Healthcare Facilities: Franklin Jarman

Sector View:

Following our initiation in October, we maintain a Neutral sector view on HY Healthcare Facilities and expect 2019 returns to be driven by divestitures, liability management, revenue execution and cost rationalization strategies. Healthcare Facilities has had a relatively solid run this year, generating a 4.2% YTD total return to position, the fourth strongest HY sector (relative to the YieldBook FTSE index). Performance has been driven by the big three for-profit hospitals with THC (16% of the sector/+5.8% TRR YTD), HCA (29%/+1.4%) and CYH (10%/+8.0%), despite market volatility in Oct/Nov detracting from even stronger gains through 3Q2018.

Exhibit 66: HY healthcare facilities has outperformed the HY Market YTD

Source: The Yield Book Inc.; FTSE Index, Goldman Sachs Global Investment Research

Much of the upside has been attributable to (1) strong same-facility results led by strength in same-facility (SS) YoY revenue per adjusted admission (RPAA) growth across providers, (2) CYH’s and THC’s ongoing focus toward optimizing their portfolios via asset sales amid a supportive M&A backdrop and (3) a HY market that has been acceptive of liability management exercises for stressed structures such as Community Health.

In 2019, we expect healthcare facilities will continue to execute on strategies that worked favorably in 2018. Hospitals in particular, whether net divesters or acquirers, will focus on right-sizing portfolios to manage high local market share groupings of hospitals. We anticipate that HCA will continue to acquire hospitals and ASCs to strengthen local market share in existing markets, CYH will pursue additional hospital divestitures beyond the 2018 program and THC will strategically divest hospitals in underperforming markets and add to its ASC portfolio. Further, we expect the capital structure rebalancing strategy to remain in effect: (1) CYH is required to refund the TL H with

asset sale proceeds and has 60% left in the 2018 program with white space for further sales and (2) THC remains focused on delevering through asset divestitures and EBITDA/FCF generation. Technicals in 2019 should remain a supportive backdrop for the industry, though less so versus 2018; particularly, we think Moody’s upgrading the HCA secured complex (20% of the sector) will be favorable for the rest of the sector as funds reallocate capital.

Nevertheless, while many of the strategies should continue, we note that strength from SS growth may become a headwind versus a tailwind in 2018. Most notably, we see the potential for RPAA growth to slow in light of the tough YoY comps in 2018 and the lower impact from smaller YoY economic improvements; in 2019, we expect RPAA growth to trend in the 1-2% range versus the 3-4% achieved in 2018. Further, volumes will continue to be a headwind, with rural hospitals exhibiting more significant volume reductions.

Exhibit 67: We expect RPAA growth to be slower in 2019 versus 2018

Source: Company data, Goldman Sachs Global Investment Research

Trade Idea #1: Buy THC 6.875% Sr. Notes due 2031 (on the HY CL). As the lowest dollar priced ($89.75) bonds in THC’s capital structure, we believe they represent an attractive take-out target that could benefit from both a Conifer separation (were it to occur) and further deleveraging across the complex. Recent market volatility as well as longer than expected execution on a transaction have caused the 2031s to trade off approximately 6 points from mid-2018 peaks and provide an attractive buying opportunity.

Per management, THC is focused on reaching its 5x net leverage target by YE2019, regardless of a Conifer divestiture; we think this target is ultimately achievable. Based on our relative value analysis, we see ~70bp of spread tightening for THC 2031 bonds if the company achieves its 5x net leverage target. This would still leave the bonds at 7.7% YTW or ~60bp behind the sector to account for higher duration and lower rating. This could potentially drive a 13% annualized IRR for investors by YE2019 (assuming flat UST levels). If Conifer is sold and the company tenders for these bonds mid-2019, the annualized IRR could be in the double digit range depending upon tender levels.

We also believe a separation of the Conifer segment could serve as a debt redemption catalyst. On the 3Q2018 earnings call, THC discussed that they are exploring additional strategic opportunities such as a tax-efficient spin-off, we believe in an effort to preserve NOLs.

Risks to the downside: Near term headwinds stemming from larger than expected volume reductions due to DMC in Detroit or THC’s inability to execute on its cost savings initiative could drive downside through the complex.

Trade Idea #2: Buy HCA 5.5% Sr. Sec. Notes due 2047. Catalyst: Moody’s upgrade.

We continue to think there is a likelihood that HCA’s secured tranche could be upgraded to IG in the near-term by Moody’s, catalyzed by an unsecured issuance to finance the Mission Health acquisition.

Recall that Moody’s has previously stated that a secured note upgrade is possible if the “relative amount of secured debt in the capital structure is reduced,” and that it would only previously have taken a $1.0bn shift of secured debt into unsecured debt to indicate a Baa3 rating. Nevertheless, after HCA refinanced $1.5bn of the 3.75% 1st Ln Notes due 3/15/2019 with $2.0bn in unsecured debt and reduced the secured percentage to 65% at 3Q2018, Moody’s took no action. Moody’s also recently (September 2018) stated that it viewed the Mission Health deal as a “credit positive” that could have “implications for certain debt instrument ratings” depending on funding.

We note that companies that obtain an IG rating on the secured tranche, despite the CFR being rated HY, generally obtain more favorable unsecured pricing as unsecured spreads are anchored to the IG market (delta above the secureds); we see this among Dell and Charter. Although not a “goal” of management to obtain an IG upgrade, we believe that anchoring pricing could be beneficial for future unsecured capital raises to fund further acquisitions.

The 2047 secured notes have traded down ~6 points following recent peaks in September to $97.0. We see 25-50bps of spread tightening upon a secured tranche upgrade, which would amount to 2-5 points upside. Given the short term catalyst, we view rate risk as relatively low.

Risks to the downside: Headwinds resulting from acquiring low margin (vs core HCA), turnaround hospitals could strain growth capital capacity. Further, any lengthened delay on a secured IG upgrade could drive downside through the complex.