Description

Community Health Systems - CYH

CYH presents a highly skewed return opportunity, with over 200% upside if the company can get a handle on a recent spike in labor costs in the next few years before running into funding issues, or 100% downside should they fail at this, and slide into bankruptcy, with the company’s heavy debt burden. There are reasons to believe that the odds of the former are greater than the latter, and hence I find it an attractive, option-like investment opportunity.

Background:

CYH runs the 9th largest hospital system in America, with 83 hospitals, 13,000 beds, and 1,000 outpatient facilities in 16 states, and is the 3rd largest publicly traded hospital company, after industry leader HCA Healthcare (also long, but not the extreme deep value turnaround that CYH is) and Universal Health Services.

CYH’s strategy (like HCA’s) is to develop strong local market shares and dense networks in the markets it operates, which gives greater negotiating leverage with the primary healthcare payors, and thus better returns. In addition, it has focused its footprint in regions in the Southeast and Southwest with attractive demographic growth characteristics versus the rest of the United States. This approach has delivered reasonably consistent EBITDA margins that have averaged 15% over the past 20 years (about 5 percentage points lower than HCA, which is a much higher quality company with significantly greater advantages to scale). Consistency in margins for the large public hospital systems is largely structural and driven by payer mix. With over 60% of revenues coming from managed care organizations (vs. 35% from Medicaid or Medicare), CYH is able to pass on changes in healthcare cost on a frequent basis when its contracts renew, or it can seek to renegotiate these contracts before renewal, when necessary. This only works when the hospital company has sufficient local density to give it leverage with the large managed care payers.

Current situation:

Year-to-date, CYH’s stock is down nearly 80%, with the biggest drop coming after its Q2 results, when the company missed sales by 6%, and EBITDA by 43%, and cut 2022 sales 4%, and EBITDA guidance by 27% (implying EBITDA margins of 10.9% vs. 14.4% previously).

The primary reason for the disappointment and guidance cut is wage inflation and elevated contract labor costs which have impacted all the major hospital chains to varying degrees. Typically contract labor is 2-3% of CYH’s total labor cost, but in Q1 it reached 13% before falling to 10% in Q2 (while a sequential improvement, this was not as much of an improvement as expected).

CYH carries a heavy debt burden, with leverage of 7.1x net-debt-to-EBITDA. After the Q2 results, credit spreads blew out and the company’s senior secured now trades around 10% yield, with a B2 rating. With this leverage, if the company is *unable* to improve its cost situation or it can’t raise capital, it could easily default in the next 2-3 years.

Why I’m optimistic:

Despite the massive disappointment in Q2, trends are moving in the right direction. As noted above, contract labor fell from 13% to 10% of total labor costs from Q1, though the company was expecting an even greater improvement. The company also reported significant improvements in retention rates for its nurses, where turnover has been cut in half since the peak at the end of last year. Additionally, the company reiterated its view that total labor cost inflation will still be in the 4% range for full year 2022, a moderation from 8.5% last quarter. Longer term, the company has numerous initiatives to ameliorate its labor situation, including its partnership with a nursing college which is on track to graduate more than 1,000 nurses per year by 2023.

CYS is not alone in reporting improvements in the labor situation. HCA saw improvements in each month of Q2, with contract labor falling 22% from April to June. It also reported improvements in hiring and retention. UHS reported a similar drop in contract labor expense last quarter, and indicated it believes the trend will continue through the end of the year. More broadly, the KaufmanHall National Hospital Flash Report indicated similar, elevated but slightly improving cost trends.

While CYS’s leverage is high, its debt is covenant-light, and its nearest maturity is in 2026, giving it significant breathing room to reduce its elevated costs and pass on the costs it can’t cut to its primary payers. In addition to cash of $346 mm, the company has an untapped ABL facility of ~$900 mm, giving it about $1.2 bn in liquidity.

And despite the cut in guidance for the year, the company still expects to be slightly cash flow positive:

Longer-term, the company retains confidence in its targets, which are buoyed by solid demographic trends in its markets and sustained expected growth in national healthcare spending:

If the company can hit its medium-term goals, it’s got way more upside...

Upside/downside:

For the first half of 2022, consensus 2023 EPS estimates were in the $1.30-1.40 range (the stock is now at just $2.67!),  and for the first quarter, the stock traded from $10 to $14 dollars, or 7.5-11x 2023 earnings, which seems to be a reasonable and undemanding valuation for the company.

Today, the company trades at less than 0.03x 2023 sales (which are expected to grow almost 5%), 8.3x 2023 EBITDA, and about 17x 2023 EPS estimates, which remain deeply depressed from normal levels at $0.16. The consensus shows a partial return to normal levels in 2024, when estimates call for $0.75 in earnings (or a 3.6x PE multiple).

If the company can avoid a highly dilutive capital raise and a debt default in the next couple years – and the cash flow situation and improving cost situation suggest this is quite possible –  there’s little question in my mind that it can rebound to the $10+ range it traded at the beginning of the year, or at least 275% upside.

If the company actually succeeds in hitting its medium-term targets (see above), then it could see over $4 of earnings power by 2026, which at any reasonable multiple would represent a home run.

Based on the appearance of greenshoots in cost, hiring, and retention trends; positive cash flow and adequate time before debt maturities; a backdrop of steady expected growth in revenues; and a structural consistency to margins at the company and in the industry, I believe that it’s more likely that the company survives and rebounds to normal earnings power than that it defaults or is forced to wash out its equity.

Hence, I see greater likelihood of the upside scenarios which easily have more (or much more) than 200+% upside than I do for the downside scenario of a total loss to equity, and find this an attractive, higher risk, but extremely positively skewed bet for my portfolio.

Catalyst

Inflation pressure alleviating

Contract labor as a % of total labor declining

Continued improvement in nurse hiring and retention

Success passing on costs to MCOs