7 Health Care Merger Plays
Here's how to play the feverish pace of M&A in the hospital sector as big health care providers vy to get much bigger

As health care costs have spiraled higher over the years, one side effect has been to create a feverish pace of merger and acquisition activity in the health care sector. In the second quarter of this year alone, the industry saw 243 acquisitions and mergers, according to Irving Levin Associates.

M&A in the hospital sector has been extremely busy, resulting in increasing concentration: more hospitals owned by fewer companies in certain markets. A report by America’s Health Insurance plans noted that 80% of U.S. hospital markets in 2009 were highly concentrated. And other reports have put that figure as high as 90%.

Mergers allow hospital groups to not only save money by sharing administration costs but they also reduce expenses by virtue of the pricing power inherent in a behemoth organization. Think of the pressure Wal-Mart (NYSE:WMT) has exerted in the retail sector by forcing its suppliers to lower prices, and it’s easy to imagine that a group of hospitals banded together could certainly influence a range of costs to go down, including physician and nursing salaries, prescription drugs and medical equipment, just to name a few.

In recent years, approximately 33 cents of every dollar spent on healthcare went into the pockets of hospitals, so the more leverage a hospital has to negotiate its prices, the more money it — and its shareholders (if a publicly traded entity) makes.

Antitrust Could Become an Issue

President Obama’s signature health care reform, the Affordable Care Act (ACA), which became law in March 2010, encourages the creation of more integrated delivery systems, called accountable care organizations (ACOs). These, in turn, may further promote M&A as a tool to increase physicians’ and hospitals’ leverage in certain markets.

The rise of mega-hospitals does raise some antitrust concerns (as well as concerns that widespread closures of less-profitable or money-losing facilities can leave many communities underserved), but until recently, regulators have not seen fit to intercede to halt many mergers in the sector. The Federal Trade Commission has stepped up its scrutiny, but the experts don’t predict any major impediments to what they see as an emerging trend.

Some analysts believe that ACA incentives now account for as many as 50% to 60% of the deals that aim to join the forces of hospitals and physicians.

And that means opportunities for investors. The organizations that will benefit (profit) the most will generally be those with the most leverage to negotiate their payments and their costs — in other words, the largest of the hospital chains. Although I think investors will have an opportunity to see similar opportunities in specialty clinics and physician groups, today I want to concentrate on the major publicly traded hospital organizations.

Short-Term Payoffs

I do not, even for one minute, believe that merging will solve all of their long-term problems. In many cases the merger will likely make the whole worse than its parts. The coupling of two or three independently managed businesses will bring communication challenges as well as difficulty in combining all administrative functions. If there is a financial efficiency payoff, it will likely not be evident for the first few years after the merger.

However, the stock market generally rewards the shares of merging companies not on their long-term reality pictures, but instead on the excitement that is stirred up by the mere announcement of the merger and the potential benefits to the merging parties.

Consequently, I believe the payoff to investors will be mostly in the short term and will be derived primarily from buying shares in the hospitals likely to come out as winners in the M&A game — before any actual deal occurs.

Here are the seven major publicly traded hospital stocks:

 

CompanySymbolMarket Cap ($)P/EQuarterly Earnings Growth (%-yoy)
Community Health Systems Inc.NYSE:CYH1.78B7.595.5
Health Management Associates Inc.NYSE:HMA2.24B12.7023.9
Kindred HealthcareNYSE:KND578.96M12.61-63.8
Lifepoint HospitalsNASDAQ:LPNT1.8712.13n/a
Skilled HealthcareNYSE:SKH157.02Mn/an/a
Tenet HealthcareNYSE:THC2.38B12.10-98.7
Universal Health ServicesNYSE:UHS4.04B12.0452.9

The group, as a whole, is quite leveraged and has been beset recently by some insider selling, although nothing too significant. And that’s not completely surprising, given the general uncertainty in the sector.

Fundamentally speaking, CHA has one of the lowest valuations LPNT’s debt/equity ratio, at 81.05, makes it by far the least leveraged of the group, with SKH leading the pack in that category at 712.27. That much leverage — in a period when companies have been drastically reducing debt — is a bit worrisome to me.

If I were looking to add any of these companies to my portfolio for the long run, I would wait a bit to see how the national health care discussions evolve. But on a technical basis — and thinking about a short-term opportunity to book some profits — each of these stocks look fairly compelling, with HMA’s shares showing the strongest potential, chart-wise.

Caveat: If you decide to add any of these shares to your portfolio, you will need to be very vigilant as to their trading activity. And as I recommend to my subscribers, always set your sell target the day you purchase the shares. Additionally, don’t forget to protect yourself by setting stop-losses for each stock.

As of this writing, Nancy Zambell does not own a position in any of the stocks named here.


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