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Tenet Healthcare Corp.’s announcement to acquire a small competitor firm – Vanguard Health Systems -- in an all-cash deal of $4.3 billion has come across as one of the major news in the healthcare industry. The transaction is scheduled to culminate by the end of this year.

The valuation is more than 70% higher than the closing price of $12.37 on Friday. This further surged approximately 60% on Monday and closed at $20.94.

Deal Amid Debt Concerns

Valued at $1.8 billion, the $4.3 billion deal includes debt worth $2.5 billion, which will be acquired from Vanguard. However, this debt could dent Tenet’s highly leveraged balance sheet.  While the financial status of Tenet will not allow it to pay beyond 6%, a major part of the debt is in the form of notes carrying interest between 7% and 8%. Even at this rate, Tenet’s combined leverage ratio, post acquisition, is expected to be over 5x and could raise the concerns of the ratings agencies.

Meanwhile, the attorneys of Vanguard shareholders believe that the company has sold itself for too less, particularly, at a time when Vanguard’s financials were witnessing noticeable improvement that showcased future growth potential too. Vanguard posted increased operating cash flow and earnings in the 9 months ended Mar 31, 2013, delivering positive earnings surprises in 6 out of last 8 quarters.

On the other hand, with a total debt of about $5.4 billion at the end of Mar 2013, Tenet would again raise debt from Bank of America Merrill Lynch, thereby further deteriorating its debt-to-EBITDA ratio. The company intends to attain a senior secured term facility worth $1.8 billion from the bank and finance Vanguard’s debt through a senior unsecured bridge credit facility worth $2.8 billion. Post acquisition, Tenet will issue high-yielding long-term notes for the amount drawn from this bridge credit facility.   

The Upsides Galore

While some cost of risk has to be borne, no deal is ever made on a base of complete drawbacks. The acquisition not only diversifies Tenet’s business portfolio but is aligned with the benefits of the healthcare reforms in the US that requires citizens to have medical insurance coverage, offering ample growth opportunities for healthcare providers as well.

The non-overlapping business of Vanguard also brings in 28 new acute care and specialty hospitals across Texas, increasing Tenet’s exposure toareas of child and heart care. The acquisition further complements the company’s strategy of expanding its operating and competitive leverage in the metropolitan markets via inorganic growth.

Meanwhile, the deal is expected to be accretive within the first year of culmination. Tenet also projects annual synergies worth $100–200 million owing to reduction in supply costs and efficient labor management.

Moreover, the improving outlook for cash flow in 2014 and beyond injects confidence and eases the debt concerns. Management expects the debt-to-EBITDA ratio to improve by the end of the first year of the acquisition. This ratio should be within 4.75x–5.0x by 2014-end and further improve to 4.25x–4.75x in the long run. Thus far, the ratings agencies appear to be comfortable with an above 4x debt leverage for Tenet, providing it with ample room for improving its business profile and financials.

Tenet reiterated its target of buying back about $200 million shares in the second half of 2013, retaining shareholder confidence. Despite higher bad debt expenses and debt leverage, we believe that the company has the potential to boost its outpatient revenue and earnings in the future.

Other Stocks to Consider

Apart from Tenet, Health Net Inc. and Centene Corp. carry a Zacks Rank #2 (Buy). Vanguard has a Zacks Rank #3 (Hold).

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