Image Source: HCA Q2 2018 Investor Update
We are becoming increasingly intrigued by the consolidation occurring in the hospital sector as HCA Healthcare is well on its way to developing a dominant position in some of the more populated states in the US.
By Alexander J. Poulos
Key Takeaways
The pace with which HCA Healthcare has built out its network of care centers is impressive, and it now holds impressive share in notable markets across the US.
By utilizing the low interest rate environment, HCA has methodically expanded its care network. We like the economies of scale and pricing power that come with its large network, but its balance sheet health has paid the price.
HCA is working to reward shareholders with a combination of share repurchases and a recently initiated quarterly dividend.
We’re adding coverage of HCA Healthcare with a fair value estimate of $115 per share. Its Dividend Cushion ratio is firmly in negative territory, and shares yield ~1.1% as of this writing.
What is HCA Healthcare?
HCA Healthcare (HCA) is well immersed in the field of patient care via its ownership of 178 hospitals and 122 free standing surgery centers (ASC) throughout the US and the United Kingdom. The company boasts a significant presence in three most populated states in the US (California, Texas, and Florida), and its market share there gives it pricing power when negotiating reimbursement terms with the managed care providers. Such pricing power will become increasingly important in the healthcare realm as cost containment initiatives spread, and its scale can help combat lower reimbursements as it wrings out inefficiencies associated with unnecessary costs in the delivery of healthcare.
Appetite for Acquisitions
HCA Healthcare has managed to build its impressive market share via a series of acquisitions since its initial founding in 1968 as a single hospital in Tennessee. The appetite for acquisition continues today as evidenced by the recently announced deal to acquire Mission Health, a nonprofit health system based in North Carolina, for $1.5 billion. The acquisition gives HCA access to a state where it lacks a meaningful presence thus, which will open a new front in its negotiations with payers. Growth via acquisition will remain a critical part of HCA’s growth story as it works to continue adding to its market share and further entrench itself in the delivery of healthcare.
Funding Growth
Oftentimes in the case of roll-up acquisition stories, the balance sheet is laden with large amounts of debt in the name of “empire building,” which can come to a screeching half if targeted synergies prove unachievable. HCA Healthcare works to judiciously utilize its strong cash flow and predictable underlying business to take advantage of attractive and targeted acquisitions, but this has resulted in the company holding a net debt position of $32.3 billion as of the end of the second quarter of 2018. Management recently raised its expectations for 2018 adjusted EBITDA to $8.65-$8.85 billion, which implies a net debt-to-adjusted EBITDA ratio of ~3.7x should its net debt balance remain unchanged through the end of 2018, which is not likely to be the case.
HCA’s debt profile is not all that concerning at current levels thanks to its track record of stable operating performance and cash flow generation, but we’re keeping a close eye on its financial leverage as industry headwinds persist and it continues to build out its network of healthcare systems. Though it is not an immediate concern, our trepidation over the degree of financial leverage at HCA is supported by its junk territory credit rating (Ba1). However, we assign HCA an attractive Economic Castle thanks in part to its formidable market share in some of the most important markets in the country, even as we acknowledge that market share has come at its balance sheet’s expense.
Building an Unassailable Network
In our view, consolidation is a key force that is sweeping over the healthcare landscape as industry participants are scrambling to lower overall healthcare spending in the US while maintaining pricing power for themselves, and there appears to be little resistance to the trend. For example, in the managed care field (one of the largest end payers of HCA’s services) the industry is actively taking cost out of the delivery of healthcare by internalizing the pharmacy benefit management (PBM) sector.
The primary example of this trend is the $69 billion acquisition of Aetna (AET) by CVS Health (CVS) to offset the coming margin compression of its critical PBM division Caremark. The Aetna acquisition further cemented CVS’ competitive position by giving it access to a new vertical (managed care market), but the move brought an enormous amount of debt to CVS’ balance sheet, further restricting shareholder friendly activities such as dividend payments and share repurchases as the company must focus on rapidly reducing leverage in the near term.
On the flip side of acquisitive strategies is the methodical pace with which HCA built its network. Though it has still resulted in less-than-ideal balance sheet health, the company was recently confident enough in its future cash flow generation to initiate a $0.35 quarterly dividend in the first quarter of 2018, which may only be the beginning of management building a shareholder-friendly reputation that is already in the works via a 2012 special dividend and robust levels of share repurchases.
Since its IPO in March 2011, HCA has generated $34 billion in cash flow from operations, and it has emphasized growth spending with that capital, investing $17.1 billion in capital expenditures and another $5.8 billion on acquisitions over that time frame. It has also paid out $3.2 billion in special dividends, spent $11.8 billion in share repurchases, and another $245 million has gone to its recently initiated quarterly dividend. This total spending accumulates to more than $38 billion, but when considering the robust levels of share repurchases and inorganic growth spending in an ultra-low interest rate environment, such spending levels are not all that unreasonable. The key from this point on will be the execution and deliverance of steady and robust cash flow generation expected from the impressive network of healthcare systems it has built.
Wrapping Things Up
HCA expects longer term EBITDA growth in the 4%-6% range, and the company is primed to be a beneficiary of the recently enacted tax reform legislation, which helped give it the confidence to raise its 2018 earnings per share guidance to a range of $9.00-$9.40 from $8.50-$9.00. Its cash flow generation should also benefit from the tax reform, and we believe this may have played a role in the timing of management’s decision to initiative a quarterly dividend in addition to its share repurchase program, of which there was $910 million authorized remaining at the end of the second quarter of 2018.
We currently value HCA Healthcare at $115 per share, and its Dividend Cushion ratio is firmly in negative territory due to its large debt load. Shares are trading in the upper half of our fair value range, which not only gives us reason for pause when considering its valuation opportunity but also the merits of its share repurchase program coupled with its lofty financial leverage. We like the underlying recession resistant nature of HCA’s business, but its valuation and lofty debt load are enough to keep us from considering highlighting it in either simulated newsletter portfolio. Shares yield ~1.1% as of this writing.
Health Care Services: CYH, DVA, EHC, HCA, LPNT, MD, THC, UNH, UHS
Related: WBA
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Heathcare and biotech contributor Alexander J. Poulos is long CVS. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.