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HCA: The Other Music City MiracleDale WettlauferCharlotte Lane CapitalNovember 24, 2015

HCA is the largest for-profit acute care hospital operator in the US, with 44,000 beds across 18 states. Relevant scale in healthcare delivery is defined by zip code or metropolitan area share; by the latter measure, HCA is a dominant player, with 25-50% share across its major markets.

Hospital supply – demand dynamics are favorable for the industry, especially against the backdrop of an aging society requiring more intensive healthcare services.

This $28B market cap / $58B enterprise value company has an incredibly strong track record of shareholder-friendly actions and operating performance. The stock is currently suffering from healthcare sector outflows. negative sentiment surrounding Affordable Care Act developments, and a flattening in income statement developments over the last two quarters. I will address these below.

HCA is most likely one of a handful of publicly traded large cap firms in the US that have been taken private twice by the founding shareholders and brought public three times. This company’s track record on capital allocation is spectacularly good and with an undervalued stock, the table is set for further value creation.

At 12.8x and 11.6x 2015E and 2016E consensus EPS (9.3x my 2016E EPS) and at FCF yields of 9.0% and 9.3%, HCA is cheap, with 67% upside to my $112 assessed value. This implies a 3-5 year IRR of 20% to 29%.

Detail. There are currently 4,974 registered community hospitals (available to the general public) in the US, 21% of which are investor-owned for-profit entities, with 796,000 beds serving 33.6 million admissions annually.1 US hospital revenues in 2013 reached $937 billion, or about a third of the $2.9 trillion of US healthcare expenditures that year. The hospital sector is more than three times the size of the retail prescription drug market’s $271B in revenue, though the fireworks in the equity market around those names and crickets chirping in the background on these companies would suggest the opposite. Combining Medicare, Medicaid, Veterans Administration, current government employees, and miscellaneous support programs, government at all levels disburses about 65% of all healthcare dollars in the US.

As a point of reference, personal healthcare expenditures in the US represent about 81% of total US healthcare expenditures. This includes “transfer payments” to individuals in the form of Medicare, Medicaid, and other outlays by the government, which are removed from government expenditures and then counted in personal consumption expenditures in the calculation of GDP. Since 1929, the trend is staggering:

1 American Hospital Association, 2014

Exhibit 1: Personal Consumption Expenditures, Healthcare / Total US Personal Consumption ExpendituresSource: BEA, CLC

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

This huge increase in healthcare spending may have crowded out all other forms of personal consumption expenditures. As we see below, all other forms of personal expenditures have been flat (+ / - 50 bps / total PCE) for 50 years, which belies the oft-heard idea US consumers are increasingly profligate with their personal spending habits.

Exhibit 2: Non-Healthcare Personal Consumption Expenditures / Total US PCESource: BEA, CLC

53%

54%

54%

55%

55%

56%

56%

Charlotte Lane Capital HCA: The Other Music City [email protected]

2

mailto:[email protected]

This is perhaps easier to visualize on a per-capita basis. In real terms, healthcare spending per capita in the United States has nearly quadrupled since 1960:

Exhibit 3: Per Capita Healthcare Spending (Real)Source: CMS2, CLC

$-

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

$10,000

Part of this is epidemiological (we eat more packaged food today than in 1960; we are more sedentary; disease survivability is greater, therefore there are more diseases of the aged, which are very costly), part of this is ethical (we believe prolonging life is a priority even if for short periods of time, even if it’s very costly, and even if the quality of life is not high), and part is demographic (median age has been climbing steadily for decades).

