Hospitals Turn Sickly

At least one analyst believes that the troubles at HCA represent a bad sign.
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Hospital stocks are really hurting.

Last week, even before

HCA's

(HCA) - Get Report

recent profit warning, veteran health care analyst Sheryl Skolnick found herself unable to recommend a single hospital stock.

Instead, the CRT Capital analyst initiated coverage of HCA and three other hospital companies with the equivalent of hold ratings and recommended selling

Health Management Associates

(HMA)

outright. She portrayed hospital stocks as unsuitable for the very investors who may have flocked to them in the past.

In essence, Skolnick said that investors shopping for growth vehicles, or even safe defensive plays, should consider looking elsewhere these days.

"We note that when the Street pushed hospitals into being growth stocks (or the companies pushed themselves), we ended up with government investigations for Medicare fraud," Skolnick reminded investors in one of several new hospital reports published by CRT Capital last week. Meanwhile, "the old 'defensive play' investment rules simply don't yield successful investment strategies for the healthcare sector anymore."

Thus, Skolnick has come to view hospital companies as real estate-based investments of sorts. And she warns that "overspending, overbuilding and underfunding could make hospital stocks sick in the long run."

Early Symptoms

HCA, the nation's largest for-profit hospital chain, has managed to trip up already.

Instead of filling its beds with aging baby boomers, HCA wound up treating fewer patients in the first quarter than it did a year ago. Only patients who lack health insurance -- and usually fail to pay their bills -- showed up in larger crowds during the mild flu season.

Skolnick had expected as much. Indeed, she has already projected that HCA will fall short of Wall Street expectations for the entire year.

Still, she sees no pressing reason to sell the stock just yet.

"Suffice it to say that if we have to make a tough call here, we will," she assured last week. "Our big frustration at the moment, however, is that there doesn't seem to be a call to make here at all -- much less a tough one. ... The real question in our minds is whether anything interesting enough will happen in the HCA story in 2006 to generate much investor interest one way or another."

To be sure, investors spent little time dwelling on the recent earnings miss. The stock took a quick blow, hitting a 52-week low of $42.51 on Monday morning before staging a late rally. HCA shares slipped 8 cents to close at $45.77 on Wednesday, but the stock is up for the week.

History Lesson

Skolnick believes that investors have yet to face reality.

"Despite all of the discussions of slow volume growth, we have the strong sense that many investors and analysts still cling to the hope that we will somehow magically return to the days of 3% to 5% volume growth," she wrote. "And that, we believe, contributes strongly to the cycle of rising expectations followed by significant disappointments."

Skolnick fears major disappointments from the hospital group as a whole. She points to history as a guide.

Back in the early 1990s, she reminds, nursing-home operators rushed to build new beds -- at great expense -- in response to the sudden "demand" created by Medicare payments for sub-acute care. However, she says, the companies never added the 200,000 beds they had planned. Instead, she says, Congress came along with the balanced budget "ax" of 1997 and eliminated the generous profits nursing homes had been pocketing for sub-acute services.

"Sub-acute care units still exist," she admits. "But no one talks about needing another 200,000 beds."

Rather, she says, people started talking about the need for 200,000 beds in assisted-living centers. In turn, she says, assisted living companies became "all the rage on Wall Street." But by the late 1990s, she adds, occupancy rates started to fall as demand for assisted-living units exceeded the supply of senior citizens willing and able to pay for them at that time.

Skolnick worries that history could now be repeating itself in the hospital sector. This time around, she says, hospitals have been forecasting the need for 200,000 new beds to accommodate aging baby boomers. Recently, however, hospitals have seen volumes weaken -- at least among paying patients -- even as baby boomers move closer to retirement age. And once they do start retiring, in 2010, Skolnick notes, those baby boomers will be relying on a Medicare fund that is scheduled to go bankrupt in a decade.

"That is why we shudder every time we hear the argument about the graying of America as an investment thesis," she says. "One of these days, there might just be a consistent, predictable way to make money off the fact that our joints creak ever more often and loudly and our bodies give out. But blindly looking at the demand side of the equation without either careful consideration of the supply side or the budget constraint is not the way to do it, in our view."

Strict Rules

Skolnick follows a strict set of rules when analyzing the hospital sector.

She has always paid close attention to the industry's growth strategy, its dependence on doctors and its reimbursement risks. Now she also focuses heavily on bad debts from the uninsured and underinsured. Meanwhile, she has learned from experience to question results that simply don't make sense.

"If results seem too good to be true, they are almost certainly not sustainable," she cautions. And "there is virtually no trend in the hospital industry that is ever company-specific for long."

In the past, she notes, both HCA and

Tenet Healthcare

(THC) - Get Report

reported dazzling results before collapsing under allegations of Medicare fraud. More recently, HCA became the first company to report weak volumes and rising bad debts from the uninsured. Like clockwork, she recalls, other companies started following suit.

But one company, HMA, seemed to take its time. The company expressed confidence that it could collect its unpaid bills -- until it failed to do so -- and kept paying high prices for more hospitals in the meantime.

Skolnick sees a troubling pattern at HMA and recommends selling the company's stock as a result. To be fair, however, she worries that the entire industry could be in denial.

"It seems obvious to us that the economics of the hospital business has changed but that the management teams of the public companies either don't agree or don't see it," Skolnick wrote. "While we believe the demand story (i.e., patients will need care even if the care moves out of the hospital), we simply do not believe that there will be enough money in the system to pay for it at a level consistent with the growth in costs. As a result, expect long-term margins and returns on capital invested to compress.

"That we are beginning to see strong evidence of both trends taking place now is of great concern to us."