HCA.pdf

9-207-076

R E V : D E C E M B E R 2 1 , 2 0 1 1

________________________________________________________________________________________________________________ Professor Richard S. Ruback prepared this case. This case was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2006, 2007, 2008, and 2011 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

R I C H A R D S . R U B A C K

HCA, Inc. (A)

In early 2006, HCA’s management asked Merrill Lynch to explore the company’s strategic alternatives. After considering a range of alternatives, Merrill Lynch recommended to management on April 5 that HCA explore a leveraged buyout at a price between $55 and $59 per share. The market price of HCA’s common stock closed at $45.95 that day, so the buyout price range represented a premium ranging from 20% to 28%.

HCA had struggled with an increasing number of uninsured patients and the resulting bad-debt expense. Management continued to be surprised by the pace of the bad-debt expense in the spring of 2006 and, as a result, lowered its forecasts for the current quarter as well as for the next few years. While those lower forecasts implied a lower buyout price, it also underscored the difficulty HCA was having as a public company and increased its interest in a leveraged buyout. The board of directors created a Special Committee (see Exhibit 1) to negotiate a possible buyout with three private equity firms: Bain Capital, KKR, and Merrill Lynch Global Private Equity, Merrill Lynch’s private equity affiliate. As the private equity firms conducted their due diligence, the Special Committee began to plan its response to a buyout offer. It decided that there were advantages to announcing a decision about the buyout at the same time that HCA had to announce its disappointing second-quarter result.

The Special Committee was informed on July 14 that the private equity firms were prepared to submit an offer of $48.75 per share for HCA. The Special Committee met on July 17 to consider that offer. At that meeting, McKinsey reported the results of its analysis of the management projections, concluding that those projections were overly optimistic and that its own projections were substantially lower. Nevertheless, the Special Committee concluded that the $48.75 offer was inadequate. Unless a substantially higher offer was proposed, the Special Committee would terminate the negotiations and instruct management to proceed with the announcement of its second- quarter results. The next day, the private equity firms offered a higher price, $50.50 per share, for HCA. The Special Committee again rejected the offer as inadequate but informed the private equity firms that it would consider an offer at $52 per share. That evening, the three private equity firms submitted their “best and final” offer of $50.75 per share.

This document is authorized for use only in 2236-Private Equity 2014 by Paulo Pinho at Universidade Nova de Lisboa (UNL) from October 2014 to December 2014.

207-076 HCA, Inc. (A)

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Background on HCA

HCA was one of the leading health care service companies in the United States. It operated 176 hospitals and 92 freestanding surgical centers located in 22 states, England, and Switzerland. Net income for the year ending December 31, 2005, was about $1.4 billion, or $3.19 per share, compared to about $1.2 billion, or $2.58 per share, in 2004. During 2005, revenue increased by 4.1% to about $24.5 billion, same-facility admissions grew at 0.1%, and same-facility revenue per admission increased 3.2%. Exhibits 2 and 3 present the income statements and balance sheets, respectively.

About 36% of inpatient revenue was related to Medicare, 10% was related to Medicaid, 49% was associated with managed care and other insurers, and 5% was uninsured. The provision for doubtful accounts increased from 11.4% of revenue in 2004 to 12.4% of revenue in 2005.1 That increase was related to an increase in the number of patient co-payments under some managed-care plans, a 9.9% increase in uninsured emergency room visits, and an 8.9% increase in uninsured admissions. On a same-facility basis, uninsured emergency room visits grew at 11% and uninsured admissions grew at 9.5%. Charity care was not reported as revenue and not included in the provision for doubtful accounts. In 2005, charity care increased by 23% to $1.1 billion.

HCA had repurchased over 145 million shares of its common stock since 2003 for a total cost of more than $6 billion. Most of those shares were repurchased in two modified “Dutch” auction tender offers. The first was in October 2004 for 62 million shares at $39.75 per share, and the second was in November 2005 for 28.7 million shares at $50 per share. Merrill Lynch, which had advised HCA on its repurchases and was also advising the company on its strategic alternatives, did not believe that further repurchases would result in substantially higher stock prices for HCA.

The Proposed Buyout Each HCA shareholder would receive $50.75 in the proposed buyout. There were about 410.8

million HCA shares outstanding, so the total purchase price of the common stock was about $21.1 billion. HCA had bank debt of about $3.5 billion and existing bonds of about $7.7 billion. Fees and expenses were anticipated to be approximately $900 million. Thus, the total cost of the HCA buyout was about $33.3 billion.

