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Trying the Triad Math

Some skeptics doubt that the big hospital deal can work.

Some financial experts have a hard time seeing how

Community Health System's

(CYH) - Get Community Health Systems, Inc. Report

looming acquisition of

Triad Hospitals

(TRI) - Get Thomson Reuters Corporation Report

really adds up.

When doing the math, those experts have focused primarily on three metrics. They have looked at the combined company's earnings power, its spending obligations and its profit margins. In the end, they see a cash-poor company posting results that could come up well shy of management's projections for quite some time.

"I firmly believe the merger is bad for both companies," says one hospital executive who is familiar with Community and Triad alike. "I can't see how Community will make this work in the first three years and beyond."

In a nutshell, that hospital insider lays out his case like this: The two companies had income from operations of $815 million last year. But after jacking up interest payments, following Community's pricey buyout of Triad, the combined company will be left with far less.

The insider estimates that the new company could end up with as little as $210 million in annual profits -- a fraction of the $1 billion-plus in capital spending that it faces.

Sheryl Skolnick, senior vice president of CRT Capital, is a bit more generous. She notes that Community has based its projections on earnings before interest, taxes, depreciation and amortization -- or EBITDA -- rather than income from operations. So she starts with this higher number as well.

Skolnick pegs Community's EBITDA, following its huge interest payments, at $644 million. "But not all of that is cash," she stresses, "and it is still untaxed." Thus, in the end she comes up with about $550 million of free cash flow -- before capital expenditures.

Still, regardless of the earnings metric used, both experts see a company struggling to satisfy the vast spending obligations that lie ahead. They break the company's cap-ex program up into three categories: routine maintenance, expansion and new construction. And they see a looming shortfall down the road.

Right now, Community spends about 5% of its net revenue on routine maintenance. So the combined company faces roughly $500 million for this obligation alone.

Expansion, which has been a bigger focus for Triad than for Community, can be harder to figure.

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"This is where it gets a little tricky," the hospital insider admits. But "the fact remains that you have to continue to grow your existing business with fresh updates and enhancements to compete. This is especially true in the semiurban markets for Triad," although less so for the rural markets that Community is used to monopolizing.

On average, the insider says, hospital companies need to overhaul 10% of their facilities every decade. He believes those big projects will cost Community $200 million annually but concedes that the company could perhaps choose to spend half as much.

Beyond that, Community still needs to follow through on three new replacement facilities for itself and another four for Triad. Together, experts estimate, those hospitals will cost the company about $400 million for each of the next three years.

By combining all three types of cap-ex projects, they conclude, Community is facing at least $1 billion in obligations annually -- and struggling to make ends meet.

"If routine cap-ex is about $500 million ... and cap-ex commitments are higher, then there isn't


free cash flow," Skolnick declares. Even "in the absence of continuing the growth cap ex, free cash flow is about $50 million pro forma for 2006 --

and that's the best-case scenario."

So, she adds, "the only way to deleverage is spend less on cap ex or do an equity offering in the future."

Skolnick recommends shorting Community and buying Triad in the meantime. She has no position in either stock herself, and her company has no business ties to either company.

Hospital Markets

Community management plans to rely on a disciplined spending approach -- while capitalizing on Triad's past investments -- to bring margin improvements instead.

But Community could find it harder to raise Triad's margins than it thinks. Last year, Triad posted net revenue of $5.5 billion and EBITDA of $694 million. Of its 53 hospitals, those in a single market -- Indiana -- generated a whopping 55% of its EBITDA. Meanwhile, hospitals in three other major markets -- Texas, Alabama and Arkansas -- contributed little or no EBITDA at all. All three are considered extremely tough markets struggling with high numbers of uninsured patients.

Based on those figures, experts say, Triad enjoys a 40% margin in Indiana but suffers from a combined 0% margin in its three other major markets. Thus, they add, the rest of Triad's hospitals have been posting a combined margin of 12% -- well below the 17% margin boasted by Community's similarly sized hospitals and the company's target for Triad's lagging operations as well.

Yet, realistically, those experts question whether such improvements can be found.

"Getting Indiana above 40% is not going to happen," the hospital insider says. Meanwhile, "Community's assertion of getting the non-Indiana hospitals to increase their EBITDA margins by 17% on the Texas-Alabama-Arkansas

hospitals and 5% on the 'all-other' bucket is ludicrous.

"That would be 78% growth in same-store EBITDA on the non-Indiana group. Where will this possibly come from?"

Surgical Cuts

Cost cuts could be tough.

With 46 million Americans now lacking health insurance -- and the number continuing to rise -- Community cannot rely on improvements in bad debt expense to help out. But even reductions in some "controllable" expenses could prove elusive as well.

Granted, Community could slash staff at Triad operations. But Triad's current labor costs, as a percentage of revenue, hover barely above Community's own. Thus, supply costs -- which differ far more -- could be viewed as the bigger opportunity.

Yet Skolnick disagrees.

"Supply costs are 12% at Community, vs. 17% for every urban provider --


(THC) - Get Tenet Healthcare Corporation Report

, HCA, Triad -- because of the difference in mix," she says. "Even



are higher. So that's 500 basis points of margin that can't be improved unless you change the mix of services."

To some, however, that option looks irresponsible if not downright impossible. Importantly, they say, Triad has been pouring money into high-acuity programs that should soon start paying off. Moreover, they add, Triad invested in those services because patients in the company's small-city markets demand them.

Ultimately, Skolnick says, "I maintain my view that there is a very real risk that the only way that Triad margin's go postdeal is down."

Second Opinion

To be fair, Community management has won over many analysts who -- based on the company's strong track record -- expect the deal to succeed. Jeff Villwock, a managing partner of Genesis Capital with no position in either company's stock, believes that the math makes sense.

This year, Villwock predicts, the combined company will grow net revenue by 6% and possibly even more. Meanwhile, Villwock feels certain that the company can achieve far greater synergies than it has promised.

"Almost every deal ever done got 2% of net revenue in savings," he explains. So "the $40 million synergy number is much too low."

Villwock himself believes that Community will enjoy $85 million in synergies the first year and another $75 million the next. But even if Community simply hits its synergy target, he says, the company needs to boost total margins by just 0.2% to make its EBITDA really grow.

Specifically, Villwock foresees Community growing its EBITDA from a pro forma figure of $1.44 billion in 2006 to $1.55 billion in 2007 and $1.66 billion in 2008. Still, even Villwock comes up with years of negative cash flow in the end.

He sounds unconcerned, however. If necessary, he feels that the company could sell a few hospitals or office buildings -- or a variety of assets -- to cover any shortfalls.

"If Community can get the margin expansion they expect, then these numbers are quite conservative and cash flow would be positive," he says. "Even with the numbers above,

earnings per share goes higher than currently expected, and the stock goes up."

Villwock, for one, has faith that Community -- under the leadership of accomplished CEO Wayne Smith -- can pull the merger off.

"He has tremendous experience," Villwock says. Moreover, "I expect that the future cap ex will ultimately be less than modeled above

and cash flows will be greater."

Ultimately, he concludes, "this deal does work."