Chemed Corporation (NYSE:CHE)
2013 Barclays Global Healthcare Conference Call
March 13, 2013 3:15 PM ET
David Williams – EVP and CFO
Brendan Strong – Barclays Capital
Brendan Strong – Barclays Capital
All right, good afternoon everybody. It’s a real pleasure to keep the afternoon going here with Chemed. With us today is Dave Williams, Company’s Chief Financial Officer with us. Look forward to hear more about the Company.
Thank you. As everyone knows Chemed, where we actually have two significant subsidiaries, our largest subsidiary makes up about two-thirds of our revenue in our overall profitability is VITAS. And the other business we have is Roto-Rooter. But obviously this is a healthcare conference, I’m going to actually direct all of my comments to the healthcare section, but if anyone has a question regarding Roto-Rooter, please feel free to ask, I am here and obviously we’re going to brief Q&A during this formal presentation as well as in the breakout session.
So we’ve obviously had meetings all day today primary one-on-ones, there certainly was a common thing and that seems to be where – government reimbursement, where it’s going. But the first thing I’d actually like to point out is talk a little bit about Chemed, our overall profitability since we owned VITAS starting in February of 2004, as well as what we’ve done with your company in terms of increased profitability. And this we think is a very, very interesting chart that we show and this by the way is on our investor presentation you can go and see this updated every quarter. But really as a benchmark of starting in 2003, the last four year where we did not own VITAS, 100% of it and then starting in 2004 when we owned it, you can actually see the green line going left or right, we showed a steady increase in our overall profitability on an adjusted EPS basis.
When I say adjusted EPS basis, it’s typically adjusted for expenses, not indicative of recurring operations and/or non-cash expenses. Those are the two largest things we pull out here is the non-cash expense related to Black-Scholes formula and our stock options, as well as the non-interest portion of our interest expense relating to our convert debt. So we include the 1.785% coupon payment in our debt, but we exclude the rest of the interest expense up to 6.5% that GAAP accounting requires us to expense that result in not a single penny of cash to anyone.
So another way of – long way of saying it is the green line basically has worked out to be our free cash flow per share, and cash flow we define as cash from operations plus capital expenditures. And we’ve got a steady increase of our adjusted EPS during this timeframe but then on the right side of that grid in the blue line basically shows a significant fluctuation in our stock price. And this is basically an expansion and contraction of the multiple our stocks trade at.
This also creates significant opportunity if you have a authorized share repurchase program, which we have it, we’ve had in place and we’ve been significantly utilizing starting in 2007, so we actually have taken advantage of these dips in the stock price. So what we say is management controls the green line, that’s within our control. Our shareholders decide the multiple our stock is going to trade at. You guys are responsible for the blue line. And we like to think we’ve done a pretty good job of managing upward the green line and producing a lot of cash flow. And we’ve now purchased over 33% of our outstanding share count.
We’ve repurchased through our share repurchase program and the average purchase price has been around now $55 a share, some repurchase shares as low as $39. And that’s been a great return for everyone concerned. So our attitude on share repurchases is part of our capital allocation program. First and foremost we want to do acquisitions, but acquisitions should be looked at in terms what do you pay as a multiple of EBITDA, but just as importantly what is our stock price trading at. And quite frankly if our stock is trading at a valuation less than these acquisitions, unless there is significant upside, or a massive amount of synergies available that are still retained for our shareholders, we believe we’re better off buying our stock.
So that’s why we’ve been passing on a lot of acquisitions that have been valued at a10 to 12 times EBITDA, and we’re buying our stock at about five times EBITDA, in some cases lower. So as a result, we’ve returned a lot of cash to shareholders over the last six years. In addition, we also think the dividend is important. Our dividend yield now is roughly 1% and we’ve had a steady increasing dividend over the last four years. We expect that dividend to continue, it’s not guaranteed it’s decided by the Board of Directors, but we think a combination of share repurchase and dividend while we’re waiting for intelligent acquisitions that will deliver value to shareholders is important.
In terms of as I talked about briefly now about 75% of our revenue comes from VITAS, about 25% comes from Roto-Rooter. We expect the VITAS business to continue to grow as Roto-Rooter is an industry that has very, very minimal growth. I’m going to quickly go to VITAS that’s where our growth is coming from that’s where increase in profitability comes from, but that also brings up the other issue is this is largely a government program hospice. 91% of our revenue comes from Medicare, 4% to 5% from Medicaid as a reimbursement basically that mimics the Medicare rates and then we have about 4% that’s private pay.
