Hospital Corporation of America (HCA) -An LBO Story

Group 10
EPGDIB 2011 - 2013

AJAY GUPTA (ROLL NO 05) HARSH GOEL (ROLL NO 30) KUNAL VERMA (ROLL NO 37) SURESH MEHRA (ROLL NO 69)

About HCA
The buyout of HCA in 2006 by a group of private investors took it from public to private for the 2nd time. At nearly $33 billion, the buyout was the largest on records. The exercise can be quite painstaking for such a large corporation because of the debt capital requirement, and neverthelessthe risk of a hostile takeover, even though it reduces the complexity of operating a public company. But HCA already had the experience of an MBO in 1988. It remained private from 1988-1992. HCA (formerly, Hospital Corporation of America) was founded by physicians Dr. Thomas Frist, (his son) Dr. Thomas Frist Junior along with Jack C Massey in 1968 in Nashville, Tennessee. It was one of the first hospital management companies in the US and it grew rapidly. The founders activated economies of scale and brought many new business practices to improve quality and reduce costs. In 1969, the company went public. It grew rapidly in the 1970s and 80s, through a series of acquisitions of hospitals and other similar companies. But the economic slump of the late 1980s made it re-look its operations. The board concurred that the Companys true value was not reflected in its share price, and decided to buy-back the shares. The company remained closely held till 1992, when it again went public. Thereafter, in 1994 HCA merged with Columbia Hospital Corporation, and Richard Scott, the then CEO of Columbia became the CEO and Chairman of the new companyColumbia/HCA. However, in 1997, fraudulent billing charges were pressed against the company, which led to heavy costs over the next decade of investigations. Scott was removed and Dr. Frist Jr. took over as the new CEO. He quickly brought to fore, his intentions of concentrating on high end healthcare in urban areas with high volumes, through a series of restructuring measures, mainly through selloffs of non-hospital businesses, low growth hospitals etc. as well as new investments in equipment and facilities. This led to huge variations in the companys operating profits. Also, the emergency room visits by uninsured patients had increased steeply between 2000 and 2005.

Also, the industry had sluggish growth and lot of restructuring in 1990s and 2000s. All these factors led to low wall-street confidence bearing the stocks down, and relatively flat profit margins and EBIDTA.

Despite all these problems, HCAs management knew that it was in an industry of bright future, since healthcare spending per capita was only on the rise. Also, it thought that it was well placed with the right focus at the right time, being an industry leader in terms of size and revenue. By December 2005, HCA had revenues of $ 24 billion and 191,000 employees. Thus, it was thought by the management that the market did not appreciate the true value of HCA. Thoughts of going private once again were doing the rounds in 2005. The company went on to acquire around 100 million shares from November 2004 to June 2006 in a series of auction tenders offers. It was also a time when private equity firms were actively looking for opportunities in healthcare. Table 1 shows the data of acquisitions from 2000 to 2009.
Table 1: Hospital Mergers and Acquisitions, 2000 to 2009
Hospital Mergers and Acquisitions, 2000 to 2009 Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Tota l 597 $74,288,939,100 Number of Deals Dollars Committed 85 82 56 37 59 50 55 61 60 52 $3,773,440,000 $3,108,119,143 $3,403,681,000 $2,341,550,000 $9,706,390,279 $2,905,728,676 $35,533,500,001 $9,257,130,001 $2,580,600,000 $1,678,800,000

The Deal
On July 4, 2006, HCA announced that it will go private in a massive $33 billion buyout led by Bain Capital, Kohlberg Kravis & Roberts, and Merrill Lynch. The following extract of a CNN news article from July 2006 tells the story in numbers: Hospital owner HCA agreed Monday to a $21 billion leveraged buyout, plus the assumption of debt, by a group that includes private equity firms as well as the company's founding family and members of management. Under the deal, HCA stockholders will receive $51 in cash, a premium of 6.5 percent from Friday's closing price, and below the price at which the stock traded in late 2005 and early 2006. The purchase also includes the assumption of $11.7 billion in debt. Shares had shot up in heavy trading on July 20, the day after the Wall Street Journal reported that there had been negotiations of an LBO, but that the deal had fallen apart in a disagreement over price. The $51 purchase price is a nearly 17 percent rise from its July 19 closing price. Shares of HCA opened at $49.80 Monday following the announcement. However, what was really interesting in the deal was the big bet that the buyers made on the business model and future of HCA. The shares were undervalued because of its recent (several years) lackluster performance. While, this could be attributed to the industrys and HCAs turbulence, rising costs with little pricing power etc. But a frequent argument was that with Americas ageing population and rising baby boomer hospital admissions, the short term forecast was great. And medical care was an essential service, with increasing political prominence in a mature consumer economy. Therefore, Government spending was expected to rise placing better pricing power in the hands of hospital companies. In addition, Hospitals also had been able to increasingly sell lifestyle services such as surgeries for cosmetic enhancements of body/ looks. HCA was well placed here also with its focus on urban hospitals.

