Last fall, Wall Street had turned a cold shoulder to for-profit hospital companies. Hospital chain executives were perfecting the art of lowering investor expectations to a point where they barely existed at all, and earnings reports were sprinkled with dire discussions of reimbursement cuts and their devastating effects on bottom lines.
What a difference a year makes.
Nashville-based HCA-The Healthcare Co., the nation's largest hospital chain, reported its profit for the quarter ended Sept. 30 rose 26% to $174 million and, despite owning fewer hospitals, the company saw its revenue jump 5% to $4.1 billion. In its most recent quarter, Tenet Healthcare Corp., of Santa Barbara, Calif., reported a 41% jump in profits and a 23% increase in earnings per share from operations. Universal Health Services of King of Prussia, Pa., reported a 107% increase in profits, and Health Management Associates of Naples, Fla., reported a 20% profit jump.
The subtle turning point for these and other for-profit hospital companies can be traced back to a little more than a year ago, when the general investment community had not yet decided to give them the benefit of the doubt.
By the end of 1999, for-profit hospital company executives were quietly but consistently pumping millions of their personal dollars into their company stock, generally a sign that the outlook would improve. Sure enough, soon after the insider-buying spree began percolating among the hospital company executives during the second half of 1999, outside investors followed.
A second look. These days, most for-profit hospital chain earnings reports trumpet record earnings growth and a sunny future; Wall Street has definitely taken a second look.
"This is a fundamental change," says Nancy Weaver, a healthcare analyst with the Little Rock, Ark., securities firm, Stephens. "A year and a half ago, the only ones who owned these stocks were value funds; but as these hospital stocks have hit and in most cases exceeded earnings estimates, you're getting the growth managers interested in owning the stocks," she says.
"It's a whole new class of investors who weren't interested in the stocks a year and a half ago."
Part of the good fortune these companies have enjoyed was prompted by external industrywide forces like reimbursement improvements. A second ingredient has been improved business practices for some, and a third has been a broad shift in the stock market away from highly volatile investments such as technology companies.
One of the investors taking a fresh look at hospital companies is AIM Management Group, a Houston-based growth-oriented mutual fund company. Michael Yellen is the senior portfolio manager of AIM's global healthcare fund, which at this point is loaded with hospital stocks.
"I own all the public hospital stocks," Yellen says.
Hospital stocks now make up about 36% of the fund's $650 million in assets, he says.
Not so at the end of October last year, when the fund's annual report listed hospital management companies as making up only 0.23% of the fund's $463 million. HMA was the only hospital company represented in the fund at that point.
"A year ago, everybody hated them; they missed the numbers and they were very, very cheap on a valuation basis," Yellen says of for-profit hospital companies. "Once they started to make the numbers and beat the numbers, that caused the price-to-earnings multiples to start expanding, and so the stocks have done very, very well off those lows."
A few examples: By mid-October, the average hospital stock had risen 45% so far this year, says Amy Arnott, a senior stock analyst for Morningstar, a Chicago-based investment research firm. As of Oct. 16, HCA had a year-to-date return of nearly 37%, compared with a -3.28% return from the S&P 500 index, according to Morningstar.
LifePoint Hospitals, HCA's Brentwood, Tenn.-based rural spinoff company, had a year-to-date return of about 205%. Universal Health Services, a Naples, Fla.-based hospital chain, had a 138% return.
In the first half of 1999, hospital stock prices sank an average of 22.7%, according to HealthCare Markets Group, a healthcare advisory and investment banking firm in Hilton Head, S.C. In the first half of this year, the same stocks jumped 45%.
"They were cheap," Arnott says. "They're definitely not as cheap now."
Public, private help. Weaver attributes this sharp uptick in stock prices to an unusual confluence of factors acting both specifically on the healthcare industry and on the market in general. For the first time in about a decade, she says, hospital chains are reaping increases in federal Medicare reimbursements at the same time they are receiving higher rates from commercial insurers, helping them achieve and overshoot earnings targets.
After the Balanced Budget Act of 1997 went into effect, it took a little while for the federal reimbursement cuts to reach hospital company bottom lines, but when they did, they hit hard. Earnings suffered, which pushed stock prices down throughout the industry. At the end of 1999, Congress passed a roughly $16.1 billion federal reimbursement relief package, restoring some of what had been cut in 1997. That relief package kicked in this year--the first time in three years that hospitals are seeing year-over-year Medicare revenue growth--at the same time that hospital companies were successfully renegotiating managed-care contracts in their markets, often obtaining 5% to 10% price increases.
