Pgiam/iStock via Getty Images Investment Summary Since my last publication on Tenet Healthcare Corporation (NYSE:THC) shares have caught a tremendous bid and now trade nearly 180% to the upside (Figure 1). The key catalyst to the repricing has been management’s divestiture of lazy assets within the company’s surgery centres portfolio. This has unlocked substantial capital on the balance sheet and provided it with new funds to deploy in high-return opportunities. Of course, this does not come without risk – it is now one of execution on management’s part. Previously I had been fairly neutral on THC given 1) the lack of reinvestment runway to deploy its operating profits, and 2) the bulk of its revenues originating from surgery centres [~50% throughout FY 2023]. Fast forward to the present, management has sold off various hospital assets to (i) unlock capital, plus (ii) shed underperforming assets from the balance sheet and increase marginal returns on capital in the business. I am now constructive on the valuation prospects THC given 1) the new operating structure, 2) management’s revised focus on the higher revenue, higher margin acute surgery centre segment, and 3) the potential for multiples expansion given the stock trades at roughly 6x trailing post-tax earnings as I write today. Investors seem to have noticed the warranted jump in intrinsic value and have repriced the company accordingly (Figure 1). According to my implied intrinsic valuation model, the jump in market value was justified on a fundamental basis. Net-net, revise to buy. Figure 1. THC implied intrinsic valuation, calculated by multiplying the marginal return on invested capital by the reinvestment rate on a rolling 12 month basis. Author’s estimates FY 2024 earnings breakdown As mentioned, management continues to unlock value by selling underperforming hospital assets. It closed the sale of 9 hospitals in Q1 FY 2024, realizing proceeds of $4 billion pre-tax on this. It immediately retired the bulk of its debt, reduced leverage ratios, and ultimately tightened up the balance sheet. It now has no major debt maturing until 2027, giving it a 3-year runway with minimal cash obligations to deploy growth. It also saw some leverage at the labour expense line, with labour costs down around 180 basis points year-on-year to 43% of revenues. Turning to the quarter, the company did $5.4 billion of business on $1 billion of adjusted EBITDA (23% growth year over year on a 19.1% margin). Management was fairly clear on its goals moving forward, saying on the call: We are pleased to deploy capital to provide more lower cost access points for the communities in which we operate that also generate very attractive returns. This is the kind of attitude that I would like to see from management – one that is confident in aggressively deploying funds into areas that could generate incremental profit growth. Given the strength during the quarter, management is raising full-year guidance and is calling for adjusted EBITDA of $3.7 billion at the top end of range, representing a 6% increase. It views this on revenues of $5 billion to $3.7 billion. The divisional breakdown on this includes the following: The USPI business clipped adj. EBITDA growth of 16% from Q1 last year, underscored by a 6.4% increase in same facility revenues. As a testament to the recent divestitures, the company saw a 40 basis point decrease in surgical case volume. The CEO said that THC has grown USPI to over 535 centres. It expects these new centres to add $80 million of incremental pre-tax earnings (~$0.81/share) within the first year of acquisition. The first quarter was a prelude to the momentum THC is building over the coming years, in my opinion. I illustrate this in my analysis below. Revision to fundamental economics Having reduced asset intensity in the last 12 months, this sets a bedrock of solid fundamentals in my view. Recent asset sales provided the company with $3.6 billion in trailing free cash flow, as seen in Figure 2. Most important in the investment debate for me is the fact that management has been increasing the rate of earnings produced and capital invested in the business. In 2022, returns on the tangible assets required to operate the business were 9%. By Q3 2023, there was no change in this level. In the past 24 months, however, the company has added 200 basis points of incremental value to its capital base by 1) removing the sloppy assets and 2) growing net operating profit after tax from $1.9 billion in 2022 up to $20.2 billion in the last 12 months. Figure 2. Company filings Critically, there have been some minor changes in the economic drivers of these returns. Post-tax margins have increased by 100 basis points as one of the levers. However, it has also grown profits incrementally for each new set of investments. In the 12 months to September 2023, December 2023, and March 2024, it produced 35, 174%, and 2% return on incremental capital injected into the business (Figure 3). It reinvested around 60% of its tax earnings to achieve this. Therefore, I’m not surprised to see the valuation climb as it has. Figure 3. Company filings What I make of all this is 1) management is aggressively deploying funds to grow the business, 2) these new assets are pulling their economic weight and increasing profitability on a marginal basis, and 3) this supports a change in the fundamental outlook of the company in my best estimation. Revised estimates of corporate value I have calculated the level of incremental investment THC required to produce a new dollar of revenues for the past three years in the figure below. Naturally, sales growth has averaged less than 1% per rolling 