Hospital Corporation of America (HCA) Analysis
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Summarize the key points for the Hospital Corporation of America case. What were the results of any analysis and what were the key takeaways.
Hospital Corporation of America (A)
In January of 1982 Hospital Corporation of America (HCA) faced a complex financial situation. Following a major acquisition in 1981, HCA’s ratio of debt to total capital approached 70%—well in excess of its target ratio of 60%. Interest coverage had dropped to 2.4 times, below its target of 3.0 times, and the lowest level experienced since HCA founding in 1968. Although some investors justified and even welcomed HCA’s more aggressive use of leverage, others were concerned that HCA’s capital structure could cost the company its single-A bond rating. Mounting interest expense on the debt could also cause HCA’s first quarter earnings per share (EPS) to decline relative to those of a year ago. If it did, this would be the first such quarter-to-quarter decline in EPS in HCA’s 13-year history. In light of these developments, HCA’s management had to decide what, if anything, should be done about its capital structure and what specific steps should be taken soon to achieve the desired mix of debt and equity. HCA’s Early Development HCA is a proprietary, hospital management company founded in Nashville, Tennessee, by two physicians, Thomas F. Frist, Sr., and Thomas F. Frist, Jr., and a former pharmacist, Jack C. Massey, who was also the former owner of Kentucky Fried Chicken. Beginning with only one, 150- bed hospital in 1968, HCA grew to become the nation’s largest hospital management company.
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By 1981 HCA owned or managed 349 hospitals in the United States and overseas and had net operating revenues of $2.1 billion. Since its founding, HCA had 32.2% annual revenue growth and 32.6% annual earnings growth. Pretax profit margins, averaging 9%, were the highest and most consistent among the major proprietary hospital chains. Recent financial statements and a 10-year summary of HCA’s operations appear in Exhibits 1–4. The Proprietary Hospital Industry Proprietary hospital management companies, i.e., corporations that own and manage chains of hospitals on a for-profit basis, were a relatively new phenomenon in the $118 billion U.S. hospital care business. The enactment of entitlement programs such as Medicare and Medicaid in 1965 stimulated demand for hospital services in the United States and virtually eliminated the tremendous bad-debt burden (i.e., weak accounts receivable) that had traditionally plagued the hospital industry. This created a valuable opportunity for private investors to build or acquire hospitals and operate them profitably. Tight control over costs and efficiencies in such areas as staffing, purchasing, and hospital design enabled hospital management companies to offer high-quality services at reasonable cost while achieving attractive profit margins. With the ability to sell equity and other financial securities not generally available to nonprofit hospitals, proprietary hospital management companies expanded rapidly in the 1970s.
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While the number of hospitals operating in the United States actually declined steadily from a high of 7,200 between 1975 and 1980, the proprietary hospital chains expanded the number of hospitals under their control at a 12.5% annual rate. By 1980, 38 proprietary hospital chains owned or operated 12.4% of the 6,965 hospitals and 7.9% of the 1,370,000 licensed hospital beds in the United States. In 1981 the five largest hospital chains controlled 632 hospitals and 87,502 beds.
(Exhibit 5 presents a comparison of the major hospital chains.) The expected revenue growth for the hospital management companies as a group was approximately 13–14% annually throughout the 1980s. The five major chains, however, were expected to grow at an annual rate of 25% during the first half of the decade. Although still rapid, this expected growth rate was less than the 35% annual rate they experienced between 1975 and 1980. The shrinkage in the number of attractive acquisitions, along with higher costs for construction and acquisition, were blamed for the expected slowdown. HCA’s Past Growth HCA achieved growth during the 1970s by acquiring existing hospitals and constructing new units.
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Between 1968 and 1981, HCA constructed 70 new and replacement facilities and acquired or leased the remaining 279 of its hospitals. Each year HCA evaluated many potential acquisitions and areas for construction, but it was rather selective in the facilities it acquired. The criteria for selection included the target community’s need for health care services, the quality of the target hospital’s medical staff and personnel, the population growth pattern in the area served, the facility’s suitability for future expansion, and the hospital’s overall financial position. Most of HCA’s domestic hospitals were located in the Southeast and the rapidly expanding Sunbelt area of the United States (see Figure A). This geographic preference reflected, in part, the more favorable regulatory environment in these areas of the United States and, in part, their more favorable demographic trends. Roughly 40% of HCA’s U.S. facilities were the only hospitals in their areas. Some of HCA’s unit growth came through the acquisition of other proprietary hospital management companies. A run on other proprietary chains was triggered in 1978 when Humana, Inc., merged with American Medicorp, the third largest chain.