"Essentially, government reimbursement has gone from being a big negative to being a slight positive from here going forward," Yellen says. "Secondly, and even more importantly from a fundamental perspective, the hospitals are getting a lot more aggressive in demanding price increases from insurers."
Some of the larger hospital chains such as Nashville-based HCA have gone so far as to walk away from unfavorable HMO contracts in some of the markets in which they are dominant players.
The contract victories have piggybacked on the success HMOs have had in upping the premium rates they charge their clients. In the past year, employer-based health insurance premiums increased 8.3%, compared with last year's 4% hike, according to a benefits tracking survey recently released by the Kaiser Family Foundation and Health Research and Education Trust.
"There's always a demand for healthcare, but the question is whether there is always money to pay for it," Weaver says. "What's going on this year is we have money to pay for it and that's coming either from the commercial side or the government side, and that means companies can earn a decent return on their investments."
Weeding out the weak. Not all hospitals and hospital companies have fared well. The 1997 budget act was like a test that weeded out the strong hospitals from the weak. Many of the not-for-profit, community-based hospitals have been slow to recover from the BBA's cuts, but their stumbling has provided yet more opportunities for market-hungry, for-profit hospital chains to grow and prosper.
"I think there is a pretty big division between the for-profits and the not-for-profits," Arnott says. "That does create an opportunity to make an acquisition where there's already an infrastructure in place."
Adam Feinstein, a healthcare analyst at Lehman Brothers in New York, notes in a report on the quarter ended Sept. 30 that "consolidation is making a comeback in the hospital sector."
The roughly 85% of hospitals that are not-for-profit have not been able to recover from the budget act as quickly as their for-profit peers, Feinstein says.
"Many of these hospitals are losing money and are in dire need of capital," he says in the report, "creating an opportunity for the stronger for-profits to make select acquisitions."
Even some of the weaker for-profits have faltered. The bankruptcy of one for-profit company, Nashville-based New American Healthcare Corp., led to the startup of a new hospital company, called HealthMont. The financial failures of a private for-profit hospital company, NetCare, beefed up two other companies, Dallas-based Triad Hospitals and HMA, which together bought three of NetCare's hospitals.
In its most recent quarter, HMA completed purchases of three hospitals. And officials from HMA told investors at an October lunch in New York that the company is exploring 15 more potential acquisitions, a clear indication that there are hospitals out there to buy.
Most of the for-profit hospital chains, in fact, have made several strategic acquisitions in the past year and plan to continue that track next year, their officials say.
Tech tumble. In addition to these healthcare-related developments over the past year, hospital companies have benefited from something completely outside their control--the tumble taken by the technology sector in recent months.
"Given what we're seeing in the economy right now and the stock market, there are other factors that make this sector particularly attractive," Yellen says. "The main concern among investors is that there will be a slowdown in the economy; and in that kind of environment, with slowed economic growth, there is usually historically more investor attraction to defensive stocks that will not miss their earnings estimates even if the economy slows."
Healthcare is seen as one of those "defensive" segments of the economy, Yellen says, because it is not necessarily affected by the slowing of the economy.
"It's just seen as a very safe place to be," he says.
Richard Driehaus, founder, chief executive officer and chairman of Driehaus Capital Management in Chicago, is another fan of hospital stocks in the current environment. A growth-oriented investment firm, Driehaus' philosophy centers around long-term earnings growth.
"Healthcare is in a recovery phase," Driehaus says. "The likelihood of reversals in their fortunes are smaller than in the tech area."
He says the hospital company stocks bottomed out a little over a year ago and have been outperforming the rest of the market ever since. In fact, he ranks hospital companies among the top 10% to 20% of potential investment sectors in the market.
Growth ahead. So what does the future hold?
Some would say that it has been easy for hospital companies to look good in the wake of 1998 and 1999, which were unusually tough years. But despite the one-time nature of some of the year-over-year comparisons, investors remain bullish on future prospects for the for-profit hospital companies.
They are likely to get even more relief from Washington, which is crafting a second, $28.5 billion relief package that would be split among various healthcare segments.
Yellen believes that while the growth among hospital company earnings for 2001 may not exceed 2000 levels, it will still be a strong growth year.
"I think they've still got upside in front of them," he says.
The federal reimbursement givebacks will continue, and hospitals are likely to be able to continue to squeeze more out of their commercial insurance contracts, he says.
Some of the dramatic cost-cutting measures that hospital companies were forced to take in the wake of the 1997 cuts now are helping them run their businesses more efficiently, which will have long-term benefits for earnings, Arnott says.
"What they're experiencing now is more sustainable," Driehaus says. "The well-run companies are the survivors, and they're acquiring the others."