12-month period, annualizing at circa 4%. Margins have been reasonably strong at 14%, but to produce this new dollar of revenue management has invested $0.65 in working capital and allocated $1.41 to acquisitions. This squares off with the economics of the business. What is impressive however is that it has still managed some revenue growth whilst reducing fixed intensity by $0.23 on the dollar per $1 of revenue growth. Figure 4. Company filings I want to see what it would look like if the company were to continue divesting fixed capital by rolling off hospital assets from its balance sheet at a similar rate over the next two years. This is shown in the modelling below (no other assumptions have changed). As observed, I get to $21.8 billion in sales this year, stretching up to $22.5 billion by 2025, on post-tax earnings of $2.4 billion and $2.47 billion, respectively. These are marginally ahead of consensus estimates. Figure 5. Author’s estimates It’s probably a bit rich to presume management can just simply find buyers for these assets just as it has been. In the scenario below I assume no change and fixed asset intensity, plus around 100 basis points of revenue growth. The major differences are that the company would realize around $500 million less of anticipated free cash flow each year but still throw off anywhere from $2 billion to $2.3 billion after all reinvestment requirements. Hard to argue with that. Figure 6. Author’s estimates The advantage of projecting cash flows out in this fashion is that it reduces the risk of being overly optimistic in the assumptions. I am simply assuming one of two scenarios –1) where THC continues exactly as it has done over the past three years in terms of financial performance and incremental capital investment, [this includes asset sales], or 2) that it makes no changes to its fixed asset base and focuses on deploying funds elsewhere for revenue growth. Valuation scenarios As seen below the market has paid a relatively constant value of 1.1x – 1.2x the capital injected into the company. This is a relatively low market value added, but one that subscribes to the former notion of slack business growth. The question is, what does this amount to when factoring in forward assumptions on capital intensity and operating profit? Should investors continue to pay 1.2x multiple, then my assumptions provide a valuation range of $233-$236 from FY 24 – FY 2026 (Figure 8). Figure 7. Company filings, Author’s estimates Figure 8. Author’s estimates As evidence this looks to be more a valuation play versus a change in earnings power, I’m going to run the scenario of buying 1000 THC shares at market today. This would cost $139,500, for net operating profit after tax of $23.50 per share, or earnings power of $23,500. This is a more than acceptable yield of around 17% at the time of writing. However, given the growth assumptions I have outlined earlier – even in the upside case – there appears to be little change in earnings power over the coming two years. If it does hit the targets, our earnings power would lift around 5% to $24,640, or $24.60 earnings per share. Figure 9. Author’s estimates But the stock trades at ~6x trailing post-tax earnings, which is well below the three-year average of 9.8x. I estimate that there is strong potential for the stock to drift back up towards this historical multiple. Should investors pay this, it also implies a valuation range from $220 up to $250 with my assumptions. In other words, any increase in the valuation multiple from here is likely to be accretive to the share price. Naturally, we want context to understand if this doesn’t occur. Let’s say the multiple doesn’t change at all, and investors still pay 6x. Based on the assumptions above, I still get to a valuation of $148 per share, or a 6% internal rate of return. In fact, my judgement is the stock could trade as low as 5.7x trailing pre-tax earnings and be fairly valued today. So the downside appears limited in this context. Figure 10. Author’s estimates Downside risks to thesis Key downside risks to the thesis include the following: Asset sales may not add long-term value in the sense they may condense the company’s revenue growth if management doesn’t deploy capital effectively. Investors may very well not increase the post-tax earnings multiple as described in the thesis. This would reduce the outlook on valuation and is a key downside risk. We can’t overlook the current level of macro-level risks either, most notably the potential spillover of 1) geopolitical and 2) fiscal headwinds into equity markets. Thankfully, the healthcare sector is relatively defensive on aggregate, but investors can’t ignore these factors. These risks must be understood in full before proceeding to any investment decision. In short THC management has undertaken the necessary steps to unlock value from the company’s large capital base. Recent asset sales alongside the aggressive view on deploying funds are attractive to the risk-reward calculus. In my opinion, the price value equation is skewed to the upside given the fact that 1) the stock appears undervalued at the current multiples, 2) if investors continue paying the 3-year historical EV/invested capital multiple of around 1.2x this gets me to a valuation of $236 per share by 2026, and 3) this is supported by a similar valuation range if the company starts to trade closer to its three-year historical NOPAT multiple of 9.8x. These factors support a buy rating and suggest that at worst, the company is worth about what we pay for it today, and at best, it could be worth multiples of. Revise to buy.
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