Of yearly hospital spending of $937B, private insurance covers 37% and almost all the rest is claimed by government outlays:

Exhibit 4: Hospital Payer Mix, 2013$ in billions

Source: CMS, CLC

Spending % of TotalPrivate health insurance $348 37%Medicare $243 26%Medicaid $164 17%Other health insurance $54 6%Total health insurance $809 86%

Other third party payers $96 10%Out of pocket $33 3%Total $937

Hospitals remain the delivery nexus for intensive healthcare services, accounting for 38% of personal healthcare expenditures in the US:

2 Centers for Medicare & Medicaid Services


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Exhibit 5: Personal Healthcare Spending Mix$ in billions

Source: CMS, CLC

Spending % of TotalHospital Care $937 38%Physician and Clinical Services $587 24%Other Professional Services $80 3%Dental Services $111 4%Other Health, Residential, and Personal Care $148 6%Home Health Care $80 3%Nursing Home Facilities and Continuing Care Retirement Communities $156 6%Prescription Drugs $271 11%Other Non-Durable Medical Products $569 2%Durable Medical Equipment $43 2%Total $2,469

Over the last ten years, personal healthcare spending has grown at a 5.2% annual rate with hospital spending growing at a 5.9% CAGR. Of the 5.9% revenue growth, pricing increased at an average annual rate of 3.2% for hospitals vs. 2.6% for national healthcare and units grew 2.7% for hospitals and 2.6% for national healthcare.

Exhibit 6: Revenue Decomposition, Healthcare, 10-Year AveragesSource: CMS, CLC

Units Price / Mix RevenueNational healthcare 2.5% 2.6% 5.1%Personal healthcare 2.6% 2.6% 5.2%Hospitals 2.7% 3.2% 5.9%Physician and Clinical Services 3.1% 1.7% 4.8%Home Health Care 6.1% 1.1% 7.2%Nursing Home Facilities, Continuing Care Retirement Communities

1.6% 3.0% 4.5%

Prescription Drugs 1.4% 3.0% 4.4%Other Non-Durable Medical Products 3.9% 0.6% 4.5%Durable Medical Equipment 3.3% 1.1% 4.4%

This share gain by hospitals is to be expected as the Baby Boomers age and the overall elderly population survives longer and requires more intensive treatments. Below we see the demographic trend in play with the growth rate of the Medicare population since 2004 and projected over the coming ten years:


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Exhibit 7: Medicare Population, YoYSource: Census, CMS, CLC

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

Over this time, HCA has maintained an average same-facility revenue growth rate of 3.9% and an average revenue growth rate of 5.9%, outperforming healthcare overall and maintaining share among hospitals.

Exhibit 8: HCA Same-Facility Revenue GrowthSource: Company filings, CLC

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%


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Exhibit 9: Revenue, Spending Growth: 2004-2013Source: Company filings, CLC

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Personal Healthcare

HCA Revenues

A key leg of growth has emerged with the enactment of the Affordable Care Act’s healthcare exchange provisions, which has reduced the number of uninsured Americans by eight million as of the end of 2014. CMS expects another 18M enrollments through 2016 to get to the more mature level of nearly 26M healthcare exchange members.

This has a positive earnings and revenue effect for HCA for two reasons. This will bring people into the healthcare system who haven’t had structured access and it will provide some revenue for admissions that were previously unpaid.

In 2014, HCA provided about $16 billion in uncompensated care, which breaks down as follows:

Charity care: $3.8BUninsured discounts: $9.0BProvisions for doubtful accounts: $3.2BTotal: $16.0B

The company won’t recover all of this, as the largest part is discounts off list price for uninsured cases. In reality, very few patients pay the list price. The average billing discount to list price is 85%, which makes gross billings before discounts a largely meaningless number. Where we will see an effect is in the $7B in annual care for charity care and bad debts. Below we see bad debt provisions as a percentage of gross revenue.


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Exhibit 10: HCA Bad Debt Provision / Gross RevenueSource: Company filings, CLC

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

This has averaged 10.1% over the last ten years, but dropped 220 bps in 2014, to 7.9%. Even if the government’s Medicaid reimbursement rates are far lower than private health insurers, some revenue for a case is certainly going to be more profitable than a zero-revenue case a hospital was formerly forced by ethical standards to accept.

With a third of the addressable population enrolled in healthcare exchanges, hospitals can look forward to more earnings growth as this structural drag is reduced. In 2014, HCA EBIT grew 19% as EBIT margin expanded 140 bps, to 14.9% and through three quarters of 2015, the company delivered 6% EBIT growth with margins flat versus 2015.

