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Monday, October 12, 1998

An Investment Opinion
by Alex Schay

Columbia/HCA: From Critical to Stable?

There were signs of life today at the nation's largest hospital chain as Columbia/HCA (NYSE: COL) gained $1 1/8 to $19 1/8 and began to distance itself from its 52-week low of $17. With the federal "raid" on Columbia's El Paso operations now well over a year old, it's interesting to review some thoughts on the matter that were published in this forum a couple months after the Medicare fraud allegations broke. In our Industry Snapshot, Columbia/HCA was featured in the August 22, 1997 "Spotlight" section:

"Does this [scandal] damage the long-term viability of Columbia/HCA? We don't think so. Have the allegations of scandal, and even the payment of fines, hurt the long-term prospects of companies like General Electric, General Dynamics, or Archer Daniels Midland? Nope. Therefore, we're going to look past the current problems of the company and at a credible scenario in which we can see Columbia/HCA growing at an annual rate in the mid-teens over the coming five to ten years. There's more than enough room to consolidate the industry, and that's where we think CEO Dr. Thomas Frist will concentrate."

Although the long-term picture still remains in focus, the exigencies of an industry-wide government probe and a focus on asset sales have both served to diminish the expectation that Columbia/HCA could hop right back on the acquisition trail. In a recent panel discussion on the broader healthcare business, Frist commented on the acquisitions outlook, "This company is still a growth company. We're just going to grow internally, and we're going to continue our stock repurchase program." Since the investigation began, Columbia has sold hospitals, outpatient surgery centers, and chunks of its home healthcare operations in order to become a more "focused" provider.

Cutting down on hospital beds used to make all the difference in the world for the most competitive hospital companies. Not only do depreciation costs per patient decrease, but staff costs per bed go down and financing costs per patient decrease, as do overall fixed costs per bed. It's hard to make an economic return when only 25% of the total capacity of a collection of fixed assets are being used. Even with the asset sales though, Columbia will remain the largest for-profit operator in the country with (currently) 318 general hospitals, 18 psychiatric hospitals, and 145 outpatient centers.

Aside from the peculiar troubles that have become Columbia's lot, the overall hospital business has experienced some sluggishness lately (independently of the downturn). Some key considerations include the nature of Medicare changes that are currently working their way through Congress, admission levels, and the value placed on recent acquisitions. With regard to the last item, in May Columbia announced that it sold 22 hospitals to a consortium of not-for-profit hospitals that were looking to acquire assets that would fill out their markets. Columbia will receive a total of $1.2 billion for the transaction, or roughly 10 times normalized earnings before interest, taxes, depreciation, and amortization (1.5 times revenues) for these 22 hospitals -- which is pretty solid pricing. Of the roughly $2.7 billion that the company has received thus far this year, it is still unclear what percentage of that sum will go toward any fines that it may have to pay to the government.

Working our way backward on the list, unseasonably warmth in the winter months hits all kinds of businesses pretty hard, including clothing retail and energy companies, but hospitals? Yep. As the number of weather-related immune system busting illnesses drop off -- like respiratory failure, flu and pneumonia -- admissions take a similar slide. In addition, stepped-up efforts on the part of managed care payors to reduce costs also have had an affect on inpatient admissions. However, the long-run growth story remains intact.

Finally, Medicare accounts for 35% to 50% of all revenue for the typical hospital. Under the Medicare program, a hospital receives reimbursement under the prospective payment system (PPS). Under the PPS, fixed payment amounts per inpatient discharge are established based on the patient's assigned diagnosis-related group (DRG). DRGs classify treatments for illnesses according to the estimated "intensity" of hospital resources necessary to furnish care for each principal diagnosis. DRG rates have been established for each individual hospital participating in the Medicare program and are based on a statistically normal distribution of severity. Patients falling well outside the normal distribution are allowed additional payments. Under PPS, hospitals may retain payments in excess of costs but must absorb costs in excess of payments, thereby encouraging them to be efficient.

Frist has stated on numerous occasions that he hopes the federal Medicare investigation will be settled in the first quarter of 1999 -- but that closure is ultimately in the hands of the government. Meanwhile, Columbia has not been as concerned about meeting analysts' expectations in the earnings department, but rather doing what it can to maximize its asset mix. The settlement (within the next 12 months) will definitely qualify as a "catalyst" for re-assessing the value of Columbia/HCA's assets. Interested investors would be advised to take a closer look now.