June 24, 2013 11:10 pm

Tenet / Vanguard: healthy debt

Leverage is unhealthy, but scale is the cure

Everybody dies. All but the lucky get sick first. This helps explain how Tenet Healthcare, already waddling around with net debt of more than four times its earnings before interest, tax, depreciation and amortisation, can blithely pay cash for Vanguard Health, another hospital operator itself labouring under a debt ratio of over 4 times. Tenet not only secured financing for the $4.3bn deal – the combined company will have a debt ratio well above 5 – but its shares rose 4 per cent on the announcement.

Even when times are tough, hospitals have customers, and while those customers sometimes cannot pay, cash flows are steady enough to support heavy debt. In 2008, for example, admissions at Tenet hospitals barely grew, provisions for bad debt rose at twice the rate of revenue and operating cash flow fell by a third, yet it could still carry a debt ratio as high as today’s. Yes, shares dropped below $5. The word “bankruptcy” came up. But cash flow stayed positive, profitability increased over the following years, and the shares go for $44 today.

Obamacare will lighten the bad debt burden for hospitals, but it will also mean tough pricing negotiations with government payers. However that balance is struck, Tenet’s deal has another appeal: running hospitals is a scale business. Size matters in purchasing, back-office systems and in negotiating with health insurers. HCA, the largest US operator, runs 162 hospitals to Tenet’s 51 and Vanguard’s 28, and will have revenues more than twice that of the combined company. Its return on invested capital is roughly double that of Tenet or Vanguard. That is surely why Tenet’s management has said it expects to stay acquisitive after this purchase. Tenet’s debt is going to remain high – frighteningly so if there should be another economic downturn. If that makes investors feel ill, they belong in a different stock.

Email the Lex team in confidence at lex@ft.com

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