3 Long Ideas That Remain Attractive Post 2Q21 Earnings

After 2Q21 earnings, we still love these three Long Ideas that have excellent opportunities for profit growth and attractive risk/reward. This week’s Long Ideas are HCA Healthcare Company (HCA: $249/share), Southwest Airlines Company (LUV: $51/share), and Verizon Communications (VZ: $56/share).

We leverage more reliable fundamental data, proven in The Journal of Financial Economics[1], with qualitative research to highlight these firms whose stocks present excellent risk/reward.

Figure 1: Long Idea Performance: From Date of Publication Through 7/27/2021

Sources: New Constructs, LLC
*Measured from the date of publication of each respective report. Dates can be seen in each company section below. Performance represents price performance and is not adjusted for dividends.

Despite Large Gains, HCA Healthcare Still Has 56%+ Upside

We made HCA Healthcare a Long Idea in June 2020. Since then, the stock has outperformed the S&P 500 by 111% and still has more upside.

What’s Working: HCA Healthcare’s 2Q21 revenue of $14.4 billion is up 30% year-over-year (YoY) and 14% higher than 2Q19. Equivalent admissions, which includes both inpatient and outpatient admissions, improved from 903 thousand in 2Q19 to 916 thousand in 2Q21.

HCA Healthcare saw its elective procedures decline in 2020 as people were more reluctant to pursue treatment during the pandemic. However, as COVID admissions as a percent of total admissions fell from 10% in 1Q21 to just 3% in 2Q21, HCA Healthcare saw a 12% increase in outpatient surgery cases from 231 million to 259 million over the same time. With outpatient surgery cases surpassing 2Q19 levels of 253 million, it’s clear that demand for elective procedures has recovered.

One of HCA Healthcare’s strengths is its ability to adapt in the ever-changing healthcare industry. Where telehealth once posed a threat to the firm’s operations, it now helps HCA navigate the challenges involved in providing healthcare service in the midst of a pandemic more efficiently. Going forward, the firm’s physical presence and improved telehealth capabilities position it to better meet the wide-ranging needs of its patients.

As the largest (by revenue) for-profit hospital operator in the U.S., HCA Healthcare leverages its scale to drive superior profitability compared to its peers. Over the trailing-twelve-months (TTM), the firm’s return on invested capital (ROIC) of 19% is more than twice the 8% market-cap-weighted average ROIC of its peers, who include Tenet Healthcare Corp (THC), Community Health Systems, Inc. (CYH), Universal Health Services, Inc. (UHS), Select Medical Holdings Corp (SEM), and Encompass Health Corp (EHC).

What’s Not Working: While most types of procedures, HCA Healthcare offers exceeded pre-pandemic levels in 2Q21, inpatient surgery cases are still 3% below 2Q19 and emergency room visits are 6% below 2Q19.

Though COVID-19 cases are well below the U.S. peak in November 2020, the Delta variant has caused cases to quickly grow over the recent weeks. If cases continue to rise, HCA Healthcare could see the recent uptrend in elective procedures abruptly stop.

The tight labor market in the U.S. could increase HCA Healthcare’s labor costs and put pressure on its margins. Additionally, if the firm is unable to retain staff and fill vacancies with well-qualified individuals, its service quality could suffer. However, the firm’s efforts related to recruitment, retention, and compensation should enable it to navigate the difficult market.

Despite Recent Gains, HCA Is Still Priced for Permanent Profit Decline: HCA Healthcare’s price-to-economic book value (PEBV) ratio is 0.8. This ratio implies that the market expects HCA Healthcare’s profits will permanently decline by 20%.

Below, we use our reverse discounted cash flow (DCF) model to analyze the expectations for future growth in cash flows baked into a couple of stock price scenarios for HCA Healthcare.

In the first scenario, we assume HCA Healthcare’s:

  • net operating profit after tax (NOPAT) margin falls to 11% (five-year average vs. 12% TTM) from 2021 through 2030, and
  • revenue grows at a <1% CAGR from 2021 to 2030 (vs. consensus CAGR of 7% for 2021- 2023)

In this scenario, HCA Healthcare’s NOPAT falls by <1% compounded annually over the next decade and the stock is worth $249/share today – equal to the current price. See the math behind this reverse DCF scenario. For reference, HCA Healthcare grew NOPAT by 6% compounded annually from 2010 to 2020.  

Shares Could Reach $387 or Higher: If we assume HCA Healthcare’s:

  • NOPAT margin falls to 11%, (five-year average vs 12% TTM) from 2021 through 2030, and
  • revenue grows at a 7% CAGR from 2021 - 2023 (same as consensus), and
  • revenue grows at a 3% CAGR from 2024 - 2030 (below 10-year average CAGR of 5%), then
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Disclosure: David Trainer owns LUV, JPM, and DHI. David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

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