Previously, I looked at Dr. Michael Burry’s Scion Capital’s most recent 13F Filing with the Securities and Exchange Commission, which detailed the fund’s four equity positions. The third-largest holding, worth $7.6 million or just over 20% of the equity portfolio (13Fs exclude cash), is HCA Holdings Inc. (HCA, Financial) Should investors follow him into the stock?
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HCA is a for-profit health care provider. At the end of 2015, the company owned and managed 164 general hospitals with 43,275 licensed beds, some psychiatric hospitals and 116 freestanding surgery centers.
Shares in HCA, like the rest of the entire U.S. health care sector, have been on a rocky ride this year as health care has become a hot topic in the U.S. presidential election. Shares in HCA entered the year trading at $66.30, down from a high of $93 in mid-2015. Rising to a high of $81.70 at the end of October, HCA is currently trading at $73.10, up 8.2% year to date and trailing the S&P 500 by 2.8%. Over the past five years, shares in the health care provider are up 245.6% compared to the S&P 500's return of 80.7%.
What does Burry see in HCA?
Year to date, HCA is trailing the S&P 500. But why does Burry like the stock? For a start, it appears Burry likes HCA because it is cheap. Shares in the company currently trade at a forward price-earnings of 10.4 and an EV/EBITDA ratio of 7.63 compared to the sector average of 10.8. The company is also generating an impressive return on its assets. Return on capital employed for the past five years has averaged approximately 20.5% and free cash flow per share has grown by 6.6% per annum since 2010. Net profit has expanded at a steady 12% per annum since 2010 and reported earnings per share have gained 12.6% per annum over the same period.
However, most of the company's growth over the past five years has been debt-funded. Net fixed assets have grown from $14.2 billion to $17.6 billion from 2010 to trailing 12-months. At the same time, net debt has risen from $27.8 billion to $30.8 billion, book value has improved marginally from $-11.9 billion at the end of 2010 to $-7.8 billion on a TTM basis. Book value per share has improved slightly from $-27.9 to $-20.6.
Just like Burry's other holding Coty, HCA is a company that is loaded down with debt, which explains its low valuation. The company's Altman Z-Score -- a measure of bankruptcy risk-- is 1.9, indicating the company is not entirely safe from financial distress. A ratio of 1.8 or less indicates the company is in danger of serious financial issues. Tests have shown that 80% to 90% of the companies earning a score of 1.8 or less collapse into bankruptcy.
Digging down
Based on the above figures, it is unclear why exactly Burry likes HCA. The company is attractive for several reasons, but none of these are overwhelmingly compelling. For example, HCA operates in the extremely defensive business of health care and is a well-established health care provider. The company’s position in the industry arguably demands a higher EV/EBITDA multiple of 7.6. That said, the company’s debt mountain warrants caution and it would appear HCA’s valuation has been discounted by the market to take into account debt.
But is the company’s debt that concerning for such a defensive business? With interest rates heading higher it could be, although management may decide to scale back capital spending and borrowing if debt costs begin to rise. The business could then use free cash flow to pay down debt.
Based on full-year 2015 figures, HCA’s gross debt to free cash flow ratio is around 13 times. Free cash flow was approximately $2.4 billion for full-year 2015. Perhaps this is Burry’s angle. If HCA stops spending and starts paying down debt, the group’s valuation could quickly shoot higher. This is purely speculation, but it is an interesting idea nonetheless.
Disclosure: The author does not own any share mentioned within this article.
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