Much of the buyout would be financed with debt. To keep the cost of this debt as low as possible, the buyout group intended to roll over the $7.7 billion of existing HCA bonds, which had an approximate borrowing cost of 7.5%. Bank debt of $14.6 billion at a cost of about 8% per year and $5.7 billion of new notes at a cost of about 10% would bring the total debt financing to $28 billion. The remainder, $5.3 billion, would be financed with equity.

The equity would be funded by the three private equity firms as well as Dr. Thomas Frist and HCA senior management. Bain Capital, KKR, and Merrill Lynch Global Private Equity each committed $1.5 billion. Up to half of those commitments could be assigned to other investors. As shown in Exhibit 4, Bain Capital and KKR each managed one of the 10 largest buyout funds.

Thomas F. Frist, Jr., MD, was a founder of HCA, had led HCA through its 1988 buyout, had brought the company public again in 1992, and was the CEO and chairman—most recently from July 1997 through January 2001. He remained a director of HCA. Dr. Frist controlled about 4.1% of HCA, or 16,868,955 shares of common stock. In addition, Dr. Frist’s adult children and other family entities 1 2005 was adjusted to include an uninsured discount that began on January 2, 2005.


HCA, Inc. (A) 207-076

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owned about 6.9 million shares. Most of that stock would roll over into the proposed buyout. Of the $5.3 billion of equity financing, the Frist family would invest $800 million in the buyout and would control about 15% of the post-buyout company.

The private equity firms identified seven senior executives of HCA, including Jack O. Bovender, the CEO and chairman since January 2002, and Richard M. Bracken, the president and COO, who were viewed as critical to the success of the proposed buyout and negotiated their participation in the buyout. Mr. Bovender, who would receive about $46 million in cash for his equity interest in HCA, agreed to invest $20 million of equity in the buyout. Mr. Bracken, who would receive about $20 million for his equity, agreed to invest $10 million of equity in the buyout.

Recent Performance

HCA had struggled in recent years to meet analysts’ earnings expectations. As Exhibit 5 shows, the company missed the market’s consensus earnings forecasts in eight of the previous 13 quarters. It seemed likely that the company would also fail to meet analysts’ expectations in the current quarter, the second quarter of 2006, which was scheduled to be announced on July 24, 2006. The consensus analyst EPS forecast for that quarter was $0.78; management estimated that the actual EPS would be $0.72.

The EPS shortfall would also affect the annual results for at least 2006 and 2007. Exhibit 6 shows that the most optimistic analyst, Merrill Lynch, had forecast EPS for 2006 at $3.25 and the least optimistic, Oppenheimer, had forecast EPS of $3.03. The market consensus according to First Call was $3.18. But current internal management forecasts were for an EPS of $2.99 for 2006. The outlook for 2007 was even more troubling, with the analysts’ consensus EPS forecast of $3.52, more than 20% above management’s internal forecast of $2.88.

Many of the performance problems at HCA could be traced to higher than expected bad-debt expenses. Hospitals had an obligation to treat patients regardless of their ability to pay. As a result, HCA treated a substantial number of patients who were either uninsured or had not yet paid the deductible portion of their insurance coverage. The uninsured population was growing nationally at a compound annual growth rate of about 3.6% over the 2000–2004 period. The uninsured population in the states in which HCA operated was growing faster than the national average over the same period—at about 4.8% per year. About 85% of uninsured patients did not pay their hospital bills. HCA’s provision for doubtful accounts grew from about $1.4 billion in 2001 to about $2.4 billion in 2005, for an annual average growth rate of about 14.4%. As a percent of revenues, the provision of bad-debt expense grew from about 7.7% in 2001 to about 12.4% in 2005. For the first two quarters of 2006, that expense had grown to 13.4% of revenues.

Management Projections

In January of 2006, the senior management of HCA constructed its forecast for the next three years. Those projections were used by Merrill Lynch as part of its assessment of HCA’s strategic alternatives, which concluded that a buyout was both feasible and likely to generate the greatest value for HCA’s shareholders. Those projections are presented in Exhibit 7.

The senior management of HCA revised its January 2006 projections downward after the first quarter to reflect lower patient volumes and higher provisions for bad debt. Those April 2006


207-076 HCA, Inc. (A)

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projections, presented in Exhibit 7, show a 7.9% reduction in 2008 EBITDA relative to the January 2006 projections.

