Community Health Systems (CYH) Q3: downward operating trends continue

Investment Summary

Following its third quarter numbers, I reiterated the thesis on Community Health Systems, Inc. (NYSE: CYH). As we continue to increase the quality spectrum at HB Insights, we are looking for selective opportunities to add tactical alpha, as well look for suitable longs and shorts in the process. CYH continues to assess a hold with declining operating margins and a lack of upside earnings going forward. See our previous analysis on CYH here.

12-Month CYH Price Trend: Substantial Decline from April FY22

CYH Q3 results reiterate previously described headwinds

In my previous outlook on CYH, there were several obvious factors that stood out as advancing red flags. From its latest numbers, we can add the theme of liquidity preservation. Quoting directly from the last report:

…[CYH] presents a number of potential headwinds while continuing to erode operational value on a quarterly basis. With little flesh to put on the skeleton here, we rate CYH neutral…until evidence arises to re-rate upwards.

As for the last trimester, there is little evidence to suggest otherwise. CYH had missed its numbers by admission in Q2 FY22 and the trends continued in the third quarter. It has reduced the downsides compared to the top and bottom consensus. Net operating income declined approximately 290 basis points year on year to $3.025 billion (“Billion”), resulting in an increase of approximately 165 basis points year on year operating expenses (“OpEx”).

As a result, the quarterly operating margin was compressed by 40% to $204 million, or 6.74% of revenue. Same-store revenue also tightened 230 basis points year-on-year, due to a 710 basis point decline in net income per entry. The reduction in revenue/intake stems from lower Covid-19 volumes. Additionally, Hurricane Ian caused a 33 basis point headwind to third quarter revenue. The impulse effect of the closures and associated costs resulted in an additional decline of 66 basis points in revenue.

A further contraction was seen in 2022 since the start of 2022, with cash from operations (“CFFO”) tightening to $291m, from $667m at the same time last year [excluding Medicare accelerated payments made in the first 9 months of FY21]. Thus, the non-GAAP EBITDA margin amounts to 9.4% and the net leverage [net debt/EBITDA] therefore increased to 7.3x. Alas, reduced cash revenue, lower net income growth and lower EPS are the main takeaways from CYH’s Q3.

These headwinds appear to have prompted CYH to tighten the liquidity taps. For example, total capital expenditure (“CapEx”) for the 9 months through Q3 FY22 tightened 14.9% to $284 million. [versus $334mm in FY21]. The decline reduced capital intensity requirements by about 235 basis points year-on-year, with quarterly invested capital falling from $10.94 billion to $10.7 billion. Ceteris paribus, this may or may not have capital intensity and ROI benefits for CYH in the future. As an additional cash preservation measure, management also extinguished $267 million of debt through an open market debt buyback program. There are now no debt maturities before FY26 for CYH.

A glimpse of what changed for CYH in Q3

There are several variables that should be noted in the CYH investment debate following its Q3 FY22 results:

• CYH operational level figures aligned with general market trends observed this YTD in health care providers [equipment, services] sector. I’ve often compared the company’s inpatient/outpatient volume trends versus the national hospital [inpatient, outpatient, community, etc] The data. According to Kaufman Hall National Hospital’s latest flash report for October 2022, hospital operating margins are still in the red for the current year, coinciding with declining revenues across the board. . Additionally, there has been only a marginal decline in spending inflows since the start of the year, with trends continuing into the past month.

• The Kaufman Hall report explicitly says “[w]Overall, spending pressures and declines in volume and revenue could force hospitals to make difficult decisions about what services they are able to safely provide to patients.” CYH has already taken such decisions by consolidating several markets that it does not foresee in the long term. return on investment. It has also tightened CapEx this year. I would say this should be looked at closely by investors, to gauge the capital intensity of the business going forward.

• CYH also realized these compression factors at the margin [described earlier] and volume of patients. Volumes were down across the board despite a decline in outpatient visits towards the end of the quarter. However, admissions to the same store fell by 220 basis points year on year, with Covid-related patients accounting for just 5% of total admissions [vs 13% in Q3 FY21]. CYH’s focus on service line investments appears to be recognized, as same-store surgeries increased 5.3% year-on-year. Growth was strongest in orthopedics, spine and neuro interventions. Compared to FY19, CYH accounts for 101% of admissions and 99% of ED patient turnover FY19. That would be an impressive stat, except that the company’s revenue is down from fiscal 2019 quarterly averages of $3.2 billion at the same time.

