Hca Case

Hospital Corporation of America (HCA)

Staff Analysis

Statement of Problem

HCA, after following a conservative financial policy since its establishment, has entered the new decade preparing to make some changes in order to realign their financial strategy and capital structure. Since establishment, HCA has often been used as a measure for the entire proprietary hospital industry. Is it now time for the market to realign their expectations for the industry as a whole? HCA has target goals which need to be met in order to accomplish milestones in the future. The problem arises as to which area holds priority to the company. HCA must decide how the key components of their financial strategy and policy should my approached in order to meet their future goals.

Background

HCA has set target goals in several areas and it is important to identify which goals hold priority: Debt Ratio, Growth Rate, ROE, and Bond Rating.

Debt Ratio:

Currently, HCA is approaching an all time high debt ratio of 70%, well above their established target ratio of 60%. The increase in debt ratio has attracted the attention of rating agencies who have clearly stated that in order for HCA to maintain their A bond rating HCA must return to their 60-40 capital structure. Now the question arises as to whether the A rating should be sought or should HCA move to a less conservative position. Some investors believe that a more aggressive use of leverage would present greater opportunities in the future. Others feel that with changes in Medicare/Medicaid reimbursement structure on the horizon, HCA should remain conservative. In order to decrease the debt ratio, HCA would have to 1) decrease the growth rate (inadvertently decreasing ROE) or 2) decrease debt/increase equity. The debt ratio is important for many reasons, but it should not be the basis of a company's future. The market will ultimately decide the value based on numerous facts, not just the bond rating.

Growth Rate:

HCA would like to see the annual growth rate in the 25-30% range, although they have also set a minimum of 13%. This would signal aggressive action in the company and with this growth rate HCA would experience a dramatic increase in ROE as well as leverage. Why would HCA want to take on a debt ratio of 86% (See Case Exhibit 1)? Vice President Bill McInnes believes that in order for HCA to compete with other management companies in the industry they must continue acquisitions. An increasing growth rate does appeal to the investors, but is it necessary to take on this kind of risk when uncertainties lie in the future. More importantly, there is evidence that increasing growth does not necessarily make you more profitable. Humana's growth in hospitals over the past 5 years is 6.80%, that's almost a quarter of HCA's at 30.1%, yet they realized a growth in net income of 54.60%. HCA on the other hand only realized a growth in net income of 32.40%(Case Exhibit 2). Hence the growth rate is not a sole determinate of future performance. In addition, a company certainly wants to allow room for future growth.

ROE:

HCA currently holds an ROE of 14.5%, lower than the target ROE of 17%. Although, when we use the leverage equation we can see that the adjusted ROE is at 17.6% (Case Exhibit 1). It is important for HCA to maintain this ratio because it is a measure of efficiency used throughout the market. In addition to the overall value of ROE as a measure, we must also consider the standards within their class. Humana currently holds an ROE of 31.31% (Case Exhibit 2) therefore setting a high standard in the industry sector. ROE is one of the most important ratios of a companies financial policy.

Bond Rating:

Without a change in the current capital structure policy, HCA will most likely loose their A bond rating by the end of the summer. Before turning the capital structure upside down, we must consider the outcomes of both sides. If HCA chooses to maintain their A bond rating, considerable changes will have to be made quickly. As mentioned earlier, there are two ways in which to decrease the debt ratio: 1) decrease growth or 2) decrease debt/equity. If HCA chooses to remain at the current debt ratio take on a lower rating, suspicion might arise among investors. In both cases opportunities exist as well as consequences. The advantages and disadvantages are outlined in Scenario 1 - 3.

Alternative Solutions (Case Exhibit 1)

Scenario 1 - Maintain Current Debt Ratio

This alternative allows HCA to remain at the higher debt ratio and meet both targets for

ROE and the growth rate.

Debt = 69%

ROE = 17.6%

G = 15%

This would also indicate that HCA receives a lower rating. This could prove to be good and bad. In some instances, companies with lower ratings experience a rise in their cost of debt or loss access to the debt market. When Du Pont lost their AAA rating they did not experience any dramatic changes. With the growth rate at 15%, HCA has an opportunity to increase in the future. An ROE of 17.6% signifies efficiency and provides evidence that the company is heading in the right direction.

Scenario 2 - Decrease Debt Ratio at all