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A Strong Prognosis for This Hospital Firm

By Robert Gold This week's S&P Focus Stock is HCA Inc. (HCA), the largest operator of acute care hospitals in the U.S., with 196 acute care hospitals and 78 outpatient surgery centers nationwide. HCA carries Standard & Poor's highest investment ranking, 5 STARS (buy).

HCA seeks to provide a range of quality healthcare services in a cost-effective manner, and its hospitals offer a full range of inpatient services to accommodate specialties such as internal medicine, general surgery, cardiology, oncology, neurosurgery, orthopedics and obstetrics, as well as diagnostic and emergency services. Outpatient services, which are provided both in the acute care facilities and the company's freestanding centers, include surgery, diagnostics, rehabilitation and physical therapy, radiation and oncology therapy.

The company has restructured its operations over the past three years in order to sharpen its geographic market focus and eliminate under-performing hospital assets, while also allowing it to streamline and decentralizing a bloated and inefficient management structure. In May 1999, HCA completed a spinoff of its rural hospitals into two independent, separately-traded entities (Lifepoint Hospitals Inc. and Triad Hospitals Inc.) which has allowed it to focus on core communities, typically located in urban areas characterized by highly integrated health care facility networks.

At 2000 year-end, these facilities were located primarily in Florida (42 facilities), Texas (40), Georgia (18), Louisiana (13), Tennessee (12) and Virginia (11), with the balance distributed rather evenly throughout the country.

In S&P's experience, the most important determinants in shareholder wealth creation within the hospital industry are: same-store admissions and pricing, operating cost disciplines and efficient accounts receivable (A/R) collection processes, all of which combine to determine the most critical aspect of value-creation: cash flow. HCA, which offers one of the deepest and most seasoned management teams in the investor-owned hospital industry, has clearly recognized the importance of cash flow management, and we believe the company will continue to execute on this front.

HEALTHY FUNDAMENTALS. S&P believes that inpatient hospital admissions in the U.S. can reach 37 million by 2005, up from approximately 33.5 million in 2000, or by a compounded annual growth rate of approximately 2.0%. By comparison, inpatient admissions grew at an average compounded annual rate of about 1.0% over the past five years. Given this expectation, we believe HCA can reasonably be expected to generate admissions growth of 3.0% to 3.5% annually in the coming five years as it captures additional market share from non-profit facilities.

When combined with annual commercial pricing growth estimated at 5%, rising patient acuity levels as the healthcare needs of the "Baby Boomer" generation increase, conservatively assuming no additional Medicare price hikes and projecting that occupancy levels move into the 60%-65% range, up from an estimated 53% at present, the company should be able to generate revenue growth in the 8% to 10% range annually during this time period. For 2001, our revenue growth objective is a modest 7% to 8%, with accelerating growth in the second half of the year.

HCA reported strong operating results in the second quarter of 2001. Highlights of the quarter included an 8.3% rise in revenues (to $4.1 billion), reflecting a same-facility admission gain of 4.2% (versus the company's long term target of 2% to 3%) and same-facility revenue per inpatient admission of 10.9%; operating margin of 19.6% versus a year-earlier 19.3%, as rising labor costs were offset by lower bad debts; a reduction in days sales outstanding (DSOs) to 64 from 67; and operating EPS expansion of 25%, to $0.50. All of these key metrics exceeded our already bullish expectations.

We believe the company's sharp focus on controlling both wage and supply costs, combined with a stronger revenue growth environment, will allow for EBITDA margins to move towards 20% or even 21% over the coming three years, versus 19.1% recorded in 2000. For 2001, our EBITDA target is 19.5%.

BOOSTING CASH FLOW. Perhaps the most fundamentally important shift taking place in the hospital industry has been the reversal of negative cash flows which characterized many large players over the past several years. The primary reason for this reversal has been aggressive reductions on bad debts and accounts receivable levels, and HCA is among those focused on further improvements. Through its Shared Services initiative, the company has formed regional collection centers dedicated to collecting payments due from commercial payers for several hospitals within specific geographic regions. At June 30, 2001, about 35% of HCA hospitals were flowing their A/R's through these centers, and their days sales outstanding amounted to 62, versus 65 days for those not using the centers, thereby significantly boosting free cash flow levels. We believe HCA has the ability to boost free cash flow by up to $250 million ($0.46 per share) annually by consolidating its billing processes.

Given our 7% to 8% top line growth assumption, 19.5% EBITDA margin target and expectation that company-wide DSOs can fall to 62, we look for free cash flow (after $1.2 billion in capital expenditures) of $910 million in 2001, and anticipate a rise to $1.2 billion in 2002.

With significant margin expansion at hand, we believe the company can leverage 7% to 10% revenue growth into net income growth of 15% to 18% over the coming three years, with share repurchases providing additional support to per-share profits. We estimate that 2001 operating EPS will reach $1.95, up 21% over the $1.61 recorded in 2000, and our 2001 estimate was recently boosted by $0.15 to $2.25.

A COMPELLING VALUE. On a relative valuation basis, the stock ranks among our least expensive hospital names, recently trading at a sizable discount to its peers on a price-to-sales, price-to-EBITDA and price-to-EPS basis. Our three-year EPS growth target is 17%, giving the stock a recent P/E to growth (PEG) ratio of 1.2 based on our 2002 estimate, versus a peer group average PEG of 1.8.

Standard & Poor's Discounted Cash Flow analysis provides further support to our bullish stance on the shares. Our assumptions of high but decelerating growth in free cash flow generation (high-teens over the coming five years, followed by low to mid-teens through 2015 and assuming a perpetuity growth rate of 5%), and a weighted average cost of capital of 9.5% implies an intrinsic value estimate of more than $60 per share, a significant premium to HCA's current quote. Gold is an equity analyst covering the healthcare services & medical products industry for Standard & Poor's

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