Case study on Hospital Corporation

Of America

Siddesh Trivedi 171Shivendra Singh 172Navjyot Singhvi 173Radha Thakore 214Ankit Shah 317Dishank Shah 318Fenil Shah 319

AgendaHCA’s performance and business strategies.Impact of the proposed change to prospective

reimbursement by Medicare/Medicaid.Should it go for growth or profitability.HCA’s concern of losing it’s A bond rating.HCA’s bond rating comparison with its

competitors.Importance of credit rating while establishing a

target debt ratio.Future financing strategies.Recommendations.

IntroductionHospital Corporation of America(HCA)

is proprietary hospital management Company .

Beginning with only 150 bed hospital in 1968,HCA grew to become the nation’s largest hospital management company.

Revenue of $2.1 Billion in 1981.

HCA had 32.2% annual revenue growth and 32.6% annual earnings growth.

Cont…The company has been following an acquisitive strategy

by taking over hospital companies and not-for-profit hospitals.

Firm is also considering expanding into new health service areas like home health care and outpatient surgery.

Ability to sell equity and other financial securities.

Revolving Bank Credits, industrial revenue bonds, long term mortgage loans funded completed hospitals and acquisitions.

In 1981 HCA added $891 million of debt to it’s balance sheet.

Sudden increase in level of debt made HCA the highest leveraged company in the US with a single A Bond rating.

60% target ratio of debt to total capital was one of the explicity stated goal of the HCA

Financial leverage has increased substantially over the past two years due to HCA borrowing for its acquisition funding needs.

It was only focusing on increase in market share and not on increasing the profit.

HCA’s PerformanceHCA’s net profit margin has declined in stark

contrast with that of its competitors.

HCA has focused on an acquisitory strategy especially by taking over not-for-profit hospitals.

HCA’s asset turnover has declined. HCA has acquired several old, out-dated assets which have not been able to generate revenue efficiently.

Cont..The interest coverage ratio has declined from 3.73

in 1980 to 2.40 in 1981.

HCA’s bond rating is expected to drop from A- in 1980 to BB in 1981.

HCA had 32.2% annual revenue growth.

HCA’s main financial goal is to maintain return of equity of 17%.It has been increasing throughout the Beginning.

• Company’s objective is to incur capital expenditure of $575 million per year.

In the early 1970s, HCA was having low relative market share as compared to high market growth rate. It acquired a substantial number of existing hospitals and constructed several new hospital units.

The hospital industry grew a lot during this period due to programs like medicare and mediciad.

From 1978 to 1981, HCA was having high market growth rate as it continued to acquire other proprietary hospital management companies and non-profit hospitals.

IMPACT OF PROSPECTIVE REIMBURMENT SYSTEMS BY MEDICARE/MEDICAID

PREVIOUS CONDITIONS

Cost-based

Included only depreciation and interest.

Excluded costs of research, losses on bad debts,

and expenses for charitable cases.

Impacts

Provides hospitals with stable revenue streams that

were largely insulated from economic cycles,

inflation, and other economy wide-risks.

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.

Prospective Reimbursement Systems

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; if not, it realized a loss.

A system is designed in which capital costs would be

prospectively set along with the other costs of providing

services.

Impact of the system

Allowable interest expenses would continue to be paid retrospectively.

ROE 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.

Due to this, It seemed probable that the virtual elimination of losses

and subsidization of capital costs provided by the cost-based

reimbursement system would be reduced.

This would instill greater volatility in hospital revenues and earnings.

SHOULD HCA PUSH FOR MAXIMUM GROWTH OR SLOW DOWN AND FOCUS ON INCREASING PROFITABILITY?

HCA would like to see the annual growth rate in the 25-30% range, although they have also set a minimum of 13%.

This would signal aggressive action in the company and with this growth rate HCA would experience a dramatic increase in leverage.

Vice President Bill Mc Innes believes that in order for HCA to compete with other management companies in the industry they must continue acquisitions.

An increasing growth rate does appeal to the investors.

But it is not necessary to take on this kind of risk when uncertainties lie in the future

More importantly, there is evidence that increasing growth does not necessarily make you more profitable.

Humana's growth in hospitals over the past 5 years is 6.80%, that's almost a quarter of HCA's at 30.1%, yet they realized a growth in net income of 54.60%.

HCA on the other hand only realized a growth in net income of 32.40% IN 1980-81 (Exhibit 1).

Hence the growth rate is not a sole determinate of future performance. In addition, a company certainly wants to allow room for future growth. 

Recommendations

HCA should adopt a financial strategy that is less aggressive than previous years but more aggressive than that of its competitors.

A less aggressive financial strategy than previous years should be adopted since there is a lack of growth opportunities by acquiring hospitals and constructing new units.

However, the financial strategy must be more aggressive than that of its competitors in order to maintain the firm’s market share in the industry as well as to take advantage of opportunities to grow through natural expansion.

SHOULD HCA BE CONCERNED ABOUT THE POSSIBLITY OF LOSING ITS SINGLE A BOND RATING?

HCA should not be concerned about the possiblity of loosing their single A bond rating

This is because its major competitors’ credit ratings range from BB+ to B+.

Those with lower bond ratings than HCA are still able to achieve higher returns on equity despite the lower bond rating.

