All about converts

Trade idea

I believe that there is an opportunity to buy LPNT 3.5% converts due 5/15/14 ahead of the Supreme Court ruling on the proposed healthcare reform. The converts trade at 103.25 versus 37.6. Using 350 credit, the converts imply 27 vol, theo delta of 30 and premium of 42%. A trade set-up on 27 delta would allow us to benefit from a significant move in the stock, especially in tail event scenarios. LPNT is a solid credit that should hold up, particularly for short dated maturities such as the 3.5% converts. The company is rated BB, converts are sub debt rated BB-.

LPNT is usually not a high vol. stock because the company has steady cash flows, low leverage relative to peers, and is generally a well-run company. LPNT also predominately operates hospitals in rural areas, which tend to be monopolistic in nature. The stock has realized about 25 vol over the past few months. However, last summer, realized vol popped from the low 20s to 40-50 after a divided Congress debated budget cuts. We may be on the verge of experiencing a similar scenario.

Supreme court decision

The next catalyst is the Supreme Court decision, which is expected to come out 6/28/12. According to Citi’s analyst, these are the four scenarios for hospital stocks:

1)      Entire law upheld: The court upholds the entire law, 2014-15 hospital earnings power increase by 45%. We estimate hospital stocks could trade 15% higher on decision day and could double in 12 months if Obama is reelected.

2)      Mandate struck/insurance provisions remain: The court rules the individual mandate unconstitutional but insurance provisions remain. This outcome would increase 2014-15 earnings power by 10% & the stocks might trade +5% higher on decision day as perceived uncertainty declines.

3)      Mandate struck/insurance provision struck: This outcome would leave hospital stocks earnings power unchanged. The stocks will likely have a muted reaction.

4)      Entire law struck: The mandate is ruled unconstitutional and inseverable from the rest of the law. While it is entirely plausible that 5 justices may rule the mandate unconstitutional, we are skeptical that 5 will agree that the entire law must be overturned. Hospital stocks could trade 5-10% lower on decision day and likely trade toward trough EBITDA valuations (low-5x forward, stock prices 30% lower) in the throes of the January 2013 fiscal debate.

Most analysts believe that options 1 and 2 above are the most likely outcomes.

2012 US presidential and congressional elections

Even if the Supreme Court rules to uphold the entire reform, the victory may be short lived. If Romney wins, the Federal funding for insurance coverage expansion (exchanges & Medicaid) would likely be withheld. According to Citi, hospital stocks would erase all their gains from a favorable court decision & heads toward trough valuations by Jan 2013.

2012 Congressional elections

Many healthcare facility stocks including hospitals were down 40-50% during the summer of 2011 as a divided Congress debated entitlement cuts. These stocks will likely see volatility if Republicans were to control both houses of congress.

Other catalysts:

Medicare fears: Congress will likely have to raise the US debt ceiling again in early 2013. The precedent has been set that such increases must be funded by spending cuts. Medicare may bear a greater burden in the next round.

Quarterly earnings:

CMS Medicare reimbursement FY13 final rule for acute care hospitals (likely in August)

Business Profile

LPNT operates 55 acute-care hospitals, primarily in rural markets (KY, TN, VA, NM, WV, AZ, LA, AL). In 52 of its 55 markets, LPNT’s facility is the sole acute care hospital provider in the market. Having sole provider status in the vast majority of its markets leads to certain benefits to LPNT in capturing organic patient volume growth as well as in negotiating price increases with commercial health insurers.

LPNT’s payor mix: Medicare 35%, Medicaid 14%, Private insurers 48%, Self-pay 19%, bad debt expense -17%)

Credit

Cash = 116M

Debt = 1.6B

Revolver 12/15/12 ($350m undrawn)

3.25% converts put 2/15/13 ($225m) (sub)

3.5% converts 5/15/14 ($575m) (sub)

Term loan 4/15/15 ($444m)

6.625% senior bonds 10/1/20 ($400m) z-spread of 450

Debt/EBITDA = 2.98

Net Debt/EBITDA = 2.75

EBITDA/Interest = 5.0

LPNT has produced steady FCF since 2004 and is expected to continue this trend. FCF should remain over $150 per year. In the past, the company has used FCF to make acquisitions and to buy back stock ($300m from 2010-2011). LPNT’s Debt/EBTDA ratio is the lowest in the hospital industry.

Covenants (Term loan and revolver)

Net debt/EBITDA < 3.75x

Convert specifics

Get last coupon even if converting

Fully dividend protected

Senior subordinate ranking

Lose 1 point on $50 cash takeout on 7/30/12, 27 delta

Net share settlement