When a large company is successful, one reason often cited is "economies of scale." The benefit of being big is that costs are spread across, or "scale" to cover, more and more situations. A doctor needs the same number of IT systems, buildings, and equipment to see 1,000 patients as she does to see the first patient -- and if she has 1,000 patients, she's more likely to get a good price on supplies. Administrative costs scale, too; the cost of managers doesn't increase with each patient who comes through the door.
Historically, the U.S. healthcare system hasn't worried much about scale, because reimbursements from insurers were based on the number of patients seen. Passage of the Affordable Care Act in 2010 began to change this "fee-for-service" model and accelerated the adoption of "value-based care," or reimbursements based on the quality and cost of the service provided. In response, the healthcare industry has been consolidating at a rapid pace; there were more than 80 mergers in both 2018 and 2019. For perspective, there were only 50 and 60 similar transactions in 2009 and 2008, respectively.
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Amid all the recent activity, Healthcare Corporation of America (HCA 2.94%) boasts a storied history. The company has gone public three times, has been taken private twice, and has grown through acquisition from 11 hospitals in 1968 to a peak of 463 in 1987. As the industry changed, the company scaled back; it currently owns 184 hospitals and 2,000 "sites of care" across the U.S. and U.K. This still-impressive scale gives HCA an advantage in a changing landscape where cost control is ever more important.
Never confuse effort with results
Larry Bossidy once wrote, "Execution is the ability to mesh strategy with reality, align people with goals, and achieve promised results." An excellent way to evaluate how well a company is executing is to compare its operating margin -- profits after paying for people, supplies, marketing, and investments in innovation -- with that of others in the industry. If the theory holds true, larger companies with more scale should see a greater percentage of their revenues translate into profits.
It doesn't always work out that way, though. A 2018 Deloitte analysis found that although expenses decline for a combined company immediately after a merger, revenue and operating margins do, too. The result is unimproved financial performance, despite the consolidation, for at least two years post-merger. The few publicly traded hospital systems didn't make the list of mega-mergers studied, but it is insightful to compare their operating margins as well.
| Company | 2019 Operating Margin | 2018 Operating Margin | 2017 Operating Margin |
|---|---|---|---|
| Healthcare Corporation of America | 14.1% | 14.2% | 13.9% |
| Tenet Healthcare (THC 3.17%) | 9.1% | 8.8% | 7.2% |
| Universal Health Services (UHS 2.35%) | 10.7% | 10.9% | 12.3% |
| Community Health Systems (CYH 4.22%) | 6.7% | 6.3% | 1.4% |
Sources: Morningstar, author's calculations.
While this is admittedly a small sample, the size of a healthcare system does seem to affect its profitability, and HCA is leading the pack. Perhaps this is why HCA's former CEO, Milton Johnson, was the highest-paid healthcare executive in the country prior to retiring, pocketing $108 million in 2018 according to Axios. His successor, Samuel Hazen, assumed the top spot with $27 million in compensation in 2019, his first year. These numbers are eye-popping, but they aren't unusual. Hospital executives' salaries nearly doubled in the decade between 2005 and 2015, far outpacing other healthcare professionals'.
If you're not the lead dog, the view never changes
HCA's ability to convert reimbursement dollars into profit has led to 19% compounded annual returns since the hospital operator's March 2011 return to public markets, when it was the largest-ever U.S. IPO backed by private equity. Since then, every segment of the healthcare industry has taken note of the power of size; the past few years have seen a barrage of mergers between physician groups, pharmaceutical companies, and even outpatient facilities and laboratories. In 2017 alone, there were 10 hospital deals valued at more than $10 billion apiece.
Despite promises of reduced patient costs and improved care, a study published by the New England Journal of Medicine found that costs to patients actually rise after hospitals merge. And the quality of care -- as measured by mortality, satisfaction, and unplanned readmissions -- may actually deteriorate. HCA rival Tenet Healthcare's acquisition of Vanguard Health Systems for $4.3 billion in 2013 made it the third largest for-profit hospital operator in the U.S., but its stock price sits 40% lower than in June 2013, when the deal was announced.
Unlike Tenet, which used its deal to expand its number of hospitals, HCA has focused on acquiring outpatient facilities to complement its existing hospitals, particularly by increasing access and reducing costs for patients. The strategy is working -- the most recent quarter saw a 38% jump in profit thanks to HCA's ability to control costs even as coronavirus expenses spiral for other hospital operators.
Headlines about big mergers and promises of "synergy" from CEOs can entice investors and line the pockets of healthcare executives, but the resulting profits don't always come through. Healthcare investors who are considering one of HCA's many imitators would do well to consider investing in the leader instead. CEO Sam Hazen summed it up well on the earnings call in response to an analyst question about profit margins amid the pandemic: "It's not something that's going to go away, necessarily. But our ability to scale up, scale down, scale up, I think, has now been proven."
