as this thing looked more distressed

  - Of course, Republicans didn't do anything to ACA, which helped hospitals 

- Then in November 2016 QHC had a surprisingly good Q3, and it seemed like QHC could potentially do $200mm+ of EBITDA again, and the stock rallied to $8-10

- QHC had yet 2 other disaster quarters for Q4 and Q1.  Ugly all around and it looked like EBITDA would probably be $160mm or much lower.  The stock fell to $3

   - the company is very lumpy where a large reimbursement payments by a state can swing quarterly EBITDA by tens of millions (for a company doing tens of millions of EBITDA).  Management had not been guiding the street or giving much disclosure,  so it was near impossible to figure out quarterly EBITDA or earnings power

   - Investors were irate and all over the company to provide better disclosure and guidance

   - the company listened and now they guide the street better and have great financial disclosure 

 In Q2 2017, they started turning the quarter and core operations were actually not too bad.  They finally beat and gave much better color

- the stock levitated to $6

- annual EBITDA looked like $170mm

In Q3 2017, the company stock tanked to $4 again since CYH was having issues and hosptials were bombing left and right due to weak admissions and high costs and bad payer mix

 - But QHC had another very good quarter operationally

- The stock caught an upgrade from MS in December sending it back up to $6-$7

Why is the stock up recently to $8-10? 

1) decent Q4 earnings 2 weeks ago.  They increased their asset sale guidance to $250-$300mm total, up from $250mm total (will use it to paydown debt).  Guided 2018 EBITDA (adjusted for divestitures) inline at $170mm (flat YoY, although they've been underpromising and overdelivering)

2)  upbeat at a recent Oppenheimer conference a week ago (details below) showing much revenue upside, margin upside, and an ability to fix their balance sheet

3) they announced (a week ago) that they can get out their CYH transaction services agreement, which is a $30-$40mm boost to EBITDA on top of the $170mm of EBITDA guidance for 2018.  CYH was overcharging and not doing a good job with collections.  That's a big boost to EBITDA

It's a small market cap, and I think people just recently woke up to the fact that this could be a $20+ stock.  Stock volume has picked recently and there's a strong bid obviously 

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Quorum gave many positive datapoints at the Oppenheimer conference on all fronts:

Management gave some more color on the TSA - a lot of cost savings 

- expects $15-$20mm reduction in costs, and the opportunity to improve collections by $15-$20mm more < that's of course a big number and tailwind for them 

- been able to save $5mm on IT warehousing 

- can save $10mm on the cost of business offices 

- in total could be a $20-$40mm tailwind in 2019

Debt - on track to refi

- has a far runway to 2021-2022

  - if they sell their target hospitals, will paydown debt, and then refi at a lower & reasonable rate 

Asset sales - sounds on track

- had an LOI to sell 2 hospitals for $110mm, but that fell through < clearly a big number are possible 

- has seven hospitals that they're working on with numerous buyers.  No LOIs at this time, but anticipate more in the near future, with buyers competing against each other to get the price up

- hopes to sell $120mm worth of hospitals before year end

Operations - a lot of room to improve

- 67% of the patients in their communities are leaving the community for health care,  that's embarrassing 

- they're doing a good job recruiting new doctors (e.g. 7 orthopedic surgeon into areas that have never seen an orthopedist) 

- expects the 6% surgical growth rate can continue for a while

- they're at 33% market share in their rural hospitals,  should be between 50-60% share

- hired 110 physicians over the last year, goal for 2018 is 75 physicians 

- expects to get 12-18% return on the $105mm of capex that they've spent on the Oregon expansion 

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Concerns / Risks

- Divestures coming along slowly: I admit their divestutre program has been slow,  but the hospital market is very hot and literally every hospital has been able to sell EBITDA negative assets for 0.3-0.4x revs and generate significant proceeds.  Just look at the billions in proceeds CYH and THC have raised from selling underperforming hospitals.  Management is very confidant about their ability to sell the hospitals and has a lot of inbound interest

- Rural hospitals: yes demographics are weak over the long term,  but QHC has a lot of share to gain, doctors to hire, service lines to expand, etc.  

- Small size / diverse geographical footprint:  QHC has hospitals all over the place, making it difficult to manage.  While this isn't ideal, I think over time they'll also prune their portfolio and bulk up in locations where they have a good footprint.  I haven't gotten as much confidence around this issue though. 

- Turnaround: the turnaround is taking time,  but you have to give them more time.  It takes time for bring collections and IT back in house.  The spin off was a mess for them and operations imploded due to uncertainty and employee/doctor defections during the spin.  It takes a while for the doctors and new service lines to generate revenues again.  They've still been setting up their standalone headquarters, IT, collections, etc.  It could be bumpy, but they only have one way to go, up 

- Accounting issues:  They were spun out from CYH (who historically has been a poor operator with very bad IT systems and planning).  I've followed CYH for years and they constantly talk about opportunities to improve basic blocking and tackling.  e.g. recently they've been talking up how they finally have real time reporting across their hospitals.  For a long time, they were always relying on operational metrics that were weeks old!  

   - Also, recently CYH, LPNT, and QHC had to adjust for accounting changes related to bad debt.  Basically it's not a change to cash flow or operations, but they had to lower their assumptions on recoverability on recivables.  Hospitals of course have to provide care to everyone regardless of their ability to pay.  Hence there is elevated bad debt.  But this isn't anything new and is more an a change in accounting rules.  This also led to their 'material weakness' in their accounting (solely around accounts receivables), and they have a plan to fix this by the end of 2018 

- Executive Turnover:  CFO and Chairman left recently.  While it's not a great sign that the CFO is leaving, it happens all the time.  People switch jobs.   Also, he's done a great job sheparding the company through the spin off and getting them on firmer footing now and in a position to refinance to cheaper debt eventually.  I think the company's future is bright.  He's also done a great job on the investor relations effort, providing a lot of color, reaching out to stakeholders, and doing a better job guiding the Street and getting expectations to be more accurate.   I think he's gotten QHC on a much better path and condition, so it's a decent time for him to leave 

The new CFO has CEO/CFO/CAO experience at an HMO and health/wellness facility company.  So he's got fairly similar experience 

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Shareholder base

- Given the levered stub / spin off nature of this stock, there are plenty of distressed debt type of investors in the equity. Notably many large funds despite the small market cap 

  - e.g. KKR, Davidson Kempner, Highland Capital, York, Silver Point, Halcyon, Contrarian, etc.  

- This shareholder base is generally pretty long term and sticky in nature.

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Sell side coverage

- strangely, 3 bulge brackets cover it (DB, CS, and MS).  But they don't really write much about it and are generally lukewarm on it 

Catalyst

Catalyst / Event Path

- Over the next few quarters, their core hospital operations should continue to improve as new physicians and service lines ramp up

- The CYH agreement officially terminates in Sept 2018, after which they should have $15-$20mm in cost savings (e.g. IT savings), and $15-20mm in improved collections.  Given CYH is by far the worst operator, I think it's easy to improve after they stop relying on CYH for basic operational items

- the new Oregon patient tower (which expands surgical and ER capacity) gets up and running.  It will be completed late 2018 and start contributing over 2019.  Total estimated cost is $105mm (they've spent $83mm on it so far over the last 3 years) and expect a 12-18% return on the capex. 

- refinancing the debt:  I think they'll refi the debt within a year

  - they have $831mm of a L+675 (1% LIBOR floor) Term loan (and no interest rate swaps) trading at 102, but is prepayable at par

  - and they have a $400mm 11.625% bond (trading at 107) for a 9.5% yield.   They have to pay a make whole if they want to call it now.  But this is callable on 4/15/2019 at 108.7, a year later at 105.8, a year after at 103.   

I think they'll try to call in April 2019.

  - the credit markets are clearly positive on the company with the securities trading comrotably above par 

  - I think they can refi it all at a 6% blended rate with a new term loan (the new issue term loan market is hot)