Description

Tenet Healthcare Corporation (“THC” or the “Company”) operates general acute care hospitals in the United States. THC is a company that is in the midst of a multi-year operational turnaround.  Tenet’s decline began with a host of medical malpractice, legal and regulatory issues that first surfaced in 2003 and sent its shares into a downward spiral.  To make matters worse, Hurricane Katrina destroyed most of Tenet’s hospitals in Louisiana in 2005, resulting in a large and permanent impairment to its operating earnings base.  Tenet’s stock price suffered even more during the summer of 2007 when a combination of industry headwinds (rising bad debt expense and weak admissions trends), poor operating results and accompanying negative sell-side analyst coverage caused a significant sell-off in the Company’s shares. 

Tenet’s management team has acted to settle substantially all legal issues with the government, exit unprofitable facilities, reinvest capital in its remaining core markets, cut operating costs, bolster its regional management talent, and increase its focus on physician retention and relationships to increase referral volumes.  Although management has expressed a high degree of conviction in their turnaround plan, Wall Street, for the most part, has been very skeptical and the majority of sell-side analysts maintain a fairly negative view of the Company.  As of September 23^rd, 2008, there were 3 Buy recommendations on the stock, 11 Holds and 7 Under-performs or Sells.  While the Company has guided to 2009 EBITDA of $1.0 billion, 2009 consensus EBITDA is only $865mm.

Tenet does not look cheap on trailing twelve month earnings multiples as a result of the significant margin compression the Company has experienced during its years of legal and operational turbulence.  However, we believe the business is poised to recover strongly over the coming quarters and years as management has implemented a significant turnaround plan.  Given the compressed margins, we believe THC’s valuation looks very attractive compared to its peers on a number of other valuation metrics, which we present below:

Enterprise Value / LTM Revenue

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CYH                1.12x

UHS                0.87x

HMA               0.98x

LPNT              1.23x

Median 1.05x

THC                0.74x

Enterprise Value / Non-Cash Tangible Assets

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CYH                1.35x

UHS                1.46x

HMA               1.24x

LPNT              1.64x

Median 1.40x

THC                0.94x

Enterprise Value / Bed ($000s)

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CYH                $670

HMA               $537

LPNT              $587

Median $587

THC                $467

It is worth noting that new hospitals today cost approximately $1mm per bed to construct; therefore Tenet is trading at about a 55% discount to replacement cost.  It is also worth noting that when HCA was bought out, the EV / Revenue, EV / EBITDA, EV / Bed, and EV / Non-Cash Tangible Assets multiples were 1.28x, 8.3x, $776, and 1.68x, respectively.

If Tenet were to trade at multiples similar to its peers on the above metrics, the stock would be worth between $9 and $13 per share or at least 40% upside from current levels.  Moreover, given the relatively defensive characteristics of the hospital industry, we believe Tenet is an ideal equity to hold in today’s turbulent markets.

Of course, we recognize that the key to THC’s success is a recovery in EBITDA margins.  THC’s results were hurt during its legal battles as patient volumes declined precipitously and facility utilization levels dropped off.  Moreover, managed care providers squeezed Tenet on pricing contracts further pressuring margins.  In the LTM period, THC’s EBITDA margin as a % of “Net Net” Revenue** was 9.0%.  This compares to its peers 5-year average margins as follows:

5-Year Average EBITDA Margins % of “Net Net” Revenue**

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CYH                16.1%

UHS                14.8%              (Acute Care Only)

HMA               21.7%

LPNT              21.2%

HCA                18.2%

Median 18.2%

Tenet LTM       9.0%

** Note: we calculate margins as a % of revenues after deducting provisions for doubtful accounts.  Industry convention is to report revenue before such expense, but due to different pricing and reserving policies amongst various companies, results are more comparable after deducting such expense from revenue to approximate “cash” revenue or “Net Net” revenue.

Clearly, THC is underperforming its asset potential and has plenty of room to improve these margins; we believe they will do so for a number of reasons.  Having settled all significant outstanding litigation, management is now focused on operational results.  Management has had a laser focus on delivering the best possible quality of care at its facilities and THC now ranks among the top hospital chains in the country for quality of care as rated by Medicare.  After cutting back on CapEx for years the Company spent significant capital in 2007 reinvesting in state-of-the art equipment.  These actions have allowed THC to renegotiate its pricing contracts with large managed care payers on more favorable terms which will provide a tailwind to THC’s revenue and margin growth.  The Company has also renewed efforts to add physicians to its medical staffs after years of relative inactivity due to the Company’s legal problems.  As the Company adds physicians to its staff, those physicians bring new patients to THC facilities thereby driving volume, revenue and earnings growth.  We note that pricing and volume growth benefit Tenet at high incremental margins given the relatively high fixed cost nature of the hospital business.

If Tenet succeeds in achieving margins similar to its peers, the implications for its equity holders is significant.  THC’s peer group currently trades at approximately 7.5x LTM EBITDA which is below the 15-year median of 8.6x.  Assuming THC could trade at an 8.0x EBITDA multiple, there is significant upside to the shares:

Margin             EBITDA          Share Price**

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12%                 $9.7B               $8.50

14%                 $1.1B               $11.25

16%                 $1.3B               $14.00

18%                 $1.5B               $16.75

** Note: based on TTM Net Net revenue of $8.1 billion.  Margin presented as a % of Net Net revenue.  Includes estimated divestiture proceeds of approximately $660mm expected to be closed in next 18 months.

The Bears point out THC’s negative free cash flow and high debt levels as a reason to stay out of the name.  We acknowledge that achievement of real free cash flow will be necessary for a successful turnaround, but if the Company achieves the EBITDA levels we describe above, there will be significant free cash flow that accrues to equity holders.  THC has roughly $400mm in annual interest expense obligations and $600 to $700mm in annual CapEx needs for total fixed charges of $1.0 to $1.1B.  THC has a substantial NOL position which means that it will not have cash tax obligations for a number of years and any EBITDA in excess of its fixed charges accrues to equity holders.  Tenet’s debt is substantially all senior subordinated notes, with no maturities until the end of 2011 which gives the Company plenty of time to execute its turnaround.  The Company also has a large, undrawn revolver that is secured by receivables and has no material operating covenants which can fund liquidity if need be. 

To further enhance Tenet’s liquidity situation, the Company has embarked on a series of asset sales that are expected to raise between $750mm and $950mm through the end of 2009.  The announced sale of three hospitals thus far in 2008 will yield approximately $370mm in cash proceeds, while the recent sale of Tenet’s minority interest in Broadlane (a group purchasing organization) yielded $144mm in cash proceeds (plus another $16mm in consideration placed in escrow) for total year-to-date proceeds of $515mm.  The Company is also in the process of selling a portfolio of 31 medical office buildings with over 2.4mm square feet of medical office buildings which do not currently contribute significantly to EBITDA.  Assuming a conservative valuation of $100 per square foot, these properties could easily be worth $250mm, which makes the low end of Tenet’s expected range of $750 to $950mm easily achievable.  While Tenet estimates that these asset sales will reduce annual EBITDA by approximately $50mm, the combined effect from eliminated CapEx, reduction of net interest expense, and other cash items would result in $80mm of annual cash savings resulting in a $30mm net positive benefit to operating cash flow.

Tenet’s turnaround is well underway.  During the Company’s second quarter earnings call, the THC announced positive comparable facility volume growth of 3.2%, a remarkably resilient figure considering the tremendously challenging period from which Tenet is beginning to emerge.  We nonetheless believe that estimates for THC remain too low and that the Company will continue to outperform expectations.

Catalyst