Universal's big play

True to form, even as Universal Health Services embarks on the biggest deal in the company's history, it's working with a safety net.

The combination of Psychiatric Solutions and the behavioral-health business of UHS, King of Prussia, Pa., would produce by far the largest behavioral-health provider in the country (See chart). In 2009, UHS' behavioral business had revenue of $1.32 billion, while Franklin, Tenn.-based Psychiatric Solutions had revenue of $1.81 billion for 2009, according to securities filings. The $3.1 billion proposed acquisition—including $2 billion in cash to purchase the outstanding shares of Psychiatric Solutions and assumption of $1.1 billion in debt—also transforms UHS, boosting its total revenue by more than a third, based on the figures the companies reported in 2009.

From 2005 to 2007, most of UHS' investor-owned hospital peers took on significant debt. Health Management Associates took on its debt to provide a special dividend to shareholders with a leveraged recapitalization. HCA sought shelter from the scrutiny of public equity markets with its leveraged buyout—and provided cash returns to shareholders, too. Two companies made significant acquisitions, as Community Health Systems bought Triad Hospitals and LifePoint Hospitals bought Province Healthcare Co.

UHS, however, resisted calls to boost its leverage or to spin off its psychiatric business to shareholders. Instead, the company waited for this opportunity, a deal that Alan Miller, UHS' chairman and CEO, called “a truly compelling transaction.” The company is going to take on a lot more debt—$4.15 billion, giving it a ratio of debt to earnings before interest, taxes, depreciation and amortization of nearly four by the time the deal closes. But, analysts said, the acquisition of Psychiatric Solutions will generate cash from operations and cost-saving synergies to pay down that debt, even before UHS takes a crack at bringing the profit margins on the acquired facilities up to its own.

Psychiatric Solutions generated nearly $56 million in cash from operations in the first quarter, according to its earnings release. UHS also estimates that it will save $35 million to $45 million annually by eliminating corporate overhead within the first two years. About 40% of those savings will come from eliminating the salaries and equity compensation that Psychiatric Solutions was paying its senior management, who will not stay on after the acquisition.

If there is a parallel for this deal, it is Community's acquisition of Triad in 2007. Both Triad and Psychiatric Solutions were targets of private equity firms initially, but that interest opened a bidding process won by strategic acquirers. In both cases, the acquiring company's management believed that it could expand margins by applying its management strategies. In both cases, the acquiring company had been more methodical about its acquisitions until a great opportunity came its way.

Community and Triad probably had more philosophical differences than UHS and Psychiatric Solutions, said Tom Gallucci, senior healthcare services analyst and a managing director of Lazard Capital Markets. Both Community and Triad boasted great physician relationships, but Triad was much more aggressive in spending capital on its physician strategies, and Community identified that as an opportunity for cost savings to boost margins, Gallucci said. UHS and Psychiatric Solutions aren't as different in that regard, he said.

“Historically, Universal has been fairly conservative on the acquisition front,” Gallucci said. “They've done deals over time, but nothing nearly this big. To me, it's a sign that they're that much more confident and excited about it because they are willing to step outside the box of their historical posture and do a deal like this.”

A.J. Rice, senior healthcare services analyst for Susquehanna Financial Group, said UHS is paying a relatively attractive price and is able to finance it relatively cheaply because it was rated as investment grade before this deal. UHS said it expects to finance the new debt at about 7%, once it fixes its rates with interest-rate swaps.

UHS bought 11 facilities formerly operated by Charter Behavioral Health Systems during bankruptcy auctions in 2000 (June 19, 2000, p. 20), but those were auctioned individually, so UHS could choose which it wanted, Rice said.

Steve Filton, UHS' senior vice president and chief financial officer, noted during a conference call that UHS' behavioral-health facilities post operating margins 200 to 250 basis points greater than those of Psychiatric Solutions. That, Filton said, suggests a lot of opportunity for UHS' experienced management team, as the company sees nothing to suggest that Psychiatric Solutions' facilities are fundamentally different from UHS'.

Rice said he can see that case on paper, but one of the risks for UHS will be how much work and management time it will take to boost the acquired facilities to the margins of UHS' current psychiatric facilities. As with almost any acquisition, perhaps there are problems with some of the facilities that UHS will be able to see only once it completes the deal, he said.

Another unknown is the outcome of a federal legal action. In a May 10 filing with the Securities and Exchange Commission, Psychiatric Solutions reported that it is cooperating with the Justice Department in relation to “various documents relating to compensation, stock sales, option awards and option exercises for certain senior-level executives and a subpoena from the DOJ seeking various other stock-related documents including, but not limited to, communications with investment firms and investors,” the filing said.

UHS said it expects to close the deal in the fourth quarter. The deal requires approval by Psychiatric Solutions' shareholders, antitrust clearance from the Federal Trade Commission and some state regulatory reviews, UHS said. With about a quarter of behavioral revenue coming from state Medicaid programs, Rice noted, the state regulatory scrutiny might take some time.