The firm needs to ensure its ability to access the debt markets at the chosen debt ratio.

If HCA decreases their debt ratio to 60%, they will retain their A bond rating in exchange for:-

a decline in their ROE (below target)

growth rate. 

The expectation that the firm will only have high growth in the next 5 years after which the firm will mature indicates that the firm should pursue aggressive financial strategy even at the cost of losing its single-A bond rating.

The firm will be able to regain its single-A bond rating when:-

-it matures since excess cash generated as a cash cow can be used to repay debt and reduce its debt-to-capital ratio.

HCA’S RATING COMPARED TO ITS COMPETITOR’S BOND RATING.

The Major Player’s…

Year HCA Humana Inc.

American Medical

International, Inc.

National Medical

Enterprises, Inc.

Lifemark

 

1980 A NR Ba Ba Ba

1981 A B+ NR BB+ BB+

HCA v/s Humana…SELECTED MEASURES OF PERFORMANCE FOR HCA

AND HUMANA

  HCA HUMANA

1981 ROE 23.7% 43.1%

1981 ratio of market to book value

2.8 4.8

Growth in hospitals, 1976-1981

30.1% 6.8%

Growth in net income, 1976-1981

32.4% 54.6%

1981 revenues per bed $48,300 $103,700

1981 net income per bed $2,200 $5,700

Conclusion…HCA indicates low credit risk as compared

to other Hospital chains.HCA’s cost of borrowings is less as

compared to its other Hospital chains.HCA has strong capacity to meet its

financial commitments as compared to others.

IMPORTANCE OF CREDIT RATINGS WHEN ESTABLISHING A TARGET DEBT RATIO.

Debt-To-Capital Ratio

A measurement of a company's financial leverageDebt includes all short-term and long-term

obligations. Total capital includes the company's debt and

shareholders' equity,

The higher the debt-to-capital ratio, the more debt the company has compared to its equity.

weak financial strength because the cost of these debts may weigh on the company and increase its default risk

Components of credit analysis

Character-managements integrity and its commitment to repay the loan.

Covenants-terms and conditions the borrowers and lenders have agreed upon

Collateral- includes assets offered as a security for the debt

Capacity to pay- borrower’s ability to generate cash flow to repay its debt obligations

Importance of credit ratingsAmount of debt that is required by the firm in the future.

If the retained earnings of the company is less than the capital expenditure, the firm then needs to borrow more money

The firm will choose a debt ratio that will result in a low WACC and appropriate credit rating.

If the retained earnings exceed capital expenditure, the firm won’t need to borrow as much money

Lesser the rating ,higher the risk

FUTURE STRATEGY

Future Financial StrategyHCA’s main financial goal is to maintain return of

equity of 17%. The return of equity in the last 2 years has been in the

range of 18-19% shareholders will continue to invest can be achieved changing the debt ratio of the

company.This will also help increase retained earnings and

then help reduce large amounts of debt and interest expense in the coming year

Maintaining a dividend growth rate of 15% is another financial goal to consider as it is important to keep paying dividends at a steady level as it sends out a positive signal to investors that the firms’ earnings are steady .

stock price performance will improve in the long run.

Funding Strategy The company’s initial objective is to incur capital expenditure

of $575 million per year

firm should consider maintaining $575 million capital expenditure for the next 5 years instead of capital expenditure ballooning because it will be difficult for revenue growth to keep up with this expenditure growth in the long run.

Capital expenditure is deferrable first and foremost because paying off our debt in the next 5 years is obligatory

This does not mean that capital expenditure cannot be incurred.

Expected to decrease in the long run since the acquisition market is shrinking and the quality of non- profit hospital assets is expected to improve in the future

The effect of debt policy on HCA Strategy:

Next few years, future debt is going to be due for repayment.

In the long-run, it will impact on the firm’s dividend payment when the repayments are made.

HCA could possibly change their source of financing to floating rate debt which has relatively lower interest rates as of now and is unlikely to rise as high a rate as that for commercial paper.

The effect of debt policy firm’s ability on raising funds:

A firm’s credit rating which is affected by a firm’s chosen debt policy is one of the factors that affect how much the firm can borrow.

If HCA has a bad credit rating, it would be difficult for HCA to access debt markets and this limits the number of profitable investments that HCA can undertake.

HCA needs to choose a debt policy that will ensure that the firm is able to access debt markets since HCA still needs debt to fund its capital expenditure.

Recommended financial strategy, target bond rating and target debt ratio.The recommended target debt ratio for HCA is

from 55% to 60%

company currently does not exceed its target debt ratio of 68.8% as indicated by the company.

The debt-to-capital ratio of 68.8% is inappropriate

The firm should increase its debt level to fund its increasing capital expenditure but must ensure that it does not exceed its 60% debt ratio policy.

The recommended target bond rating for HCA is from A to BBB. Even though the table in indicates a target bond rating between BBB to B+.

HCA is a market leader in the industry with a proven track record and a good reputation .

Market expectations of improved future profitability suggests that the firm’s actual credit rating should be around A to BBB.

The target rating of A to BBB is appropriate as it allows the firm to access the debt market.

The firm will still be able to access the debt market if the bond rating is within this range.

THANK YOU…