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Knockin’ on healthcare’s door: finding value in an industry under the knife

Valuations in the US public hospital sector are looking attractive, and that’s led us to reassess the investment opportunities within the US high-yield healthcare universe. But a highly selective approach is needed: Republican efforts to overhaul Obama-era policies have put healthcare facilities’ earnings potential under pressure, causing volatility.

Mama, take this ballot off of me…
Policy change in Washington takes centre stage
President Trump’s first attempt to repeal and replace the Affordable Care Act (ACA), or Obamacare, during his first 100 days in office served as a litmus test for the new administration’s ability to deliver on its campaign promises. The initial failure of the bill to make it to the House of Representatives floor dealt a sharp blow to the Republicans, but this was short lived: a second repeal package was approved two months later, with 217 votes in favour outnumbering 213 against.

Since the approval, with multiple draft revisions, the Senate has been unsuccessful in reconciling the bill. An attempt to repeal the ACA without a replacement also failed, and the closed-door process has been much derided by Republican leaders. Partisan efforts are now focused on tax reforms, and this, of course, also has implications for healthcare policy through the repeal of the individual mandate – the legal requirement for individuals to purchase health insurance or pay a penalty if they fail to.

It’s gettin’ dark, too dark to see…
Forecasts for a significant decline in healthcare coverage
US healthcare providers enjoyed a boom in patient-admissions growth from 2014-16 due to the expansion of Medicaid eligibility across 31 states, the establishment of health insurance exchanges and the individual and employer mandates, and other measures under the ACA that combined to reduce the nation’s uninsured population to 11% from 18%.

The nonpartisan Congressional Budget Office (CBO) has assessed each healthcare repeal bill this year, and in its analysis of the Better Care Reconciliation Act proposed in September, the CBO provided a chilling set of estimates: insurance premiums would increase by 20% in 2018, Medicaid spending would decline by $772bn over 10 years and the number of people without healthcare coverage would grow by about 22mn by 2026. Even though attempts to fully repeal Obamacare failed, we expect that measures enacted by the current administration will likely undermine ACA enrolment. Reduced funding for advertising, shorter windows for enrolling in insurance exchanges, and higher insurance plan deductibles (the dollar amount that a patient commits before their insurer begins to pay) are all expected to negatively impact hospital admission volumes.

That long black cloud is comin’ down…
Are healthcare high-yield issuers cheap for a good reason?
Constituent bonds in the BAML US High Yield Healthcare index sold off following President Trump’s election in November 2016 – presenting an opportunity for us to seek out suitable discounted investments. The sub-sector index remains more than two standard deviations wide in spread terms when compared to the historical three-year performance of the broader index (see figure 1) and, while it may no longer be pricing in a full repeal of Obamacare, credit investors’ sentiment towards healthcare facilities remains low given the recent decline in patient admissions growth.

Although the sector is often viewed as defensive and non-cyclical, hospitals in the US are facing a structural, secular shift. US healthcare spend per capita is the third highest in the world, at around 18% of annual GDP. However, by most metrics the quality of healthcare in the US is not viewed as commensurate with this level of spending. As such, scrutiny of insurers and patients’ demands for lower costs have driven a move away from the fee-for-service model that healthcare providers are familiar with to a model that demands value and quality in exchange for payment. This new demand environment has resulted in patient-admissions growth transitioning away from general acute-care hospitals towards more flexible, less capex-intensive outpatient facilities.

Figure 1: Painful prognosis: Relative performance of US healthcare

Fig1 Painful Prognosis

Source: ICE BAML indices as of December 2017

Knockin’ on healthcare’s door…
Attractive opportunities in HCA’s capital structure

In our view, Tennessee-based HCA is a high-quality healthcare provider that is well positioned to navigate the uncertainties related to government reimbursement that the industry faces. HCA has more than 46,000 beds across 177 hospitals and 119 ambulatory surgery centres, which provide same-day surgical treatment. It is both the largest for-profit operator of general acute-care hospitals and freestanding emergency rooms in the US.

Thanks to its size, HCA benefits from economies of scale and can negotiate more favourable reimbursement rates from managed-care organisations (health-insurance plan providers) and lower expenses from its suppliers. This is reflected in HCA’s EBITDA margin of 19%, which leads its peer group. The hospital operator’s portfolio is also strategically positioned in urban areas with below-average rates of unemployment, fast-growing populations (of over half a million) and in core markets where it has a leading market share – demographic and scale benefits that have supported HCA’s above-average volume growth (see figure 2).

The company is also expanding its reach by building urgent-care centres and freestanding emergency rooms to address the shift in patient preferences for low-cost outpatient services. HCA’s strong free cash flow growth has enabled it to make internal investments at above the industry average (its capital expenditure in the last 12 months amounts to about 7% of its revenues), helping it to improve the attractiveness of its assets, optimise its existing hub-and-spoke networks and, in turn, make gains in market share.

Moreover, HCA’s balance-sheet strength allows it to maintain the financial flexibility to redeploy cash towards further consolidation opportunities and, through its highly disciplined approach, seek value-adding facilities to complement its existing networks without significant deterioration in its credit metrics. This is exemplified by its recent acquisition of Tenet Healthcare Corporation’s three hospitals in Texas, which we believe will add long-term value and fortify HCA’s leading position in that key market.

Figure 2: Same-store adjusted admissions growth: HCA vs peers

Fig 2 Same Store Adjusted Admissions

Source: HCA, Tenet and Community company filings, as of September 2017

We prefer high-yield issuers with large capital structures that provide opportunities to capture superior relative value – and HCA offers just that. During this period of policy uncertainty and softening volumes, we have expressed our preference for higher quality healthcare facilities, leading us to switch out of our unsecured HCA positions into a selection of three-to-seven-year non-callable HCA first-lien bonds. These senior-secured tranches are rated BBB- by S&P and Ba1 with a positive outlook by Moody’s, underscoring their potential to be upgraded to investment grade status – with the significant spread compression that this should bring – over the next 12-18 months.

With trailing 12-month EBITDA of $8bn at the end of Q3 2017, HCA’s capital structure was levered by 2.1x through its first-lien debt and 4x when including its senior unsecured tranches (total net leverage). We don’t believe the extra spread provided by unsecured paper with comparable maturities compensates us for the additional risks it involves (see figure 3). That said, HCA’s long-dated senior-unsecured 2095 maturities are an exception, as they offer an attractive risk-adjusted yield – aligning with our view that a number of longer dated instruments in the US high-yield universe are currently undervalued and represent attractive investment opportunities.

Figure 3: Spread differential between HCA’s secured and unsecured bonds

Fig3 Spread Differential

Source: Bloomberg, as of December 2017

This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. Past performance is not a reliable indicator of future results and targets are not guaranteed.  The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

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