And the reason is there is an exceptionally strong correlation between terminal illness and age over 65. So because of that, Healthcare Reform doesn’t really impact VITAS as a healthcare service provider, because we are under a government program Medicare. And then we all know about sequestration and for us it was originally scheduled that we would get a 2% rate cut starting February 1, the government put in a 60-day delay and now that’s scheduled, we’ll get a 200 basis point cut in our reimbursement starting April 1st of 2013.
And we have an average reimbursement of about $205, $210 per patient per day if you look at our Medicaid and Medicare overall revenue and we’re talking about a $20 million cut annualized that would impact our revenue. And if we don’t do anything to offset that, that also would be about a 200 basis point reduction in our EBITDA margin or annualize about $20 million reduction in our overall EBITDA, but this 2% sequestration really will only run for calendar year ’13 for nine months, so that $20 million goes down about a $15 million impact. We have an effective tax rate between – we pay at the federal statutory rate of 35% plus state, so we have about 39% effective tax rate. Long way of saying is if we don’t do anything to offset sequestration, it’s about a $9 million impact in 2013 or we have right now outstanding about 18.4 million shares. So we’re talking real, real round numbers about $0.50 a share before we do an offset.
We believe there is significant opportunity for us to offset overtime this impact on sequestration and I would – we don’t necessarily like the word cuts and expenditures, we like the word reengineering and we’ll drive cost out of the business. But healthcare is a very unusual business model in terms of we have an army, we have 12,000 hospice workers in the United States, people who work for VITAS, a significant portion of them in the field providing care at the bedside.
If we turn around as that our shareholders are looking for 2% higher profitability, it will change their behavior to drive greater profits, they would be very upset and they wouldn’t appreciate that action. We explained to them that government has implemented, they are paying less for the same care we’re providing, so we have to be more efficient on indirect costs and infrastructure costs, so we don’t impact bedside care, but we’re more efficient getting workers to that bedside because the government is now paying less, that creates the opportunity.
So we really see our reengineering process commencing in April, sequestration happened which I believe at this point it will. We’ll drive these costs and we think over a long enough period of time, probably about a year plus, we think we could vastly offset the impact of this 2% cut. So that’s the negative. But what’s the positive on this? VITAS is the largest hospice provider in the United States. We have over on an average daily census over 14,000 patients are being treated by VITAS for end of life care on any given day. We’ll treat 75,000 unique beneficiaries, Medicare beneficiaries in 2013.
And our size, although this is mostly a variable cost business model in terms of the more patients you have, the more nurses, home health aides you have. We do have some fixed costs in our system. We have about $80 million of infrastructure costs. There is also some indirect costs in the field. That’s allowed us to have an EBITDA margin around 14% to 15%, the highest in the industry because we’re the largest provider and we’re about 77% of the overall market. So we think our size and what little leverage and scale there is gives us a huge competitive advantage as the government is squeezing reimbursement.
So let's just work on our 14.5% EBITDA margin. Our competitors for MedPAC [ph] are estimated to have about a 4% to 6% margin. And about half of the hospices in the United States are estimated to have a negative margin and they manage to keep their doors open through charitable contributions. So as the government has turned around in taking 200 basis points out of reimbursement, the bottom half of this industry, the people are – that hospices they are barely getting by, they are going to find it even more difficult to survive. So we think that 2% cut in reimbursement is basically going to leave to the inevitable consolidation that’s been kind of hanging over this industry for decade.
And we think we’re in a great opportune position to take advantage of that consolidation through direct competition and strategic acquisitions as long as those acquisitions provide profitability and increased value to our shareholders. So we have an under-levered balance sheet today. We basically have – we have about – as of today, we have $60 million in cash. We have a $187 million in face value convertible debt and we produce over a $100 million of free cash flow per year, a little over $200 million of EBITDA so basically we are under-levered and we’re prepared to utilize our balance sheet through intelligent share repurchase and acquisitions and as well as to increase our marketing effort to capture referral sources as our competitors begin to slacking on the quality of their care.
