The Centers for Medicare and Medicaid Services (or CMS as it is commonly known) recently announced on January 31st a six-month delay on what has come to be known as the Two-Midnight Rule. The Two-Midnight rule is somewhat complex and basically governs when a patient can be processed as an inpatient admission. The details are rather arcane, by the net effect of the six-month delay is that it will alleviate some of the near-term pressures facing hospitals as a result of low utilization levels. For major hospital company Tenet Healthcare (THC), the rule is a modest positive.
Tenet like most hospital chains has been suffering a double-headwind recently, and the rule delay is not enough to fix that. First, like so much of the rest of the economy, hospitals have been seeing lower utilization levels as more people go without insurance and forgo trips to the hospital. Few hospitals have been more impacted by this than Tenet. THC is one of the largest hospital companies in the country and it has been reporting strong volume headwinds for a while now.
In the most recent quarter, the firm saw same-facility admissions and adjusted admissions fall y-o-y by -2.6% and 0.5% respectively. In contrast, outpatient visits and emergency room visits were up 3.5% and 3.1% y-o-y respectively. These are much lower profit margin areas for THC on the whole though, and this shift was a major factor in driving THC's $0.01 bottom line miss. The story here is the same for THC as for the rest of the industry - weak inpatient volumes due to a lackluster economic recovery. And of course the two-midnight rule, which makes it harder to admit inpatients does not help this issue (which is why its 6-month delay is a modest positive).
The second major factor hitting Tenet is the CMS reimbursement cuts and pressure from commercial insurance carriers on their reimbursement rates. THC hopes to offset some of these two headwinds by bulking up and hopefully getting increasing returns to scale. That was the rationale for THC's purchase of Vanguard Health Systems at the end of last year. Between the two firms, THC will now have 79 hospitals and 157 outpatient facilities in 15 different states. Between this merger and the California Provider Fee program extension through 2016, (from which THC should recognize just shy of $500M in net revenues over the three-year period including $140M in 2014), THC will keep its earnings growing nicely for the next few years. Yet at the same time the $4.6B company is facing enough external turmoil that investors are right to be wary of the stock.
In particular, I was more optimistic about Tenet last year after the VHS acquisition was announced. Since then though, THC's guidance has disappointed and the Obamacare rollout has been disappointing with far less of a decrease in the uncovered insurance population than I expected initially. This is particularly important for THC given its payer mix. At last report, ~23% (~29%) of THC's revenue (admissions) was from Medicare, 8% (12%) from Medicaid, 57% (49%) from commercial insurers, and 12% (10%) from self-pay. The obvious takeaway is that commercial insurers and self-pay patients punch, Medicare is a little bit of a bad deal for the hospital, and Medicaid is just an awful deal. Industry executives routinely talk about how difficult it is to collect on self-pay accounts. And that's 100% true. Yet at the same time, even taking bad self-pay debt into consideration, it is still worlds better than Medicaid. Unfortunately, over the last few years, THC's payer mix has trended away from self pay and towards entitlement payers. Reversing this trend would help the company a lot, but is far easier said than done.
The Obamacare rollout then has been a major disappointment as it relates to the future prospects of hospital firms. The legislation was largely sold as a way to drive more people onto the commercial insurance rolls, when in reality thus far the biggest effect has been to put people onto the Medicaid rolls. Since Medicaid is generally regarded as money losing proposition for hospitals, this is a bad outcome. Indeed, the only positive outcome from Obamacare thus far might be if hospitals are at least able to collect something from patients they previously had to treat as charity cases. Now of course even this will backfire if the former charity case patients end up using more money-losing medical services under Medicaid than they were before as charity cases. The exact outcome health reform is still impossible to determine - even insurers don't know what's going to happen as evidenced by Aetna's recent comment that they might drop out of Obamacare - but what is clear so far is that the program will not be a runaway positive for the health industry. And of course, all of this is before we even take into account the on-going reimbursement rate pressures across the industry which obviously don't help.
Tenet's recent acquisitions will undoubtedly boost firm revenues greatly. Taking into account VHS, Tenet is likely to see 40-50% revenue growth over 2013 which itself is running 6-7% ahead of 2012 for the first three quarters which have been reported. Of course, revenues aren't the ultimate consideration of investors, profits are and in that sense THC's story is less positive. Gross margins were ~13.3% in 2012 but look like they will come in closer to 12% for 2013 and 2014 (driven in large part by the less profitable operations of Vanguard). Indeed one key driver of profitability for Tenet long term will be getting VHS' facilities up to Tenet's more profitable standards. This won't be easy, but it could be a source of medium run profit growth.
I alluded to this above, but the other major key to driving higher profits (and a correspondingly higher stock price) at THC will be improved admissions statistics on the inpatient side. THC's adjusted admissions are doing fine (for the most part), helped enormously by strong outpatient visit levels, but for utilization (and profit) numbers to normalize, the company needs better inpatient flows. To be fair, inpatient numbers have been pretty atrocious across the entire industry probably mostly due to a bad economy, but in a world with lots of different investment choices, investors don't care much for excuses.
These headwinds, along with a heavy debt load, and THC's miss last quarter make me cautious about the stock. Longer-term, I think that the company will benefit from its expanded geographic footprint, cost synergies with VHS, and general efficiency improvements in legacy-VHS assets. The company should be able to throw off enough cash to de-lever relatively quickly and get back to a more normal balance sheet. But all of that is a ways down the road. In the short-term, Tenet still missed numbers, and is facing a tough operating environment and a less than stellar Obamacare rollout. With the stock trading at a slightly rich valuation versus comparable peers, THC still has to prove itself in my book.