Senior management once again reduced its forecasts at the end of May 2006 to reflect the continuing downward trend in the company’s results. As shown in Exhibit 7, the management projected substantially lower 2008 EBITDA of $4,517 million, which was 3.2% below the April 2006 forecast and 10.9% below the January 2006 forecast. Much of that reduction was traceable to an increase in the provision for bad debt.

The board of directors of HCA also retained McKinsey & Company to analyze the management projections. McKinsey had worked for HCA in the past and had expertise in the health care industry. Interestingly, the buyout group asked permission to engage McKinsey as a consultant almost immediately after beginning its due diligence on May 26, 2006. HCA denied that request but agreed that the results of McKinsey’s analysis would be shared with the private equity firms.

McKinsey studied five drivers for the profitability of HCA: (1) net revenue per admission, (2) volume, (3) provision for bad debt, (4) labor cost, and (5) supply cost. The major difference between McKinsey’s forecast and management’s was attributable to the provision for bad debt. Management had forecast that bad debts would grow at an annual rate of 12.3% over the years 2006–2009. McKinsey believed that those forecasts were too optimistic. For example, management projected an 8% annual growth in uninsured admissions. Historically, those admissions had grown at almost 11% per year over the prior three years, and McKinsey forecast a 10% per year growth with a range of 9%–12%. Overall, McKinsey expected bad debts to grow at an annual rate of 16.5% per year over the years 2006–2009, with a range of 12.2%–21.1%. As a result, McKinsey forecast 2009 EBITDA that was $220 million lower than the management forecast, with $187 million of that difference due to the different forecasts for the provision for bad debt.

Premium On July 18, 2006, the day the Special Committee received the $50.75 buyout offer, HCA’s stock

price was $43.29. The implied premium was about 17% compared to an average premium in large cash deals of 35% and 20% in large LBOs. The offer price was below the 52-week high for HCA of $52.57 on December 12, 2005. It was also below the average target price reported by analysts of $52.46. The target price of analysts along with the valuation formula they used is shown in Exhibit 8.

One explanation for the relatively low premium was that the buyout group, management, and the board of directors had more information than the market about the recent performance of HCA. In particular, the disappointing second-quarter results had not yet reached the market. It was likely that the announcement of the second-quarter results, absent any other news, would lead to a reduction in HCA’s stock price.

HCA had been trading at a price-earnings multiple of about 13.6. Based on management’s forecast of its 2006 EPS of $2.99, HCA’s price would fall to about $41. Also, the 2006 second-quarter results would lead to a revision in the target price reported by analysts. Assuming the analysts’ valuation approach was unchanged, the average target price would be $43.62, with a range of $50.20 to $36.39.


HCA, Inc. (A) 207-076

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Valuation Analysis

The Special Committee retained two investment banking firms, Credit Suisse and Morgan Stanley, as financial advisors throughout the buyout process. As part of their analysis, the investment banks evaluated the proposed offer using three different valuation approaches: discounted cash flow, comparable companies, and comparable transactions.

For the discounted cash flow approach, the financial advisors discounted the unlevered free cash flows (Exhibit 9) by the weighted average cost of capital (Exhibit 10). Beginning with the management’s estimate of EBITDA, the unlevered free cash flows were estimated by adjusting EBITDA for non-operating items, taxes, depreciation, capital expenditures, and changes in working capital. The weighted average cost of capital was calculated by unlevering the equity betas from six comparable firms and applying that unlevered beta to a range of different debt-to-value ratios to get an estimated weighted average cost of capital that ranged from 7.0% to 8.0%. The terminal value was estimated as a multiple of EBITDA, with a range of multiples from 6.5 to 8. After subtracting the debt and adding cash and other investments in HCA’s insurance subsidiary, the resulting range of share values was $45–$61 per share. These calculations are presented in Exhibit 11.

For its comparable companies analysis, the financial advisors identified six hospital chains, three of which—Tenet Healthcare, Triad, and Universal Health Services—were urban and three of which—Health Management Associates, Community Health Systems, and LifePoint Hospitals—were rural. It examined total enterprise value to EBITDA and price-to-earnings ratios for the six companies for 2006 and 2007 estimates. The resulting reference range was $36–$46 per share. That analysis is summarized in Exhibit 12.

For its comparable transactions analysis, the financial advisors identified eight hospital buyouts since 1996. Using multiples of revenue and EBITDA, the resulting reference range was $45 to $55 per share, as shown in Exhibit 13.