Now, if we revisit, HCA, a firm founded by the family of the Republican Senate majority leader, Bain, a firm whose founders include Massachusetts governor and GOP presidential aspirant Mitt Romney, and KKR, a firm run by Henry Kravis, a major Republican donor, are betting on the continued expansion of government. HCA's sale is essentially a $33 billion investment in the idea that government will take an even bigger role in health care. In addition to the $5.3 billion of equity from the buyout group, the new firm would raise an additional $20.3 billion through new bank loans and the sale of bonds (as shown in Exhibit 3). The new HCA corporate entity would assume certain HCA bonds with a principal amount of $7.71 billion. These bonds would remain outstanding after the buyout. Exhibit 4 shows the overall capital structure with $28 billion (84%) debt and 5.3 billion (16%) equity.

Exhibit1:

Exhibit2:

Exhibit3:

Exhibit4:

Exhibit5:

Analysis 1. Recent performance

From Exhibits1 and 2:

1) The overall picture at HCA is a discouraging one. Revenue growth has slowed dramatically in the past 5 years 2) Return on equity rose in 2004, because equity dropped due to repeated large stock buybacks. 3) Return on assets has been up and down, but most recently has fallen 4) Financial leverage has generally increased, with debt growing fast while equity does not grow 5) In general, the performance has been lackluster. Operations have slumped, masked by rising leverage.

2. Optimal Capitalization
1996 Revenues Operating expenses EBIT EBIT margin Net income Net profit margin 18,786 15,888 2,898 15.4% 1,461 7.8% 1997 18,819 17,274 1,545 8.2% 182 1.0% 1998 18,681 17,172 1,509 8.1% 532 2.8% 1999 16,657 14,953 1,704 10.2% 657 3.9% 2000 16,670 14,652 2,018 12.1% 292 1.8% 2001 17,953 15,801 2,152 12.0% 886 4.9% 2002 19,729 17,042 2,687 13.6% 833 4.2% 2003 21,808 19,199 2,609 12.0% 1,332 6.1% 2004 23,502 20,980 2,522 10.7% 1,246 5.3% 2005 24,455 21,772 2,683 11.0% 1,424 5.8%

1) Operating margins dropped in 1997-99 but have stabilized considerably in the past six years 2) The litigation settlements and restructuring costs would be non-operating items, so do not affect EBIT margin 3) EBIT margin however may be affected by excess capacity and bad debt experience.

3. HCA Projections for Valuation

Calculation of Free Cash Flow:
Sales growth INCOME STATEMENT ($ in millions except per share amounts) Revenue () Operating expenses (excluding depreciation) () Depreciation (+) Other operating income EBIT (+) Non-operating income (net) Income before income taxes Provision for income taxes (c) Net income EBIT margin Other data: Capital expenditures Reduction in deferred taxes ASSETS Current assets Property and equipment, at cost: Accumulated depreciation Net property and equipment Other fixed assets Total assets LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities Other liabilities Deferred income taxes Stockholders equity Total liabilities and stockholder equity Cash needs Annual cash needs Free cash flow Working capital Net income Depreciation Change in deferred taxes Change in working capital Capital expenditure Free cash flow 7.4% 7.1% 7.0% 7.1% 7.2% 6.6% 6.2% 6.0% 5.5% 5.0% 5.0%

2006E (b) 25,199 21,249 1,393 40 2,597 139 2,736 1,026 1,710 10.3%

Projected Fiscal Year Ending December 31, 2007 2008 2009 2010 27,071 28,995 31,027 33,215 23,029 24,783 26,633 28,588 1,446 1,538 1,632 1,734 53 60 66 74 2,649 2,734 2,828 2,967 50 50 50 50 2,699 2,784 2,878 3,017 1,012 1,044 1,079 1,131 1,687 1,740 1,799 1,886 9.8% 9.4% 9.1% 8.9%

2011 35,602 30,733 1,842 81 3,108 50 3,158 1,184 1,974 8.7%

2012 37,952 32,761 1,964 86 3,313 50 3,363 1,261 2,102 8.7%

2013 40,305 34,793 2,085 92 3,519 50 3,569 1,338 2,230 8.7%

2014 42,723 36,880 2,210 97 3,730 50 3,780 1,417 2,362 8.7%

2015 45,073 38,909 2,332 103 3,935 50 3,985 1,494 2,490 8.7%

2016 47,326 40,854 2,449 108 4,132 50 4,182 1,568 2,613 8.7%

2017 49,693 42,897 2,571 113 4,338 50 4,388 1,646 2,743 8.7%

grows with sales grows with sales grows with sales unrelated - doesn't grow 37.5% rate

1,779 #N/A

1,800 100

1,500 100

1,500 100

1,500 100

1,500 100

1,964 100

2,085 100

2,893 0

2,995 0

3,085 0

3,239 PPE at cost 0 Decline stops

5,867 22,597 10,832 11,765 5,691 23,323

6,303 24,397 12,278 12,119 5,691 24,113

6,751 25,897 13,816 12,081 5,691 24,523

7,224 27,397 15,448 11,949 5,691 24,864

7,733 28,897 17,182 11,715 5,691 25,140

8,289 30,397 19,024 11,373 5,691 25,353

8,836 32,361 20,988 11,373 5,691 25,900

9,384 34,446 23,073 11,373 5,691 26,448

9,947 37,339 25,283 12,055 5,691 27,694

10,494 40,334 27,615 12,718 5,691 28,904

11,019 43,418 30,064 13,354 5,691 30,064

11,570 46,657 32,635 14,022 5,691 31,283

grows with sales Net PPE + accum. depr. previous + depreciation grows with sales flat

