Are Hospital Stocks Worth Buying?

By Todd

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Major hospital chains HCA Holdings, Inc. (NYSE: HCA) and Tenet Healthcare (NYSE: THC) have reported second-quarter financials, and investors reacted to the reports by selling off shares. Are investors wrong to give up on these stocks -- and should bargain hunters step up and buy?

First, a look at the financials

Falling bad debt expense tied to an increasingly insured population has offered hospital operators profit tailwinds since Obamacare's launch, but admission growth is in the low single digits, and the capital-intensive nature of the industry means that hospitals are heavily leveraged and that revenue growth is crimped by costs.

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Last quarter, sales at HCA, which operates 169 hospitalsand 116 freestanding surgery centers,grew 4.3% to $10.3 billion. Admissions to hospitals on a same-facility basis grew a tepid 0.6% in the past year, but revenue per admission did tick up 2.1% versus a year ago, thanks to pricing.

In keeping with prior quarters, the amount of money HCA set aside in the quarter for doubtful accounts declined to $762 million from $1.04 billion in the same quarter of 2015. That decline is due to an increasingly insured patient population because of Obamacare, Medicaid expansion, and job growth.

The company's spending on salary and benefits was about in line with a year ago, at 45.5% of sales, while its spending on supplies fell slightly to 16.7% of sales from 16.9% of sales last year. As a result, net income attributable to HCA totaled $658 million, or $1.65 per diluted share, compared to $507 million, or $1.18 per diluted share, in the second quarter of 2015.

Over at Tenet Healthcare, their 79 hospitals,20 short-stay surgical hospitals, and over 470 outpatient centers produced $5.2 billion in revenue in the second quarter, up from $4.84 billion last year.

Revenue at hospitals owned by Tenet Healthcare throughout the year improved 4.4% due to a 0.5% uptick in adjusted admissions and 3.9% growth in revenue per adjusted admission.

The company's $352 millionprovision for doubtful accounts was 6.7% of pre-bad debt revenue, down from 7.3% last year, and spending on salaries and benefits improved to 47.6% of revenue, from 48.6% last year. Spending on supplies ticked up slightly to 15.9% of sales from 15.7% last year.

Although spending was kept in check, the company reported that adjusted net income fell to$38 million, or $0.38 per diluted share, during the second quarter of 2016 -- falling from $76 million, or $0.75 per diluted share, last year. Second-quarter net income was dragged down $0.67 because of an agreement in principle to resolve investigations into a kickback scheme at hospitalsin Atlanta that have since been sold. That potential agreement forced Tenet Healthcare to increase its reserve for this settlement from $407 million to $516 million in the quarter.

Tailwinds versus headwinds

There are 76 million aging baby boomers, and that means that there are significant tailwinds supporting future revenue- and profit-friendly hospital admissions. Investors also benefit from growing demand for elective outpatient procedures, which picks up alongside job and wage growth, and from expansion into urgent care services.

The potential for growth tied to those tailwinds, however, is tempered by risks that could threaten Obamacare's long-term survival. If Donald Trump wins the presidential election in November, he has said that he will seek to dismantle the program -- if so, that could cause a spike in bad debt expense.

Even if Trump doesn't win the election, Obamacare enrollment could also suffer if insurers stop offering plans through the exchanges en masse.

In the past year,UnitedHealth Group, the nation's biggest insurer, announced plans to exit the exchanges because it's losing hundreds of millions of dollars on the program every year.Similarly, bigger-than-expected losses on its exchange business in Q2 haveAetna saying it could exit the exchanges in some markets next year, too.

If those insurers exit and new insurers fail to enter, it could lead to big increases in healthcare insurance costs or changes to the program that could reduce enrollment, lower reimbursement, and increase the amount of uninsured charity care that hospitals provide.

A patient approach

The potential bump-up in demand from baby boomers is diminished by short-term question marks regarding the long-term sustainability of insuring low-income Americans. As a result, investors should approach companies likeHCA and Tenet Healthcare cautiously. The two hospital operators should continue to grow patient volume and revenue by low- to mid-single-digit rates, but rising sales could be erased if bad debt provisions soar in a post-Obamacare world.Depending on how the election plays out in November, hospital stocks like these could be worth revisiting, but for now I think investors should embrace watchful waiting.

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Todd Campbell has no position in any stocks mentioned.Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may have positions in the companies mentioned. Like this article? Follow him onTwitter where he goes by the handle@ebcapital to see more articles like this.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.