5-10 Year Implications. If I extrapolate the margin improvements that have already happened, based on the expected path of healthcare insurance exchange (HIX enrollments), margins would expand rapidly given there is a sizable fixed cost base in play. In healthcare, however, Newtonian physics appear to rule to a large degree: ‘For every action, there will be a reaction,’ if not to completely equal and opposite degrees, to some extent. For instance, I believe more employers will dump their employees onto healthcare exchanges as they offload private health insurance cost volatility and regulatory risk. That would drive more of the population from higher-reimbursement private insurance plans to lower reimbursement-paying plans.

Having reviewed the matter with the industry, I believe hospitals with high market shares will be able to counter higher credit risk with higher pricing. This isn’t meant to be extractive, but if the loss content per dollar of revenue goes from 7% to 10%, pricing sufficient to offset those losses can be enacted.

I thus assume a very gradual margin progression (15 bps annually over three years, and flat afterward) as capacity utilization and overhead absorption benefits are offset by net payer pressure. The net benefit, however, is still substantial, with nearly 5.5% comps for five years and over 5% comps for ten years as the demographic and regulatory benefits trends play out. Compounding these with 10 bps of annual EBIT margin expansion over five years and 5 bps over ten years create 6.5% EBIT growth annually through 2019 and 5.5%+ annually through 2024.


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Combined with share repurchases, this translates to 20% average EPS growth from 2015 through 2019 and 8% in the five years thereafter.

HCA is already a good business, as the statistics below demonstrate:

Exhibit 11: HCA ROICSource: Company filings, CLC

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

14.0%

Exhibit 12: HCA Cash Source / (Uses), 2005-2014$ in millions

Source: Company filings, CLC

Net income 16,609$ Total D&A 15,170$ Gross cash f low 31,795$ Change in w orking capital (1,357)$ Net cash from operations 30,438$

Capex (16,803)$

FCF 13,635$ % of net income 82%

Dividends for common (7,918)$ % of FCF 58%Share repurchases (19,121)$ % of FCF 140%

Net M&A (1,432)$ Net debt issuance 17,254$


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There is room for improvement, however, as HCA and hospitals in general operate at 50-55% occupancy. The last room, the last mile, or the last seat is always incredibly profitable for entities with perishable inventory. As the Medicaid and Medicare populations grow, HCA will be able to expand its occupancy rate by 0.5 – 3.0 percentage points per year, which is an important EBIT driver here.As the #1 or #2 in its markets and as a consolidated industry, where the top three players in each market take more than 75% of market revenue3, growth in healthcare spending should not diffuse to subscale players. As the Affordable Care Act picks up momentum with the implementation of Population Health initiatives and Accountable Care Organization reimbursement, scale, vertical integration, and cost management will be able to compete more ably versus competitors lacking these attributes.

Among its two largest competitors, HCA matches up well on every profitability metric:

Exhibit 13: Large Hospital Profitability Metrics, 2015E$ in millions

Source: Bloomberg, CLC

Revenue Margin ROICEBIT EBITDAHCA $39,557 14.8% 19.6% 14.7%Community Health $19,632 8.7% 14.8% 4.6%Tenet $18,436 7.6% 12.4% 6.3%

HCA has leveraged its scale by metro area and by practice area. After decades of consolidation, the company has selectively pruned lower share markets and is more concentrated in Florida, Texas, and Tennessee, where 42, 36, and 13 of its 168 acute care facilities are located. Furthermore, the company has leveraged its scale in numerous ways and prunes carefully its business line selections.

The company engages in minimal research or teaching, which are low-margin activities, and has 114 freestanding outpatient surgery centers, which is among the most profitable portions of the healthcare services industry (leaders AmSurg and Surgical Care Affiliates showed EBIT margins of 23-25% in 2014 and HCA is the #4 player nationwide).

HCA has also insourced group purchasing organization activities (a 24% EBIT margin business for industry leader (among publicly traded companies) MedAssets4, manages internally its Electronic Health Record and revenue cycle management software, and gets natural benefits from being a vertical producer of acute care services (it doesn’t have to send patients to other specialists in many cases). Size makes HCA highly relevant to physicians, suppliers, and payers.

