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Stock Strategist Industry Reports

A Healthy Challenge for Hospitals

The industry must spend again as patient volumes pick up.

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A Poor Economy Drives Lower Health-Care Utilization
With the economic recession and ensuing rise in unemployment, hospital services have declined as patients forego elective procedures. Orthopedic surgeries and child births have been particularly affected. Same-facility surgical procedures declined at  HCA Holdings  (HCA) and  Tenet Healthcare (THC) in 2010, while inpatient admissions have been flat to slightly down since 2007. The increasing unemployment rate, which increased from an average rate of 4.6% in 2007 to 9.6% in 2010 according to the Bureau for Labor Statistics, also has affected privately insured patient volumes. A decline in the private payor patient segment puts hospitals at particular risk since Medicare and Medicaid, the two other largest patient segments, often provide reimbursement payments that are below hospital operating costs. Private patients therefore often provide the majority, if not all, of hospital profits.

Hospital Cost-Cutting Offsets Weak Patient Volumes
Despite the decline in patient volumes, hospitals have offset top-line pressure through cost-cutting measures since the recession. Chart 1 below shows hospital earnings before interest, taxes, depreciation, amortization, and nonrecurring costs (adjusted EBITDA) margin during the last five years. The hospital industry uses EBITDA as a common measure of profitability. Although higher unemployment has resulted in an increasing provision for doubtful account expense, hospitals have been able to drive higher profits by reducing salary, supply, and other operating costs. The average supplies expense as a percentage of sales, for example, reached its lowest point in over three years during the fourth quarter of 2010. Chart 2 shows the decline in average hospital inventory days and inventory turnover during the last decade. We note that 2009 appears to be the inflection point for hospital inventories. The slight decline in provision for doubtful accounts in 2010 on Chart 1 stems from hospitals recognizing less revenue through higher charity care and uninsured discounts. The two hospitals we cover at Morningstar, HCA and Tenet, each drove over 250 basis points in margin expansion during the last five years, while Community and Universal Health witnessed similar EBITDA margin improvement.

In addition to higher EBITDA margins, hospitals have been able to minimize capital expenditures, which has improved free cash flow (here defined as operating cash flow minus capital expenditures). Chart 1 also shows the decline in capital expenditures as a percentage of sales leading to the recent higher free cash flow margins. Chart 3 presents hospital capital expenditures per adjusted patient admission (inpatient admissions including an equivalent outpatient adjustment) and as a percentage of sales. Capital expenditures as a percentage of sales have fallen to the lowest level during the decade. Specifically, the first quarter of 2010, as an average of HCA, Tenet, Community, and Universal, appears to be the lowest point at approximately 3.7% of sales. The increased profitability and reduced capital expenditures have culminated in higher returns on capital for these hospital operators. Returns on capital at HCA increased from 8% in 2006 to 18% in 2010, while Tenet's returns climbed from negative 1.7% to 12.5% during the same period.

We Predict 2011 as the Turning Point of the Next Hospital Spending Cycle
We think 2010 marks the peak of hospital free cash flows. As the economy improves, we think operating costs gradually will increase, but the rate of growth likely will be determined by the pace of economic improvement and inflation. A rise in hospital staff and nursing turnover, in addition to increased competition in hiring physicians, should increase salary expenses. Likewise, hospital suppliers should begin to see a pickup in demand. An improvement in unemployment should lower provision for doubtful accounts helping to limit EBITDA erosion from higher operating costs. We think hospital capital expenditures bottomed in 2010 and will start to sequentially rise beginning in 2011. Combined with pressured EBITDA margins, these expenditures should cause a decline in future free cash flow for hospitals. Management for HCA, Tenet, and Community Health estimate capital expenditures will rise next year, and we expect capital spending to grow approximately 15% in 2011, or nearly 5.2% of estimated sales, still well below historical norms.

Increased Hospital Spending Bodes Well for Hospital Suppliers
While higher operating costs and capital expenditures do not bode well for hospitals, the trend should benefit hospital suppliers, equipment providers, and device manufacturers. We believe that the recession and ensuing capital expenditure declines have led to a peak in profitability and cash flows for the hospital sector. Since we expect margins and free cash flows will begin to gradually decline, we don't view hospitals as a compelling investment opportunity. In addition to viewing HCA and Tenet as fairly valued, we think the hospital industry's weak power over customers (managed-care organizations and the federal government) and suppliers makes it a no-moat industry. Sustainable and attractive returns on capital in this industry are rare.

Conversely, equipment makers, such as  Intuitive Surgical (ISRG),  Thermo Scientific (TMO), and  Stereotaxis (STXS), and device manufacturers, such as  Zimmer Holdings (ZMH),  Medtronic (MDT), and  Covidien (COV), should witness higher revenue growth as hospital spending rises. In addition to capital equipment sales, these companies should also see increased use of consumables thanks to the gradual improvement of patient volumes. Thermo Scientific, Zimmer Holdings, Medtronic, and Covidien are four companies that we at Morningstar currently view as undervalued.



Michael Waterhouse does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.