The healthcare facility industry includes hospitals, ambulatory surgery centers, long-term care and other facilities such as psychiatric centers. Many of the performance drivers are the same for the group as a whole, although hospitals face some unique challenges – they operate in a high fixed-cost environment with profit-loss centers such as emergency rooms that cannot turn away patients and thus rack up bad debt expenses. Surgery centers and long-term care have for-profit business models that have lower fixed costs and negligible bad debt.
Uniqueness of Hospitals
Despite high fixed costs and increasing competition, hospitals have shown steady historical growth in part because of government assistance through legislation. Since most U.S. hospitals are not-for-profit and in rural settings where the hospital may be the only source of medical care for many miles around, the government has an unwritten obligation to ensure they are financially able to operate. Medicare reimbursement rates tend to be high enough to ensure most hospitals stay afloat, creating a downside buffer for publicly traded hospitals.
Therefore, any hospital that can maximize its profits by running efficiently through cost controls and garner market share by offering a better service and product (orthopedics, cardiac services and more renowned doctors) can grow faster than its peers. Over the past decade, hospitals' two-year EBITDA CAGR has been 10%, which is an extremely steady and strong growth over a full economic cycle.
Important Investment Metrics
The stock prices of companies operating healthcare facilities are primarily driven by the Medicare reimbursement level. When Medicare makes changes to its payments, it often impacts profits and share prices to a greater degree than expected, both on the upside and downside. Other drivers include (data quotes are from Bank of America Merrill Lynch's report in April 2013):
- Volumes or occupancy, which in the long run are tied to population growth plus demographic shifts, but also depend on the competition level. Historically, hospital volumes have shown growth of about 1-2%, but it is now closer to 0-1% because competition (surgery centers and long-term care) are stealing volumes. Some hospitals are now at risk for failing. As a result, the federal government has enacted laws that do not allow new outpatient faciliites to be built so that competition decreases.
- Pricing that insurance companies pay hospitals for patient services, also called commercial pricing (non-government health insurers), which is based more on market trends than government budgets and is negotiated between each hospital and insurer. Historically, commercial pricing has seen about 5-7% annual growth.
- Cost growth - the largest components are labor and supply costs, and a hospital’s ability to contain them.
- Capital deployment in the form of acquisitions. Hospitals are high free cash flow businesses, and they usually go through acquisition cycles by employing their free cash flow plus leverage. Hospitals are not scalable, so investors should look for companies that buy underperforming assets in good locations (positive demographic/population) and where improving operational efficiency can increase margins. Acquisitions tend to be positive for stocks in the long run as margins improve. However, investors should be wary when companies make acquisitions to increase growth because the growth in their current facilities has slowed.
- Bad debt, which is the amount of uncollectible bills that hospitals write off from uninsured or under-insured patients. This tends to be a negative risk for stocks, because investors perceive bad debt as more negative to profitability than it actually tends to be, resulting in a downside risk to stock prices. Bad debt historically has shown 8-10% growth, but healthcare reform should mitigate it somewhat.
When deciding whether to invest, the following should be considered:
- Is the sector attractive? Prior to investing in healthcare facility stocks, investors need to determine if the regulatory environment will be positive. These stocks are subject to a tremendous amount of risk anytime the media reports on Medicare pricing changes - some of which impact a companies’ profits and some that impact from a purely psychological standpoint. For example, on Aug. 15, 2013, Medicare announced a reimbursement rate below expectations - an increase for 2013-14 that will only be 0.7% versus the expected cost increase of 2.5%. Community Health Systems (NYSE:CYH), one of the largest public hospital groups, saw its stock fall 5.9% on the day of and the day following the announcement.
- Following a positive sector call, the next step is to determine which type of facility is attractive. Of all the publicly traded healthcare facilities, hospitals have the largest market cap and offer the greatest number of stocks to choose from. The decision may not be an all-or-none choice. For example, if Medicare rates are expected to rise greater than expected, then investing in a hospital and long-term care facility may be prudent. The decision should also be based on expectations for competition levels and the expected regulatory environment (e.g. moratoriums on new builds for ambulatory surgery centers, etc.).
- Once the type of facility is chosen, then a deep dive into the individual names is required. Facility location is crucial to occupancy. If a facility is located in an area where population growth is expected to be greater than average due to migratory trends (immigration, baby boomers moving south, etc.), then those facilities should exceed the expected average volume growth of 0-1%. In addition, if the higher volumes are expected to result in more profitable procedures (cardiac or orthopedics), then the profit per volume growth will push EBITDA growth above the average. It is important to also note whether the volume growth will result in higher uninsured patients, potentially causing bad debt to increase above the average 8-10% level, resulting in a negative impact on profits.
- Finally, the strength of the management team should be considered. Insight into successful acquisition strategies, ability to contain costs through prudent cost controls and the foresight to build or improve facilities are keys to a successful long-term investment.
Determining whether the stock is attractively priced is the final step. Healthcare facilities' stocks are best valued using an enterprise multiple metric. This is the preferred metric because it adjusts for leverage, which can be high during a strong acquisition cycle and for depreciation and amortization, which are impacted by building/real estate. Historically, hospital stocks have traded in an EV/EBITDA range of 5.5-9.0. If using a price-to-earnings (P/E) multiple to compare against other sectors, the historical average P/E for hospital stocks has been 14.1, and in a range of 10-20. Valuation for long-term care and ambulatory surgery centers has been on a stock-by-stock basis since very few public companies are in each subsector. Any stock identified as being an attractive investment and trading below the average or outside the range should be considered a buy.
The Bottom Line
Healthcare facilities can provide attractive investment opportunities. The stock prices in this sector have produced a five-year CAGR of 13.6% compared to the S&P 500 at 10%, according to a report published by Bank of America Merrill Lynch Global Research in April 2013. There are many key drivers, some of which are out of the companies' control. However strong fundamentals, including operating efficiency, should allow taking advantage of the key drivers. Medicare reimbursement is critical, as well as expected and actual volumes, bed occupancy rates and the competition level. EV/EBITDA is the preferred valuation metric and should be used to compare companies to find undervalued opportunities.
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