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5 stocks with surprisingly healthy prospects
Hospital chains that focus on rural markets are better able to generate stronger profits than their urban brethren. The secret: less competition, favorable demographics and a shift in the political winds.
By Michael Brush
At a time when Fed chief Alan Greenspan has fingered deflation as public enemy No. 1, at least one type of business is having very little difficulty raising prices: rural hospitals.
Thanks to a melange of favorable factors -- including friends in high places, the aging of the boomer generation and good ol' monopolistic market positions -- rural hospitals across the United States should continue to see some nice profit growth because theyll be able to keep on charging more for their services.
This outlook finally has sunk in on Wall Street over the past few weeks, which saw investors flocking to shares of small-town hospital chains such as LifePoint Hospitals (LPNT, news, msgs), Community Health Systems (CYH, news, msgs), Health Management Associates (HMA, news, msgs), Triad Hospitals (TRI, news, msgs) and Province Healthcare (PRV, news, msgs).
There are certainly big risks to holding these hospital companies -- chief among them, a strong economic recovery, for reasons well explore below. But all of the factors permitting rural hospitals to keep charging more look like theyre here to stay. That suggests these companies are good, long-term, buy-and-hold stocks, especially if youre not so sure a robust economic turnaround lies ahead.
Heres why:
Political support has shifted
A hospitals ability to generate a profit is heavily influenced by Medicare, which contributes about 30% of a hospitals annual revenue, according to the Centers for Medicare and Medicaid Services (CMS), the agency that helps manage Medicare. For years, the Washington power structure governing Medicare spending was dominated by big-city politicians, like Daniel Patrick Moynihan, the late senator from New York. So naturally, Medicare favored urban hospitals. Now thats changing.
Republican Chuck Grassley of Iowa now chairs the Senate Finance Committee, and the ranking Democrat is Max Baucus. He hails from the decidedly rural state of Montana. Its a similar story in the House. I think the senior leadership in Congress understands the plight of the rural hospitals because they are from those states, says John Merriwether, who handles investor relations for Health Management Associates, based in Naples, Fla.
The stars have aligned for the rural operators, says Steve Speil of the Federation of American Hospitals, the Washington lobbying group for hospitals. On the Republican and Democratic side, you have folks who represent rural areas. And for some time, they have spoken about the inequity in Medicare payments between rural and urban hospitals.
Now theyre doing something about it -- in the form of bills that tweak Medicare reimbursement formulas to channel more money to rural hospitals. The details are complex and still not set, but most agree that the boost for rural reimbursements will be significant. I think the changes would substantially fix the rural equity issues, Speil says.
On a separate track, CMS decided two weeks ago that rural hospitals would get a 5.8% increase for inpatient procedures in 2004, while urban hospitals will get only a 1.2% increase. Last week, CMS gave rural hospitals a 4% increase for outpatient procedures, while big-city institutions received a 3.7% increase. Altogether, these changes translate into a $121 billion increase in Medicare payments to all hospitals in 2004, Prudential Equity Group analyst Diane Duston estimates.
Pricing power has juiced revenue growth
Hospital admissions nationally dropped considerably in the first quarter, and no one is quite sure why. It might have been the cold weather, the preoccupation with the war in Iraq, worries about getting SARS in hospitals, or even the departure of many surgeons for service in Iraq. Admissions picked up again in the second quarter, but they remained weak -- ranging from slight declines to modest increases of 1.5% or so, compared to historic growth of 3% to 4%.
Despite this challenge, hospitals posted impressive revenue and earnings growth, thanks largely to price increases. Industrywide, hospital revenue growth was in the 8% range, with many rural hospitals leading the way. The typical industry earnings growth in the last quarter was 15% to 20%. But two rural hospital chains, Community Health Systems and Triad, topped the earnings charts with gains of 25% and 27%.
One contributor to weak admissions is the tough job market. More people are out of work and have no insurance. Because the job market is weak and companies are trying to cut costs, employers and insurance companies are pushing more costs onto consumers by increasing co-payments. Faced with higher co-payments, people are going to the hospital less. That trend is likely to continue, according to Hewitt Associates, the big health-care benefits consulting company.
