HealthSouth Sent to the E.R.

By Brian Graney (TMF Panic)
September 10, 1999

Shares of outpatient surgery and rehabilitative services provider HealthSouth Corp. (NYSE: HRC) headed south in a hurry this morning after the company decided to let a proposal from earlier this summer to split its inpatient and outpatient operations into two separate companies sit tight in the waiting room for a while.

The split was intended to renew investor confidence in the company's stock, which has been in the sick ward for more than a year now and was down 49% year-to-date prior to last night's announcement. That figure swelled dramatically this morning as investors and analysts alike didn't take to kindly to the spin-off blow off. According to Bloomberg, 8 of the 11 sell-side analysts covering the stock trampled over themselves in a rush to issue downgrades.

At its current price level of about $5 per share, HealthSouth's enterprise value of $4.87 billion is a slim 1.2 times the firm's trailing 12-month revenues and a scant 0.71 times invested capital (not including the effects that the firm's many pooling transactions have had on invested capital over the years). Despite slippage in the second half of the year attributed to various operational and Medicare reimbursement issues, operating margins are still expected to be a relatively healthy 27% to 29%. The company continues to expect cash flow this year on the order of $1.2 billion. Moreover, Chairman and CEO Richard Scrushy emphasized that annual earnings growth should be in the 15% to 20% range next year.

What gives?

The rationale behind HealthSouth's less-than-heart-stopping current valuation is fairly straightforward -- it's in an industry where value creation is extremely hard to come by.

According to a study by Credit Suisse First Boston and outlined in report by analysts Michael Mauboussin and Bob Hiler last fall, the healthcare - hospital management sector of the S&P 500 (which includes HealthSouth) sported the slightest of slight spreads between return on invested capital (ROIC) and weighted average cost of capital (WACC). In fact, the hospital management business ranked within a stethoscope's throw of such low value-creation industries as chemicals and food distribution. Throw in the changes to Medicare reimbursement rules that have reverberated throughout the industry this year and building shareholder value in this sector becomes about as difficult as performing a thoracotomy with one hand tied behind your surgical back.

But as Mauboussin and Hiler note, "...excess returns can be earned even in the worst industry groups. What separates the winners from the losers is how they organize their activities." In this area, HealthSouth appears to be anything but organized and doesn't seem to know what to do next.

The spin-off rethinking is a glaring example of a company desperately looking for a strategy. In the past, HealthSouth has used its substantial cash flow and taken out debt to grow through acquisitions, adding hundreds of surgery centers, rehab facilities, and diagnostic centers in the past three years. The returns from those investments, however, have not showed up on the income statement as the entire for-profit healthcare system in the U.S. has come under a pincer attack from consumers and regulators.

HealthSouth's primary response to this situation has been to use its cash flow to buy back huge amounts of its outstanding shares. With the spin-off on hold, the company plans to restart its $1 billion stock buyback plan. Even Scrushy himself intends to invest $25 million in the company's hemorrhaging stock. Judging from recent experience, though, the buybacks haven't turned out to be winning investments for the company or for shareholders. Until a fundamental change in the company's strategy can produce an idea resembling something close to a true value driver, investors may want to keep clear.

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