Capital Allocation at HCA

Summary
HCA was the largest owner and operator of hospitals and other healthcare facilities in the
US. Its Executive VP and CFO Bill Rutherford was faced with the dilemma to look for
opportunities to invest the excess free cash flow the company was generating. HCA had
recently seen the exit of its private equity sponsors in a leveraged buyout of $33 billion.
HCA has oscillated multiple times from going public to private when the growth of the
company seemed stagnant in order to increase its efficiencies. It went from private to
public in order to cash in some profits for its private shareholders and raise capital through
equity for debt leveraging. The growth of the hospital-based industries slowed down due to
unattractive targets for acquisitions in the late 90s. The ACA act in 2010 changed the
playground and it provided healthcare packages to nearly 20 million people in order to
reduce the number of uninsured people hence showing a positive sign for the industry. The
healthcare industry consisted of high operating leverage and fixed costs, for HCA
approximately 40-50% of its costs were fixed. The market consisted of competitors who
were not in a favorable position compared to HCA due to their acquisitions going south in
the case of THC and CYH acquiring Vanguard Healthcare and HMA respectively. This led to
the share prices of the companies falling by 70-80%. HCA had a good operating structure in
place which was reflected in the stock performance. HCA now had certain alternatives in
place to assess where it should invest its free cash flows given the second largest market
player in the healthcare industry.

Capital Allocation Alternatives

1. Focus on Existing Markets

HCA had committed to $4.5bn over the next 3 years in capital expenditure and it had spent
$2.8bn in 2016. This investment was in hindsight to increase the scope of its projects in the
future. HCA could look to invest in new emergency rooms, new towers and more
investment into information technology. HCAs engineering and construction group was
already operating at near full capacity and in order to go for additional expansion HCA
needed to first look at increasing its capacity and network.

2. Acquiring Large firms to enter new markets

HCA had acquired small tuck in firms and Health Mid-west in 2002. HCA could look to
further expand horizontally or vertically. Horizontal expansion meant acquiring more firm
and it required heavy capital investment. It had laid down criteria for the firms to be
acquired which were:
 a. Attractive demographic and economic growth profiles
b. Enabling HCA to be the leading or 2nd largest leader in the market
c. Adding value by applying HCA operating model
d. Acquisition price should provide HCA with considerable returns

Given this there were a number of targets in the market that meet these criteria and HCAs
M&A pipeline looked active. HCA could go for acquisition of the companies with revenues
in $1- $1,5 billion range. HCA could also look for vertical integration into healthcare
products, entering pharmacy managenment, and post acute care services.

3. Reducing the leverage

HCA could push its funds to reduce the debt exposure and thereby reduce its leverage of
$31 billion in 2016. Its existing policy was to maintain its debt in the 3.5-4.5x EBITDA range
which was 3.8x in 2016. It also wanted to maintain its liquidity between $1.5 to $2 bn
which stood at $2.1 and its floating-rate interest was at 12.4% which fell in range of 10-
20% as desired by HCA. Given its suitable position in terms of leverage, HCA could further
look to reduce its exposure to interest and financial risk. This would help to improve its
credit rating which stood at Ba1 in 2016.

4. Return Cash to Shareholders

The sentiment to issue dividends to shareholders for a company is when the company has
excess cash flows and does not have a lucrative opportunity in the existing market to
capitalize on the returns. HCA had in the past provided its shareholders with cash
dividends and share repurchases in its recent LBO exit. The company also had the option to
go for quarterly cash dividends given its financial position which meant a positive trend in
its stock price. Given HCA had a lucrative option for acquisition and further horizontal
expansion it should look for first acquiring companies and then distributing the excess
earnings if any to the shareholders.

Conclusion
HCA should look for acquiring more companies in the wake of gaining a more stronger
market position and capitalizing on the opportunity that a significant number of firms meet
its acquisition criteria. Given that the retained deficit is negative, HCA can look into capital
investment opportunities other than providing dividends and furthering its market
position.