2023-09-11 11:27:39 ET
Summary
- Universal Health Services has seen a decline in operating income and profitability, leading to stagnant share prices in recent years.
- UHS's strategy of focusing on behavioral health has resulted in subpar results compared to peers who have pursued different approaches.
- The company requires a bold restructuring effort to improve its financial and operating performance, although such plans are unlikely to materialize.
Background
Universal Health Services (UHS) is a mid-cap healthcare company which owns and operates hospitals and other healthcare facilities. With nearly 400 facilities across the US and UK, net income for FY22 totaled $675 million, a decline of roughly 32% from the year prior.
Although the company has consistently grown top-line revenue over the years, expenses have increased even more rapidly. Margins have been squeezed and profitability remains weak. Furthermore, the company’s growth outlook appears somewhat dimmed in the wake of the COVID-19 pandemic. It’s unclear to me whether or not the company will achieve such positive results anytime soon. As a result of these developments, UHS’s share prices have remained stagnant in recent years.
UHS Stock Price (Seeking Alpha)
I believe that there is significant value to be unlocked at UHS, especially in light of their attractive valuation. However, the company requires a bold restructuring plan to realize such improvements in its financial and operating performance. More specifically, I believe that shareholders would be better served if the company leveraged its REIT arm to finance its real estate assets, freeing up capital which can be reallocated towards expansion. I also think that resources should be re-concentrated on acute care, the division that primarily drove UHS’s growth throughout its 44-year history.
Unfortunately, I don’t expect that such change will come anytime soon, given the company’s highly-centralized governance structure. Public shareholders have virtually no influence in corporate affairs at the company, since insiders retain over 90% of the outstanding voting power through UHS’s multi-class share structure.
For these reasons, my outlook for Universal Health’s stock is currently a Sell. I wouldn’t recommend shorting the stock, but I would suggest that existing shareholders reduce their exposure to the company.
History & Financials
United Health Service was founded by Alan B. Miller in Pennsylvania in 1979. The company rapidly expanded by acquiring several hospitals, and IPO’d just one year later. By the mid 1980s, the company formed the Universal Health Realty Income Trust (UHT), a healthcare REIT which enabled the company to offload real estate assets from its balance sheet.
UHS continued to grow at a healthy clip through the 1990s and 2000s, and was even named as the best performing healthcare stock by the Wall Street Journal in 2001. Throughout their history , the company primarily expanded by purchasing other healthcare companies or hospitals. The founder of UHS, Alan Miller, was also consistently recognized as one of the top leaders within healthcare, and the company earned a reputation as a good employer.
Since 2016, the company has seen its revenues ((TTM)) increase from $9.6 billion to $13.8 billion in Q1/23 ( annual report ), making for a CAGR of ~6.2%. However, EBITDA ((TTM)) has hardly increased over this period, starting at $1.70 billion and now at $1.73 billion. But rather than stagnate, TTM Operating Cash Flow has actually decreased from $1.36 billion to $1.17 billion today.
UHS Total Revenues (Koyfin) UHS EBITDA (TTM) (Koyfin) UHS Operating Cash Flow (Koyfin)
The company’s valuation is somewhat attractive, with a TTM P/E ratio of 13.8x and an EV/Sales ratio (TTM, again) of 1.04x. Compared with the sector’s median value of 30.3x and 3.71x respectively, UHS certainly looks like a bargain. Here’s a quick valuation comparison with a few of their peers:
P/E ((TTM)) | EV/Sales ((TTM)) | |
((UHS)) | 13.8x | 1.0x |
23.2x | 2.0x | |
16.5x | 1.3x | |
25.8x | 3.1x |
The main question for investors is "Why is the company trading at such a discounted multiple?" I would posit that the reason for this is because the company has a negative narrative and growth outlook at this point. And unfortunately, the reasons which underlie those pessimistic factors do not appear to be going away anytime soon.
One way that the company could improve performance is by selling more of its real estate assets through its REIT arm (i.e, UHT). This could free up significant capital which could be used to acquire suppliers or competitors in existing markets, thereby enhancing Universal Health’s market position (via vertical or horizontal integration). I believe that shareholders would be better served if capital is deployed for expansion, rather than for holding onto real estate assets.
However, the company continues to hold the vast majority of its assets on its own books and it has not taken full advantage of its REIT subsidiary (as competitors like Ensign have done). In my view, this is a bearish sign which indicates that management is not looking to optimize its balance sheet through asset sales or a financial restructuring. Without such efforts, the company's return on assets (ROA) may continue to decline.
Strategy & Competition
The company has consistently pursued an inorganic growth strategy for most of its history, enabling it to expand without needing to allocate significant resources to site development (i.e., planning, construction, logistics). UHS has historically concentrated on healthcare operations, while its REIT arm generally acquires and finances its real estate assets.
Over the past decade, the company has pivoted away from the acute care services area to behavioral health. Its revenue mix has changed from 80:20 (acute:behavioral) to roughly 50:50.
According to the current CEO , Marc D. Miller, this pivot comes as the company has tried to avoid competitive pressures in the acute healthcare space. As other firms have made more aggressive acquisitions, UHS has been more cautious in its activity on the acute healthcare side.
Unfortunately, this strategy has resulted in subpar results, since behavioral healthcare is at least as competitive as the acute space. UHS’s performance in recent years has fallen behind peers who have opted for different approaches to the market.
