News Analysis date published New: 
Thursday, March 3, 2011 - 07:00
New Date created: 
Thursday, March 3, 2011 - 09:06
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Thursday, March 3, 2011 - 07:00

How a Controversial Law Could Increase This Company's Margin by 600%

Thursday, March 03, 2011 7:00 AM

As the editor of Fast-Track Millionaire, I'm a sucker for a smart, profitable company that's able to use its ability to innovate, dominate and make money. That's why I've taken an interest in Hospital Corporation of America (HCA), which is about to launch an initial public offering, or IPO.

The sale of stock is expected to be on Thursday, March 10 and could raise up to $4.2 billion.

HCA is notable as a hospital operator for two reasons. First is its size: It's the largest in the United States, with some 151 hospitals with more than 38,000 licensed beds.

The second reason, and the focus of this article, is its bottom line. HCA is far more profitable than most of its competitors. In the latest annual results, for fiscal 2010, the company achieved a 4.9% profit margin, nearly twice the industry norm, as the chart below shows.

A few more facts about this company: It handles nearly 6 million emergency room visits a year, performs 490,000 in-patient surgeries and, at any given time, has 20,523 patients in bed, which gives it an average occupancy rate of 53% and a total patient count of some 1.5 million admissions a year.

Were that the end of the story, you and I would be forced to part ways at this point. A company with a 5% margin is nice and all, especially relative to its competitors, but I'm interested in capturing more serious returns. Show me a business with a 40% margin and I'm interested. Hey, it's not like that's impossible -- 10 companies in the S&P 500 do it.

Now, it's one thing for a company like, say, Google (Nasdaq: GOOG), to grow fast and huge. But it's quite another to see an established business with a multibillion-dollar market cap energize its earnings and move the needle on its profitability. So I'm always thinking about which companies might actually be able to pull that off. When they do, Wall Street is ready to reward them with a richer stock price.

The market shows us what happens when margins increase. The table shows Community Health (NYSE: CYH) has a margin of 2.0% and trades at 13.3 times earnings. Universal Health Services (NYSE: UHS), on the other had, has a 5.0% margin. So to put the price-to-earnings (P/E) ratio in different terms, a dollar of Universal's earnings is worth $17.50 to Community Health's $13.30. That's a 30% profitability premium. HCA's 4.9% profit margin in 2010 translates into a fair-market value in today's market of 15 times earnings, or about $18 billion.

The point that becomes utterly fascinating to me at this point, then, is this idea of increasing margin. Is there any factor that can materially juice a multibillion-dollar hospital company's earnings? There is. And we can discover what it is by looking at three critical areas that all hospitals have on their books...

The "Provision for Doubtful Accounts" is cash the hospital sets aside for people who don't pay; "Uninsured discounts" are reductions in charges made to patients who don't have insurance on the idea that a hospital would rather get something than nothing. Finally there's "Charity Care," medical services the hospital gives away. All of these elements detract from the bottom line dollar-for-dollar.

Take a look at HCA:

These numbers are important because of recent changes in federal law. ObamaCare mandates everyone have insurance. And when that happens by 2014, hospitals won't need to set aside money for doubtful accounts, give a discount to uninsured patients or give away charity care. Why? Because everyone will be covered.

This means we would need to revise the income statement for HCA's 2010 results. The revised results would look like this: Net earnings of $1.2 billion plus add-backs of $9.6 billion, for revised earnings of $10.8 billion and a margin of 35.3%.

Hospitals really are not a low-margin business. They just look like one because one of all the unpaid accounts. The fact of the matter is that Google, Coca-Cola (NYSE: KO) and Microsoft (Nasdaq: MSFT) would all see their fat margins shrink dramatically if a third of their customers didn't pay. So an entire sector of the economy -- one of the few industries that always grows -- rightfully earns a 35% margin but is forced to accept 2% or 5%. ObamaCare -- some would argue -- fixes that, dramatically.

Action to Take --> Is HCA a good buy? Overall, I'd say investors can typically expect to be rewarded by the largest and best-managed players in any industry. HCA fits the bill in this case.

[So, given the federal law and what it could mean for the potential revision of hospital margins, are the leading hospital operators Fast-Track worthy? Nah. Fast-Track is for the big winners. But don't worry. My portfolio still has some great health-care stocks in it.

Want to know my best health care picks? Hey, find out. Those companies are already in the Fast-Track Millionaire portfolio. Go here to find out more.]

Andy Obermueller does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.