2023-04-26 16:54:45 ET
Summary
- Universal Health has started the year well, Q1 revenues ahead of consensus and up 5% YoY, 11% trailing ROE.
- The CFO calls for a return to long-term normalcy, and this report examines what that looks like.
- The firm has recycled incremental capital well over an extensive period.
- Net-net, I rate the stock a buy.
Investment Summary
Universal Health Services, Inc. ( UHS ) has been defensive for the most part of 3 months in FY'23. After rolling over in March, shares have caught a bid once again. It reported another beat at the top line, growing revenue 5% YoY to $3.47Bn, a solid number, despite a step down in cash from the previous year. Still, the top-line growth aligns with CFO Steve Filton's remarks on the Q4 FY'22 earnings call in " projecting a gradual sort of return to normalcy". Looking back from FY'13–22, despite a hit to reported profits last year it continues growing the top line [Figure 1] and does pay a slight dividend (not discussed here).
If these are the trends for normalcy, then it could be worth it to sit on the stock for a while trading at 14x forward earnings and 1.6x book value, as of today. The investment debate is relatively simple for UHS and the growth profile is a slow but steady one for patient investors. That's not necessarily a bad thing for some risk profiles, portfolio strategies, etc. Profitability and earnings growth are a standout feature for UHS albeit at low, but consistent rates of incremental return. Yet, dividend safety is rated highly which says a lot about the stability of UHS' cash flows, along with the findings corroborated in this report. I rate UHS a buy.
Fig. 1
Data: Author, UHS 10-K's
What does normalcy look like
It could be argued the CFO was referring to long-term averages by normalcy. If that's the case, then it could be a very positive sign for UHS. Even with a tight year last year, it rebounded well in Q1. Consider the following.
One, UHS still generated $291mm in operating cash flow for the first quarter. At this rate, it could be $1Bn annualized for FY'23. That's not bad on ~$3-4Bn in revenues, and I'd note that cash outflows in both Q1 this year and Q4 last year have been geared towards CapEx so could rebound into growth. Another point is that it expects to be able to reduce premium pay by ~30% this year as well. Regarding the CapEx, it spent $735mm in Q4 so any upside on that would be welcomed as well. Also worth mentioning there's $800mm in authorized buybacks as well, potential 8% forward buyback yield. (8.5% with forward dividend yield).
Two, capital has been utilized well over the long-term and productivity has been quite high. With the earnings retained from investors, it appears the company has taken good care of them, growing both NOPAT and earnings, as profits were reinvested back into the business. It is no wonder to see profitability rated so highly, despite the fact gross margins are a step below the sector. This has fallen off tremendously last year, but a return to normalcy would be a strong period of growth.
Fig. 2
Data: uthor, UHS 10-Ks
The gross margin has fallen off in the most recent years as the company dealt with one-line items, such as physician subsidy expenses that are booked alongside revenues. This is a fairly new headwind for the acute hospital industry, and the firm expects another $45–$50mm increase in these costs this year. This is something that must be factored in, surely, as this could hit operating margins and slow the revenue growth underpinning this thesis beyond that. It's something I'll be keeping a close eye on. For now, it looks as if capital has been well recycled compared to the sector. This, despite the gross margin pressures from above. Below, you can see the outperformance vs the sector across a range of other measures [Figure 3].
Fig. 3
Data: Seeking Alpha, see: UHS, "profitability"
Three, there has clearly been a strong correlation in the growth of equity and assets, without the use of excessive leverage. You can see below, that there is currently ~$6Bn in equity holding up $13.5Bn in assets with long-term debt of $4Bn. The annual debt portion is unchanged from the last 10-years, but the assets have lifted from $8Bn in 2013 to $13.5Bn, equity from $3.2Bn to $6Bn in this time. So the capital is being recycled into asset growth and additional growth in equity, at fairly sturdy growth percentages. If you look at FY'19 as well, before the pandemic, to the latest annual result below, there's been a fairly standard step-up in both once more. This is pleasing to see.
Fig. 4
Data: Author, UHS 10-K's
So the case really hinges on UHS' ability to convert existing capital into future value, and for that, it needs to generate a return on incremental capital ahead of the market's rate of return. If it is going to retain $6Bn in retained earnings (which, by the way is down from FY'20-'21), instead of dividends to investors, then it must at least keep a positive rate of return on the capital in allocates to business growth. If you think the market can return ~10-12% on average these next 5-years, then it might help to know UHS has spent an average 74% of NOPAT each year as CapEx the last 5-years.
Further, top-line growth is a feature for UHS. But annual post-tax earnings have matched CapEx spending on a cumulative basis. The growth on incremental capital has remained positive up until FY'22. It will need to have a fabulous year this year in order to drive up this level in my estimation. Not unfeasible, considering the strong Q1, but let's see Q2, etc. Much of this hinged on the ability to push back to long-term 10-15% growth rates looking ahead. My numbers suggest this year it can. Beyond that, will be another story in waiting.
Fig. 5
Data: Author, UHS 10-K's
Valuation and conclusion
I certainly do believe UHS can converge to the sector multiple of 20x forward earnings, and/or 28x GAAP earnings. At 14x this is appropriate value especially seeing the long-term performance of this name. At a long-term target multiple of 20x, you're looking at $199 for UHS, even at 17–18x it could be $170–$180 (using FY'23 consensus estimates as a base). I believe these are reasonable expectations over a long-term period of time. Especially given the growth in book value and 11% trailing ROE, off a 5-year average of 14.9%. I'd be comfortable looking at the 15% ROE number, and it would be nice to see the firm do $1Bn in CFFO this year. If not, there could be another informed appraisal – the Q2 and Q3 numbers will reveal more.
Perhaps one important thing to focus on here, is that UHS is doing the same thing it was several years ago. It doesn't need a whole lot of change to keep generating revenue growth. This is a big plus, for those who just want to keep the equity line moving steadily higher.
In that vein, it is appropriate to sustain a buy rating on UHS for the time being, with a long-term horizon in mind. Best to thing long-term with this name, and the low-volatility on offer here is also conducive to this thinking. It could move to 17x forward earnings over time, which could be $170. Not a bad proposition, for a low-vol, defensive play. Looking forward to future coverage.
For further details see:
Universal Health Services: What A Return To Normalcy Looks Like