By Susan Kelly
CHICAGO (Reuters) - Shares of U.S. hospital operators have been on a tear this year, on average posting triple the gains of the broader stock market, as investors tallied up the benefits of President Barack Obama's healthcare reform.
While some on Wall Street have held back amid signs of trouble as U.S. states prepare to implement the reform law, long-term investors still see more reward than risk on the horizon for hospital stocks.
They expect company earnings to strengthen as more Americans gain insurance coverage and hospitals lose less money treating the uninsured. The reform law has spurred consolidation among hospitals, and further merger activity could lift valuations.
"We believe there is still a significant amount of upside in the stocks, particularly if you believe these companies have the ability to sustain their earnings growth through acquisitions," said Jessica Bemer, analyst with Snow Capital Management. Snow Capital identified the potential in hospital shares early on and has holdings in Community Health Systems Inc and Health Management Associates Inc.
Since the start of the year, shares of the largest publicly traded hospital chain, HCA Holdings Inc, are up 34 percent, while No. 2 Community Health has climbed 71 percent. Tenet Healthcare Corp and Universal Health Services Inc each have risen 50 percent; and Health Management, fueled by takeover rumors, has leaped 79 percent. The Standard and Poor's 500 index, by comparison, is up 15 percent.
For the top five hospital operators, analysts are projecting combined growth of 21 percent in adjusted earnings per share in 2014, according to Thomson Reuters I/B/E/S data. That would represent a price to earnings ratio for the group of 12.76, based on 2014 estimates and current share prices, compared with 14.5 for the S&P 500.
Once investment underdogs, the stocks began to take off after the Supreme Court upheld most of Obama's health reform law last June, paving the way for millions of uninsured Americans to obtain coverage in 2014. The rally stumbled this spring when hospital companies reported surprisingly low admissions, and government estimates suggested that not everyone who is eligible will sign up for "Obamacare" on day one.
Other investors have expressed concern about the many variables still to be worked out, including whether key Republican-led states like Texas and Florida will accept federal funding to expand their Medicaid programs for the poor, helping pay for the care that hospitals in those regions now deliver for nearly no compensation.
"It will be rough, it will be rocky, and it will take time," said Tim Nelson, analyst with Nuveen Asset Management, which owns shares of Universal Health. Nelson believes other names in the sector are fully valued.
ROLLING OUT REFORM
The biggest benefit from health reform is expected to be an influx of patients whose treatment will be paid for either through expanded Medicaid programs or with private insurance obtained from state-based exchanges that will take effect on January 1.
That should help drive down the percentage of revenue now being written off as bad debt for treating the uninsured, which can be up to 20 percent or greater for some hospital chains.
"They definitely will be winners at least in the near term under healthcare reform," said Jeff Jonas, a portfolio manager for Gabelli Funds, which hold shares of HCA and Tenet. "We should see some pretty significant reductions in their bad debt in particular and maybe a little increase in volume."
Jonas estimates HCA and Tenet stocks each could add another 10 percent this year.
Another positive for companies in the sector has been the ability to refinance debt loads at significantly lower interest rates. "They've locked it in for years to come," said Jonas.
Hospitals are also managing their own expenses better than in the past. Efforts to centralize supply sourcing are driving annual decreases in prices for medical devices such as heart stents and orthopedic implants. Bringing doctors on staff by acquiring physician practices has also helped to control costs.
"It is going to be a multiyear period of benefiting from health reform," Jonas said.
The drive for efficiency is accelerating consolidation across the industry, as hospitals partner with other facilities within geographic regions to form networks that can offer a wider range of specialties or reduce duplication.
Many uncertainties remain. Hospitals still don't know how they will be reimbursed under health plans sold on the state insurance exchanges. The extent to which employers drop commercial coverage for their workers and direct them to the exchanges is another major variable. And states are progressing at different rates in setting up their exchanges.
The federal government hopes to get 7 million Americans to sign up for health plans on the exchanges in their first year, and 24 million by 2016, aided by subsidies to purchase coverage. Enrollment begins October 1 for plans that take effect in January.
Perhaps the biggest wildcard for hospitals is the expansion of Medicaid, which is being determined state by state and will affect companies differently based on where their facilities are located. HCA's stock performance, for example, has lagged its peers, Nelson said, because of its concentration of hospitals in Florida, where the state legislature has blocked Republican Governor Rick Scott's support for Medicaid expansion.
Nelson said there was a real opportunity to reduce the amount spent on treating uninsured people for free, but he added: "How real it is and how big just depends upon the geographic footprint."
If high-deductible health plans, which have become increasingly popular with small employers, predominate on the insurance exchanges, hospitals may not see as great a reduction in bad debt expense as hoped, because they will still need to collect the uncovered portion of a patient's bill, he said.
Weak demand for healthcare services dragged on hospitals' earnings in the first quarter, exacerbated by the still-high jobless rate and the rising number of patients with high-deductible health plans who are staying away from the doctor. Some do not see that picture improving soon.
"The economy isn't picking up fast enough. I think the hospitals are in a holding pattern at least through the summer and possibly into fall, until we get clarification on Obamacare," said Les Funtleyder, healthcare strategist at investment firm Polliwog, which does not own hospital stocks.
"Over time, if the economy improves and we get visibility on Obamacare, the valuations still have a little bit of room on the upside," he said. "I wouldn't short them."
(Reporting by Susan Kelly in Chicago; Editing by Michele Gershberg and Claudia Parsons)