CYH - Community Health Systems: Anticipating Stagnating Growth Into FY 2023

Summary

• Healthcare providers have endured a spate of macro-level headwinds over the pandemic period.
• Added to that, many individual names have had to divest key operating assets to stabilize liquidity and sure up operating cash flow.
• Community Health Systems has faced similar issues, resulting in a negative rate of growth across the pandemic period to date.
• This adds to a near decade of pressure on its stock price.
• Net-net, we reiterate CYH is a hold.

Investment summary

Equity investors in Community Health Systems, Inc. ( CYH ) have endured a difficult period over several years. Despite catching a strong bid across the pandemic period, shares have pulled back to the long-term range after a large selloff last year (Exhibit 1).

Exhibit 1. CYH pulled back to the long-term range after catching a bid across the pandemic period

Moreover, investors have pushed up demand since October FY22, resulting in a snap-back rally off the stock's 52-week lows, where it has climbed ~58% over the past 6 months to the time of writing. However, this looks to be largely beta-driven (Exhibit 2), telling us there's nothing idiosyncratic about the rally. Moreover, it looks to have exhausted, with weekly outflows over the past 6 weeks increasing supply.

Exhibit 2. CYH rally is largely beta-driven

Exhibit 3. Weekly outflows from CYH equity over the past 6 weeks, exhausting upside, and increasing supply

We've covered CYH extensively in the past (see: here and also here ), and I'm back here today to outline in further detail why we believe investors should avoid the stock for the time being. Most specifically, profitability and growth are key issues, and the company is divesting key operating assets in order to maintain level operations. Net-net, reiterate hold.

CYH capital woes spell troubles for profitability, growth

We continue to remind investors that a company generates value for investors when it generates a return on invested capital ("ROIC") above the periodic cost of capital. A negative spread means that any growth is destructive to value. At the same time, it can even hamper growth, depending on capital structure, operating expenses, and other obligations. The market is very receptive to this as well, and it's not surprising to see the correlation between return on capital, reinvestment rates, growth rates, and geometric stock return.

You'll see in Exhibit 4 that, from Q1-Q2 FY22, CYH's ROIC failed to beat the hurdle rate, with the negative spread widening into its Q3 earnings print (rolling TTM figures are shown). Over this time, the CYH share price gave away ~83% of its value, slipping from $12.30 and bottoming at 52-week lows of $1.88.

Exhibit 4. CYH negative ROIC/WACC spread Q1-Q3 FY22

Effectively, the market recognized the destruction in value, re-rating it swiftly to the downside. Moreover, CYH generated a hefty $6.98Bn in TTM post-tax earnings from Q1 FY20-Q3 FY22. However, there was no additional growth in NOPAT over this time, when factoring in the impacts of its tax burden. Per the Q3 10-Q , the increase was primarily " due to an increase in non-deductible interest for 2022 compared to 2021, compounded by an adverse change in the IRC Section 163(j) limit for deductible interest expense beginning in 2022". Note, it paid $204mm in interest during the quarter, and $614mm in interest on borrowing for the 9 months. Consequently, it booked an overall post-tax loss of $986mm over the FY20-Q3 FY22 period on a rolling TTM basis (Exhibit 5).

As such, the reinvestment of post-tax earnings was negative (Exhibit 7). This can arise for several reasons . First, if the depreciation charge exceeds CapEx over each period, or a number of periods. Second, if working capital decreased substantially over time. Finally, if the firm has decided to liquidate key operating assets over time - without replacing these assets - it will draw down on working capital, leading to declining earnings over time. All 3 of these scenarios apply to CYH. In particular, it completed 6 divestitures over 2021-Q3 FY22 (Exhibit 6).

Exhibit 5. CYH NOPAT vs. Invested Capital, FY20-Q3 FY22

Exhibit 6. CYH completed divestitures

Unsurprisingly, therefore, CYH's growth in post-tax earnings was negative 14.13%, corresponding to the 13.8% geometric decline in its share price over this time (Exhibit 7).

Exhibit 7. CYH negative growth priced in accordingly by the market

Consequently, we estimate another 14-15% decline in CYH's post-tax earnings for FY23E, and look forward to the company's FY22 full-year numbers over the next 1-2 months to reappraise or confirm this estimate. This calls for FY22 EBIT of $731mm, and, factoring in an estimated depreciation charge of $530.5mm in FY23E, we arrive at an EBITDA forecast of $1,271, slightly behind consensus.

In short

CYH has run into capital budgeting troubles over the past few years, resulting in declining profitability and a negligent rate of growth. We believe these challenges could persist into the near future, especially as the hospital segment faces unresolved inflationary, labour market issues, thereby hurting margins further. As such, we reiterate that CYH is a hold.

For further details see: