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Medicare Rule Change a Win-Win for Investors

Hospitals like Tenet Healthcare (NYSE: THC  ) and HCA Holdings (NYSE: HCA  ) have been in the cross-hairs of Medicare for years. Care provided by hospitals costs Medicare billions every year and reducing Medicare's payments to hospitals is a key goal for those looking to offset higher Government spending tied to the Affordable Care Act (also known as Obamacare).

As a result, hospitals have been quick-to-embrace strategies that diversify revenue away from inpatient care to potentially higher margin outpatient services.

Source: Tenet Healthcare

That shift is coming out of necessity
Obamacare is expected to increase the number of people with insurance by 30 million over time and the ACA exchanges signed up 8 million people during their first open enrollment period late last year and early this year.

In addition to millions of newly insured members in private plans offered through exchanges, another six million people also got coverage through Medicaid, either due to expansion in states adopting reform, or thanks to increased awareness of the program and its benefits.

The resulting surge in health care services tied to new members is likely to strain an already tight market for patient care and that has hospitals gobbling up physician practices and opening urgent care and surgery centers in order to meet that demand.

According to Merritt Hawkins, a national health care recruiting firm, over 90% of new physician job openings handled by it during the past year came from hospitals rather than independent practices.

HCA Holdings is one of the hospitals ramping up its outpatient services. The company is a leading player in ambulatory surgery centers and has spent more than $5 billion on growth initiatives including free standing emergency rooms, urgent care centers, and surgery centers in the past three years.

The industry spending spree means that operators are getting more revenue from outpatient care than ever before. According to data from the American Hospital Association's annual survey, roughly 40% of hospital revenue now comes from outpatient services. The percentage of overall sales coming from outpatient care at Tenet, for example, has grown by over 4 percentage points in just the last five years.

Source: American Hospital Association

Good timing, considering
The industry focus on expanding outpatient offerings appears savvy. Medicare agreed to 1.8% bump up in Medicare reimbursement for outpatient services in 2013, reimbursement climbed another 1.7% in 2014, and based on newly issued guidance, payments could increase 2.1% more in 2015.

Those increases are likely to have a big impact on hospitals given that Medicare spent $37 billion on outpatient care in 2013.

Overall, Medicare accounts for roughly 40% of all revenue collected by hospitals and the bump up in payments for outpatient services will increase revenue even as reform causes hospitals' bad debt expense to fall.

In the first quarter, Tenet reported that a 17% jump in Medicaid admissions in four states adopting expansion helped lower uninsured and charity admissions by 33%, and that suggests that revenue growth and fewer write offs should prove margin friendly for the Tenet and HCA next year.

Source: American Hospital Association

Higher reimbursement will also help profit because more patients are using outpatient facilities and outpatient services account for a significant share of hospital's overall net income. Although outpatient services represent  40% of sales, they can account for 85% of a hospital's operating profit -- indicating that it's a higher-margin (and therefore profit-friendly) business.  

Outpatient visits grew 2.9% in 2012, far faster than the 0.7% increase in 2011, and much better than inpatient visits, which fell 1.2% last year. So far this year, that trend has continued with Tenet reporting same-hospital outpatient visits were 2.5% higher and inpatient admissions were 0.4% lower year over year in the first quarter. 

Fool-worthy final thoughts
Tenet, HCA, and industry peers will continue to lobby for higher Medicare reimbursement rates because the industry continues to lose money treating Medicare patients. According to the Medicare Payment Advisory Commission, the average hospital had a -5.4% average margin on Medicare patients in 2012. If industry efforts pay off with higher reimbursements, for-profit hospitals will benefit most given that their 1.5% Medicare margin is already considerably better than the industry average.

Overall, higher payments from commercial insurers, better Medicare margin, and growing use of outpatient services are already improving hospitals' financial health. That's translated into an overall industry margin of 6.5% in 2012 -- a 20 year high. Given Medicare's headwind appears to be easing, now might be a good time for investors to start thinking about these potential investments.  

A huge investment opportunity
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Todd Campbell

Todd has been helping buy side portfolio managers as an independent researcher for over a decade. In 2003, Todd founded E.B. Capital Markets, LLC, a research firm providing action oriented ideas to professional investors. Todd has provided insight to a variety of publications, including SmartMoney, Barron's, and CNN/fn.

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