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Shares of Community Health Systems (CYH) have seen a fair bit of volatility on Tuesday after the company announced the acquisition of Health Management Associates (HMA).

This latest hospital deal marks yet another chapter in the consolidation wave ahead of the Affordable Care Act which becomes effective next year. While synergies appear to be attractive, the significant leverage makes shares extremely vulnerable for a setback.

The Deal

Community Health Systems announced that it has entered into a definitive merger agreement with Health Management Associates.

The sizable deal marks yet another mega-deal in the US hospital and healthcare industry as the industry prepares for the introduction of "Obama-care". Community Health Systems will pay $7.6 billion in total for the company, including $3.7 billion in debt.

Shareholders in Health Management Associates stand to receive $10.50 per share in cash and 0.06942 shares of CHS, valuing the company at $13.78 per share. Shares of Health Management ended Monday's trading session at $14.92 per share. This implies a 7.6% discount to Monday's closing price.

Shareholders in HMA will hold a combined 16% stake in Community Health Systems going forwards. Shareholders in HMA could receive a contingent value right for each share they own up to $1.00 per share following the outcome of legal outcomes regarding admission practices.

Following the transaction, Community Health will operate 206 hospitals in 29 states, with a total capacity of 31,000 beds.

CEO and Chairman Wayne T. Smith commented on the rationale behind the deal, "This compelling transaction provides a strategic opportunity to form a larger company with a diverse portfolio of hospitals that is well positioned to realize the benefits of health care reform and to address the changing dynamics of our industry."

Obviously news about the deal does not come as a surprise after HMA's board commenced a strategic review a while ago. The board has evaluated all alternatives for the business, and has concluded an outright sale is the best. The eventual price tag at 8.3 times trailing cash flows is a premium to what the board believes would be the value for the firm on a stand-alone basis.

For the year of 2012, Health Management Associates generated revenues of $5.88 billion, up 15% on the year before. Net income fell slightly towards $164.3 million. Based on the enterprise valuation, HMA is valued at 1.3 times annual revenues and 46 times annual earnings.

Community Heath Systems believes the deal will have a neutral impact on earnings per share in the first year following the closure of the deal. The deal will be accretive to earnings per share after year one.

The deal is expected to close in the first quarter of 2014. The transaction is subject to a 70% approval vote from HMA's stockholders, antitrust clearance and normal closing conditions.

Valuation

Community Health Systems ended its second quarter of 2013 with $251 million in cash and equivalents. The company operates with $9.5 billion in total debt, for a very sizable net debt position of $9.25 billion. The company has already arranged financing for the deal with CHS.

Revenues for the first six months of 2012 came in at $6.55 billion, essentially unchanged from last year. Net income fell by almost a third towards $109 million. The sizable debt position took a toll on earnings, as CHS paid $311 million in interest payments for the period. At this pace annual revenues will come in around $13 billion, as the firm could earn some $250 million.

Trading around $47 per share, the market values Community Health Systems at $4.4 billion. Including the $9.2 billion net debt position, the enterprise is valued at $13.6 billion. This values the company at 1.0 times annual revenues and 55 times annual earnings. The company equity is valued at 18 times annual earnings.

The company does not pay regular dividends at the moment.

Some Historical Perspective

Shares of Community Health Systems have seen a fair bit of volatility over the past decade. Shares rose from $20 in 2003 to highs of $40 in 2007. Shares fell to lows of $10 in 2008 and have seen some weakness in 2011 as well. The general stock market recovery and introduction of "Obama-care" send shares to all time highs around $50 in recent weeks.

Between 2009 and 2012, Community Health has increased its annual revenues by a cumulative 11% towards $13.0 billion. Net earnings rose by a similar percentage towards $265 million over the past year.

Investment Thesis

The transaction is quite a sizable deal. Health Management Associates is valued at $7.6 billion for the total enterprise, or 1.3 times annual revenues. The firm is valued around 9 times annual EBITDA.

In comparison, Community Health itself is valued at $13.6 billion. This is equivalent to 1.0 times annual revenues an a comparable 9 times annual EBITDA.

Following the deal, Community Health will have some 112 million shares outstanding, currently valued at $46 per share, or $5.15 billion. The new entity will operate with $13.1 billion in net debt.

Pro-forma, the new entity will generate annual revenues of $19 billion on which it earns about $425 million. Annual interest payments on the sizable debt position are estimated at $900 million. Factoring in annual cost savings of $150 to $180 million within two and a half years, earnings could increase towards $600 million. While the debt position continues to be an issue, the price-earnings ratio could come down towards 10 times rather soon.

While acquisitions usually involve a premium to induce shareholders to tender, Community Health is offering less than Monday's closing price. Shares of Health Management had already risen sharply, hitting highs of $17 in recent weeks on takeover speculation. The high debt, stagnating profits and fresh subpoenas regarding its emergency room operations, left the board no other choice but to tender.

Health Management, and hospitals in general have been struggling to deal with bad debts, lower insurance reimbursements and falling admissions. The new Affordable Care Act, which should come into effect on the 1th of January 2014, should provide a boost for hospitals going forward, thereby already triggering a consolidation wave.

Don't get me wrong. The deal could create a lot of value given that synergy estimates become a reality and the Affordable Care Act really does boost demand for hospital services, while cutting bad debts. Yet the sizable leverage remains a concern leaving the combination extremely vulnerable for a setback.

I remain on the sidelines on leverage concerns.

Source: Hospital Consolidation Continues - Community Health Systems Acquires Health Management Associates