Hospitals' Terminal Disease Health-care spending continues to rise--so why is this industry struggling to grow?
By Maggie Mahar

(FORTUNE Magazine) – Say "health care" and many an investor will respond "safe haven." Invariably the explanation is demographics. As everyone knows, the baby-boomers are aging, and it seems safe to assume that the group that has led every consumer trend from Hula-Hoops to housing will continue to drive the expanding market for medical care. By that logic, hospital stocks should offer a great opportunity. Hospitals already attract one-third of all health-care dollars. And a recent study published in the respected industry journal Health Affairs projects that the amount Americans spend on hospital care will rise by some 75% from 2002 through 2012.

That investment strategy certainly worked through the bulk of the bear market. For the three-year period ended March 31, 2003, shares of hospital chains like HCA, Triad Hospitals, and Universal Health Services rose by more than 60%. Since then, however, investor-owned hospitals have fallen on hard times as more and more employers have rolled back health-care benefits, leading to a spiraling number of uninsured patients. The bad news reached an apogee of sorts this spring, when both HCA and Universal Health Services slashed earnings estimates. The problem, they explained: deadbeat patients. Their stocks swooned.

Now the dropoff has some value-oriented investors convinced that hospital stocks are on their way to becoming a bargain. "Compared with other health-care stocks, hospitals are relatively inexpensive," says Jordan Schreiber, manager of Merrill Lynch Healthcare fund. "The market overreacted to the news." He believes that with admissions increasing, and costs under control, "companies like HCA will be able to stabilize the debt problem."

But unpaid bills are a growing problem for hospitals (for more, see "Reality Checkup" on fortune.com). In addition to HCA and Universal Health Services, competitors like Triad Hospitals, Community Health Systems, and LifePoint Hospitals have reported an increasing amount of bad debt. Industrywide, the stack of "uncollectibles" has nearly doubled in 13 years, to $22.3 billion.

What's even worse for investors, though, is that unpaid bills may represent just the tip of the industry's problems. A closer look suggests a larger underlying issue: a basic flaw in the business model.

Two of the biggest obstacles investor-owned hospitals face are well known: First, they must scramble to compete with nonprofit hospitals that are exempt from both corporate income and real estate taxes. Second, while not-for-profits are able to raise capital relatively cheaply in tax-free bond markets, for-profits depend on equity markets where investors expect double-digit growth. And therein lies the heart of the problem.

"Hospitals simply can't generate the year-after-year earnings growth that Wall Street wants," explains Sheryl Skolnick, a health-care analyst at Fulcrum Global Partners. "Wall Street rewards 15% to 20% earnings growth. You just can't get that from a labor-intensive, real-estate-based business." Unless they're adding capacity, hospitals are lucky to wring out 6% top-line growth, Skolnick adds. And the need to reinvest in the buildings inevitably cuts into that. "The only way for the company to continue to grow is to buy another hospital, fix it, grow it, and do it again," says Skolnick.

In other words, to survive, a hospital company must become a serial acquirer. The catch is that as for-profit hospitals consolidate, the quality of hospitals up for sale declines, says James C. Robinson, a professor of health economics at the University of California at Berkeley.

No question, running a hospital is a tough business: By some estimates, more than 60% strive to stay afloat on profit margins of just 2%. When hospitals made their debut on Wall Street, many assumed that hard-nosed business decisions combined with free-market competition would make them more efficient--and so better able to contain costs. Gerard Anderson, director of the Center for Hospital Finance and Management at Johns Hopkins University, says that at the outset hospital chains managed to cut costs by consolidating purchases. But now that not-for-profits have formed purchasing alliances, "for-profits no longer enjoy a distinct advantage. And they don't seem to have any other innovative solutions." This may explain why, after gaining 15% of the market, the for-profit industry's share has remained flat for roughly a decade.

It's not that Wall Street can't handle slow-growth businesses, points out Robinson. As long as growth is steady, risks are minimal, and P/Es remain low. But, he says, the pressure of the equity markets brings out the worst in for-profit hospitals, forcing them into cycles of overexpansion and bust. And a few years of quick growth can too easily whet unreasonable expectations, says Robinson, leading investors to mistake a "modest-growth business for a go-go industry."

This may explain why more than one chain has been tempted to game its numbers over the years (think HealthSouth or HCA's predecessor, HCA-Columbia). It seems that in some cases, the only way these companies can make their numbers is by inflating them.

Given the uphill battle these companies face to grow profits at a rate that satisfies Wall Street, investors would be well advised to heed this broad piece of advice: Stay out of hospitals.