Hospital stocks sold off last week after a federal judge ruled that the Obama administration's practice of reimbursing health insurers for the extra cost of providing care to low-income Americans without an appropriation from Congress was unconstitutional. The news heightened investor uncertainty about the direction of health care after Obama's presidency, and added to worries that lower reimbursements would pressure growth and profitability going forward. One of the stocks to sell off was Tenet Healthcare Corporation (NYSE:THC), one of the largest private hospital operators in the US, which declined 10% on the news. THC now trades at a forward P/E of 11.9, and while the firm's recent results show strength, THC's valuation accurately captures the significant risks to Tenet's outlook.
Tenet's Q1 results beat analyst expectations on revenue and earnings. Sales increased 14% Y/Y, as the company performed well in all three segments. In the Hospital segment (~ 90% of revenues), same-hospital patient revenue grew 6% thanks to 2.2% growth in adjusted admissions (driven by higher exchange volumes in Florida and Texas), and a 3.7% increase in revenue per adjusted admission. Management's strategy of focusing on higher-acuity services such as orthopedic surgery, cardiothoracic surgery, and trauma, appears to be having a positive impact on volume and pricing. Tenet's Ambulatory segment (~ 5% of revenues) delivered same-facility revenue growth of 11%, driven by an 8.6% increase in cases and a 2.2% increase in revenue per case. The company's decision to expand this segment seems to be a prudent one, and according to CEO Trevor Fetter, reflects the preference of consumers for "healthcare services that are offered in lower-priced, more convenient settings" (Q1 Earnings Call). Finally, third-party sales in the Conifer segment (~5 % of revenues) grew 20%, on top of last year's difficult comp that included non-recurring revenues related to a Catholic Health Initiatives Contract.
Tenet's performance reflects favorable fundamental growth drivers. Most of the company's facilities (more than 50%) are located in Sun Belt states such as Texas, California, and Florida that contain high growth urban areas where it is easier to raise premiums. Compared to many small health service firms, THC has a relatively large market share in these areas, and the company's high concentration of outpatient centers gives the firm some bargaining power with managed care organizations. THC's scale also helps the firm reduce management, marketing, and other expenses, and utilize resources more efficiently. The company's presence in these regions should help sustain growth in patient volumes and partially mitigate pricing pressures from reimbursement cuts. In addition, an ageing population will further fuel health-care utilization. The baby-boomer generation will be the fastest growing demographic in the US over the next ten years. Tenet's significant operations in Florida, the state with the highest concentration of individuals over the age of 65, position the firm favorably for long-term demographic trends.
Figure 1: Competitive Analysis
But THC also faces several headwinds, and the lack of any sustainable competitive advantages leaves the company exposed. Lower Medicare and Medicaid reimbursements from the US government, the company's largest customer, will hurt pricing and lower revenue growth. The hospital industry is highly fragmented, with Tenet accounting for roughly 2% of hospital admissions, and while THC's scale in concentrated urban areas provides some leverage, there is little the company can do to withstand the efforts of the government to curb payments. At the same time, THC will have trouble offsetting weaker pricing by negotiating with its comparatively large suppliers. This is because physicians typically specialize in a specific medical device rather than take the time to learn new ones, which raises switch costs for Tenet. In addition, the dependence on high-skilled labor makes it difficult to curb wage increases. Finally, with a D/E ratio of 23, Tenet's high financial leverage prevents the firm from being profitable as interest payments swallow operating profits. The firm's dependence on borrowing exposes the firm to a downturn in demand as well as the risk that interest rates increase.
Going forward, we expect total admission growth to average 3-5% over the forecast period, but pricing growth will slow as the government lowers reimbursements and Medicare patients account for a growing portion of revenues (due to population ageing). The ambulatory care segment will grow 6-7% annually, while outpatient growth will average 8-10%. But despite expanding its network of higher-margin outpatient and ambulatory services, THC will not be able to prevent a decline in margins as operating expenses continue to rise. We expect operating margin to contract from 5.68% in 2015 to a range between 4.5% and 5% over the forecast period. Assuming interest expenses as a percentage of revenues remain at their long-term average of 4.5-5%, Tenet will struggle to earn returns on capital. Therefore, given the significant risks associated with THC, we don't expect the stock to appreciate significantly within the next year.
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