Regardless of the pros and cons of the Affordability Care Act, better known as Obamacare, one thing is certain. The ACA has spurred a huge wave of consolidation throughout the health care sector. Efficiencies and economies of scale, improved and sustained competitive position and entry to new markets are driving deals.
There has been a tremendous amount of consolidation among health care providers. Consolidation has also been occurring among health insurers. Consolidation can bring efficiencies: it can reduce inefficient duplication of services, allow firms to combine to achieve efficient size, or facilitate investment in quality or efficiency improvements. On the other hand, consolidation can enhance the market power and lead to increased prices or reduced quality.
Technology in the healthcare industry is continually changing the way things are done, and with those changes come more regulations. One way healthcare providers can keep in line with new rules--such as the HITECH Act and Office of the National Coordinator of Health IT's 10-year interoperability plan--is through acquisitions.
The topic of consolidation within this sector has been a long running theme for this author. I wrote about the health insurers, as a group, back in 2011. The national health care law reinforces the trend of providers, including doctors and hospitals, to merge into large regional health systems that dominate local markets. Among the numerous provisions of ACA, the law introduces new rules and restrictions that reduce the degree of competition in the insurance market. The provisions of the law do so by:
- Closing off alternatives to paying for health care by requiring individuals to purchase comprehensive insurance.
- Reducing the ability of insurers to compete with innovations in benefit design by requiring standardized benefit packages.
With the law's individual mandate, forcing most Americans to purchase health insurance regardless of cost, the power of insurers and providers to profit from a captive market is likely to increase even further.
Pushing back against rising hospital bills, managed-care organizations (MCOs) became increasingly prevalent during the 1990s. As motivated, capable, and price-sensitive purchasers, MCOs were able to check the ability of providers to inflate costs. By threatening to steer patients from one provider to another ("selective contracting"), MCOs had leverage to insist that prices be kept within reason.
Accountable care organizations (ACOs) disburse capitated payments for integrated organizations to provide all-inclusive packages to Medicare enrollees, rather than reimbursing them for services provided-allowing them to keep part of the savings relative to Medicare fee-for-service.
The creation of federally supervised health insurance exchanges and expansion of Medicaid under Obamacare will further marginalize the ability of new providers to undercut incumbents by offering cheaper services directly to patients. Insurers are likely to gain more by merging to improve their bargaining position.
The ACA is also changing the way insurers reimburse health care providers, impacting many health care facilities' cash flows and leading to increased risk.
Health care providers traditionally were reimbursed using the fee-for-service model, in which insurance companies paid them separately for every service they provided. But the ACA is encouraging the use of a "bundled" or "episodic payment" model in which insurance companies pay out lump sums for a single medical episode. If a patient suffers a broken hip, for example, an insurance company would pay out one lump sum covering everything from his or her hospital room to his or her surgery to his or her subsequent physical therapy.
Though the episodic payment model has not yet been adopted across the board, it is becoming more commonly used as part of the Medicare Shared Savings Program and Bundled Payments for Care Improvement Initiative.
This change in reimbursement models has implications for investors. Currently, the health care industry has not yet fully transitioned from the fee-for-service model to the episodic payment model. Therefore, a health care facility may have different prospects for cash flow depending on factors such as its location, its reliance on Medicaid, and the insurance companies it deals with. This can affect the way a health care facility is valued.
A discounted cash flow model is often used to value health care entities such as hospitals, ambulatory surgery centers, cancer centers, and imaging centers. Uncertainty over reimbursement rates is likely to impact the discount rate which could cause some decline in value. Less commonly, a market approach is used to value health care facilities. In this case, uncertainty may cause multiples to decline, and impact projected cash flow streams, as revenue growth rates on a per-unit basis are likely to be suppressed.
Deal volume and deal value increased greatly in 2014 over 2013 levels. According to the 2015 Health Care Services Acquisition Report, Twenty-First Edition, deal volume for the health care services sectors rose 18%, to 752 transactions versus 637 in 2013. The dollar value of those deals grew 17%, to $62 billion, compared with $52.7 billion in 2013.
The biggest hurdle to healthcare transactions next year is the identification of suitable targets. Humana (NYSE:HUM) is reportedly on the block. Potential acquirers include Aetna (NYSE:AET), Anthem (NYSE:ANTM) or Cigna (NYSE:CI).
I think there are several attractive mid-tier companies worth a look. My current favorite is Health Net (NYSE:HNT). The company's return on invested capital is 10.52%. Health Net appears to have successfully repositioned its commercial business and has reported favorable experience in its growing Medicaid business. Importantly, earnings disruptions that created material volatility in past years are absent. Health Net is trading at a 6.6 EV/EBITDA ratio and has a free cash flow yield of 27%.
Another strong prospect is Centene (NYSE:CNC). CNC is trading at 12.8 EV/EBITDA and has a free cash flow yield of 9.59%. Long term debt is well covered by free cash flow. Revenues have been growing sequentially each quarter as has the value of equity.
My final pick is Cardinal Health (NYSE:CAH). Cardinal has a return on invested capital of 18.6% and trades with an EV/EBITDA multiple of 12.5. The free cash flow yield is 7.36%. Cardinal is also successfully growing revenues sequentially by quarter and operating income is growing. Cardinal pays a dividend yielding 1.8% and has been buying back shares.
Disclosure: The author is long CAH, CNC, HNT, HUM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.