Mergers occurring between companies in the same industry are usually worth checking out. The acquirer often benefits by significantly reducing cost through the elimination of duplicative expenses. These savings, and other merger advantages, can also help shareholders gain. Such opportunities might currently be found in the hospitals industry. A recent purchase by Tenet Healthcare (NYSE: THC ) and a proposed combination by Community Health Systems (NYSE: CYH ) could provide investors with some noticeable upside.
Tenet Healthcare's acquisition is compelling
Tenet Healthcare recently closed on a $1.7 billion purchase of Vanguard Health Systems. Vanguard Health, owner of 28 acute care and specialty hospitals, seemed a typical industry performer. In its latest fiscal year, revenues of $5.3 billion were flat versus the prior year and cash earnings, basically net income plus non-cash charges such as depreciation and amortization adjusted for expected capital expenditures, of $209 million delivered a solid profit margin of 3.97%.
Tenet Healthcare, who itself was an acquisition target in 2010, will join Vanguard's assets to its own 77 hospitals and 176 outpatient centers. Tenet reported recent quarterly results slightly better than industry averages. Revenues of $2.4 billion increased an impressive 8.4% year-over-year and a 4% profit margin produced cash earnings of around $96 million.
A successful integration of Vanguard could provide gains for Tenet shareholders. The combination will likely produce annual results of near $14.8 billion in revenues and $608 million in adjusted cash earnings. Profitability will be helped by an expected $125 million in cost savings, at the lower end of Tenet's planned $100 million to $200 million in synergies. Benefits will be offset by additional debt service expenses brought on by the acquisition, however.
If these results can be achieved, Tenet's fair value could be around $47 to $53 per share based on a multiple range of 8 to 9 times cash earnings. Since this valuation depends materially on the multiple, it's prudent to ask if the range is reasonable. A comparison with an industry leader indicates it is.
HCA: A leading hospital operator
HCA Holdings (NYSE: HCA ) , one of the largest health care companies in the U.S., is no stranger to hospital combinations. It was created through a merger of two large owners in 1993. The company -- owner of 162 hospitals and 114 freestanding surgery centers -- might be considered the premier operator in the industry.
In its latest quarter, HCA posted revenues totaling $8.5 billion, an admirable 4.9% jump from 2012. Cash earnings came in at $525 million producing an outstanding 6.2% profit margin. Full-year 2013 expectations are equally laudable. Revenues are anticipated at $34 billion, about 3% higher year-over-year, with cash earnings of $2.1 billion at the same 6.2% margin.
HCA's shares currently trade at roughly 10 times expected cash earnings, a fair multiple given the company's excellent profitability and solid business volumes. HCA saw quarterly hospital admissions increase when most competitors reported declines.
Community Health's proposed merger looks appealing
Community Health Systems and Health Management Associates announced a merger agreement this past summer. The deal, expected to cost Community roughly $3.0 billion and 18 million shares, will deliver Health Management's 71 hospitals. Combining the entities will likely go smoothly. Community, which currently operates 135 hospitals, has plenty of experience. It added 53 hospitals from its $5.1 billion purchase of Triad Hospitals in 2007.
While the merger is being finalized, both companies reported quarterly results. Community reported revenues of $3.2 billion, stable year over year. A strong 4.06% profit margin produced adjusted cash earnings of about $130 million. Health Management posted revenues of $1.4 billion, a slight 1% decline compared to 2012, and cash earnings of $33 million came in with a 2.35% margin. The weak profitability measure, well below its average 3.40% margin year-to-date, may have been due to some major distractions.
Glenview Capital, a hedge fund with a roughly 14% stake in Health Management, led a shareholder revolt that unseated the company's entire board of directors in August. Community Health, in which Glenview has about 9% ownership, probably viewed the turmoil as an opportunistic time to make a bid, which only added to the commotion.
Community's offer, when fully accepted, may be a win for its shareholders. On a pro forma combined basis, yearly revenues look to be around $18.7 billion generating cash earnings of $720 million. Included are an increased interest expense from additional borrowing needed to finance the deal and $160 million in expected cost savings, at the low end of Community's anticipated $150 million to $180 million in reductions.
If everything goes as planned, Community Health shares may have a plausible business worth of $45 to $51 a share based on a multiple range of 7 times to 8 times cash earnings. The discounted multiple range due to the substantial debt added to Community's already large burden.
While the numbers suggest that Tenet Healthcare's acquisition and Community Health Systems proposed merger could benefit shareholders meaningfully, there are risks. The industry's business environment isn't very friendly. Hospitals continually face the threat of lower reimbursements. Pressure on fees, especially those received from crucial Medicare and Medicaid programs, may increase as general medical costs rise. The industry must also deal with a recent trend of declining demand. In the latest quarter, Community Health reported a 6.8% decrease in total hospital admissions and Tenet saw a 2.6% decline in their inpatient admits.
Hospital have been around a long time and shown an ability to adapt, however. Given the industry's history, investors may want to check out these recent hospital deals even with the associated risks. If the combinations can post results anywhere near expectations, shareholders may be well rewarded.
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