Investing in Healthcare Businesses: The Metrics that Matter Most

For companies providing healthcare services, the landscape is crowded, fragmented and messy. The financial data often hides more pertinent information than it reveals, rendering a rather murky due diligence process. The path to profitability can be distorted and volatile.

Nonetheless, healthcare businesses, large and small, continue to be attractive targets for investors as the demand for healthcare services grows with the demographics. Whether a healthcare company is being considered for an acquisition or simply under review by industry analysts or potential shareholders, financial metrics (those found in income statements, balance sheets, cash flow reports, etc.) are undisputedly accepted as a means of evaluating the performance of any business. These common metrics objectively reflect the results of things going well or not so much.

Financial metrics are the common scoreboard that provide the comparable and historical “what.” However, they provide neither the “why” nor the “how.” To get the story behind the financial performance metrics, we have to take a deeper dive into the metrics that reveal the strengths (advantages) and the weaknesses (vulnerabilities) of the company from an operating perspective.

So, let’s start with culture. For healthcare services companies to grow and sustain their business model, culture is everything. Cultural stability is often viewed as “soft stuff” (i.e., difficult to assess and to quantify) and therefore it usually eludes outside analysis by buyers/investors. As healthcare services are inherently more labor intensive than product-generating businesses, cultural stability is a really big deal.

Are there metrics that can actually determine cultural stability? Yes indeed. The most obvious, high-level example is “employee turnover rate.” Even more revealing is “employee turnover rate within the first 12 months of employment.” Employee turnover metrics should be further segmented by location or functional areas to gain a more specific insight. These metrics are just a starting point that leads to other metrics pertaining to cultural issues both positive and concerning.

Top line revenue growth, as well as its vulnerability, is usually the focus of a “quality of earnings” analysis. Quality of earnings is derived from the “quality of revenues” (i.e. how sustainable are current and last year’s revenues?). Without stable and growing revenues, “quality of earnings” means nothing. The answer is not found in historical financial data, but it is obtainable and often the most valuable.

With healthcare companies, the indicators and drivers of sustainable revenues, and the resulting earnings, require an understanding of factors that do not apply to most other industries in which the customer and the payer are one and the same. In healthcare markets, the third-party payer system dictates a multilevel insight prompting two basic, but essential, questions:

1) Where do the customers (patients) come from?

2) How do you get paid?

Once again, the answers to these two questions are clearly not available in the financial performance data, yet they determine quality of earnings, not to mention the overall viability and vulnerability of the business as an investment.

For question No. 1, we break down the actual sources (called “referral sources”) and their behavior pattern over a period of 12 months corresponding to the reporting periods reflected in the financial data. Referral sources vary from one local market to another. Some types of healthcare businesses have more narrowly defined referral sources than others and, as with any business, the more diverse, larger and consistent the numbers of referral sources, the less vulnerable are the revenues.

For question No. 2, we focus on the consistency and trending of the payment rates, which are usually negotiated annually with the various payer sources (insurance both commercial and governmental). In the past few years, we have seen a substantial “ forced sharing” of healthcare expenses vis-à-vis steeply increasing deductibles. This increase in what we call “first-dollar coverage” placed on consumers has negatively impacted the revenue outlook for many healthcare businesses. This is why a company’s quality of earnings can rapidly fall off a cliff. The metric here is called “payer mix” and it is used by all providers of healthcare, from hospitals to outpatient businesses, to measure financial vulnerability.

With many service businesses that are local in nature, such as healthcare services with all of its niches, the focus needs to be on future performance revealed by those metrics that tell the story beneath the basic financials. It’s these metrics that provide insight as to how the company is positioned to sustain external changes in market conditions. Whether it is internal culture or referral sources or payer sources or other aspects of the business that usually escapes the due diligence process, there are metrics that can locate all of the skeletons (as well as exactly which closets to find them in). Managing risks is always part of the task, but you can’t manage risks unless you know them. Whether you are identifying the most valuable employees or retaining the most valuable customers or targeting what needs to be fixed inside the operations, getting to the right metrics is what matters most.

Kevin O’Donnell is managing partner at Dallas-based HRA Partners LLC, an affiliate of Healthcare Resources of America, which provides M&A assistance and operating expertise to healthcare corporations and private-equity investors.

Posted in Expert Opinions.