A Winner Under Obamacare

05/23/2013 7:00 am EST

Focus: STOCKS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

As regulations pressure medical facilities to do some major cost-cutting, this company is positioned to prosper, says Benjamin Shepherd of Personal Finance.

Patients in a hospital or long-term care facility receive more than just medical attention. They require clean sheets, towels and gowns and three meals a day.

Running kitchens and laundries are major cost centers for medical facilities, particularly small ones that aren't part of a larger network that can pool resources and run those operations from a central location. In today's cost-cutting environment, where every dollar in the health-care budget is accounted for and stretched as far as it can go, many facilities are seeking more efficient ways to handle those operations.

Furthermore, reimbursements under both the federal Medicare and state Medicaid programs are facing tight caps in the coming years under Obamacare, and facilities will have to stretch every dollar even further. One of the easiest ways is to reduce expenses through outsourcing.

Healthcare Services (HCSG) provides housekeeping and dietary services to more than 3,500 hospitals and long-term care facilities in 47 states.

In partnership with 3M (MMM), the company develops facility-specific housekeeping protocols, procedures, and systems to ensure that clients meet the highest hygienic standards in line with regulatory requirements. It also designs, installs, operates, and maintains laundry systems, and provides facility maintenance and plant management services.

The company also handles dietary services through three basic systems: Homestyle Settings, Personal Select, and Classic Café. Because the company handles all aspects of dietary management from purchasing and preparation to service and maintenance, Healthcare Services can leverage its economy of scale to maximize cost efficiencies.

Due to recently implemented health care reforms, medical providers are increasingly compelled to be more mindful of their expenses. Those that achieve the best possible health outcomes at the lowest cost receive more generous reimbursements.

Consequently, Healthcare Services has been extremely successful in securing new contracts for housekeeping services. Because the company typically charges less for these contracts than for dietary services, they're a springboard for new and higher-margin business.

The company has averaged better than 15% annual revenue growth over the past three years. With a better than 90% client retention rate and excellent cost controls, most new business flows straight to the bottom line, with free cash flow per share growing from 37 to 83 cents last year. Earnings per share have grown from 45 to 65 cents.

Much of that free cash flow is returned to investors via dividends. Healthcare Services has increased its payout in each of the past 39 quarters, for a current yield of about 3%. The company has also been historically generous with stock splits, initiating two 3:2 splits over the past decade.

And it's solid from a valuation and balance sheet perspective. Its price-to-earnings ratio of 29.9 is well below the industry average 38.8. It's also currently trading at just 1.4 times trailing 12-month sales, compared to an industry average of 1.7.

Recently, two large corporate clients reduced their service levels, which slowed revenue and earnings growth in recent quarters. Service reductions such as those are fairly rare occurrences, particularly with large clients. As a result, Healthcare Services is likely to return to double-digit growth in upcoming quarters, especially considering the size of its potential market.

According to data from the American Hospital Association, the country's 6,915 hospitals currently spend nearly $64 billion per year on housekeeping, laundry, and food services, with only about a quarter of them outsourcing those services. The nation's 23,000 long-term care facilities spend about $25 billion annually on those services; only about 18% of them outsource housekeeping and laundry services, while less than 5% outsource food services.

That's a huge pool of potential clients, as cost controls become a growing concern for health-care facilities.

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