A recent Hewitt survey suggests the number of insurance policies charging a co-pay of $20 to $24 for a basic visit to the doctor will rise to 36% next year from 10% this year. The number charging less than $15 is expected to fall below 10%, down from 40% this year. Itll be the same story for co-pays for visits to specialists, hospital stays and emergency room visits.
Again, this favors rural hospitals, because they generally have fewer patients with managed care insurance, which is the kind that's most aggressive about increasing co-payments. Rural patients are more likely to have Medicare, or premium insurance policies that feel less pressure to increase co-payments because they cost more in the first place.
Rural hospitals face less competition
In addition, massive consolidation in the hospital industry over the last decade means theres little competition in a community. They typically have monopolies or duopolies, says John LaForge, a portfolio manager with Phoenix-Hollister fund group, which owns rural hospitals to take advantage of their pricing power. Health Management Associates and LifePoint both enjoy the lack of competition that comes from being the only game in town, says David Nicholas, who manages the Nicholas II fund (NCTWX), which has stakes in rural hospital companies.
The population is aging
A recent study by the University of California at Los Angeles predicts that the demand for surgeries typically done on people over 65 -- like eye and heart surgery -- will increase nearly 50% by 2020. The number of people over 65, an age group that spends more time in hospitals, will be up 53% in the same time frame, says the study. This will help all hospitals, but it will boost rural hospitals in particular because seniors constitute a much higher percentage of rural populations.
Rural hospital chains are hungry acquirers
Not-for-profit community hospitals -- which one typically finds in rural areas -- are having trouble keeping up. They cant always operate as efficiently as publicly-traded hospital chains, and raising capital for new building projects is more difficult. So they continue to be take-out targets or joint-venture partners for the chains, Nicholas says. There is a big opportunity for the for-profit hospitals to buy the not-for-profit hospitals, he says. Triad, for example, expects to add four to five new hospitals per year after 2004, through acquisitions, joint ventures and new construction.
Rural hospital chains are moderately valued
Despite the sharp moves in hospital stocks recently, the group still looks moderately valued, trading at an average price of 14 times 2004 earnings estimates. Thats about right in the middle of their historic valuation range. At these levels, many of the rural hospital stocks are trading well below their projected growth rates. If the stocks can move to trade at least in line with those growth rates, that would mean prices substantially higher than today's. Many sell-side analysts think this is possible.
| 5 rural hospital chains to consider | | Company | Recent price | 2004 EPS estimate | 3-to-5 year growth rate* | Projected price** | | Community Health Systems (CYH, news, msgs) | $22 | $1.47 | 19.80% | $29.11 | | LifePoint Hospitals (LPNT, news, msgs) | $27 | $1.83 | 18.60% | $34.04 | | Health Management Associates (HMA, news, msgs) | $20 | $1.34 | 16.80% | $22.51 | | Province Healthcare (PRV, news, msgs) | $13 | $0.94 | 16.30% | $15.32 | | Triad Hospitals (TRI, news, msgs) | $30 | $2.56 | 17.70% | $45.31 |
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*Projected. **Price if the price-to-earnings ratio equals the growth rate.
Here are the risks to take into account
One problem for hospital stocks is that they have moved up a lot since the end of July. So a little stock-market consolidation here would be natural. UBS analyst Kenneth Weakley, for example, recently downgraded several hospital stocks because of the recent move up.
But the biggest risk for hospital shares would be strong signs of a recovery. That would have investors tripping over themselves to get out of "non-cyclical" companies generally thought to have steady revenue growth regardless of the economic climate -- such as consumer staples and hospitals. Theyd sell these stocks to move even more money into economically sensitive groups such as technology, basic materials and energy. "If you think the economy is going to pick up a head of steam and we are going to see 4%-5% growth in the second half, then my guess is hospital stocks are going to lag a little," says Linda Miller, who manages the John Hancock Health Sciences fund (JHGRX).
On the other hand, stocks such as Community Health Systems, Triad Hospitals, LifePoint Hospitals and Province Healthcare are still anywhere from 30% to 48% below their highs of the last two years, and their valuations really arent that pricey. Besides, a strong enough economic recovery and a better labor market could work to the hospitals' advantage -- by reversing the trend toward higher co-pays (as corporate America starts competing more intensely for workers again) and by healing those unhealthy admission rates.
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