Obamacare Makes HCA a Buy

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Aug 24, 2015
  • Affordable care act will continue to benefit U.S. hospitals.
  • Improving economy and aging population are also some of the bullish indicators.
  • HCA is set to buck the trend as the largest for-profit hospital chains in the U.S.

HCA Holdings, Inc. (NYSE: HCA) is a health care company that belongs to the industry of hospitals. The company provides health care services through a network of hospitals and surgery centers. As of June 30, HCA operated 168 hospitals and 112 surgery centers. The company also owns and operates diagnostic and imaging centers, radiation and oncology centers and physical therapy centers etc. 4%-5% inpatient care in the U.S. is provided by HCA. The company invests around $1.5 billion annually in facility up-gradations.

Net revenue of HCA Holdings totaled $19.57 billion during the first half ended June 30; revenue grew 7.2% on a year-over-year basis. Revenue growth of the company depends on in-patient occupancy level and auxiliary services. HCA generates most of its revenue from Managed Care and Insurers segment; 54.5% of the revenue came from this segment during the first half of 2015. Around 40% of the company's revenue comes from government health programs including Medicare and Medicaid. Geographically, ~47% of the company's revenue is concentrated among Texas and Florida. HCA Holdings, Inc. was founded in 1968 and is headquartered in Nashville, Tennessee.

Thesis

U.S. hospitals are gaining from the Affordable Care Act (ACA), informally known as Obamacare. Increased insurance coverage under the act is helping in the reduction of the uninsured rate. A study tracking insurance rate between 2012 and 2015 found out that uninsured rates have dropped 7.2% by early 2015. According to Medicare and Medicaid services' report, health spending has increased 5.8% during 2014, and they’re expected to increase 5.8% p.a. until 2024. Health care spending is rising amid expanded coverage enabled by affordable care act, improving economy and aging population. It is worth mentioning that Medicare expenditures will double to reach $1.2 trillion by 2024 at a CAGR of 7.2%.

As the largest for-profit hospital operator in the U.S., HCA is set to benefit from the trend. Obamacare helped HCA post better than expected Q2 2015 results. Same facility patient visits increased 4.1% during the period on a y/y basis. Further, as Medicare and Medicaid make up a large proportion of the company's revenue, the company will profit from the growth of related spending.

Thanks to declining uninsured rate, the sentiment is turning bullish for HCA. Estimates have witnessed 14 upward revisions from analysts for the year ended 2016; nine analysts also revised earnings estimates for the current year. Due to revisions, HCA is trading ~15 times forward earnings while S&P is trading around 18. HCA is certainly looking cheap on forward earnings basis.

Further, HCA Holdings is registering growth. Number of hospitals has been increasing. The company now operates 168 hospitals as compared to 165 hospitals operated during 2014. On a same facility basis, revenue increased 6.2% during the first half of 2015. The company now expects to meet the high-end of its 2015 earnings guidance. Analysts are expecting double-digit earnings growth for HCA during the next five years. Cash-flows are also strong; price/cash flow of HCA stands at 8.3 as compared to 11.7 of S&P 500. Based on the assumption that the company will post 2% perpetual growth in its operating cash flow, the stock is trading at a 25% discount to its fair value. Given Obamacare, health care spending trend and analysts' expectation, 2% perpetual growth is plausible.

HCA is also outperforming its peers and the industry. It supports a higher gross and net margin compared to Tenet Healthcare Corp. (THC, Financial) and the industry. Further, the company trades at a PE of 18.9 as compared to PE of 57 and 24 for Tenet and the industry respectively.

To review, industry trend boosted by Obamacare, improving economy and aging population bodes well for HCA. The company is a bargain given its cash generating ability and cheap relative valuation.

Risks

Healthcare spending may be increasing going forward but HCA is already trading at a high multiple. PE (TTM) of 18 is not exactly cheap for a market that is already trading on a higher side. Further, growth is expected to be around 11% during the next five years, which translates into PEG that is greater than 1. The point being, HCA is not trading cheaply rather investors are willing to pay a premium amid potential Obamacare benefits. The stock is up 28% YTD, which is indicative that health reforms' sentiment is already baked-in the stock price.

Regarding health care reforms, or Obamacare, the company pointed out in the earnings call that the benefits may be leveling off. Note that self paid, uninsured volume for HCA has increased 8.7% during Q2 2015 despite affordable care act reforms. Moreover, HCA has not seen much benefit from the reforms as it's not heavily exposed, thanks to several states not yet opted for Medicaid coverage under the law.

Industry trends may be positive but the stock is already trading at a premium amid market perception. Obamacare benefits might be wearing off, which can impact HCA's valuation going forward; the company is only modestly exposed to such benefits in the first place. Investor excitement may be unjustified.

Valuation

Value distribution based on Monte Carlo simulation indicates that the stock at trading at the lower side of the valuation curve. This distribution is based on 2% perpetual growth is residual earnings, which is highly likely as earnings are expected to grow at 11% p.a. during the next five years. In fact, the company’s perpetual growth in residual earnings can surpass 3% based on the assumption of 11% CAGR during the next five years, see the EVA valuation below. All in all, the stock is trading at a discount even with prudent assumptions i.e. 2% perpetual growth.

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Source: Prudena

EVA approach to valuation also reveals moderate upside.

Assumptions:

  • EPS is expected to grow at CAGR of 11% during 2015-2019. 0% growth is assumed in perpetuity.
  • Retained earnings are projected to turn positive during 2018
  • CAPM is used to calculate the cost of equity. NASDAQ composite is assumed to reflect the return on market.

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Bottom line

HCA is the largest for-profit hospital chains in the U.S. It, most certainly, will benefit from the positive trend in the industry. Not only Obamacare is boosting the outlook for health care providers, improving economy and aging factor is also providing a boost. HCA is not reaping much of the benefits of affordable care currently but adoption of Medicaid plan by the states covered by HCA will be catalytic for the stock price growth going forward. Insurance enrollments will also increase during 2016 amid strict penalties for individuals next year. Therefore, it may not be a high time to dump HCA. Discounted cash-flow analysis reveal value in HCA's stock. HCA Holdings may not provide instant value, but it's a stock to own for a long-time horizon given the state of industry.