Following that acquisition, by 1981 ten other hospital management companies were acquired by the five majors; HCA accounted for four of these acquisitions. The last of HCA’s four acquisitions occurred on August 26, 1981, when it purchased Hospital Affiliates International from INA Corporation, an insurance company, for $425 million cash and common stock valued at $190 million. This acquisition gave HCA ownership of 57 additional hospitals and management contracts for another 78 hospitals.1 With revenues of $704 million and earnings of $29 million in 1980, Hospital Affiliates had been the nation’s fifth largest hospital management chain. Sources of Capital HCA’s operations generated substantial cash for reinvestment.
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However, its ambitious construction and acquisition program also required substantial financing from external sources. External financing during HCA’s early growth period generally followed a simple pattern: revolving bank credits were used to fund hospitals under construction, while industrial revenue bonds and privately placed, long-term mortgage loans from insurance companies funded completed hospitals and acquisitions. Other sources of capital proved difficult to tap at first because of the newness of the proprietary hospital industry, the small size and short track record of HCA itself, and the generally poor image of hospital management companies at that time. As the hospital management industry matured, however, and HCA’s strong performance became recognized, HCA began to use other types of financing. HCA’s $33 million issue of 15-year first mortgage bonds in 1975 was the first public bond offering undertaken by a hospital management company. Standard and Poor’s initially rated the bonds BBB and later upgraded them to A.2 Attempting to tap sources of funds overseas, HCA also issued $25 million of Eurodollar notes in 1978. In another first for the industry, the company sold $47 million of commercial paper in 1980; the issue was rated A-2 by Standard and Poor’s and P-2 by Moody’s. In 1981 HCA added $891 million of debt to its balance sheet. Most of this debt was to mature in less than seven years, and a substantial portion of it bore fluctuating interest rates that were tied to the prime rate or the London Interbank Offered Rate (LIBOR).3 (Exhibit 6 shows a complete schedule of HCA’s debt.) Revolving bank credit (used to finance the purchase of Hospital Affiliates) constituted $425 million of this debt.
This sudden increase in the level of debt made HCA the highest leveraged company in the United States with a single-A bond rating. HCA had also issued common stock on several occasions. It built its capital base with public offerings of new equity in each of the three years from 1969 to 1971. After 1971 HCA had only two public offerings of stock: one in 1976 and the other in 1979, when it sold 2.2 million common shares and received net proceeds of $85.8 million. This was the largest stock deal by an industrial company that year. HCA also issued new common shares in connection with some of its acquisitions. HCA’s management did not want to issue new equity any more frequently than every other year. Nonetheless, management carefully maintained close contact with the equity market. It did so through frequent presentations to security analysts and clear and complete disclosure of information in HCA’s financial reports. HCA’s Future Growth One of HCA’s principal objectives was to realize at least 13% annual growth in earnings per share (after inflation). This meant that HCA needed annual growth in the 25% to 30% range (including inflation) for the foreseeable future. This aggressive rate was sought for several reasons. One major reason was the competition from other management companies in acquiring hospitals. As Bill McInnes, vice president of finance for HCA, noted: There is a feeling here that we must be prepared to strike while the iron is hot. There are only 7,000 hospitals out there, and we can’t expect to have them all. With, perhaps, three to five good years [of growth by acquisition] left, we will have to move along expeditiously to get our fair share.
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Management also recognized that HCA’s expected growth rate was a major factor influencing the price of the company’s equity. McInnes observed that, “This is a company in which people check the stock price two or three times a day. No one wants to see what will happen [to the stock price] if the growth rate starts to unwind.” The officers and directors of HCA as a group owned 3.6 million shares of HCA’s common stock and 1.8 million options on HCA’s common shares. Management’s attention to growth and its impact on equity prices was undoubtedly heightened by security analyst reports on HCA, many of which predicted 1982 earnings per share of $3.00, a 35% increase over 1981. Management expected growth to come from the same four sources that had provided it since the company’s founding: acquisition, construction of new hospitals, expansion of services, and the signing of new management contracts. There were some indications that the company was likely to expand into new areas, but only into other health services such as home health care and outpatient surgery. As for future acquisitions, it seemed likely that a somewhat different tack would be taken. Many analysts and industry participants believed that antitrust laws would limit the acquisition of other hospital management companies as a major source of new growth for the large chains in the 1980s. It was believed that further growth by acquisition would have to occur primarily through the purchase of nonprofit county, municipal, and religious-order hospitals. Many such hospitals had old buildings that required renovation, had obsolete equipment, and had unsophisticated management systems. The unwillingness or the inability of their owners to raise taxes or issue new debt to continue operations meant that many of these units would be offered for sale. HCA appeared to be well positioned for this market. Interestingly, this position had as much to do with HCA’s quality image as its financial strength. Because of its industry leadership, its decentralized management style, and the high quality of its corporate management, HCA was considered to be one of the most attractive bidders among the major hospital management companies. Its list of directors read like a page from Who’s Who in Finance and Industry: the board, chaired by Donald MacNaughton, former chairman and chief executive officer of Prudential Insurance Co. of America, included such prominent business leaders as Robert Anderson, chairman and CEO of Rockwell International Corp.; Frank Borman, chairman, president, and CEO of Eastern Air Lines; Owen Butler, chairman of Procter & Gamble Co.; John de Butts, retired chairman and CEO of American Telephone and Telegraph; and Irving Shapiro, chairman of the finance committee of E. I. duPont de Nemours & Co., Inc.
