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Depth Check – HCA Healthcare, Inc. (HCA) – Heads and Tails – Even Better Than We Thought

In August, we published a piece recommending HCA Healthcare (ticker: HCA). We noted that the stock had traded down in the first quarter on fears that suspension of high-margin elective surgeries to focus solely on Covid-19 patients would result in terrible financial performance. When we published the piece, we believed the stock was trading at a discount multiple due to the uncertainty surrounding whether the hospitals would continue diverting almost all resources to virus patients, or whether we’d see a return to a more normal operating environment. Our thesis was that we would either see excellent 3Q performance because HCA had received billions in government funds as an advance on treating both Covid-19 and Medicare patients, or we’d see excellent 3Q performance due to a return to a normal operating environment. We titled the piece “Heads I Win, Tails I Win” because in either scenario, we expected strong results. Last week, HCA gave an update on 3Q performance, and it’s even better than we expected.

HCA’s 3Q Update:
Return of CARES Act Funds: There were two key aspects to the HCA update. The first was the company announced they’d return $6 billion of government funds received under the CARES Act. The original reason the government funded the hospitals was fear that they’d go out of business. In a relatively short amount of time, the hospitals have learned to deal with Covid-19. Patient results are improving, and hospital staff is safer and under less stress. Our understanding was that the funds were originally intended as compensation for lost revenue due to focusing the entire business on Covid. Once the hospitals started to print great earnings, the bar shifted to an operating income test. HCA had just reported 2Q earnings that were 46% above the prior year, and figured they’d have to return most or all of the funds.

In the press release, the company wrote that “returning these taxpayer dollars is appropriate and the socially responsible thing to do.” We agree, but note that on the conference call the next morning, the company gave some additional clarification. We pulled the transcript from and in an answer to a question about capital allocation, company CFO, Bill Rutherford, said:

“We’ve historically had a very balanced allocation of capital between our internal capital spending, acquisition capital, dividends and share repurchase. Obviously, with the pandemic, we suspended those that I think were prudent under the circumstances.

You are right with the return of our CARES Act. We do see some flexibility to evaluate when is the right time to return to some of those historical allocation policies, but we haven’t made any firm decisions on those. And that will be part of our capital planning as we go into 2021.”

It seems that business is good enough that HCA is already thinking about acquisitions, dividends, and stock buyback.

A Return to a More Normal Operating Environment: The second key aspect to HCA’s 3Q performance was the return of high-margin procedures. In our initial piece, we wrote:

Long-term, there has to be a return to normalcy in the hospital business. While restaurants may go out of business because people choose to eat at home, and technically, no one needs to get on a cruise ship (although people are lining up to do just that), we can’t have our high-end medical infrastructure be all-Covid all the time. There is already a significant backlog of people who haven’t had other medical problems tended to because they were afraid to enter a hospital where there were contagious virus patients. Some of those people who need to get a hip or knee replaced can go on for a while with discomfort. Others who have heart problems or cancer need to get in for treatment.

In the press release, HCA noted that same facility admissions were down 4% and that emergency room visits were down 20% vs the prior year. Despite that, same facility revenue per equivalent admission was up 15% and total revenue was up 5%. The reason for this is exactly what we predicted above. Long-term, there does have to be a return to normalcy. The reason revenue is up while visits are down is because acuity has increased. Simply stated, people have waited so long to get treatment due to fear of catching Covid-19 in the hospital, that by the time they make the trip to the hospital, they are much sicker and require longer stays. The company is reporting a higher number of people who are “dead on arrival”. There is a backlog of people who require treatment for non-virus medical issues.

Future Implications of this Backlog: This backlog of untreated people is likely to help HCA over the next couple of quarters. Many of the delayed procedures haven’t been rescheduled yet, but will need to be. And many of the delayed procedures that have been rescheduled haven’t been completed yet. It’s going to take a while to work through all the high-margin elective surgeries now that hospitals are starting to schedule them again.

Second, the acuity issue shouldn’t be understated. Because people have delayed getting important treatment so long, medical issues that would have either been outpatient procedures, or a one-night hospital stay, are now becoming multi-night stays. People were initially afraid that treating Covid-19 would be a negative for hospitals’ financial performance. It appears likely to be a tailwind that will lift earnings above expectations for the next couple of quarters.

Potential Downside: There is some concern that a second wave of virus-related hospitalizations could stress the system again. If that happens, the hospitals would still get paid for treating Covid-19 patients, but without the CARES Act in place, they would likely have to absorb the cost of treating the uninsured. While this scenario is possible, we note that the hospitals now have substantial expertise in handling high volumes of Covid patients. We also note that while shutting down the hospitals to non-Covid surgeries again is a possibility, there is an increased awareness of the high medical cost to patients with other health issues.

A Good Guess at Earnings:
HCA didn’t release an earnings number last week, but they did give information that can be used to make a good guess at what earnings might be when the company reports later this month. The press release said that 3Q income before taxes would be about $950MM which included a reversal of the $822MM the company recognized from the government in the second quarter. That would make normalized income before tax about $1,772MM. The tax rate last quarter and in 3Q of 2019 was 22%. While that could change this quarter for many reasons, we’ll use that as an estimate for now. That would make 3Q earnings after tax $1,382MM, or about $4.04 a share. That’s a huge increase over the $2.23 in normalized 3Q 2019 earnings, and well above analyst expectations of $2.45.

HCA’s business is not only returning to normal; it’s starting to see a backlog of high-acuity high-revenue cases from people who have waited to get treatment. On the conference call, the company talked about starting to reschedule the delayed elective surgeries. We expect to see continued strong fundamental performance, and believe the stock is cheap relative to earnings.

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