207-076 HCA, Inc. (A)

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Exhibit 1 Composition of the Special Committee

Committee Member Biographical Sketch Number of Shares No. of Option

Shares Frederick W. Gluck, Chairman

Frederick W. Gluck held various positions with McKinsey & Company, Inc., from 1968 to 1995, including leading the firm as its managing partner from 1988 to 1994. Mr. Gluck is also a director of Amgen Inc.

22647 48415

Glenda A. Hatchett Glenda A. Hatchett is an author and has hosted a nationally syndicated television court show, "Judge Hatchett," since 2000. Ms. Hatchett served as the Chief Judge of Fulton County Juvenile Court from 1991 until May 1999.

15755 29328

Charles O. Holliday, Jr. Charles O. Holliday, Jr., is the Chairman and Chief Executive Officer of E.I. du Pont de Nemours and Company.

8791 21650

T. Michael Long T. Michael Long is a partner with Brown Brothers Harriman & Co., a private banking firm.

16282 33415

Kent C. Nelson Kent C. Nelson served as Chairman and Chief Executive Officer of United Parcel Service from November 1989 to December 1996.

14504 48415

Financial Advisors: - Credit Suisse - Morgan Stanley Legal Counsel: - Shearman & Sterling LLP

Source: HCA proxy soliciting materials, Form 14A, filed September 19, 2006.


HCA, Inc. (A) 207-076

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Exhibit 2 HCA, Inc., Consolidated Income Statements for the Years Ended December 31, 2005 and 2004 ($ millions, except per share amounts)

2005 2004 Revenues $24,455 $23,502 Salaries and benefits 9,928 9,419 Supplies 4,126 3,901 Other operating expenses 4,039 3,797 Provision for doubtful accounts 2,358 2,669 Gains on investments (53) (56) Equity in earnings of affiliates (221) (194) Depreciation and amortization 1,374 1,250 Interest expense 655 563 Gains on sales of facilities (78) — Impairment of long-lived assets — 12 Government settlement and investigation-related costs — — 22,128 21,361 Income before minority interests and income taxes 2,327 2,141 Minority interests in earnings of consolidated entities 178 168 Income before income taxes 2,149 1,973 Provision for income taxes 725 727 Net income $1,424 $1,246 Earnings per share: Basic earnings per share $3.25 $2.62 Diluted earnings per share $3.19 $2.58

Source: HCA 2005 Annual Report.


207-076 HCA, Inc. (A)

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Exhibit 3 HCA, Inc., Consolidated Balance Sheets December 31, 2005 and 2004 ($ millions)

2005 2004 ASSETS Current assets: Cash and cash equivalents $336 $258 Accounts receivable, less allowance for doubtful accounts of $2,897 and $2,942 3,332 3,083 Inventories 616 577 Deferred income taxes 372 467 Other 559 673 5,215 5,058 Property and equipment, at cost: Land 1,212 1,185 Buildings 8,063 7,981 Equipment 10,594 10,127 Construction in progress 949 677 10,818 19,970

Accumulated depreciation

(9,439)

(8,574) 11,379 11,396 Investments of insurance subsidiary 2,134 2,047 Investments in and advances to affiliates 617 486 Goodwill 2,626 2,540 Deferred loan costs 85 99 Other 159 214 $22,225 $21,840 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $1,484 $1,230 Accrued salaries 561 579 Other accrued expenses 1,264 1,254 Long-term debt due within one year 598 486 3,895 3,549 Long-term debt 9,889 10,044 Professional liability risks 1,336 1,283 Deferred income taxes and other liabilities 1,414 1,748 Minority interests in equity of consolidated entities 828 809 Stockholders' equity Common stock $0.01 par 4 4 Accumulated other comprehensive income 130 193 Retained earnings 4,729 4,210 4,863 4,407 $22,225 $21,840

Source: HCA 2005 Annual Report.


HCA, Inc. (A) 207-076

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Exhibit 4 Ten Largest Private Equity Funds

Top 10 Funds Current/Target

Amount

Texas Pacific Group $14,000 Blackstone $13,500 KKR $12,000 Apollo $10,138 Carlyle $10,030 Bain Capital $10,000 Goldman Sachs Capital Partners $8,500 Thomas H. Lee $8,000 Warburg Pincus $8,000 JP Morgan Partners $7,900

Source: Merrill Lynch presentation to HCA’s board of directors dated May 25, 2006, as contained in the HCA 13E3 filed August 9, 2006.


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HCA, Inc. (A) 207-076

11

Exhibit 6 Analyst Earnings per Share Projections for 2006 and 2007, as of July 11, 2006

Firm 2006E EPS 2007E EPS Banc of America $3.12 $3.46 Bear Stearns $3.14 $3.58 Buckingham $3.20 $3.70 CIBC $3.23 $3.53 Citigroup $3.14 $3.71 Credit Suisse $3.16 $3.58 Deutsche $3.08 $3.40 Goldman Sachs $3.18 $3.58 Harris Nesbitt $3.24 $3.59 Jefferies $3.24 $3.59 JP Morgan $3.18 $3.58 Lehman $3.13 $3.51 Merrill Lynch $3.25 $3.70 Oppenheimer $3.03 $3.12 Prudential $3.16 $3.37 SG Cowen $3.22 $3.44 Stephens $3.10 $3.51 UBS $3.10 $3.65 Wachovia $3.22 $3.68

Source: Bain Capital, KKR, and Merrill Lynch. Materials prepared for Special Committee advisor, July 11, 2006, as contained in HCA 13E3 filed September 18, 2006.

Exhibit 7 Management Revenue and EBITDA Projections ($ millions)

2006 2007 2008 2009 2010 2011 January projections Revenue 25,645 27,464 29,370 EBITDA 4,446 4,740 5,068 April projections Revenue 25,554 27,299 29,231 31,261 EBITDA 4,399 4,471 4,666 4,876 May projections Revenue 25,403 27,071 28,995 31,027 33,215 33,602 EBITDA 4,327 4,330 4,517 4,716 4,965 5,223

Source: HCA proxy soliciting materials, Form 14A, filed September 19, 2006.


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(1,8

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(1,5

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Less

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king

Cap

ital

134

(98)

(1

68)

(178

) (1

94)

(219

) Le

ss: C

hang

e in

Det

erre

d Ta

xes

24

(100

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00)

(100

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(100

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Flow

69

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107

1,48

2 1,

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9 1,

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Sour

ce:

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and

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gan

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ley

pres

enta

tion

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ard

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tors

, Jul

y 23

, 200

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s con

tain

ed in

HC

A 1

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File

d A

ugus

t 9, 2

006,

and

cas

ewrit

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stim

ates

.


207-

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-1

4-

Exhi

bit 1

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ost o

f Cap

ital C

alcu

latio

ns fo

r HC

A

Assu

mpt

ions

:

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isk

Free

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Ris

k Pr

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m

7.10

%

Ta

x ra

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37.5

%

Com

pany

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To

tal D

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Mkt

Equ

ity

Deb

t/Mkt

Eq

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Tax

Rat

e U

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Unl

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Beta

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net H

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1.35

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09

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1%

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0.66

Hea

lth M

anag

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t Ass

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tes

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%

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17

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Com

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tem

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41

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42

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%

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32

Tr

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58

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%

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44

U

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Life

Poi

nt H

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0.83

1

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%

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52

0.55

HC

A

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Av

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) C

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ty

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7.

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8.0%

9.

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%

0.0%

0.

0%

0.45

1.

00

0.45

8.

2%

8.

2%

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11

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0.

45

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48

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%

25.0

%

0.45

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16

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6%

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30

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45

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57

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%

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0.45

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42

0.64

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7.

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50

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10

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45

1.63

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73

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%

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60

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15

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0.

45

1.94

0.

87

11.2

%

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70

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23

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45

2.46

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10

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%

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8%

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(1) T

he le

verin

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equ

als

(E+

D (1

-- ta

x ra

te))/

E

(2) T

he u

nlev

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bet

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the

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div

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fact

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redi

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sse

and

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gan

Stan

ley

pres

enta

tion

to th

e bo

ard

of d

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, Jul

y 23

, 200

6, a

s con

tain

ed in

HC

A 1

3E3,

file

d A

ugus

t 9, 2

006.


207-

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Val

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Pro

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Bas

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Man

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11 E

BITD

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, Jul

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tain

ed in

HC

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file

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t 9, 2

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cas

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tiple

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lo

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high

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PS

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x $4

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00

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, Jul

y 23

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nnou

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04

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& S

tow

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and

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gan

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ley

pres

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tion

to th

e bo

ard

of d

irec

tors

, Jul

y 23

, 200

6, a

s con

tain

ed in

HC

A 1

3E3,

file

d A

ugus

t 9, 2

006.


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