• CYH achieved a 500 basis point year-over-year increase in labor costs [avg. hourly employee rate], pushing the company to cut hours worked, reduce hospital days, and convert employees to contract labor. It does this while simultaneously reducing contract labor. Contract labor spend in Q3 FY22 was $100 million compared to $60 million in the prior year, but down from $150 million in Q2 FY22 and $190 million in Q1 FY22 . At the same time, internal hiring of registered nurses has increased by 12%, although there is no mention of the origin of the workforce and the guarantee this has in terms of efficiency and quality of service. Cost-cutting is a big shift in the dialogue this year and has been mainstream throughout the third quarter earnings call. From CEO, Tim Hingtgen:

Under additional expense reduction initiatives, I have already mentioned consolidation and service closure activities in a small number of markets, which will reduce expenses and investments where we simply do not expect a long-term return. term.

These were thoughtful and deliberate decisions and we were careful not to disrupt long-term growth potential while recognizing that in the current environment some operations are sometimes not sustainable given this dynamic. Our margin improvement program, now in its third year, also continues to deliver strong results and Kevin will provide more details in his remarks.”

Our internal forward estimates for CYH’s top-to-bottom lines are summarized in Appendix 1. We see a sharp drop in net earnings for FY22, with a recovery not until FY24. It is not unreasonable to see FCF convert back to $0.63 per share in FY24 [from $1.05/share this year] in my estimation, and combined with an increase in the cost of capital/discount rate, this reduces the future value of CYH’s cash flows in the future.

Exhibit 1. CYH forward estimates [quarterly, annual] in FY24

Evaluation and conclusion

After strong selling in FY22, stocks have been repriced sharply lower and are trading at just 1.6 times earnings. Consensus has CYH priced at 1.76x forward earnings. As shown in Figure 3, in the upside scenario, our Q4 EPS estimate of $0.51 would value CYH stock price at $5.53 or 11 times forward earnings, which represents a substantial upside from current market value and a large divergence from consensus. However, looking at annual loss per share estimates of ($2.25), the deal plays out. The question is really whether these multiples are justified and attractive [or not] and how much is already included.

As shown in Figure 2, taking our estimates for fiscal years 22 and 24 on face value, there appears to be a lack of upside earnings going forward, coupled with increased FCF conversion. This is consistent with CYH’s current trends of shrinking operating margins and reduced return on invested capital. Alas, it is difficult to predict a multiple expansion for CYH on these projections.

Exhibit 2. Forward estimates point to a lack of EPS upside coupled with a broadening of FCF conversion, casting doubt on multiple expansion

With that in mind, it then comes down to the cost and compensation that we accept in a position with CYH. As seen below, CYH’s TTM earnings yield is 10.75%. For our investment, there is an implied risk premium of 9.13% above the risk-free rate, while CYH’s fair cost of equity is also 10.75%.

In our base case, we see the company’s FY22 loss per share turn negative, we’re holding firm at $2.44 per share [from previous analysis]. In the upside case below, the price target indicates 88% upside potential, however, I don’t see that materializing with confidence once the company’s FY22 numbers are released. next year. The valuation in the bullish scenario, however, keeps me neutral at this point.

Exhibit 3. CYH Upside Case: Sequential earnings growth implies potential misvaluation of CYH stock price. However, FY22 revenue is likely to tell a different story. The question is how much is already charged.

Net-net, I continue to rate CYH as an expectation after its Q3 numbers. The downside risk to earnings continued this quarter and management has been particularly active in reducing cash drains and pressures. With a likely further decline in earnings, I can’t help but assume that this will negatively impact CYH’s stock price. Looking ahead to the quarter, stocks could be undervalued at 11 times our FY22 fourth quarter EPS estimates, but looking to FY22 results, that appears to be offset. The question is to what extent the market has already priced this drop in advance. At this point, I’m not entirely sure, but there are still too many unanswered questions. Rate maintained, PT unchanged at $2.44.