Why Is This Buyout a Sign of Things to Come?

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In a sign that the healthcare industry may be on the cusp of a broad wave of consolidation, Tenet Healthcare (NYSE: THC) recently announced that it would buy hospital company Vanguard Health Systems (NYSE: VHS) in a deal with an aggregate value of $4.3 billion. The all-cash transaction would represent one of the largest health system mergers in recent memory and could pave the way for additional moves by similar American companies.

At first glance, it appears that Tenet is paying a healthy premium for Vanguard: Its offer price exceeds Vanguard's pre-announcement value by about 70 percent and seems designed to ward off challenges from competing firms. However, the deal has attracted the attention of some shareholder-rights firms and may need to clear some steep legal hurdles before closing. If everything goes according to plan, Vanguard and Tenet should merge at some point in late 2013 or early 2014.

Healthcare Industry

The American healthcare industry is highly fragmented. For various reasons, it appears to be populated by a vast array of small and medium-sized companies that operate in fairly well-defined geographical areas. Although this has begun to change, the industry remains somewhat behind the times. Accordingly, it would be fitting to compare Vanguard with cross-town rival HCA Holdings (NYSE: HCA).

Vanguard is the smallest of the three firms by a massive margin. Even after Tenet's offer, the company has a market capitalization of just $1.6 billion. By comparison, Tenet has a market cap of around $4.6 billion. Much larger HCA is valued near $16.5 billion. This significant size discrepancy is reflected in these companies' revenue figures as well: In 2012, Vanguard notched a narrow $65 million profit on revenues of just under $6 billion. For its part, Tenet managed an even more narrow profit of $42 million on revenues of $9.2 billion. With a profit of $1.4 billion on a total take of $33 billion, HCA was the clear winner in this department.

Despite their apparent shortcomings, Tenet and Vanguard are more expensive than HCA. In Vanguard's case, a forward P/E of nearly 26 can be explained by Tenet's seemingly generous buyout offer. Although Tenet's forward P/E of 12.4 seems slightly high for a company that broke even last year, it is roughly in line with other healthcare firms. Meanwhile, HCA has a forward P/E of less than 10.

How the Deal Is Structured

The terms of this deal are straightforward. Tenet will issue cash payments of $21 per share to each Vanguard shareholder on the deal's yet-to-be-determined closing date. It will also assume Vanguard's hefty debt burden of about $2.5 billion. Between its cash payment of $1.8 billion and its debt assumption of $2.5 billion, Tenet will take a balance-sheet hit of roughly $4.3 billion on this transaction. 

At Vanguard's current stock price of $20.70, this transaction does offer a small but meaningful arbitrage premium of about 1.5 percent. Since this figure looks likely to fluctuate in the weeks and months ahead, the situation could provide short-term traders with repeated profit opportunities. Enterprising investors should look to buy Vanguard on price dips and sell near $21 per share.

Synergies and Other Benefits

The merger between Tenet and Vanguard offers several important benefits. For starters, it will create a larger company that can compete with much larger firms like HCA on somewhat equal footing. Tenet and Vanguard also have strong footholds in the southern United States. This deal will strengthen this regional presence and create additional economies of scale. Further, Tenet has recently found some success in its attempts to reduce costly inpatient admissions and increase traffic at its outpatient centers. The combined company may be able to accelerate these efforts and boost its profitability. 

Potential Impact on the Competition

If the combined company is able to realize these synergies, it will find itself on a more level playing field with competitors like HCA. Conversely, these competitors could make scale-boosting moves of their own. In addition to accelerating ongoing drives to develop higher-margin outpatient care centers, companies like HCA may begin to look for smaller acquisition targets in especially fragmented markets. Investors may wish to look at smaller public healthcare firms in areas that lack dominant healthcare providers. Such firms could become more attractive in the wake of this deal.

Long-Term Outlook and Ways to Play

It should be noted that this deal faces legal hurdles that could alter its complexion or scuttle it altogether. Indeed, these issues could be the reason for the persistent premium in Vanguard's shares. Although no formal lawsuits have been filed, the "investigations" that surround the deal could become problematic. Since a customary shareholder vote is required to advance the transaction, a prolonged battle that convinces shareholders to vote against the deal could force Tenet to come back with a higher offer.

Assuming that this does not occur, investors can play this deal with a long position in Vanguard. Aside from the arbitrage premium, the transaction's inherent synergies cannot be ignored. Savvy investors may also wish to begin looking for other healthcare stocks that seem ripe for consolidation. Given the rapid changes that continue to sweep the industry, those who position themselves ahead of further consolidation could reap the rewards.

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