Jenks Healthcare Business Report November 2002

In the November 2002 issue:

Medicare: The Bane Or The Benefactor of Health Care?

In today’s world, most health care providers cannot survive without Medicare, but the growing dependence on the federal program leaves some companies overexposed to changes in reimbursement or new interpretations. Cases in point are HealthSouth and Tenet Healthcare, but there were many before them. See page 1

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Public Equity Market

While the public equity market remains tenuous, an IPO and a secondary offering managed to get priced, and a medical device company filed its registration statement for an IPO early next year. See page 7

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Venture Capital Market

A record 34 companies raised $371 million in the venture capital market this past month. Particularly good news is that after a weak showing for most of the year, several service companies attracted new capital. See page 8

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Acquisition Market

Acquisition Market
Deal volume was strong this month, especially in Medical Devices and Pharmaceuticals, but the average deal size was small, with only three surpassing the $100 million mark. See page 12

Jenks Healthcare Business Report

Medicare: The Bane Or The Benefactor of Health Care?

Although the country’s modern health care system really began 60 years ago when employees first received tax-free health care benefits as a corporate means to bypass wage controls, the growth in health care spending can be traced back to the beginning of Medicare in the mid-1960s.When the cost of hospitalization became relatively free to the elderly, it was no wonder that utilization would increase dramatically, even though the original designers of the system failed to take that human element into account. Medicare spending, as we all now know, grew at rates never forecasted, as did the construction of new hospitals to meet the converging health care needs of the baby-boomers, the expanding elderly population and the 40-year emigration to the West and South.

Most of the for-profit hospital companies that were born between 1965 and 1975 no longer exist, and, in terms of financial performance and the disappearance and appearance of new hospital chains, the hospital industry has been cyclical ever since. In one period, it may be changes in Medicare spending, in another, new pricing policies from HMOs. But Medicare seems to have an unnatural ability to disproportionately impact the fortunes of health care companies, and their investors, across all sectors of the health care economy. One only has to look at the home health care and skilled nursing sectors in the late 1990s, when up to 80% of their combined market capitalization was wiped out subsequent to Medicare reimbursement changes. This is one reason why the major pharmaceutical companies fear a takeover of pharmaceutical pricing by Medicare. Now, although under very different circumstances, two dominant providers in the rehab and acute care sectors, HealthSouth (NYSE: HRC) and Tenet Healthcare (NYSE: THC), respectively, have fallen victim to their growing reliance on Medicare and their respective interpretations of how the reimbursement system works.

The saga at Tenet has been well-documented in the mainstream press, but one of the biggest concerns of investors is that management, or what’s left of it, still has not come clean on what its strategy was regarding Medicare’s so-called "outlier" payments. These payments, which are four to five times the relative amount being received by THC’s large competitors, are designed to provide hospitals with additional funding for patients whose cost of treatment are far above certain reimbursed costs.

Making the leap of faith that the 40-agent raid on the one Tenet California hospital is an isolated instance of alleged personal greed, the outlier payment controversy, while significant, may still be overblown in terms of what it has done to THC’s market value. The impact on the other hospital stocks was certainly a case of abandoning the hospital ship on any bad news, and even more irrational than the 75% plunge in Tenet’s shares. Without sounding like a broken record, because of the relatively recent run-up in hospital stocks, early investors were looking for any bad news to take their gains and run. Unfortunately, many of them did not get out fast enough.

Kudos obviously go to Ken Weakley, the UBS Warburg analyst who brought up the issue of unusually high, and growing, outlier payments to Tenet (put one in the win column for independent research), and even changed his rating to sell, a rarity on Wall Street. To believe that these payments, which apparently grew from less than 8% of inpatient Medicare payments in THC’s fiscal 2000 year to more than 23% projected for the 2003 fiscal year, were accidental without someone in management knowing exactly what was going on is naïve at best. Although officially there was no connection, did we forget to mention that two top executives recently departed? Either the other hospital companies, with just 4% to 5% of inpatient Medicare revenues derived from outlier payments, did not understand how to manipulate these payments or they did not want to. While the former is most likely, it may have been a combination of the two.

A certain amount of perspective, however, must be kept when looking at Tenet’s problems. Outlier payments of approximately $760 million represent just 5% of the company’s total annual revenues, and presumably THC will not lose all of these payments regardless of the outcome of the investigation into its pricing methodology. Most likely, the worst case scenario is that these payments will be reduced to a level more consistent with other companies, such as 1% to 2% of total revenues. This would knock out $450 million to $600 million in annual revenues, which is material since a large portion flows to the bottom line but hardly enough to warrant a $15 per share value (compared to over $50 per share a month ago). In addition, if there is a change in Medicare’s reimbursement for these outlier payments, Tenet may try to scale back the number of these costly procedures. The great unknown, however, is what any of these changes will do to managed care pricing for Tenet in particular, but also for all hospital companies in general.

One analyst, Sheryl Skolnick of Fulcrum Global Partners, has put together a worst case earnings scenario for Tenet, which includes a nearly 50% reduction in earnings per share for the fiscal year ending May 31, 2003 (as well as the following year) if THC’s aggressive pricing strategy is removed from the revenue equation. This is "worst case" because a 60% to 80% reduction in outlier payments could cut earnings per share, given an assumed 40% tax rate, by just 25%. Consequently, Ms. Skolnick has obviously assumed that managed care pricing would come under pressure as well. At a projected $1.52 per share for fiscal 2003 (with a lot of moving assumptions), that means that THC is trading at just 10x earnings. Still, she is projecting a 19% increase in earnings per share to $1.81 for fiscal 2004 (down from $3.62).

Now, does it make sense that a company with 19% projected earnings growth, with worst case assumptions utilized, should be trading at just 8x its fiscal 2004 earnings estimate? The answer is no, and that the current price levels have more to do with an overreaction to the current high level of uncertainty and to a situation that can simply be called a mess, for management as well as shareholders. For the brave investor who is willing to stick it out for a while, shares of Tenet, as well as a few other hospital stocks that have suffered from the fallout and have now dropped 50% from their 52-week highs, can join our fallen angel group from last month. The one certainty, however, is that Medicare will continue to be the devil that health care companies will have to dance with, reimbursement horns and all.

Read the past headlines.