Is This the Last Tie-Up in the Hospital Sector?

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The top hospital operators have been active lately in the M&A market, as they try to catch number one hospital operator HCA Holdings. Tenet Healthcare offered to acquire Vanguard Health Systems in June 2013 to gain operating scale, adding facilities with over 7,000 beds. Not to be outdone, Community Health Systems (NYSE: CYH) offered to acquire smaller competitor Health Management Associates (NYSE: HMA) in July 2013, adding over 10,000 beds to its operating network. The question is, are there any other targets for investors to consider?

What’s the value?

Health Management Associates is certainly not without trouble, given open investigations by the Department of Justice into billing practices in various states. Of course, investigations are nothing new for the sector, as the federal health reform legislation that was passed by Congress in 2010 increased both audit activity and fines for found violations. Despite the obvious downside risks, Health Management Associates has a valuable network of 70 hospitals, mostly located in the southeast U.S. where it has limited competition.

In its latest fiscal year, Health Management Associates reported double-digit sales growth, thanks to meaningful acquisitions in late 2011 and early 2012 that added twelve hospitals to its operating base. However, its adjusted operating margin declined significantly, due to lower average occupancy rates at its hospitals and higher technology costs to upgrade systems at acquired properties. On the upside, Health Management Associates enjoyed strong volumes in its emergency room operations, with revenue up 16.5% for the period, which is a key area that drives usage of other hospital services.

In FY2013, Health Management Associates has struggled with declining overall admissions, as customers have limited trips to the hospital, often choosing outpatient or clinic alternatives. However, the company’s hospitals are well-positioned for the expansion of the Medicaid program, a cornerstone of the reform legislation, with a majority of its facilities located in states with high percentages of low income populations. At a purchase price of roughly 15 times adjusted operating income, Community Health Systems is getting a decent long-term value.

Looking for cost savings

Of course, the main goal of the acquisition is synergies, as the combined company will be able to leverage administrative overhead and negotiate better terms with its payors. Like Health Management Associates, Community Health Systems has struggled with higher operating costs and government investigations into its billing practices, including the alleged excessive use of ICD implants.

In FY2013, the company reported weak financial results, with flat revenue growth and a 24.3% decline in operating profit. However, the combination should enhance its operating margin as it adds higher-margin facilities that are the dominant acute healthcare providers in their respective markets.

A potential target

With Health Management Associates out of the mix, the next target might be Select Medical (NYSE: SEM), a niche operator of 122 specialty hospitals that primarily takes referral cases from general acute care hospitals. While it has a strong hospital system, its main value may be its network of almost 1,000 rehab centers, one of the largest networks in the country. More importantly, Select Medical’s specialized focus allows it to earn higher payment rates, leading to an above-average operating margin.

In its latest fiscal year, Select Medical reported continued growth in its financial results, with increases in revenue and adjusted operating income of 5.2% and 5.1%, respectively, versus the prior year. The company’s sales growth benefited from the addition of hospitals and clinics to its network, as a well as being helped by a small gain in its average reimbursement rate. While implementation of the healthcare reform legislation will undoubtedly lower reimbursement rates for the industry, Select Medical’s customer base of long-term care patients are the least likely to feel the brunt of the changes.

The bottom line

The hospital sector has been a good pick over the past twelve months, as investors speculate that a greater number of insured people will mean lower bad debt write-offs and higher profits for the industry. Of course, the federal healthcare programs’ persistent funding problems mean that a gradual reduction in rates and a higher level of audit oversight is a foregone conclusion. As such, Select Medical will probably fall into the arms of a larger competitor that wants a strong position in the growing rehab segment. Therefore, the company deserves a position on investors’ healthcare watchlist.

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Robert Hanley owns shares of Health Management Associates. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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