3,279 2,499 1,145 5,170 12,093 11,230

3,522 2,499 1,045 6,857 13,924 10,190 -1,041 1,041 2,780 1,687 1,446 100 192 1,800 1,041

3,773 2,499 945 8,597 15,814 8,709 -1,480 1,480 2,978 1,740 1,538 100 198 1,500 1,480

4,037 2,499 845 10,396 17,777 7,087 -1,622 1,622 3,187 1,799 1,632 100 209 1,500 1,622

4,322 2,499 745 12,281 19,847 5,292 -1,795 1,795 3,411 1,886 1,734 100 225 1,500 1,795

4,633 2,499 645 14,255 22,032 3,322 -1,971 1,971 3,656 1,974 1,842 100 245 1,500 1,971

4,938 2,499 545 16,357 24,339 1,561 -1,761 1,761 3,898 2,102 1,964 100 241 1,964 1,761

5,244 2,499 445 18,587 26,776 -328 -1,889 1,889 4,139 2,230 2,085 100 242 2,085 1,889

5,559 2,499 471 20,950 29,480 -1,786 -1,458 1,458 4,388 2,362 2,210 -27 248 2,893 1,458

5,865 2,499 497 23,440 32,302 -3,398 -1,612 1,612 4,629 2,490 2,332 -26 241 2,995 1,612

6,158 2,499 522 26,053 35,233 -5,169 -1,771 1,771 4,861 2,613 2,449 -25 231 3,085 1,771

6,466 2,499 548 28,796 38,310 -7,027 -1,858 1,858 5,104 2,743 2,571 -26 243 3,239 1,858

grows with sales flat grows with sales after 2013 previous + net inc.

2,588 1,710 1,393

Calculation of Cost Capital:

Comparable companies: ----------------------------------------- in millions ------------------------------------------------------Common Estimated Short-Term Long-Term Shareholders Shares Estimated 2006 Company Equity Beta Debt Debt Equity Outstanding 2006 Sales Interest CVH 1.10 10 761 2,555 162.7 6,611 54 HUM 1.05 561 514 2,474 163.2 14,418 78 THC 1.00 19 4,784 1,021 469.7 9,614 408 TRI 0.60 8 1,696 2,928 86.4 4,747 136 UHS 0.65 5 638 1,205 53.9 3,936 48 WLP 0.80 481 6,325 24,993 660.4 44,513 493 ----------per share---------Estimated 2006 Earnings Stock Price 3.48 52.20 2.80 49.41 0.15 7.32 Comparable to HCA 2.85 38.23 Comparable to HCA 2.70 49.45 Comparable to HCA 4.60 69.82

Company CVH HUM THC TRI UHS WLP

Equity at Market 8,493 8,064 3,438 3,303 2,665 46,109

Debt / Equity 0.091 0.133 1.397 0.516 0.241 0.148

Unlevered Comparable Beta to HCA? 1.009 No 0.927 No 0.417 Yes 0.396 Yes 0.524 Yes 0.697 No 0.446

Estimated 2006 Net Income 566 457 70 246 146 3,038

Estimated 2006 EBIT 960 809 521 530 281 5,354

Net Operating Profit 600 506 326 331 176 3,346

Estimated Tax Shield 289 403 1,801 639 241 2,552

Unlevered Market Value 8,975 8,735 6,440 4,368 3,067 50,363

Unlevered Unlevered P/E Ratio Price/Book 15.0 2.70 17.3 2.46 19.8 1.11 13.2 0.94 17.5 1.66 15.1 1.58 16.8 1.24

Mean unlevered beta: Return on HCA debt at optimal capitalization = kD = Relevered beta at optimal capitalization Riskfree rate Equity risk premium Cost of equity k E = Weighted average cost of capital WACC = 8.27% 5.17% 0.678 5.22% 5.00% 8.61% 7.43%

Terminal Value:
Perpetual growth formula Comparables: By price/earnings ratio By price/book ratio 76,445 29.3 times 2016 earnings.

43,921 32,208

Perpetual growth formula= Free Cash Flow of 2017/ (WACC-Sales Growth) = 1858/ (7.43%-5%) =76445

Valuation:
Free cash flows Terminal value based on comparables Total 1,041 1,041 1,480 1,480 1,622 1,622 1,795 1,795 1,971 1,971 1,761 1,761 Shares 415.098 1,889 1,889 1,458 1,458 1,612 1,612 1,771 43,921 45,692 1,858

Value of debt and equity Less existing debt = Value of existing equity

32,554 11,230 21,324

Existing offer for HCA: Purchase price of common stock21,170 Refinance existing debt 3,520 Roll-over of existing bonds 7,710 Fees & expenses 910 Total uses 33,310

Our valuation is slightly below the existing offer