Tenet Healthcare And Universal Health Services: Secular Tailwinds

Investment Thesis

Previously, we wrote about HCA (HCA) and the broad demographic changes occurring in the healthcare system that may provide tailwinds. Our investment thesis for these two stocks is broadly the same: on a secular basis, an aging population provides significant recession-resistant growth prospects for the healthcare sector.

Tenet Healthcare (THC) – Free Cash Flow Healed by Core Competency Expansion

THC is a geographically diversified healthcare service provider focusing on specialist and surgical care. THC had 8.2 million patient encounters in 2022 across 527 hospitals and 109 outpatient care sites. THC is split into three segments: Ambulatory Care, Hospital Operations, and Conifer segment.

Operational Results

Conifer provides value-added care services, such as IT consulting, to 670 non-THC clients. THC owns a 76% controlling interest in Conifer. Conifer has struggled to recoup inflationary costs, with EBITDA shrinking by 8%. However, there are significant tailwinds for Conifer in the future, with a large portion of its business being outsourced admin services. As discussed in our previous article, administration equates to almost 25% of all healthcare costs and the first place healthcare firms are seeking to recoup costs. The largest growth driver for Conifer has been outsourced Medicaid eligibility determination services.

THC operates its ambulatory care network through its fully owned subsidiary USPI. USPI is the largest ambulatory care network in the United States, offering outpatient specialist services and outpatient surgical procedures. USPI was the largest grower which saw a 16.4% EBITDA growth year over year. EBITDA margins stayed constant at 40%. Largely, this has been attributed to pent-up demand from elective procedures that could not be conducted because of COVID-19. Total patient volume was up 6.6%, with per-case revenue up 2.9%. To continue this growth path, THC will allocate $250 million per year to growth in the USPI area, adding 12 new facilities in 2Q23.

In the Hospital segment, THC’s financial profile has improved despite COVID-19 and inflationary pressures. Revenue increased 7.6% year over year in 2Q23, with non-COVID admissions increasing by 5%. Additionally, contract labor has decreased in usage in THC hospitals now making up 4.3% of salaries and benefits, a decrease of 190bps. Expansion in this area is concentrated on internal infrastructure improvements and higher acuity service offerings, which often have higher margins. EBITDA margins in this segment are 10%, which is above average for hospitals.

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Outlook

THC does not currently pay a dividend but has a share repurchase program with $660 million in authorization remaining, repurchasing 7% of outstanding shares in 2Q23. Debt repayment remains a priority, with the 2Q23 leverage ratio being 4.14x debt to EBITDA and an average interest rate of 5.6%.

FY23 is expected to be a recovery in cash flows and EBITDA despite remaining COVID-19 and inflation headwinds. THC is expected to generate $1.2 billion in FCF for FY23, a return to its pre-pandemic form.

Universal Health Services (UHS) – Tailwinds in Mental Healthcare Demand

UHS operates mental and acute health services in the United States and the United Kingdom. Across 400 facilities, it had 3.4 million patient interactions. UHS is a leader in mental healthcare, running 341 mental healthcare facilities in the US and UK. Compared to other forms of medical care, mental healthcare tends to have more stable pricing and lower capital costs. Despite only making up 20% of topline revenue, the behavioral health segment makes up 43% of net profit.

Operational Results

UHS is benefitting significantly from the increased need for mental healthcare. Demand for mental healthcare services has outpaced supply, with the World Health Organization estimating that there has been a 13-25% increase in mental health conditions and substance abuse since before the pandemic. UHS estimates the total addressable market for clinical mental healthcare services is $50 billion.

UHS has 3 under construction facilities in the acute care segment, adding 436 beds by FY25. In the behavioral health segment, a 96-bed JV with Trinity Health is expected to open in FY24. Historically, capital allocation is split equally between Acquisition and organic growth investments, with opportunistic share repurchases. Since FY19, UHS has reacquired 20% of outstanding shares. UHS pays a 0.63% yield. Current debt to EBITDA is 2.9x, a large increase year over year due to a ramp-up in capex spending.

Outlook

During 2Q23, overall revenue growth was 9.7%. On a granular level, behavioral health revenues increased on average by 6.2% year over year on a per-patient basis, with acute health revenue increasing 2% year over year on a per-patient basis. UHS is seeing a significant amount of pent-up demand release with 8% same-facility admission growth year over year.

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Risks

The risks to both of these firms are shared, and tend to be for the whole sector.

Shortages in nurses and healthcare professionals will likely continue to be harsh on the balance sheet of healthcare firms. There is an estimated shortage of 200,000 nurses and 50,000 doctors by 2025, which will need to be filled by far more expensive travel nurses and contracting professionals.

Inflation and increased utilization with the end of major COVID-19 lockdowns may continue to have negative short-term impacts on the balance sheets of healthcare firms. Due to the cyclical nature of contracts, firms can be effectively locked-out of increasing prices to insurers or the government. McKinsey estimates that inflation and COVID-19-related expenses have reduced the EBITDA margins of the healthcare industry by 600bps.

Conclusion

Despite continuing short-term headwinds such as staffing shortages and persistent cost inflation, both THC and UHS have a clear path to grow. Both stocks are already seeing cost recovery and business model expansion, only bolstered by secular tail winds that will persist well into the future.

For THC, the commitment to expanding core competencies through the profitable USPI-run ambulatory care segment makes the long-term prospects attractive. For UHS, increased demand for mental healthcare services bolster its growth prospects outside just an aging demographic.