Capital Structure Is the Most Important Difference Between Two Great Hospitals

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Obamacare has completely changed the economics of many companies in the health care industry. If it is successfully implemented, scores of previously uninsured or under-insured patients will become profitable for institutions that once lost money on these customers.

No other health care institutions will benefit more from an increased ability to pay than hospitals. Hospitals have long set aside provisions for uncollectible receivables from patients that were unlikely to pay in full. However, as insurance companies start paying for the bulk of health care services, accounts receivables write-offs will become a much smaller burden for hospitals.

An increasing ability for customers to pay in full for services provided is only one of the many things that serve as a tailwind for hospitals going forward. Long-term investors would do well to look at a few publicly-traded hospital operators to determine which is best-positioned to take advantage of long-term tailwinds.

Capital structure is key

Many publicly-traded hospitals are above-average businesses. For instance, HCA Holdings (NYSE: HCA) has a 25% market share in most of its core markets -- many of which are still under-penetrated. The company's network of hospitals is the largest in North America, which allows to earn higher operating margins due to economies of scale.

Meanwhile, LifePoint Hospitals (NASDAQ: LPNT) steers away from the highly-competitive metropolitan markets in favor of the less-competitive rural markets. By doing so, LifePoint is usually the largest and best-equipped hospital in its markets, which gives it a tremendous advantage over local competitors. This allows it to earn high and reliable margins year after year.

However, there is a key difference in the safety and attractiveness of HCA and LifePoint for long-term investors. The difference is in the companies' capital structure.

HCA's debt to revenue ratio is 0.88 to 1, while LifePoint's debt to revenue is only 0.37 to 1. Since both companies' operating margins are roughly the same, LifePoint has the more conservative operating structure by a long shot.

A case in point

Hospitals tend to be reliable profit-generators, so some may find an aggressive capital structure of little concern. However, a quick glance at Tenet Healthcare's (NYSE: THC) struggle with a heavy debt load may give investors second thoughts about debt.

Tenet is a decent company that has a debt burden between those of HCA and LifePoint. However, the company's profits have been unstable, which has forced it to restructure its operations and be a perennial bankruptcy contender.

Tenet believes that the favorable demographics of its core market -- the state of Florida -- warrant a more aggressive capital structure. The company's second most important market, the Sun Belt region, is one of the most favorable markets for insurance companies -- and therefore hospital reimbursements.

However, investors that own Tenet continually flirt with holding a zero. The reward for a successful turnaround may be high, but the risk is too high.

Bottom line

Long-term investors would be wise to adhere to Warren Buffett's two rules of investing:

Rule #1: Don't lose money

Rule #2: See Rule #1

HCA and LifePoint are good businesses -- and both are better than Tenet. However, despite trading at a lower earnings multiple, HCA is a much riskier investment than LifePoint because its debt burden makes the possibility of losing money much greater than if it operated with a conservative capital structure. HCA is looking to get rich quick, while LifePoint is content to grow profits at a steady and safe pace. Long-term investors should much prefer the latter to the former.

Obamacare will undoubtedly have far-reaching effects. The Motley Fool’s new free report, “Everything You Need to Know About Obamacare,” lets you know how your health insurance, your taxes, and your portfolio could be impacted. Click here to read more. 

Ted Cooper has no position in any stocks mentioned. 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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