Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

Tenet Healthcare Corp (THC), HCA Holdings Inc (HCA): Why Buy Hospitals?

Under the Affordable Care Act, also known as ObamaCare, hospitals are in a bind.

Tenet Healthcare Corp (NYSE:THC)

More wellness care should mean lower patient counts. The Centers for Medicare and Medicaid Services are pushing automation for best practices, and checklists for operations, aiming to lower re-admission rates. Mistakes will no longer be tolerated, financially. While bringing more people into the pool will reduce the number of uninsured whose care must be accounted for, this may not result in higher capacity utilization.

As a result, hospital chains are under pressure. Yet many have matched the market’s move upward since the act was signed. At least two have engineered triple-digit gains in their stock price.

The question for investors, however, is what happens next. Should you be buying these stocks for capital gains, for yield, or for some other purpose?

Tenet Flies Highest

The highest flyer in the group is Tenet Healthcare Corp (NYSE:THC), up 160% since April 2010. Most of that move, however, has come just in the last year.

The catalyst was a 1:4 reverse stock split last October, which came alongside a $500 million stock buyback. That buyback represented 10% of the company’s equity, at current prices, and almost twice as much at the time the split occurred.

The purpose of the move was to fund acquisitions, and in June it announced a big one, agreeing to acquire Vanguard Health Systems, Inc. (NYSE:VHS) for $4.3 billion, a roughly 70% premium over the pre-deal price.  This included $2.5 billion in debt, much of it taken out at high prices, which Tenet Healthcare Corp (NYSE:THC) could profitably retire, making the deal accretive. Vanguard Health Systems, Inc. (NYSE:VHS) owned 28 hospitals, and complementary facilities, which Tenet Healthcare Corp (NYSE:THC) added to its own 49 hospitals and 126 outpatient centers.

Financially, however, Tenet is not much to write home about. Revenues of $2.387 billion for the first quarter of the year were little changed from the previous year’s $2.302 billion. Tenet Healthcare Corp (NYSE:THC) actually lost money in that quarter, and its balance sheet shows a debt-to-assets ratio of over 50%, which reads like they own auto factories. The only bright spot is operating cash flow, which has been on a steady upward track and was almost $600 million in 2012.

One way Tenet Healthcare Corp (NYSE:THC) has tried to keep growing is by playing hardball with insurers like United Healthcare, with which it has been battling out a reimbursement fight in the California desert.

So you don’t have a great company. It’s moving due to financial engineering, not operations. It pays no dividend, and its current price/earnings (PE) multiple is a sickening 68.22. Overall, a good stock to avoid.

Yet there are buyers. Why? Let’s look elsewhere for an answer.

HCA Flies Lower

HCA Holdings Inc (NYSE:HCA) owns 157 acute care hospitals, along with five psychiatric and one rehabilitation hospital. It did not join the move upward in price, and is only up 24% from the price it fetched five years ago.

Instead of focusing on acquisitions, HCA Holdings Inc (NYSE:HCA) has focused on yield. It paid $8.50 in dividends during 2012, mainly to avoid the consequences of higher tax rates that kicked in during 2013. This makes sense when you realize that insiders own 172 million shares, out of a total of 446 million.

The company’s finances are little different from those of Tenet Healthcare Corp (NYSE:THC). During the last quarter it brought just 7.5 cents in every dollar down to operating income, and only half of those escaped tax. Total revenue is only 10% better than it was in 2009, and it actually has more debt than assets. Operating cash flow, however, is approaching $4.5 billion, and the slope of that improvement is better than Tenet’s.

HCA Holdings Inc (NYSE:HCA) has been doing deals, just smaller ones than its smaller rival. This month, for instance, it agreed to buy three community hospitals in Florida,  bringing its total there to 42.

When the latest hospital consolidation trend began, it was assumed the reason was health reform. The idea was that hospitals would be in a better position to negotiate high rates of reimbursement if insurers had fewer choices.

But what if there was another motivation?

Insurers Are Buying Facilities

While hospital chains have consolidated, insurers have been slowly buying health care facilities, and facility managers.

Most of these deals involve groups that serve Medicare and/or Medicaid patients. Aetna Inc (NYSE:AET) bought Coventry Health last year. UnitedHealth Group Inc. (NYSE:UNH) bought XL Health.  Cigna bought a collection of plans in selected markets. Those are just three deals — there have been others.

At the same time insurers are buying facilities, hospital chains are getting into insurance. Spurred by the lower costs of groups like Kaiser and Intermountain Health, which both provide care and handle insurance funds, other non-profit hospitals are preparing to offer their own health plans.

It’s this kind of integration, on both sides, that is the real story here. Consider that HCA Holdings Inc (NYSE:HCA) carries a market cap of $17 billion, and Tenet just $4.5 billion. By contrast, UnitedHealth Group Inc. (NYSE:UNH) is worth $73.5 billion, and Aetna Inc (NYSE:AET) $24.8 billion. The insurers, not the hospitals, are the likeliest survivors as consolidation accelerates.

The idea of owning both facilities and financing makes sense under health reform. If you own facilities you can control costs, and the market attitude of health reform is to give insurers reasons to control costs.

What large insurers are learning in owning Medicare and Medicaid providers, in terms of automation and best practices, delivered to high-risk patients and under government payment, are the same lessons they will need to prosper in the private market under health reform.

Why buy hospitals? So you can sell them to insurers. Watch for small deals, from companies like UnitedHealth Group Inc. (NYSE:UNH), the purchase of individual hospitals in areas where they have a high concentration of customers. Since the pre-reform market usually had just one or two insurers controlling the bulk of each state’s market, this is the likely first move.

It won’t be the last. Buy when the buying starts, and be ready with shares in the low-value big players, like HCA Holdings Inc (NYSE:HCA). Because their time will come.

Dana Blankenhorn has no position in any stocks mentioned. The Motley Fool recommends UnitedHealth Group (NYSE:UNH). Dana is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

The article Why Buy Hospitals? originally appeared on Fool.com is written by Dana Blankenhorn.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

DOWNLOAD FREE REPORT: Warren Buffett's Best Stock Picks

Let Warren Buffett, George Soros, Steve Cohen, and Daniel Loeb WORK FOR YOU.

If you want to beat the low cost index funds by 19 percentage points per year, look no further than our monthly newsletter.In this free report you can find an in-depth analysis of the performance of Warren Buffett's entire historical stock picks. We uncovered Warren Buffett's Best Stock Picks and a way to for Buffett to improve his returns by more than 4 percentage points per year.

Bonus Biotech Stock Pick: You can also find a detailed bonus biotech stock pick that we expect to return more than 50% within 12 months.
Subscribe me to Insider Monkey's Free Daily Newsletter
This is a FREE report from Insider Monkey. Credit Card is NOT required.