Tenet Rises to Outperform

We have upgraded our recommendation on Tenet Healthcare Corp. (THC - Analyst Report) to Outperform from Neutral based on its strong operating performance in the third quarter of 2011, which raises ample optimism for future growth.

Tenet reported third-quarter 2011 operating earnings of 4 cents per share, beating the Zacks Consensus Estimate of 1 cent and operating loss of 1 cent in the prior-year quarter. The improvement was driven by strong results in all lines of business, especially the robust growth in outpatient volumes and higher admissions.

Since 2006, the company has been steadily generating operating revenue growth. The improved results are attributable to significant contribution from Tenet’s general hospitals, which have been showing a revenue growth trend due to increase in outpatient visits, improvement in managed care pricing and a favorable shift in managed care payer mix.

Additionally, Tenet has been gradually expanding its operating capacity via acquisitions. In August 2011, the company announced an agreement to acquire CardioVascular Associates P.C. during fourth quarter 2011 and subsequently, merge it with subsidiary Brookwood Medical Center to form CardioVascular Associates of the Southeast, which will act as a subsidiary of the group company.

Further, during the nine months ended September 30, 2011, Tenet acquired one diagnostic imaging center each in Florida and South Carolina, two oncology centers in Texas and Florida and 18 physician practice entities. Additionally, the company also purchased majority interests in a diagnostic imaging center in Georgia, three ambulatory surgery centers in Texas and one in South Carolina.

Going ahead, the company also aspires to acquire hospitals and other health care assets to increase its outpatient revenues, as historically, the outpatient business has generated significantly higher margins than the other business lines.

Moreover, the issue of new 6.5% senior secured notes is likely to be beneficial for Tenet as the subsequent repayment of 9.0% senior secured notes from the proceeds will significantly reduce interest payments. While the total debt of the company has increased with the issue, the new debt has improved the company’s debt maturity profile.

Additionally, the health care reform bill signed in March 2010 is expected to impact hospital companies like Tenet positively. It aims to expand the pool of insured patients by imposing an annual penalty on uninsured individuals and employers who do not provide health insurance cover to employees from 2014 onwards, which should aid the hospitals' bottom lines.

In addition, given the concentration of Tenet’s operations in California, Florida and Texas, which historically have higher percentages of uninsured and underinsured patients, the company enjoys a strong competitive advantage in benefiting from extended insurance coverage.

However, on the downside, Tenet is a highly leveraged company with approximately $3.97 billion of long-term debt and $169 million of letters of credit outstanding under the senior secured revolving credit facility as of September 30, 2011.

Additionally, Tenet has been experiencing a high level of operating expenses during the past few years. The impact of industry-wide and company-specific challenges have led to the rise of operating expenses to $8.57 billion in 2010 from $8.48 billion in 2009, $8.27 billion in 2008 and $7.81 billion in 2007.

Nevertheless, the positives far outweigh the negatives, leading to increased earnings expectation for the upcoming quarters. The Zacks Consensus Estimate of fourth-quarter earnings is currently 14 cents per share, up 45% from the year-ago quarter. 12 out of 15 firms covering the stock have revised their estimates upward, while no downward revisions were witnessed in the past 30 days.

For 2011, Tenet’s earnings are expected to be 43 cents per share, up 4% from 2010. The company competes with HCA Inc. (HCA - Snapshot Report) and Community Health Systems Inc. (CYH - Snapshot Report).

On Thursday, the shares of Tenet closed at $4.68, up 0.65%, on the New York Stock Exchange. The company carries a Zacks #1 Rank, which implies a short-term Strong Buy rating.