Already operating as a low cost provider, HCA continues to outperform large for-profit peers on medical cost trends. Over the last three years, its operating cost trend per admission has risen at a 2.6% average quarterly rate vs. 3.9% for peers:

3 JAMA, 2013. http://scholar.harvard.edu/files/cutler/files/jsc130008_hospitals_market_share_and_consolidation.pdf

4 HCA announced in Q2 2015 #3 for-profit acute care operator Tenet had joined its GPO.


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http://scholar.harvard.edu/files/cutler/files/jsc130008_hospitals_market_share_and_consolidation.pdf

Exhibit 14: Medical Cost Trends by QuarterSource: Baird, CLC

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%Peers

HCA

Over this same period, the company has held pricing per admission below large peers, at an average 2.4% quarterly rate vs. 2.8% for peers. “Nonprofit” is also a misnomer in the hospital world. Large university hospital systems are very profitable, according to regulatory filings Baird has analyzed. In Dallas, for instance, where HCA has two similarly-sized competitors that are not corporate entities, the market does operate on a profit-generating model:

Exhibit 15: Dallas Acute Care Hospital Market, 2011$ in millions

Source: Baird, CLC

Beds Revenue EBITDA MarginTexas Health Resources 2,877 $2,425 10%Baylor Healthcare 2,666 $2,803 15%HCA 2,425 $2,060 16%Parkland Memorial 755 $620 23%

Despite the many changes to healthcare regulations in the last 12 years, HCA has shown very little revenue and earnings volatility. EBITDA rose 20% in 2009 and 7% in 2010 with minimal M&A help and over ten years, these two measures have grown at a 6% CAGR with only 2.4 percentage points of standard deviation in the revenue line.

Ownership and Capital Structure. HCA is in its third generation of family oversight, having been founded by Thomas Frist Sr. and Jr.. Thomas Frist Sr. stepped off the board when the company went private with KKR and Bain in 2006 in what was then the largest-ever private equity deal. Currently sitting on the board are his son, Tommy III and nephew, Billy Frist. Tommy accounts for a 17% beneficial stake on behalf of Frist family interests. HCA has a very good history of capital allocation with one ding, and that was buying Columbia (which was fraudulent and whose disgraced former CEO is somehow the governor of one of the largest states in the US). To HCA’s credit, they fixed that bad situation. But other than that, how many companies this size have LBOed / MBOed themselves twice and come public thrice? Not


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many that I know of. I don’t have the multiples on the first MBO in 1988, but in 2006, management bought this out a second time at 8.3x TTM EBITDA and 1.3x revenue. At the end of 2015, that will give us a value of $83 and a year from now, $100.

As of the end of 2006, the company was leveraged at 6.7x and has since brought that down to 4.1x. The weighted average maturity of its debt is six years and its weighted average coupon is 5.9% currently, though its 10-year debt trades +367, so there is ample room to continue to bring this down as the company rolls off old debt. If the company chooses, it can de-leverage fairly rapidly. My base case capital allocation has debt coming down to 2.5x five years out, though there are better uses for capital with in-market acquisitions at the right price and, currently, share repurchases. The company has expressed it is in no hurry to pay down debt.

The top of HCA’s leverage range is 4.5x and the company announced in Q3 it has raised its share repurchase authorization to $3.2B. I assume the company engages in an accelerated repurchase of $3B in Q4 with an average repurchase price of $72 per share. I follow this with a $4B repurchase in 2016, though I assume this is done along the equity accretion slope at $119. This brings leverage to 4x at the end of both 2015 and 2016.

From a competitive perspective, HCA has slightly lower debt than its six largest acute care competitors:

Exhibit 16: HCA Leverage vs. Acute Care CompsSource: Baird, CLC

3.0x

3.5x

4.0x

4.5x

5.0x

5.5x

6.0x

6.5xAvg ex HCA

HCA

Relative to the overall hospital industry, including not-for-profits, HCA’s leverage is about half a turn higher, according to benchmarking data from Becker’s Hospital Review.

Why is the Stock Cheap? HCA has been a bit of a hedge fund hotel and a number of larger holders were selling in Q3 on the slowing in fundamentals. Also perhaps to blame are the conflagrations in other healthcare subsectors, where cross-ownership has forced holders’ hands.

