Private hospital and pathology operator Healthscope Ltd (ASX: HSO) updated the market this morning to say that first quarter conditions were weak and, if they continued for the whole year, the company’s Hospital segment would deliver no growth in operating Earnings Before Interest, Tax, Depreciation, and Amortisation (EBITDA).

This is likely to knock some of the gloss off the company’s shares this morning, with Healthscope trading at a rich 25 times last year’s earnings. The Hospital segment accounted for just over 80% of the group’s operating EBITDA last year, and grew at 8.3% during the past 12 months.

Management also stated that New Zealand pathology operations (around 11% of EBITDA) are likely to revert to more ‘organic’ growth in Financial Year 2017 after growing at 22% in Financial Year 2016.

So?

Needless to say, 25 times earnings is a pretty hefty price tag for a company that appears poised to deliver low-single digit growth for the year. Investors should be aware however that hospital utilisation rates are hard to predict, and lower-than-expected growth in this area recently contributed to big profits for Medibank Private Ltd (ASX: MPL). This could mean that utilisation rates may well improve throughout the year.

Enter the Insurers

Insurers are desperate to keep healthcare costs from spiralling out of control, and the other big market player, Bupa, has partnered with Healthscope to deliver a number of initiatives in this area.

Bupa’s ‘Pay For Qualityinitiative links patient outcomes to financial incentives or disincentives for hospital operators like Healthscope – with the ultimate goal being to reduce errors and decrease readmissions. Medibank uses a similar scheme with a number of its partners.

Another recent partnership between Healthscope and Bupa, known as ‘Always Events‘, aims to cut hospital readmission for medication issues, which reportedly accounts for between 20% and 30% of all medical (i.e., not surgical) hospital admissions for over-65s.

Hospitals and Insurers have a strange relationship, with each using the other to drive demand (hospitals) and achieve lower costs and better outcomes (insurers). Yet it’s insurers who ultimately foot the bill, and they appear to hold much of the bargaining power.

Is Healthscope overpriced?

On the face of it, yes. I’m not interested in the company anywhere north of $2.50. Yet Healthscope does have a strong development pipeline, with a number of new hospitals reaching completion this year. This will significantly add to the company’s earnings potential, and Icon Group’s $65 million investment in radiology facilities at Healthscope sites will significantly strengthen the group’s cancer offering.

Management also pointedly mentioned Healthscope’s $2.2 billion in available debt facilities and 10-year maturity, which suggests more acquisitions could be on the cards. So although I’d much prefer to get a price substantially below today’s levels, Healthscope does have growth potential.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.