Summary of investments
We remain optimistic about the long-term prospects of Universal Health Services, Inc. (NYSE: UHS) taking into account the factors of resilience and quality of the company. Let’s get one thing straight – you’re not buying UHS for the growth potential or as a long-term speculative play in a stock portfolio. UHS is as defensive as it gets, with 5-year total returns of just 2.28%.
Exhibit 1. UHS 7-Year Price Action: Long-Term Sideways Territory
Defensive in nature: UHS offers investors less volatile returns as a quality portfolio stabilizer that also offers a marginal dividend yield. Since 2015, returns have been flat, with shares trading at $143 each in August FY15. However, over the same period, investors have taken advantage of resilience and defensive characteristics to smooth equity returns, as the stock has a 5-year TTM risk-adjusted return (Sharpe ratio) of 1.57 , while the impact of Covid-19 is clearly visible on the action. prices as shown in the table below. In light of the quality premiums on offer, we rate UHS as a buy.
UHS 5-year TTM Sharpe ratio (red) versus price (blue).
Strong second quarter sales with long-term trends intact
Starting from a high base in Q2 FY21, sales in the second quarter of this year increased by 390 basis points to $3.23 billion. Alas, operating results were well below initial projections and this fell due to volatility in non-Covid patient turnover, with trends recovering at a slower pace than initially expected. The last time cases started to decline, there was a rapid recovery in patient turnover and the backlog was sorted quickly. This resulted in minor expense savings here, but we believe the opportunity cost of lost revenue is higher.
This time, however, management notes that the recovery in demand has been slow, underscored by labor shortages that prevent the company from meeting demand in the first place. In other words, there was a rapid slowdown in Covid-19 patient turnover, but that was not replaced by non-Covid patients, which hurt the declining P&L revenue. To illustrate, in Q1 FY22 Covid patients accounted for 13% of total admissions, and this dropped by 10 percentage points to 3% in Q2 FY22. Management was unable to provide certainty on the continued impact of Covid-19 on patient turnover when the results were called.
Segmentally, acute care saw its net revenue/day drop year-over-year, while the behavioral healthcare segment saw its net revenue per admission increase by 260 basis points year-on-year. Behavioral healthcare net income per day also increased 180 basis points year-on-year. Moving down the P&L, UHS reported operating income of $209 million, down about 50% year-on-year due to a vertical increase in OPEX. This reduced that result to net profit of $164 million or $2.20 EPS from $3.79 EPS in Q2 FY21.
We encourage investors to consider looking at normalized numbers or averages with UHS given the value proposition that is offered here. As shown in Table 2, quarterly trading metrics continue to stretch on a sequential basis regardless of when the market starts. This trend has been in place since FY15 to date. UHS printed $444 million in FCF in the last TTM and investors are making about a 5% return on that and if we take this data into account, it is not unreasonable to believe that Covid-19 will decline and that patient turnover trends will revert to longer-term averages. On this point, we are convinced that UHS is well positioned to take advantage of this.
Exhibit 2. Quarterly operating metrics continue to increase sequentially without fail
Regarding days lost due to lack of staff capacity, although there was no quantified response from management, CFO Steve Filton said:
We follow this [lost days from staffing issues] internally. We don’t release those numbers in part, because I think different hospitals track them a little differently, et cetera, and we don’t consider them to be the most accurate statistics. But we know we turned down during the pandemic, a significant number of patients either because we didn’t have the staff to care for them or because we had some beds blocked because the patients couldn’t be exposed to other COVID patients, etc.”
We note that CAPEX has also come back in line with a change in hospital capital budgeting cycles from 6 to 12 months in some cases. With that, and debt-related factors in mind, the company reduced capital budgeting spending by approximately 20% or $100 million for the first half of FY22.
This won’t be a problem given UHS’s excellent profitability metrics. On a quarterly basis, it averages a 5-year ROIC of 10%, well above its WACC of 6.8%. As a result, UHS has an ROIC/WACC ratio of 1.47x and this should be factored into the valuation. A quarterly ROI of 10% guaranteed substantial FCF for the business and continues to be the resilience factor we seek exposure to in FY22. With this in mind, we can have more certainty about the predictability of UHS’s future cash flows and more confidence in estimating its expected return.
Exhibit 3. Normalized 5-year ROI of 10% that easily beats the WACC hurdle
Portfolio Statistical Summary
Portfolio construction in FY22 should reflect the potential distribution of outcomes for the global economy. Namely, a reasonable safety margin to absorb a further 20% decline in US earnings and also sufficient to withstand a further 20% decline in the benchmark.
Thus, low equity beta and high-quality players such as UHS have added a layer of resilience and smoothed volatility in equity portfolios this year. As seen in Tables 4 and 5, an equally weighted balanced portfolio with exposure to alternatives for market neutrality [Portfolio 2] crushed the 60/40 and/or risk parity setups from January to July FY22, on an equally weighted basis. As shown in Figure 5, it produced a total return of 2.4% with a standard deviation of around 6%, but most impressively it recorded a maximum drawdown of just 322 bps.
Chart 4. Balanced portfolios with alternative weighting outperformed watermarks in FY22
Accordingly, the inclusion of UHS in the equity portfolio [Portfolio 3] produces surprisingly similar risk without adding too much transfer to equity risk. At equal weight, we see a positive return of 17 basis points (+12.45% alpha) with a max drawdown of 8%, well below the benchmark’s 19%. returns are similar with weighting reduced to 2%. If we assume that the medium-term outlook somewhat reflects prevailing trends, we can draw conclusions from the data. What this tells us is that an allocation to UHS in the equity tranche will not hurt equity risk significantly and will add a layer of resilience to long-biased equity portfolios. It’s not just diversification benefits either – it’s equity, and the SPY has 500 holdings in it. Rather, they are idiosyncratic bonuses.
Exhibit 5. Equal weighted UHS allocation with backtesting exhibits resilience characteristics in reducing downside, minimizing volatility and stock performance
The shares trade at 1.4x book value and also trade at 2.2x enterprise value (“EV”) to book value. At these multiples, we appear to be paying $111 and $177 per share, respectively. At this level, the stock is overvalued by 3% to 62% depending on the measure of value used. Given its stability on the chart, it’s not unreasonable to use stock prices, and so we’re comfortable saying that UHS is within fair and reasonable valuations at these levels.
We also recognize an ROE of 7.5% of FCF when we pay 2.2 x EV at book value, resulting in an equity duration of 9.6 years. The question then boils down to his strategy and his propensity to pay a premium. We pay ~11x forward C/E, 1.4x book and 18x FCF to access stable and persistent cash flow and an average ROIC of 10% per quarter, while mitigating related risk to stocks in stock portfolios. UHS therefore seems quite expensive at its current levels by estimate.
Despite the revenue challenges associated with lumpy patient turnover trends, the long-term buy scenario remains intact for investors looking to reduce volatility within equity portfolios. Our findings show that the stock can be added to an equally weighted balanced portfolio of up to 2% to reduce drawdown, stabilize returns and volatility relative to the benchmark. ROI has also averaged 10% per quarter for the name, so UHS appears to be a prime candidate to add a layer of resilience to equity portfolios in FY22. Buy Rate.