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HCA’s quality image helped overcome the misgivings that some of the owners of nonprofit hospitals often had about selling to a profit-oriented management company. Many nonprofit hospitals were directed by politicians, public agents, and other public figures who sometimes balked at the thought of profits being earned on the care of sick people, or who incorrectly believed that the past abuses associated with nursing home companies also characterized the proprietary hospital management business. HCA’s quality image was often the critical factor in overcoming the doubts of such trustees and convincing them to sell to HCA. HCA’s Financial Goals Besides its growth objective, HCA had several other explicitly stated goals and guidelines, and a very important one among them was its 60% target ratio of debt to total capital. This target was in line with the degree of leverage more or less expected by the rating agencies for an A-rated hospital management company. Its origin, however, was somewhat informal. It was the practice for real estate development projects to be financed on a 75% loan-to-value basis, but in its early years HCA’s management reasoned that since 15% of its expenditures on hospital projects were for equipment rather than property or plant, management would be conservative and use only 60% debt financing for its hospital construction. Ultimately, this ratio became the standard for the entire proprietary hospital management industry.
Many hospitals in the 1980s, however, were built and operated on a stand-alone basis, with as much as 90% debt financing, and a case could be made on comparative grounds for a higher debt ratio for a healthy hospital management company. In fact, several of HCA’s managers expressed the belief that HCA could comfortably accommodate as much as 75–85% debt in its capital structure. Return on total capital was expected to be a minimum of 11% after taxes, and return on equity was expected to be at least 17% after taxes. These target rates of return were important, but they were difficult to maintain during periods of rapid growth, especially when the growth was achieved largely through acquisition. Acquired hospitals usually needed to be turned around, and this process often took several years of operations with reduced profit margins.
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HCA’s other goals included a dividend payout of 15% of net income and the maintenance or improvement of net profit margins as a percent of operating revenues. Sam Brooks, senior vice president of finance and chief financial officer of HCA, had also expressed his desire to keep the average interest cost for all HCA’s debt at 15% (or lower) in the foreseeable future. Regulatory Change and the Future The future of the hospital management industry appeared bright in several respects. In the near term, continued growth in revenues and earnings seemed assured by the acquisition of nonprofit hospitals, and in the long run, as growth by acquisition and new construction subsided, the natural expansion of an aging U.S. population was expected to increase occupancy rates and provide further growth. Moreover, because of the high operating leverage created by hospitals’ fixed costs, much of the growth in revenues due to higher occupancy rates was expected to translate directly into higher earnings. The provision of additional services and a concentration on further cost containment, rather than geographic expansion, could further add to growth in earnings in the long run. This industry scenario was not without its risks, however. The federal government had been exploring ways to cut federal expenses for Medicare, VA hospitals, and other government-backed health care programs. Various forms of industry deregulation were favored in the political climate of the early 1980s as a means of improving efficiency and increasing consumer welfare. Regulatory reform of health care could have far-reaching implications for the hospital management companies.