While EPS guidance for the year stands at a range of $5.20 to $4.25 vs. the range of $4.55 to $4.95 expressed as of Q4 2014 reporting, momentum in positive guidance revisions stalled out at mid-year as high admissions growth and mix shift changes introduced some process control difficulties. These include using more contract clinical labor than expected. In addition, uninsured admissions grew faster than overall admissions, giving rise to increased provisions for bad debt. Credit statistics remain strong, however.


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http://www.beckershospitalreview.com/lists/200-hospital-benchmarks.html

Exhibit 17: HCA Net Charge-Offs / Gross A/RSource: Company filings, CLC

21.0%

26.0%

31.0%

36.0%

41.0%

46.0%

51.0%

Exhibit 18: Credit Loss Provisions / Net Charge-OffsSource: Company filings, CLC

40%

60%

80%

100%

120%

140%

160%

Because provisions for doubtful accounts as a percentage of gross revenue increased by 220 bps and 290 bps in Q2 and Q3, EBIT margin declined to 15.6% and 13.5% in Q2 and Q3, down 110 bps and 130 bps, respectively. On a pro-forma basis, backing out JOBS Act electronic healthcare record incentive


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payments and an unusual credit to the P&L from a Medicaid waiver payment in Q2 2014, EBIT margin increased by 60 bps in Q2 and declined by 110 bps in Q3.This has given rise to the concern the benefits of ACA have played out for HCA. The data don’t bear this out. Through November 23, weekly average enrollments in Federal HIXs were 24% higher vs. 2014. As of Q2 2015, 36% of the potential 27.4M potential enrollees nationwide had in fact enrolled in Federal and State marketplaces, so the benefit to healthcare facilities operators remains largely untapped.

This is a key point in my 3.4% same-facility admissions growth rate for HCA over a five year horizon. I know of no large entitlement programs in the US that have been rolled back once enacted and I believe the 90% to 100% reimbursement threshold for Medicaid expansion reimbursement to States from the Federal government will also eventually induce HCA’s key markets of Florida and Texas to enter the program. Let’s say, though, ACA stalls out for political reasons this growth driver goes away. That leaves the growth of the Medicare population and Sunbelt growth as the key admissions growth drivers for HCA.

The base case model calls for an average daily census at HCA facilities of 27,000+ by 2019. Based on CDC data5, full ACA uptake would increase HCA daily census by about 10% over five years, adding 1.9 percentage points to my base case. Assuming ACA growth is zeroed out, credit loss provisions revert to their pre-ACA level of 10.3% of gross revenue, and HCA loses opex absorption, the alternative fundamental and valuation scenarios stack up against the base case as follows:

Exhibit 19: Base Case vs. Alternative ScenarioSource: CLC

Base Alt Base Alt

Revenue 39,642$ 39,642$ 51,960$ 43,031$ 5-yr CAGR 5.6% 1.7%EBIT 5,892$ 5,892$ 8,021$ 5,753$ EBIT margin 6.4% (0.5%)Net income 2,134$ 2,134$ 3,800$ 2,152$ 5-yr CAGR 12.2% 0.2%EPS 5.03$ 5.03$ 11.30$ 6.27$ 5-yr CAGR 17.6% 4.5%ROIC 12.6% 12.6% 16.6% 11.4%FCF per share 6.23$ 6.23$ 9.25$ 4.94$ 5-yr CAGR 8.2% (4.5%)

Assessed value 112$ 67$ Upside / (Downside) 67.7% (0.2%)$ in millions, except per share

2015 2020

I would give the alternate scenario a 30% probability and the base case a 70% probability, for a weighted average value of $99.

