Vanguard bets on urban strategy

Vanguard Health Systems Inc., an investor-owned hospital chain based in Nashville, Tenn., has the financial ability to purchase Detroit Medical Center in a $1.5 billion package deal, but two financial experts who have reviewed the proposal tell Crain's that the proposed acquisition has risks because Vanguard's 15 hospitals are losing money.

“Vanguard was formed to acquire underperforming hospitals with the intent of turning them around, but their hospitals are losing money,” said Mike Boudreau, director of transactional financial consulting with Bloomfield Hills-based O'Keefe & Associates.

“You cannot sustain a successful business model by losing money from your core operations and filling the gap by squeezing cash from your assets and issuing debt.”

While its cash flow is sufficient to service its current debt, Vanguard, a privately held investor-owned hospital chain, has posted positive net income in only two of the past five years including 2009, when Vanguard earned $28.6 million in net income, Boudreau said.

During that five-year period, Vanguard has posted an aggregate net loss of more than $170 million.

On the other hand, while eight-hospital DMC has been profitable the past six years, there are a lot of DMC-identified risks to remaining independent: small operating margins, aging facilities, lack of access to capital to improve them and an underfunded pension, said CEO Mike Duggan.

Duggan also wants DMC to sell to Vanguard  for $417 million to ensure its hospitals remain competitive with other nonprofit health systems in Southeast Michigan that are also funding capital projects to expand market share.

The proposed acquisition by Vanguard would immediately solve a couple of those problems by providing nearly $850 million in sorely needed capital over the next five years and fund $278 million in pension obligations.

The belief is that the investments would ultimately lead to improved market share and margins.

The risk to the acquisition, though, according to Boudreau and Joshua Nemzoff, president of Nemzoff & Co., is that Vanguard's long-term financial prospects are based on an urban market strategy that may or may not be successful, depending on the economy, and how well the recently approved health care reform bill reduces DMC's uncompensated care costs.

So far, Vanguard's results are mixed.

In the first six months of fiscal 2010 that ends June 30, Vanguard posted a net loss of $17.7 million, financial reports show.

Those losses would have been much more if it weren't for Vanguard's three health plans in Illinois and Arizona posting profits of $27.2 million. Vanguard's 15 hospitals, which it has acquired over the past 13 years, lost $46.3 million.

Vanguard's 2009 annual report describes it as “a highly leveraged company” with $1.75 billion in debt and a 72.5 percent debt-to-equity ratio.

“Vanguard is more leveraged (than other investor-owned chains), but it is not outrageous. They can service their debt comfortably,” said Nemzoff, whose New Hope, Pa.-based consulting company specializes in nonprofit hospital merger and acquisitions.

Besides, Nemzoff said, Vanguard does have an ace up its sleeve.

Some 66.1 percent of Vanguard's stock is owned by The Blackstone Group, one of the nation's largest and richest private equity investment firms. But Boudreau said Vanguard can only count on investments from Blackstone for so long.

“No matter how much money Blackstone has, when someone lends money to Vanguard, the investors want to know they will pay it back with interest,” Boudreau said.

Duggan and DMC Board Chairman Steve D'Arcy say the accounting firm of Ernst and Young and such business savvy trustees as Roger Penske and Carl Camden have concluded that Vanguard can live up to its promises to DMC.

“We went line by line through every hospital, and we are intimately knowledgeable with their finances,” Duggan said. “In markets where Vanguard has a critical group of hospitals (Phoenix and San Antonio), they have excellent performance. They will do well here in Detroit.”

From a strategy standpoint, Boudreau said, Vanguard will try to increase DMC's profit margins at least to that of Vanguard's EBITDA margin of 9.5 percent.

EBITDA, a financial indicator used to measure efficiency and profitability, is earnings before deducting interest, tax, depreciation and amortization.

“Vanguard has to push DMC to become more efficient and cut costs,” Boudreau said. 

Duggan said that while DMC's profit margins are 2 percent, its EBITDA margins are 6.5 percent. With capital and operational improvements, Duggan said, DMC's EBITDA margins are likely to increase above 7 percent.

“If they put that kind of money into our operations, I will be looking for significant improvement in DMC's profitability, and Vanguard is expecting that, too,” D'Arcy said.

In 2009, DMC earned net income of $30 million, D'Arcy said. For 2010, DMC is projecting net income of $10 million.

Boudreau said that if DMC can increase its EBITDA margins to  10 percent, Vanguard can generate an additional $160 million of cash per year.

“Vanguard may be able to borrow roughly five times that amount or $800 million to $900 million,” Boudreau said. “These funds could be used to either repay the debt they took on to do the acquisition, fund the $850 million of (capital improvements) or some combination of the two.”

However, Boudreau added, “If they are unsuccessful at improving the operations, then the projected (capital improvements) could be delayed.”

To safeguard against delayed or canceled projects, DMC negotiated a provision that requires Vanguard to place shares of its stock valued at $500 million in an escrow account that would be controlled by the new DMC Foundation, D'Arcy said.

“If they default on obligations, then we end up owning a large part of Vanguard. Blackstone is never going to allow that to happen,” D'Arcy said. “It is intended to ensure that Vanguard's priority is to DMC and not to purchase other hospital systems.”

D'Arcy said the new DMC foundation could sell the stock and use it to fund projects in Detroit.

Trip Pilgrim, Vanguard's chief development officer, said Vanguard is in growth mode. He declined to discuss other hospitals it may purchase in the future.

Vanguard hopes to close on a deal in Chicago by June 30 to purchase two Catholic hospitals owned by Resurrection Health Care. It also is negotiating to purchase a third hospital outside of Boston.

Pilgrim said Vanguard has the financial resources to purchase all 11 hospitals, including DMC.

“We have enough free cash flow in our existing credit facilities to fund (DMC) over the next five years without borrowing, but that doesn't mean we won't,” said Pilgrim.

Boudreau said he expects Vanguard will increase its bank debt borrowings to help fund the DMC acquisition.

In January, Vanguard refinanced $950 million of debt at lower interest rates, Duggan said.

However, New York-based Gimme Credit, which conducts corporate bond research for subscribers, said it “warned investors that (Vanguard's) 8 percent coupon was not sufficient compensation for the increasing credit risk with management's propensity to layer on and maintain debt.”

D'Arcy said he expects DMC and Vanguard to finalize the deal sometime in May.

On Thursday, the Detroit City Council approved a renaissance zone for the plan. DMC and Vanguard meet this week with the Michigan Strategic Fund for final approval of the zone.

Attorney General Mike Cox is reviewing the proposed sale to make sure the DMC's nonprofit assets have been valued correctly, and to look for conflicts of interest and ensure that the DMC board conducted due diligence in deciding to sell.

Under the proposed deal, Vanguard would invest the $850 million in about 20 projects, including a new tower at DMC's Children's Hospital of Michigan, a cardiovascular institute at Harper University Hospital and Hutzel Women's Hospital and expansion of the emergency department at Sinai-Grace Hospital.

“This is a very, very unusual deal for an investor-owned company and by far the biggest deal Vanguard has ever done,” Nemzoff said.

 “It is a great deal for DMC and for the people of Detroit. I have questions whether Vanguard will do the deal (because) they are spending a lot of money in one market, and it is Detroit. The economy has taken a hit,” he said.

D'Arcy said he is confident that Vanguard has the liquidity to close the DMC deal.

“There is always a business risk when you do a deal like this,” he said.

Jay Greene: (313) 446-0325, jgreene@crain.com