CYH, HCA, LPNT, THC: Hospitals are cheap, but you shouldn’t buy them – here’s why

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Richard Evans / Scott Hinds / Ryan Baum

SEE END OF THIS REPORT FOR IMPORTANT DISCLOSURES

203.901.1631 /.1632 / .1627

richard@ / hinds@ / baum@ssrllc.com

@SSRHealth

February 25, 2016

CYH, HCA, LPNT, THC: Hospitals are cheap, but you shouldn’t buy them – here’s why

  • Hospitals are a full 1 s.d. below their usual relationship to the broader SP500 on price to FY+2 EPS. And, such low relative multiples have historically signaled subsequent outperformance
  • Fundamentally however, Hospitals’ relative performance tracks the rate of acceleration or deceleration in revenues – so we view low multiples as a secondary consideration, and the question of whether revenues are accelerating or decelerating as the primary question
  • All indications are that revenues are decelerating. Per-capita health services employment is a fair coincident indicator of demand, and appears to have peaked. And, consensus forecasts for GDP growth and employment call for slowing growth on both metrics. This matters greatly to health services demand, because a household with employer-sourced insurance consumes 3x the healthcare of an age and health-status matched household without health insurance
  • As unit demand appears to slow, real pricing (gross) is almost exactly zero – and we see no prospect for pricing acceleration in the near- to mid-term (narrow networks are pressuring gross prices, and difficulties collecting insured patients’ rising share of charges is pressuring net prices)
  • We conclude that it’s too early to buy Hospitals, despite the low valuations. ‘True’ employment (adjusted for labor force participation) remains very low, and average job quality also is low – so there is tremendous capacity for health services demand growth if and when job growth meaningfully re-accelerates – but not before

Where we’re BULLISH: Biopharma companies with undervalued pipelines (e.g. AMGN, BMY, GILD, SHPG, VRTX); Biopharma companies with pending major product approvals (e.g. ABBV, ACAD, ADMA, ALIOF, BIIB, CHMA, CLVS, CPRX, CTIC, GILD, ICPT, JAZZ, LLY, LPCN, MRK, NVO, OCUL, PTCT, SRPT, TEVA, ZSPH); SNY on sales potential for Praluent (alirocumab); CFN, BCR, CNMD and TFX on rising hospital patient volumes; XRAY and PDCO on rising dental patient volumes and rising average dollar values of dental products and services consumed per visit; CNC, MOH and WCG on bullish prospects for Medicaid HMOs; and, DVA and FMS for the likely gross margin effects of generic forms of Epogen

Where we’re BEARISH: PBMs facing loss of generic dispensing margin as the AWP pricing benchmark is replaced (e.g. ESRX); Drug Retail as dispensing margins are pressured by narrowing retail networks and replacement of AWP (e.g. WBA, CVS); Research Tools & Services companies as growth expectations and valuations are too high in an environment of falling biopharma R&D spend (e.g. CRL, Q, ICLR); and, suppliers of capital equipment to hospitals on the likelihood hospitals over-invested in capital equipment before the roll-out of the Affordable Care Act (e.g. ISRG, EKTAY, HAE)

Hospitals’ fPE on FY+2 EPS is almost exactly 1 s.d. below its normal relationship to the broader SP500 (Exhibit 1). And, when hospitals have been so cheap in the past, they’ve typically then outperformed (Exhibit 2)

If we were to stop here, we might rationally conclude Hospitals are a buy. However, looking deeper, we can see that Hospitals historically have traded like cyclicals – outperforming on accelerating revenue, and underperforming on declining revenue (Exhibit 3). Thus multiple compression typically has been a secondary consequence of the underlying fundamentals, rather than an independent indication of when to buy and sell

