Investing in health care - Personal Finance - Statistical Data Included - Industry Overview

Healthcare Financial Management, Sept, 2002 by Craig Conti, Steven Elek, III

Over the past seven years, the healthcare sector has experienced higher average returns than nearly every other industry sector followed by Standard & Poors (S&P). During this time, the S&P Healthcare Price Index increased, on average, 14.9 percent per year compared with an 8.9 percent per year average increase in the S&P 500 Index. Only the S&P Financials Index was slightly higher. Even given the market volatility and drop in index values over the past year, the S&P Healthcare Price Index has outperformed the S&P 500 Index by nearly five percentage points, or about 25 percent. (a) Add in strong growth and earnings trends, and the result is numerous opportunities for investors who understand health care's complexities and can navigate its somewhat circuitous terrain.

Current State of Health Care

According to estimates from the Centers for Medicare and Medicaid Services, annual healthcare spending increased an average 8.3 percent during the past two years, and should grow 7.3 percent annually through 2011. (b) This means that healthcare spending, the third largest component of the U.S. gross domestic product (after government and real estate), will reach $2.8 trillion in 2011. Higher prices and fees--especially for prescription drugs, medical devices, and medical services--and aging baby boomers are fueling growth. The Census Bureau estimates that the population 65 years of age or older will increase 50 percent over the next 20 years. (c)

Earnings estimates also are strong. Goldman Sachs projects long-term annual growth rates will be 15 to 25 percent for hospitals, 25 percent for clinical laboratories, 14 percent for medical devices, and 10 percent for pharmaceuticals. (d) Compare these rates with the 8 percent long-term earnings growth Goldman estimates for the S&P 500, and it is easy to see why the sector has investor appeal.

Another attractive feature for investors is the industry's level of merger and acquisition and initial public offering (IPO) activity. Although healthcare consolidation slowed in 2001, the industry still ranked fifth in the number of deals announced in 2001 and through June 30, 2002, according to Bloomberg, LP. (e) Merger and acquisition activity in the industry for the second quarter of 2002 totaled 238 deals as compared with 207 deals in the 2002 first quarter (up 15 percent), and 213 deals in the first quarter of 2001 (up 12 percent), according to Irving Levin Associates, Inc. (f) In terms of the number of transactions, long-term and home health transactions showed healthy increases, while hospital, laboratory, medical device, and pharmaceutical transactions continued at a steady pace. Efforts to rationalize cost structures continue to fuel mergers and acquisitions among hospitals, laboratories, and MRI and dialysis centers; and a desire to build volume and broaden product lines fed the consolidation amon g medical device manufacturers.

Healthcare IPOs held up fairly well in an otherwise slow market. Healthcare issues constituted 20 percent of total IPOs during 2001, although falling to 11 percent through June 30, 2002. (g)

In short, the prospect of long-term revenue and earnings growth coupled with the perception that the healthcare sector has greater stability than many other industry sectors continues to attract investors. However, because health care is so significant to our economy and directly affects everyone's physical well-being, prospective investors must thoroughly understand the sector's unique set of legal and regulatory issues to maximize returns.

Healthcare Due Diligence

Thorough due diligence on an acquisition candidate not only helps identify risks, but also provides information investors can use to structure and negotiate the transaction and set integration priorities. Standard diligence procedures (eg, assessing strategic fit; analyzing the quality of revenue, earnings, and assets; determining working capital and cash-flow levels; identifying unrecorded and under-recorded liabilities; and identifying tax exposures) are relevant in assessing healthcare businesses. However, diligence on an investment in health care also must focus on certain aspects unique to the industry, including the payer mix, incurred-but-not-reported (IBNR) claims, research and development (R&D), the Health Insurance Portability and Accountability Act (HIPAA), and regulatory compliance.

Payer mix. Payer mix is important to assess because some payers tend to pay at higher levels than do others. The payer mix of a typical for-profit hospital might be 30 to 40 percent Medicare, 30 to 40 percent managed care, 20 to 40 percent commercial insurance and private pay, and 5 to 15 percent Medicaid.

Any trends or shifts in a provider's payer mix uncovered during diligence should be analyzed for their impact on revenue and receivables. Red flags that could indicate increased risk include a shift toward payers that make smaller payments, such as managed care or Medicaid, or too much revenue from a single individual or payer segment. Familiarity with how payers and their payment practices vary by geographic area also is essential in identifying risks. Once identified, payer-mix trends should be worked into forecasts and valuation models.