Are Hospitals on the Mend?

HCA Inc. (HCA) owns and operates approximately 169 hospitals and 116 freestanding surgery centers in 20 states and London, England. In addition to traditional hospital care, the company operates psychiatric hospitals, which provide therapeutic programs for child, adolescent, and adults. This care includes alcohol and drug abuse treatment and counseling. The freestanding surgery centers offer outpatient health care, ambulatory surgery, freestanding emergency care, urgent care, and walk-in clinical care for diagnostic, imaging, rehabilitation and physical therapy, radiation and oncology therapy, and physician practices. In 2016, they earned $2.9 billion ($7.30/share) on $41.5 billion of sales.

The hospital sector is another area of the health care system that has been ignored by investors. This is another example of how the uncertainty around the continuations of Affordable Care Act (ACA) in its current form seems to have chased investors away from the health care sector. Many participants in the healthcare sector continue to run their company’s well and generate good profits on reasonable margins. With healthcare companies out of favor, many companies are cheap. In this note, we are focusing on hospitals in general and HCA in particular. The following exhibit shows a chart of The Options Edge Hospital Price Index. It shows the average stock price for the 16 companies listed on the NYSE. A close review of this chart shows that hospital stocks fell by almost 50% from the middle of 2015 to the end of 2016. After basing for about 2 quarters, it looks to us like the hospital stocks are either breaking out to the upside or at least forming a long-term base from which price will move higher.

The chart below shows the price action of HCA stock. One can quickly see by comparing its price action to the index above that the shares of HCA have outperformed the average hospital stock. When the average hospital stock was falling, HCA was trading sideways. A review of the financials shows that HCA revenue and earnings were growing during this period as well. In short, HCA was outperforming its peers and we think it will continue to do so going forward.

With a strong financial performance, we think valuation is supportive of the bullish case. The shares are priced at a PE multiple of 12 based on trailing earnings and 11 based on analyst’s expectation of future earnings. Enterprise value relative to cash flow (EV/EBITDA) is a modest 7.8. Another bullish factor is the company’s historical growth rate. Over the past 2 years, revenues have grown at a 6% compounded annual rate, and earnings adjusted for extraordinary items grew at a 17% annual rate. The growth rates are far higher than the average large-cap stock, which tends to grow revenues at a rate somewhat slower than nominal GDP (circa 5%). In a typical year, the company generates over to $5 billion in cash from operation and uses about half of it for share repurchases. The remainder goes into CapEx as the company does not pay a dividend.

On the one hand, with sizable share repurchases and a depressed valuation, we see modest downside risk. On the other hand, there is uncertainty around what will happen as the current administration reformulates the way health care is delivered and financed in the years ahead. Let’s not forget that changes to the ACA will require an act of Congress. It takes time to debate and formulate legislation. While we expect some proposals in the next few months, what ever the government decides to do will take time. If you believe that the changes will be good for the industry and/or any potential negatives are already priced into the stock, we suggest you buy the shares outright. If you think the uncertainty will keep the share within a trading range with a positive bias, we suggest you sell a put spread. With the stock trading at $87.34, we would consider the following structure.

In this example, we suggest a near the money put spread due to our bullish bias. To initiate this trade, the investor will collect $170 per put spread up front. The breakeven price is $85.80, which is 2% below the current price. The efficient market hypothesis suggests there is a 56% chance of success on this trade. The maximum one can lose on the trade is $330, which would occur if the share price traded below $82.50 a share at expiration, which is 6% below the current price. (If you are not quite so bullish and looking for more room for error, consider selling $85/$80 put spread with the same expiration. This will increase the probability of success to 67% and the breakeven level will be reduced to $83.85. With lower risk comes lower reward. The credit one collects is reduced to $115.)