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For example, under the present regulatory system, hospital expansion was controlled by local, health-planning agencies through “certificates of need.” These certificates, needed for new hospital projects, were granted only if it could be demonstrated that a genuine need existed for the new services or expanded capacity. These requirements were a bureaucratic headache for hospitals, but they restricted new hospital construction and thus tended to provide existing hospitals with protected franchises. This protection would be removed under proposals to eliminate these certificates. This might stimulate rapid expansion by competing hospitals and possibly result in the duplication of services, excess bed capacity, and lower occupancy rates. The average occupancy rate for all U.S. hospitals was already only 75% in 1979, down from 83% in 1969. Various proposals to reform the nation’s system of health care insurance so that consumers would become more price sensitive and hospitals more cost conscious were of equal concern. Because 90% of all Americans were covered by some form of health insurance, the bulk of hospital revenues came from third-party payers, and the demand for hospital services by the consumer was relatively price insensitive. It had been estimated that hospitals could vary their prices by as much as 20% (up or down) without a material effect on patient utilization.4 Similarly, because most hospitals received a substantial part of their reimbursements from government-backed programs such as Medicare and Medicaid, their incentives to control costs were diminished. Such reimbursement programs were “cost based”—that is, hospitals were reimbursed for their costs of providing services to covered patients. Costs allowable under Medicare/Medicaid programs included depreciation and interest, but excluded costs of research, losses on bad debts, and expenses for charitable cases. In addition, Medicare allowed a return on equity (excluding assets and liabilities unrelated to patient care) at a rate equal to 150% of the average annual interest rate on certain debt obligations of the Federal Hospital Insurance Trust
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Fund. The pretax return on equity allowed was 12.3% in 1978, 13.7% in 1979, 16.5% in 1980, and 20.0% in 1981. One of the effects of this insurance system in the United States was to provide hospitals with relatively stable revenue streams that were largely insulated from economic cycles, inflation, and other economy-wide risks. Another result was that hospitals tended to compete with one another on the basis of quality and breadth of services, reputation of medical staffs, and advertising, rather than on the basis of low prices. Proposals to make consumers bear a greater proportion of their hospital expenses out of their own pockets and to change Medicare and Medicaid to something other than cost-based reimbursement systems would change these characteristics significantly. Some of the proposals being considered included treating health insurance premiums paid by employers as taxable income to employees, increasing the level of out-of-pocket expenses borne by Medicare/Medicaid patients, turning the Medicare program into a voucher system that provided fixed benefits independent of costs, eliminating return on equity provisions in Medicare and Medicaid reimbursements, and revising the Medicare/Medicaid programs so that they were prospective reimbursement systems. Under prospective reimbursement, hospitals would be paid on the basis of “prospectively” set rates rather than actually realized costs. If a hospital provided services at a cost lower than the established rates, it earned a profit; it not, it realized a loss. Most industry analysts predicted that some form of prospective reimbursement would be implemented in the 1980s, but the exact composition of hospital costs that would be covered by such a system was unclear. A system might be designed in which capital costs would be prospectively set along with the other costs of providing services. If this were to occur, hospitals would no longer be able to count on recouping the full amount of their allowable interest expense from the federal government.
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Another possibility was that interest expenses would continue to be paid retrospectively, but the return on equity provisions would be dropped altogether. This outcome would place even greater pressure on the private-patient side of a hospital’s business to provide an adequate return on capital. Whatever type of prospective reimbursement system might be adopted, it seemed probable that the virtual elimination of losses and the subsidization of capital costs heretofore provided by the cost-based reimbursement system would be reduced. This would instill greater volatility in hospital revenues and earnings. HCA’s Financial Decisions HCA’s growth objective called for capital expenditure outlays of $575 million in 1982. This amount could be expected to expand by 20% a year for the next several years. Given these increasing capital requirements, its debt repayment schedule (see Exhibit 6), the future prospects of the hospital care industry, and HCA’s other goals, senior management had to determine how best to prepare financially for HCA’s future. The first issue to be addressed was HCA’s target capital structure: Was its long-standing 60% target ratio of debt to total capital too high, too low, or about right? The rating agencies declared that HCA would have to return to its 60–40 capital structure if it was to retain its A bond rating. In a meeting with the rating agencies prearranged for the day after the acquisition of Hospital Affiliates was announced, Sam Brooks was “given the distinct impression that we had roughly until the end of the summer of 1982 to do something about our debt ratio.” Loss of its A bond rating could make access to the debt markets more difficult for HCA. (Historical data on debt issued with various credit ratings are presented in Exhibit 7.) Others, however, saw HCA’s high level of debt in a more positive light. A Wall Street analyst was quoted as saying that the acquisition of Hospital Affiliates and the debt burden that accompanied the transaction “removes the stigma, if it is one, that Hospital Corp. is too conservative. It said for a long time that it would stick to a 60–40 ratio of debt to equity . . . [This] shows they’re willing to be flexible when the right move comes along.”5 Although maintaining its high degree of leverage would cost HCA its A bond rating, the loss might not be all that damaging. DuPont, for example, lost its long-standing AAA bond rating after its acquisition of Conoco in 1981 without a dramatic rise in its cost of debt or decreased access to the debt market. Others argued that even a 60% ratio of debt to total capital would be too high in light of the potential changes in the regulatory environment. By increasing the risk surrounding the cash flows of the hospital management companies, such changes might necessitate a capital structure with only 50% debt or less. Reducing leverage to such a level would take time to accomplish and would require corrective action well in advance of the anticipated changes even if one were beginning at a 60% debt level. As Bill McInnes said, “A $2.5 billion capital structure can’t be turned around on a dime.
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