Appendix

5 http://www.cdc.gov/nchs/fastats/hospital.htm


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HCA’s has a durable moat as a high market share provider in an oligopoly industry that has experienced decades of declining supply, both on absolute and per-capita bases. Intra-industry competition is not intense, based on low market share volatility and the lack of antagonistic not-for-profit behavior. Despite competitors being run by public institutions in many cases, they aren’t money losers. In many cases, they’re more profitable and charge more than HCA, based on Baird data. Below we see a composite of five large markets for HCA vs. competitors (Dallas, Houston, Denver, Miami, and Tampa):

Exhibit 20: HCA vs. Competitor CompositeSource: Baird, Company filings, CLC

Revenue Expenses EBITDAAverage ex HCA 946$ 792$ 154$ HCA 833$ 673$ 160$ HCA relative 88% 85% 103%

Per Bed ($000)

Replicating these assets is not easy, either. These are large-scale projects that require years of entitlement planning and accreditation. A major competitor might add a new wing, but there is very little chance a meaningful competitor will start de novo in a market and challenge the 2-3 top competitors, especially as the quality of care and quality of facilities are improved by consolidation while pricing power is enjoyed by the consolidated industry, according to the above-referenced JAMA article. So barriers are to entry are high while barriers to entry are low. Below we see the number of hospital closures running at 66% the rate of openings over the last ten years and 78% since 2000.

Exhibit 21: US Acute Care Hospital Openings and ClosingsSource: CMS, CLC

0

10

20

30

40

50

60

70

80

90Opened

Closed

This has resulted in a steadily rising ratio of population to hospitals, a trend that has been in place for decades:

Exhibit 22: US Population per Acute Care Hospital


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Source: CMS, CLC

55,000

56,000

57,000

58,000

59,000

60,000

61,000

62,000

63,000

64,000

The threat of substitutes for surgeries is low, as HCA recaptures these through its freestanding surgery centers. Depending on the treatment, substitution risk can vary. There is no substitution risk for trauma cases while various therapies can be done in clinics or in homes. Overall, I believe the threat of substitutes is reasonably small here.

While there is payer risk, I believe this is mitigated by the fact that physician groups choose the hospitals with which they do business, which are then reimbursed by payers. The payers will negotiate hard for rates, but it’s hard to kick out a hospital system in a metro area where there may only be one or two substitutes. In addition, the hospitals are then forced to jack up their out-of-network pricing when the insured lands in their hospital for an unforeseeable emergent reason. Regulatory pressures are high, however. As we go down the road with the later stages of the HITECH Act provisions of Affordable Care Act, population health initiatives, and the Accountable Care Organization reimbursement model, hospitals will be challenged to improve continually. Large deviations from mean pricing and medical outcomes will be penalized with lower reimbursement rates, which creates uncertainly among investors in this industry. I believe the fringe players will suffer most from this dynamic as non-vertical industry participants with fewer insourced services and a lower number of case iterations that make them less subject to the law of large numbers. I believe this is bearish for supply in the industry and thus helpful for those with the largest market shares.

Bear case 1: Supreme Court Decision / Political Pressure. This was the prime bear case in my April, 2015 initiation piece. The Supreme Court decision in question was King v. Burwell, which alleged Federal legislation only enables healthcare subsidies on insurance arranged through state-run health insurance exchanges, not Federal exchanges. The Court ruled against the plaintiff in this case through some admittedly convoluted reasoning.

This rollback of ACA was unlikely, in my opinion, as legislators on both sides of Congress expressed their support for work-around plans that would kick in upon an adverse ruling. Few members of Congress want to take away healthcare services now that the structure of ACA is in place. For instance, a Milwaukee family of four earning US median household income of $53,000 would lose $7,800 annually in subsidies (according to the Kaiser Family Foundation) if an adverse ruling comes down and there is no workaround. Both GOP voters as well as the traditional Democratic base receive ACA benefits and taking this away isn’t something GOP members of Congress will flirt with.


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The Obama Administration certainly doesn’t want to see this, either, and likely constructed a workaround to enable the Federal health insurance exchange to be “white labeled” for use by States. In other words, the States would have put a front end on a website while the back end is operated in the federal cloud. Nevada, New Mexico, and Oregon already operate under this model, according to Reuters. Other models include regional health insurance exchanges or using states as a conduit for Federal disbursement of subsidies.

Health insurers, 22 States’ attorneys, hospitals, current and former members of Congress, AARP, major medical societies, the NEA, SEIU, and State legislators were against repealing ACA, according to a Constitutional Accountability Center tally of amicus briefs filed in the case. The healthcare industry is the second-largest private sector employer in the US, after full-service restaurants, and that’s just private hospitals. When we include public hospitals, which constitute the majority of US hospitals, this is the largest employment sector in country. Politically, it will be very difficult to roll back coverage to pre-ACA levels and there is widespread support across the political spectrum not to do so.

