U.S. Markets closed

Awaiting A Mandated Tail Wind

After enduring their share of economic pain for the past few years, acute care hospitals are seeing some sharp gains.

In the second quarter, hospital operator HCA Holdings (HCA) saw earnings jump 67% — a fourth straight quarter of double-digit profit leaps. Smaller peer Vanguard Health Systems (VHS) saw EPS growth slow to 71%, after three quarters of powerful advances.

But patient traffic for the seven publicly traded acute care hospitals, measured in same-facilities admissions, were down an average of 2.3% in the second quarter, vs. a year ago, according to analysts' reports. Those admission levels, driven by high unemployment and cautious spending by health care consumers, are keeping pressure on the hospital group's earnings, says Susquehanna Financial Group analyst Chris Rigg.

"But the companies have done an effective job at controlling costs, which has allowed them to grow or maintain earnings, despite difficult admissions head winds," he said.

Analyst consensus outlooks for HCA, Vanguard and others slow sharply in the next two quarters as they run up against difficult year-over-year comparisons. The group has seen uneven traffic improvements as the economy slouches ahead. But the big prize hangs in the result of the November presidential election.

"The biggest tail wind for the industry remains the expected increase in the number of insured lives once provisions of the Affordable Care Act go into effect in 2014," said Jefferies & Co. analyst Brian Tanquilut.

The Patient Protection and Affordable Care Act — ObamaCare — mandates that all Americans maintain a minimum level of health care coverage. To meet that objective, it expands Medicaid coverage, provides federal subsidies to assist low-income individuals when they obtain health insurance and establishes insurance exchanges through which individuals and small employers can purchase health insurance.

The acute care hospitals are seen as the primary beneficiaries of the Affordable Care Act. The Medicaid provision and individual mandate are expected to reduce the uninsured population by approximately 30 million, says Tanquilut, which should then translate into reduced bad debt for hospital providers.

Hospitals are required to give everyone care. They collect only 7 cents on the dollar for uninsured patients, says analyst Whit Mayo of Robert W. Baird & Co. So the Affordable Care Act's increased coverage would, theoretically, lower the amount of uncompensated care.

Other than HCA and Vanguard, IBD's Medical - Hospitals group is home to other acute care hospital operators including Tenet Healthcare (THC) and Community Health Systems (CYH). The group ranked No. 30 on Friday out of 197 industry groups tracked by IBD.

The group's index is up 25% so far this year, putting it in the top 15% among industry gains. Much of that performance has hinged on election expectations, as the group moves almost in "lock step" with President Obama's performance in the polls, says Rigg.

Business HCA is the nation's largest acute care hospital provider in number of facilities, sales and market cap.

It also boasts the group's highest cash operating margin at roughly 19%.

During the past three quarters, HCA was also the only company in the group to see a year-over-year increase in same-facilities admissions.

HCA has 163 hospitals, with 157 general, acute care hospitals; five psychiatric hospitals; and one rehabilitation hospital. In addition, it has 108 free-standing surgery centers.

Its strengths are its management and operational expertise, says Mayo.

HCA's focus on fast-growing urban markets has worked to its advantage, says Tanquilut, buffering it from the volume weakness plaguing many of its peers the past few years. HCA has also aggressively acquired physician practices, as well as leveraged its size and scale into competitive technology and price advantages, says Mayo.

Vanguard's 28 acute care and specialty hospitals and related facilities are in several large urban and suburban markets. But it operates on a different model than some of its peers.

It's focused on acquiring large facilities that have had challenges in hopes of turning them around. One recent acquisition was the roughly $365 million cash purchase of Detroit Medical Center, which it completed last year. Detroit Medical was losing money at the time of the buy, but Vanguard turned it around, says UBS analyst A.J. Rice. He figures Detroit Medical now accounts for about 35% of Vanguard's revenue.

The types of facilities Vanguard acquires, like Detroit Medical, have a high percentage of Medicaid and uninsured patients, Rice says. That helps explain why Vanguard's cash operating margin of 9.2% is the lowest of its peer group, says Rice.

Select Medical Holdings (SEM) operates specialty hospitals. It has 111 long-term acute care hospitals — with a length of stay 25 or more days — and 12 acute medical rehabilitation hospitals.

Its earnings per share rose a hefty 75% in the second quarter on a revenue gain of 17%.

Mayo says Select's volume growth rebounded and its debt-related costs dropped as the company substantially trimmed its leverage in the past 24 months. There remains a high degree of uncertainty regarding the regulatory environment for the long-term, acute care industry.

But "Select is probably one of the best managers of long-term acute care hospitals," he said. "They have among the best assets in the marketplace.

Climate The general acute care hospitals like HCA and Vanguard are not depending on a windfall in 2014, when the incremental coverage of the uninsured is scheduled to take place under the Affordable Care Act, Rice says.

"If that happens, they come out ahead," he said. "But if it gets repealed, it's not going to make things worse for them.

The current environment for acute care hospitals is a "relatively steady state," he says. Apart from a rebound in the economy and implementation of ObamaCare, he's not forecasting any major change in the environment.

Acute care hospital providers are benefiting from other trends. Consolidation has been very important for the industry, says analyst Rigg.

With the exception of HCA, most of the other companies in the group would have had much lower top-line growth without the benefit of acquisitions, he says.

Consolidation brings scale, and scale is important in the industry, adds Tanquilut. It's a way to maintain and improve margins and get better pricing with managed care outfits.

Now, with many smaller single hospital operators struggling with soft volumes, there's an opportunity for the larger players to make acquisitions, he says, and the prices are cheaper than they were four or five years ago.

Market Hospital services are the largest component of health care. They represent roughly 33% of total spending in 2011, or $849 billion, according to the Centers for Medicare and Medicaid Services. Hospital spending increased 4.3% in 2011, slower than the 4.9% growth in 2010 and 6.4% growth in 2009, tallies the CMS.

An aging population should drive steady demand for hospital services over time, notes Rice in a report.

CMS projects the annual growth rate in hospital spending to be below the trend line at 4.2% in 2012 and 4.1% in 2013, writes Rice. The CMS sees the rate accelerating to 6.7% in 2014 — or 5.7% in the absence of health reform — and to grow an additional 6.2% per year during the period 2015-20.

Medicare spending growth, notes Rice, is outpacing private health insurance spending growth, reflecting the shift of baby boomers onto the Medicare rolls. According to the U.S. Census Bureau, in 2005 there were an estimated 36.8 million people aged 65 and older in the U.S., representing 12.4% of the total population. By 2020, this age group is expected to increase to 54.8 million people, or 16.1% of the population.

Outlook All eyes are on the presidential election results. Analysts see a win by President Obama as a huge positive for the hospital group. And they see the possibility of a repeal of the act or some of its provisions if Gov. Romney wins.

Rigg says valuations are low for the hospital group.

"If President Obama prevails, it will be a meaningful positive for the group because of the Affordable Care Act," he said.

The Affordable Care Act would meaningfully improve the earnings power of most hospital companies. Mayo estimates health care reform may be accretive to hospital earnings by 15% to 20% going into 2014.

That's the upside. But regardless of what happens with the election, Rigg says, the admissions environment and core industry fundamentals appear to be stabilizing.

"As long as we stay in a slow, steady rebounding situation, there's probably not a lot of downside to earnings," he said.