Stock Performance Comparison for UHS Peer Group (UHS 10-K)
In particular, Ensign Group ( 10K ) has been able to plow ahead by shifting its attention to “high acuity” patients (i.e., those who require multiple medical services). These patients tend to be higher yielding, since Ensign can provide several solutions to patients with more complex medical situations.
As part of its focus on high acuity patients, Ensign sold off its urgent care operations back in 2016. Patients who come in for urgent care tend to have more basic, one-off medical issues that don’t involve an assortment of healthcare services. Instead of attending to these routine medical situations, Ensign has directed its resources to the skilled nursing, senior living, and rehabilitation markets, which require a more comprehensive suite of services.
To illustrate the strategic contrast, one may note that UHS operates dozens of free-standing emergency departments. Patients who come into these facilities may lack insurance coverage or may be otherwise unable to afford medical treatment. However, UHS is still required to provide care in most circumstances, which results in significant costs to the company each year. For 2022, UHS estimated their cost for providing uncompensated care was around $245 million, marking a 13% increase from the year prior. This figure already accounts for government programs which alleviate the cost to the hospital for providing such treatment.
Ensign’s specialization allows the company to increase operating efficiency and revenue per patient. One metric which reveals the companies’ distinct priorities is their utilization rate. Ensign boasts an overall occupancy of 75%, which surpasses Universal Health’s rates of 62% (Acute Care) and 71% (Behavioral Healthcare). With higher utilization, Ensign is able to add incremental revenue while taking advantage of fixed costs.
Another key difference between Ensign and UHS is that the former has made organic expansion a central part of their growth strategy, while the latter is more focused on acquisition-driven growth. Ensign works to increase revenue at their existing facilities by improving clinical systems (i.e, technology) and staff development (i.e., training and career development). These factors drive higher employee retention while also reducing the company’s exposure to overtime compensation and temporary nursing services. As a result, Ensign has been better able to manage payroll and G&A expenses (which declined as a percentage of revenue in 2022).
These differences have become more apparent in each firm’s operating results, with UHS’s Net Income Margin falling to 5%, while ENSG’s has expanded to 7%.
Net Income Margin for UHS and ENSG (Koyfin)
With regards to overall strategy, I’m not very confident in UHS’s bet on behavioral healthcare. That subset of the market is expected to grow by only 5.1% per year until 2032. So unless UHS can expand its market share (which will be difficult in such a fragmented and competitive market), the company may face strong headwinds going forward.
The company could potentially surpass expectations on this front partnering with employee benefit providers and corporate insurance companies to enhance its distribution mix. This approach could enable UHS to leverage its existing operations in different cities while also securing batches of new patients. However, management has not indicated any interest in such an approach, so it seems unlikely to be executed.
Governance
Universal Health Services’ biggest drawback is perhaps its current ownership structure. The company offers 4 different classes of stock, with only one class (Class B) being publicly traded. The founder (Alan B. Miller) holds 87% of the general voting power, which designates UHS as a “controlled company”.
The danger of investing in a controlled company is that the controlling party has unilateral authority over management, while common shareholders are left powerless. Aside from being controlled by the founder (who is no longer acting as CEO), the company’s board of directors remains classified, which means that directors stand up for reelection less frequently. As a result, classified boards tend to be more entrenched and less likely to effectively regulate management , especially if insiders retain significant voting power.
UHS Ownership and Control (UHS 2022 Proxy Statement)
So far, the new CEO appears unlikely to institute any aggressive changes at the company. His general approach appears to be “stick to the course and the results shall follow”, even though performance has been underwhelming since 2016. Meanwhile, stock-based compensation (SBC) has nearly doubled from $46 million to $87 million over the same period.
UHS Stock-Based Compensation (Koyfin)
One final area of concern with regards to corporate governance is the change to director compensation which occurred last year ( proxy statement ). Namely:
-
Director remuneration includes more cash and less equity (reducing the alignment of interests and skin in the game)
-
Equity awards are based on a fixed dollar amount, rather than fixed number of shares (resulting in greater dilution to other shareholders)
These moves are particularly troubling because they make the board of directors less exposed to changes in the company’s share prices going forward. As a result of this compensation structure, the board may be less incentivized to promote strong growth and financial performance. For this reason, I would not expect radical change to come from incumbent leadership.
I believe that significant value could be created by consolidating the company’s four classes of stock into a single class with equal voting rights for all shareholders. Along the same lines, I think that shareholders would also benefit from the declassification of UHS’s board to promote greater refreshment and input from unaffiliated shareholders.
These changes would foster greater accountability on the board by providing investors with the ability to replace ineffective leadership at their discretion. Over time, this could result in greater interest from institutional investors (who often hold heightened corporate governance standards for their investments), while also driving superior financial performance.
Conclusion
Although I find that Universal Health Services is a cheaply-valued company, the reasons for this pessimistic outlook appear justified: the company is controlled, necessary change is nowhere on the horizon, and competitors are exploiting UHS’s missteps within specific sub-sectors of the market. As a result, I maintain a Sell rating on UHS at this time, although I certainly hope that leadership can clarify its strategy and kickstart performance once again.
For further details see:
Universal Health Services: Seeking A Cure For Flat Performance