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Potential budget cuts, economy weigh down HCA's stock

by Lisa Ward | Published November 7, 2011 at 12:50 PM

When HCA Holdings Inc. went public eight months ago -- one of several large, sponsor-backed companies to do so -- the conventional wisdom was that equity investors had finally become comfortable with highly leveraged companies throwing off cash to reduce debt.

That assumption appears to be holding, on the face of things. The news earlier this month that profits for the country's largest hospital operator plummeted about 75%, or about 49 cents a share, after it spent $406 million to pare debt, didn't faze investors. Net income also fell from $243 million to $61 million. Yet HCA's stock opened 26 cents higher on the morning of Nov. 1, after the earnings results was released and was up 5 cents at the $23.50 closing price.

For equity investors, the news was a mixture of good and bad. According to analysts, the Nashville company has delevered its balance sheet since its initial public offering and holds enough free cash flow to pay off debt. Longer term, however, its stock has come under pressure from the dual overhang of budget cuts coming out of Washington as well as a weak economy that could erode cash flows. HCA shares have lost about 22% since it IPO'd in March.

Prior to the U.S. debt downgrade, the stock was trading at around $34 but within two weeks it spiralled downward to $18.19. The stock has recovered modestly, settling at around $23 since.

"Equity investors have a love-hate relationship with the hospital sector," Susquehanna Financial Group LLLP analyst A.J. Rice said. According to Sam Goodyear, an analyst at CreditSights, HCA "is valued on Ebitda, not earnings per share," and HCA's adjusted Ebitda rose 4% to $1.4 billion. That's about $85 million ahead of analysts' consensus expectations.

Rice highlighted a 5.3% year-over-year revenue gain in his earnings analysis, saying HCA's $8 billion in revenue is about $64 million ahead of the consensus estimate.

Private equity firms Bain Capital LLC and Kohlberg Kravis Roberts & Co. LP led a $33 billion buyout of HCA in 2006. With about 183,000 employees, HCA operates 164 hospitals and 106 freestanding surgery centers in 20 states and Great Britain.

In March, HCA used $2.6 billion in proceeds from its IPO to pare debt, paying down the balance of its outstanding bank facility and credit revolver.

HCA has made strides in deleveraging in large measure because high-yield investors have treated the hospital sector favorably due to its stable cash flows.

While high-yield inflows have seesawed in recent months, HCA took advantage of a refinancing window this year. In June it redeemed about $1.1 billion in second-lien secured notes. Then, in July, it upsized a proposed $1 billion bond offering by $4 billion for a total $5 billion, the largest such bond offering since the financial crisis. This comprised $3 billion of 6.5% first-lien secured notes due 2020 and $2 billion of 7.5% unsecured notes due 2022. It used the proceeds to redeem higher-yielding debt due in 2016.

The effect of all this, according to Fitch Ratings Ltd. analyst Megan Neuburger, is twofold. First, HCA managed to push out the maturities beyond 2016, when $5.6 billion in second-lien and unsecured debt would have come due.

It also reduced cash interest expense by about $195 million, about 10% of the company's 2010 cash interest expense of $1.9 billion, Neuburger said in a recent report.

To be sure, the economy has had an impact on HCA's balance sheet as shown in two indicators. The company's bad debt provision, a composite of unpaid accounts, uninsured discounts and charity care, increased from 26% in the third quarter of 2010 to 28% in the third quarter of 2011. At the same time, the number of surgical and high-acuity patients, who are more lucrative for the hospital, decreased, as people tend to forgo or postpone surgery during lean times.

Rice said HCA has plans to cut costs to offset the lost income. Labor costs, which account for as much as 40% of HCA's total costs, are also more likely to remain constant as long as the economy remains stagnant, said Neuburger.

Perhaps the bigger overhang has to do with what is happening in Washington, as big government programs such as Medicare, hospitals' biggest client, are threatened with budget reductions.

Many equity investors are waiting on the sidelines until the Congressional Super Committee, charged with cutting the national deficit, announces where the cuts stand, Rice said.

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Potential budget cuts, economy weigh down HCA's stock

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