Price Cuts Are Hammering Hospitals

The health care sector could face another year of pain.

Already, financial experts have kicked off 2005 by warning that current wounds -- especially for hospital companies -- may continue to fester. Piper Jaffray analyst Darren Lehrich on Tuesday downgraded the nation's two largest for-profit hospital chains, HCA ( HCA) and Tenet ( THC), due to both industry and company-specific concerns.

Lehrich worries that "two critical issues" -- politics and pricing -- could wound the hospital sector in the future. He warns that Congress may cut back on both Medicare and Medicaid spending in an effort to balance the budget. Meanwhile, he says, private insurance companies may also scale down their payments as they grow more powerful through consolidation and begin rolling out high-deductible consumer-driven health plans.

Even now, Lehrich notes, hospitals are already hurting. He points out that patient volumes have softened, bad debt expense has worsened and competition has heightened over time. Going forward, he believes that even industry leader HCA faces clear challenges as a result.

"While we continue to view HCA as having some of the best-positioned acute-care assets in the industry, we simply believe stiffer competition in several of its faster-growing, higher-profit markets will make it difficult for HCA to produce meaningful upside," Lehrich wrote on Tuesday.

Lehrich cut HCA from outperform to market perform and introduced a new target price of $43 for the stock. Shares of HCA slipped 39 cents to $39.65 after the downgrade.

Still, Lehrich clearly views Tenet -- which has spent more than two years in intensive care -- as the far sicker patient. After reviewing the company's vital signs, he decided that Tenet is even weaker than he once thought.

When downgrading the company's stock from market perform to underperform on Tuesday, Lehrich warned that Tenet could face "an extremely challenging 12 to 18 months." Moreover, he also questioned whether the company will ever recover enough to deliver the kind of margins he once expected.

Lehrich sees the company tending to multiple wounds. For starters, he says, Tenet must regain the confidence of referring physicians and the trust of those who pay for its hospital services. Meanwhile, he says, the company must rationalize its cost structure in order to adjust to a loss of market share. Looking ahead, he adds, the company will continue to face "meaningful competitive threats" from both physician-owned facilities and well-capitalized not-for-profit health systems in some of its core markets.

Tenet has come under scrutiny for its financial arrangements with physicians and its aggressive pricing strategies of the past. The company remains under investigation by multiple government agencies.

The Tenet Shareholder Committee, a group long critical of management, has expressed "grave doubts about whether there will be a future" for the company at all.

Already, Tenet has shed dozens of hospitals in an attempt to recover and move on. But the shareholder committee questions the strength of Tenet's remaining "core" hospitals as well. In commentary published late last month, the committee noted that Tenet itself has acknowledged that 29 of its 69 core hospitals have either low or negative margins. The committee singles out one Florida hospital -- which it attempted to buy -- as an example.

The committee portrays North Ridge Medical Center, located in Tenet's crucial Florida market, as a "wasting asset" that the company probably can't repair.

"Given the damage already done, the promises made locally and not fulfilled, the business strategy best characterized as 'all earnings out and little or nothing in,' the loss of doctors and nurses, the loss of morale and increasing competition, it is hard -- if not impossible -- to imagine Tenet in the role of slum landlord who suddenly found religion," the committee wrote. "The more likely outcome is a continued decline, leading eventually to the kind of 'give-away' that is occurring with many of the 27 hospitals in the company's current divesture program."

The committee goes on to claim that its chairman, M. Lee Pearce, offered $323,000 per bed for the facility -- nearly three times what Tenet has collected in other sales -- but got "angrily rejected ... without due consideration." For its part, Tenet has questioned Pearce's motives in the past.

Still, the committee has correctly warned of trouble before. And it remains convinced that Tenet must eventually sell more -- perhaps nearly 20 -- of its hospitals in order to survive.

By now, however, Tenet has grown immune to dark forecasts. The company's stock slipped just 5 cents to $10.66 after Tuesday's downgrade.

Meanwhile, Express Scripts ( ESRX) actually rose 27 cents to $76.29 despite a downgrade of its own. AG Edwards analyst Andrew Speller cut the stock from buy to hold due to its rising valuation. He also voiced concerns about the company's slowing profit growth and litigation exposure.

Express Scripts has attracted scrutiny from New York Attorney General Eliot Spitzer for allegedly overcharging state customers. The company's two larger peers, Medco ( MHS) and Caremark ( CMX), face government probes as well.

Gimme Credit analyst Carol Levenson sees "fear factors" -- including regulatory issues -- across the health care industry as a whole. To be fair, she still sees strength in the sector's fundamentals. But she worries about negative headlines and potentially severe legal exposure.

"The biggest 'con' in this sector is the ever-present threat of legal liabilities, which can tempt the management of even a solvent company to consider bankruptcy," Levenson wrote. And "we expect to see further negative market reaction to industry risks this year."

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