Financial Analysis of Universal Health Services (UHS)

Introduction

Note: This analysis is based on financial data available as of November 2008, using UHS annual reports for 2006 and 2007 and Reuters financial data.

Universal Health Services (UHS) is a well-managed, national healthcare provider and the number three operator of healthcare facilities in the United States. Their primary strengths lie in sound management and geographic diversity. They do not, however, have any particular source of competitive advantage. Moreover, they are highly leveraged, which has allowed them to grow profitably but also compromises the company in the long term relative to their competitors.

UHS is liquid despite their debt. Their current ratio and receivable turnover are solid if unspectacular. They receive the bulk of their revenues from three customer classes: Medicare, Medicaid, and managed care companies.

Strengths and Weaknesses

The company's income statement reveals strong top-line profitability, but they lag their competitors in terms of bottom-line margins. This is due to high operating expenses, which have grown more rapidly than revenues over the past several years, creating a drag on profit growth. One result is that the company has not been able to grow its cash from operations despite strong increases in capital investments in recent years.

It is recommended that UHS improve its financial performance by focusing on operational efficiency. They need to hold the line on operating expenses, which have grown significantly over the past year. This has expanded their infrastructure, but the company must now focus on growth through infill of their current growing markets. This will allow them to utilize their existing infrastructure more efficiently.

Universal Health Services (UHS) is a healthcare provider operating in 32 states nationwide. By revenue, they are the seventh-largest operator of healthcare facilities. Some of the larger firms, however, are not direct competitors — for example, dialysis clinics Fresenius and DaVita. Within its peer group, therefore, UHS ranks third behind Community Health Systems and Tenet Healthcare Corporation. By market capitalization, UHS is the largest firm in the industry.

UHS stock is traded on the New York Stock Exchange. The closing price on November 7, 2008 was $40.80, representing a price-to-earnings ratio of 11.05, versus an industry average of 12.46. This price represents a lift from the 52-week bottom, which occurred on October 27th at $36.76. The stock dropped roughly in line with the broader market over the fall, and its slight rebound has also mirrored market performance. Overall, UHS has a beta of 0.85. Over the five years ended December 31, 2007, UHS significantly outperformed its peer group, improving share price by 16.56% while the peer group's value declined. However, UHS significantly underperformed the S&P 500, which improved 82.86% over the same period.

Universal Health Services is a well-managed company with good geographic diversity. Several indicators reflect the quality of UHS management. First, the company has not experienced any scandals, governance issues, or major incidents of negative publicity in recent years. Second, they have been able to maintain high gross margins at a time when many competitors have not. Third, UHS has developed a strong system for managing accounts receivable — the core of its revenues — which come from a handful of major private and public payors. Management of these revenues is critical, and UHS has an advanced system to perform this function. This dedication to excellence in a staff function indicates a thorough management team that understands the key drivers of its business.

Another example of management strength is the company's handling of its capital structure. When UHS retired a significant portion of its debt in 2005, it also experienced a decrease in financial performance. The company then increased debt again in 2006, and performance recovered. This careful management of the capital structure indicates a team that understands how to utilize debt to grow the company without compromising long-run profitability.

Geographic diversity is another source of strength in the healthcare industry. It provides insulation from regional economic cycles and demographic shifts. UHS has a presence in many growing areas, such as southwest Florida, Las Vegas, and markets in Texas, which has allowed the company to maintain growth despite demographic shifts away from some of its other markets. By operating as far afield as Puerto Rico and Alaska, UHS also gains valuable experience in different operating environments and cultures.

There are, however, a couple of key weaknesses. The company's high degree of leverage has been a boon to operations and has facilitated smart growth, but it also constricts future opportunities. UHS is more highly levered than its competitors and consequently is more exposed to shifts in the economy and interest rates. It may also experience reduced ability to raise debt in the future.

Another weakness is that UHS has no apparent source of sustainable competitive advantage. The company has strong management and conducts its business well, with little inherent downside risk. Yet there is nothing significant to distinguish it from any other major healthcare provider — good at everything, but great at nothing. This leaves UHS exposed to competitive forces from both larger firms and niche players.

Liquidity Analysis

Lastly, UHS has a high cost structure. Very strong gross margins do not translate to the bottom line. UHS underperforms its competitors with regard to operating and net margins despite outperforming them on gross margin, indicating that the company is not operating as efficiently as it could be.

UHS has moderate liquidity. Compared to other firms in the sector, UHS has significantly lower-than-average liquidity; however, it is broadly in line with the wider industry average. For example, UHS's current ratio is 1.37, compared with a sector average of 3.72 and an industry average of 1.47. The quick ratio is also 1.37, compared to sector and industry averages of 3.30 and 1.38 respectively. The company has a poor cash ratio of 0.03.

Over the past couple of years, liquidity has remained stable. The company experienced a deterioration in liquidity in 2005, from which a new liquidity paradigm has emerged. Liquidity prior to 2005, as measured by the current ratio, was well above current levels. Long-term debt to equity stood at 66.5% on December 31, 2007 — an increase over the previous couple of years, but lower than levels seen earlier in the decade. The figure was 58.5% a year prior.

Long-term debt levels are high for the sector but low for the industry. Long-term debt to equity for UHS is 59.72, compared to 10.17 for the sector and 230.47 for the industry. The structure of debt emphasizes the long term: for example, the current portion of long-term debt is $3.1 million on a total long-term debt of over $1 billion. UHS has a healthy interest coverage ratio of 3.97, which is higher than the sector average of 1.02 but lower than the industry average of 5.63.

Long-term debt to net assets was 27.9% as of December 31, 2007, compared with 25.0% the previous year. This figure is lower than the ratio the company held earlier in the decade, and the recent increase in debt is attributable to ongoing capital projects. It is worth noting that over the past five years, UHS has delivered better performance in years with higher debt levels, as measured by net income before extraordinary items. UHS earned $170.5 million last year and $192.1 million five years prior, both in high-debt environments. Its lowest year for debt was 2005, when it earned just $109.8 million on continuing operations.

The company's receivable turnover is 7.9, higher than the sector average of 0.96. The industry average is less relevant because many firms in the industry are suppliers rather than direct healthcare providers and do not face the same collection issues involving Medicare, Medicaid, and charity patients. This receivable turnover results in an average collection period of 46.2 days.

The two largest payors for UHS are managed care providers (HMOs and PPOs) and Medicare, accounting for 45% and 24% of revenues respectively. Medicare and Medicaid are significant public payors, with Medicaid contributing 13% of revenues. The remainder derives from individuals. At 18% of revenues, this portion represents the longest collection periods and the highest rate of defaults, though because this base is so widespread, no single payor can be identified.