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Hospital Stocks Might Be in a Holding Pattern

Long-term, these hospital managers should perform well, but they might coast a bit following Wednesday's dose of reality


Hospitals took it on the chin yesterday as Health Management Associates (NYSE:HMA) sickly Q1 guidance had investors running for the exits — on a day when the S&P 500 was up 1.22%, no less. HMA itself lost 16.4% on the day, closing at $10.53, its lowest point since mid-February.

Hospitals have had a good run in 2013, so is HMA’s stumble a sign the industry has hit a wall? Or conversely, is this opportunity calling?

Deutsche Bank downgraded HMA — along with Community Health Systems (NYSE:CYH) and Tenet Healthcare (NYSE:THC) — to “hold” from “buy” yesterday, suggesting the entire hospital space has run too far too fast providing few buying opportunities. In a note to clients, it stated that it believes the Patient Protection & Affordable Care Act provides hospitals with higher EBITDA/EPS growth due to the wider coverage created by the act.

Having said that, DB analyst Darren Lehrich stated, “Near-term fundamentals are not strong enough to give investors confidence in chasing the group.”

With the Morgan Stanley Healthcare Provider Index up 57% over the past 52 weeks, it’s hard to argue against his logic.

Although HMA’s revenue and earnings guidance for the first quarter were both dramatically lower than analyst expectations, the figure that jumps out at me is doubtful accounts, which the company expects will be 14% of revenue — 210 basis points higher than in the same quarter last year. Payroll taxes, higher gas prices, increased health insurance premiums and higher emergency room volumes all contributed to the increase. For all of 2013, HMA expects doubtful accounts to be somewhere between 14% and 15%. The combination of these deadbeat accounts with hospital admissions that could drop by as much as 3% in 2013 means HMA’s business could be taking a beating.

Fortunately, suggests CRT Capital Group analyst Sheryl Skolnick, these problems appear to be company-specific and not necessarily a broader industry concern.

The mandatory requirement of Americans to have insurance coverage starting in 2014 will ultimately be good for hospitals because it will add approximately 30 million new customers. These people previously would have been charity cases or uninsured discounts, and while uncompensated care is still going to take place, it won’t be nearly as high once more people are brought into the fold.

Take Universal Health Services (NYSE:UHS). It operates acute care and behavioral care facilities across the U.S. employing more than 65,000 people. Its uncompensated care in 2012 amounted to $1 billion, or 13% of its net revenue. That probably seems high, but the cost of that care is estimated at just $177.2 million — while I’m sure management would prefer getting paid for those services, it’s not suffering. The PPACA will significantly reduce its uncompensated care, leading to higher revenues and profits.

The giant question mark for hospitals at this point is Medicaid and Medicare. As many as 18 states aren’t planning to expand Medicaid at the same time that the PPACA is implementing significant reductions in disproportionate share hospital payments. Universal Health received DHS payments of $47 million and $107 million in 2012 from states and the federal government, respectively. This number will be dramatically reduced come 2014.

But again, when you’re talking about a multibillion-dollar business, that’s not the end of the world.

Although there are a lot of unknowns for everyone in the healthcare industry, I see private hospitals being a net beneficiary of the move to increased insurance coverage. Utilizing economies of scale, hospitals should be able to generate higher revenues in 2014 while keeping a lid on expenses, resulting in higher profits for shareholders. The hospitals most threatened by the changes will be those serving a large number of Medicaid and uninsured patients. Companies operating in one or more of those 18 states are most at risk.

So where does this leave hospital stocks?

Clearly, HMA’s soft first quarter spooked the markets, but a breather at this point is probably good for the entire industry. It gives investors a chance to figure out who will meet the challenges of the PPACA and profit from the new healthcare paradigm. I personally believe all of the hospital stocks are fairly valued at the moment with enterprise values around seven times EBITDA.

If you’re investing for the long-term, I’d be looking for two things: operating margins that are as high as possible and uncompensated care as low as possible.

Take HMA and UHS for example. In 2012, HMA’s operating margin was 4.5%, while UHS’ was more than double that at 9.9%. HMA’s uncompensated patient care was $1.38 billion, or 20% of overall revenue. UHS’ was $1 billion, or 13% of revenue. Furthermore, UHS was able to provide that care at a significantly lower cost per patient. Of the two stocks, I’d definitely be more inclined to invest in UHS.

Long-term, I see hospital stocks doing well. However, the growth experienced over the past 15 months has likely come to an end until more information is known beyond HMA’s miserable quarter. If good earnings reports flow over the next quarter or two, you can be sure that hospital stocks will once again be a great momentum play.

Until then, I’m afraid we’re in a holding pattern.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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