We would still be left with an industry experiencing a demographic tailwind as Baby Boomers graduate to Medicare coverage and we would still be left with caring for the entire population with 600 fewer hospitals in 2014 than existed in 1985, according to AHA, CMS, and other data sources. Supply has tightened steadily over the years as Great Society inducements to expand have rolled off, payers have become more demanding and have consolidated themselves, and as inefficient producers have had to exit the market.

This has a double benefit of being an industry that has barriers to entry (especially for the scale players) and lower barriers to exit:

Exhibit 23: US Acute Care Hospital Openings and ClosingsSource: CMS, CLC

0

10

20

30

40

50

60

70

80

90Opened

Closed


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http://theusconstitution.org/sites/default/files/briefs/CAC-King-Brief%20Summaries-Govt-Side.pdf

Exhibit 24: US Acute Care HospitalsSource: CMS, CLC

4,400

4,600

4,800

5,000

5,200

5,400

5,600

5,800

Bear case 2: Payer Pressure. Will insurers or the Federal government want to “get” the hospitals? Of course payers want to pay as little as possible for services, but this is an omnipresent worry in the healthcare industry. Congress and the CMS haven’t expressed a desire to alter the profit pool of the hospital industry. Medicare and Medicaid already operate under a capitated payment system in which various morbidities are classified under diagnostic related groups, or DRG codes.

Medicare and Medicaid pay for an outcome, not a fee+ price, so the system already looks like an accountable care organization (ACO) model. In this model, there is some incentive for doing better than average and some disincentive for doing worse. Scale players have the law of large numbers working in their favor. They have so many patients going through their systems they are less susceptible to statistical anomalies that would skew their average healthcare outcome and thus reimbursement rate.

For insurers, they’re dealing with hospital groups that have market shares as large as those of the insurance industry or larger, so there is parity or greater market power in the hands of hospitals. If United Health wanted to lower the rates it pays to HCA in Memphis and that rate is unacceptable to HCA, HCA would lose volume but the insurer would then have to pay astronomical out-of-network rates to HCA when their members are treated in HCA’s facilities. Most companies in oligopoly industries would take 25% of units for a 75% increase in pricing.

Insurance companies also don’t select hospitals based solely on rates. Doctors have long affiliations with hospitals and they choose the hospitals with which they do business. Doctors in most metro areas have 2-3 large systems with which they can do business and they are choosing based on quality of facilities, colleagues, overall medical environment, proximity to the rest of their practice or home, and a host of other personal and professional factors. Insurers get one shot at kicking a large hospital system out of their network and after that, they’re dealing with a duopoly or monopoly among scale hospital systems in


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a particular market. To pick a fight with a particular hospital, payers will need to also pick a fight with a huge portion of their medical practice partners.

While hospitals claim the largest share of national healthcare spending, this is the setting in which the most intense care is delivered. So while this seems like an easy target, this would be attacking a conduit through which doctors, device manufacturers, capital equipment providers, nurses, pharmaceuticals companies, and a host of other large interests generate their revenue and personal income. Given the majority of hospitals are not-for-profits and many are owned by States, cuts to rates would also throw off state budgets, for which hospitals are often key profit centers. I wouldn’t say insurance companies and CMS cannot change their rates, but the bear cases I have seen that claim it’s going to happen, no problem, and therefore the hospitals must be avoided appear to me to treat this issue without much consideration for a very broad host of strategic and macroeconomic issues.

Given HCA is among the lowest-cost providers in hospitals and generates a 15.5% EBIT margin vs. the industry’s 6% (AHA data) while charging the same or less than not-for-profits and achieving better overall clinical and patient scores, I don’t think HCA or the for-profit hospitals are first in the sights of payers.


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http://thehealthcareblog.com/blog/2012/08/20/profits-quality-and-u-s-hospitals/

http://thehealthcareblog.com/blog/2012/08/20/profits-quality-and-u-s-hospitals/

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