This leads directly to the question of whether Hospitals’ revenues are accelerating or decelerating – we believe they are decelerating, meaning it’s too early to buy. We track hours worked in healthcare settings as a reasonably well-proven coincident indicator of health services demand. Aggregate health services employment appears to have peaked (Exhibit 4); Hospital employment has grown quite rapidly in the trailing period but has not yet slowed (Exhibit 5); and, employment gains in physicians’ offices appears to have peaked (Exhibit 6). Our expectation is that the Hospital employment picture will follow the pattern that seems to be emerging in health services employment more broadly and physicians’ offices specifically – i.e. we expect Hospital employment will also begin to slow, reflecting a deceleration in underlying ‘unit’ demand for Hospital services

To begin with, recent coverage gains from the Medicaid expansion, launch of the Affordable Care Act (ACA) health insurance exchanges (HIEs), and growth in employment all occurred on top of one another in the trailing period, making for a very difficult comparable. Because a household with employer-sponsored insurance (ESI) consumes roughly 3x the healthcare of an age and health status matched household without ESI, economic growth and in particular employment growth is a major driver of healthcare demand. Consensus expectations for US economic growth generally (Exhibit 7) and employment growth specifically (Exhibit 8) are easing; this points to a corresponding deceleration of healthcare demand

What’s more, Hospitals’ US pricing is weak – flat, in real terms (Exhibit 9). N.B. the PPI data in Exhibit 9 are gross of write-offs for invoices that cannot be collected – and such invoices are a growing problem. Specifically, as commercial forms of health insurance come with higher deductibles (Exhibit 10), insured patients are responsible for larger percentages of Hospital charges. And, as these charges grow in absolute terms, they’re more difficult to collect (Exhibit 11)

exh9_alt

More detail if you want it …

The shift to higher-deductible plans (HDHP’s) has a direct effect on collections, and thus on net pricing (Exhibit 11, again). We get the sense that HDHP’s also are blamed for reducing unit demand for Hospital services – yet this is probably not true, at least not in any permanent / structural sense. The best analysis of HDHP demand effects that we’re aware of is a 5-year longitudinal comparison of two parallel cohorts – one that entered HDHP coverage in 2006, and another that remained in more traditional coverage throughout the comparison period (2006 – 2010). The authors found that after an early trend to fewer inpatient days in the HDHP group (designated as the ‘CDHP’ group, in green, in Exhibit 12), that admissions and inpatient days patterns between the two cohorts were not statistically significantly different by the end of the 5-year period. We conclude that rising HDHP enrollment is plainly consequential for Hospitals’ net pricing, but that HDHP enrollment has not been shown to be a permanent headwind to ‘unit’ demand for Hospital services. This implies that once demand for Hospital services accelerates (presumably as the result of rising employment and/or job quality), that we might prefer to own Hospitals’ commodity suppliers (all of the unit demand, none of the collections pressures), rather than Hospitals themselves. For the moment, it’s too early to own either

We also want to emphasize that we remain bullish on the prospects for expansion of Medicaid in all 50 states, though we expect the hold-out states to expand eligibility to 100% of the federal poverty level (100 FPL), rather than to the full 138 FPL target called for by the ACA. We believe this is likely as early as 2017. Plainly this benefits Hospitals in the affected states, and of the publicly traded names HCA is most exposed to states that have not yet expanded (Exhibit 13). As attractive as these gains might be however, we don’t think they’re large enough to offset slowing economic and employment growth

Finally, we want to take issue with the headline employment rate – which does not take account of labor force participation, and so overstates job formation. We prefer to look at participation-rate adjusted employment rates, or more simply the percent of persons 16 and older who are employed (Exhibit 14). On this measure, we’ve gained relatively little ground since the trough. And, average job quality also is low, as indicated by the relatively low percent of those employed who are working full-time (and thus likely to have employer-sponsored health coverage, Exhibit 15). The fact that employment rates and job quality are low shows that there’s still enormous potential for Hospital ‘unit’ demand to grow, if and when economic growth and job formation picks up. However, despite the potential for these significant gains, the fact that economic growth and job formation currently is slowing indicates it’s just too early to own Hospitals

©2016, SSR, LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. In the past 12 months, through a wholly-owned subsidiary SSR Health LLC has provided paid advisory services to Pfizer Inc (PFE) and to Merck (MKGAY) on both securities-related and non-securities-related topics

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