So a long way of saying is, we think we’re in for some very, very challenging times in terms of margin, but significant increase in profitability as long as we can provide more quality of care for government dollars in our compensation. And that really comes up to an interesting point what would get asked a lot is, what’s the future of VITAS? We also have this equivalent chart of what’s the future of Roto-Rooter. And from our attitude in the short-term, we’ll continue our organic growth.
We’ve been expanding – we estimate we’re going to grow our admissions 4% to 6%. We also think we’re only going to – right now have a 90 basis point increase in revenue and in billing, but we also – there is the risk of sequestration but we also have expanding length of stay. If we can go from an 80 – our average length of stay is 80 days, if that goes to 84 days, that’s a 5% revenue growth. A fragmented industry is getting squeezed by reimbursement that we think is going to result in consolidation and those mom-and-pop, not-for-profits are eventually going to have drive to get larger or go away.
And we are the most under-levered for-profit hospice publicly traded that there is out there. And we think – and we have a $350 million bank credit facility, so we’re prepared to take advantage of that access to capital if we can deliver value to our shareholder. Long-term we feel the government reimbursement structure is going to drive our future. Even beyond sequestration, I think it’s safe to say that government is going to challenge all Medicare healthcare providers, probably all healthcare providers to be more efficient or going to squeezed. We have to drive non-value added costs out of the system and be more efficient but basically margins over the long-term will come down.
But we also think consolidation brings a larger top line, a greater efficiency, so the fact is margins can come down but as long as we provide more healthcare quality than our competition, we can actually deliver more value to our patients and more profits to our shareholder through our efficiencies. If pure play to be a standalone hospice dominates, consolidation will continue. However there is also a scenario where pure play standalone won't dominate. And inevitably, if we see the potential from merging all large healthcare providers and large insurance providers, if the lines between those two become blurred, if we start seeing an individual markets like Cincinnati, San Diego, Detroit, Los Angeles, as we see these markets always going to be dominated by say a large insurance carrier or a large healthcare provider, then I think you’re going to a see a scenario whereby continuum of care plays out.
And in that case, maybe it makes sense for an insurance company or a large healthcare provider to actually have a very dominant hospice provider within that continuum. Then we think it’s inevitable that VITAS could very well become part of that, and can it will be acquired or hospice will be inserted into that continuum of care. But under any of these scenarios, given our positioning, we have the opportunity to provide significant value to shareholders as the most profitable hospice with the highest margin, delivering more care as measured by business per patient per day than anyone within the industry or certainly the average within the industry.
Kind of looking in terms of – my clock is not running, so I’m not sure what our time is. There it is. You had some questions though that you wanted to post Brendan in terms of?
Brendan Strong – Barclays Capital
[Inaudible - Microphone Inaccessible]
For ’14, yes. So as a result of the healthcare reform, one of the issues was basically instructed CMS, no earlier than fiscal ’14, which starts October 1 of ’13 to come up with a proposed change in reimbursement for hospice, because the hospice – the overall structure of a hospice reimbursement really hasn’t changed since the early 80s. There has been some tweaks and some nuance adjustments, but its largely untapped. And that’s actually reflective of how well hospice has worked, but it’s inevitable there is going to be a proposed change in reimbursement coming out of CMS.
And we meet annually with CMS in Baltimore, where we have a very good discussion on the future of a chronic care in hospice. And their attitude is they keep reinforcing that they were quite yet [ph] come out with something earlier than ’14, and they certainly can do it later. We’ve taken that as they have a lot of issues on their plate. There is a lot going on in healthcare through CMS. And they don’t seem to be in a rush to come up with a proposed change. We are actually working through The National Hospice and Palliative Care Organization, as well as through our own lobbying arm trying to at some point get something stapled to a bill that would actually mandate when CMS comes out with their proposed change in reimbursement.
After the comment period, require them through a demonstration project that show how that reimbursement impacts access to care before it’s rolled out nationwide. So we’re very concerned about that. We think what’s been proposed as theoretical change in reimbursement, what they call a u-shape curve. You pay more for the first X number of days in hospice, more at the last X number of days at hospice before discharged through death, and less in the middle. That actually has a strong correlation to the cost to provide of operative [ph] care.
So we’re very much in favor of that change. Our concern is actually not so much the strategy of reimbursement, to correlate cost of care to reimbursement. We’re concerned about the rules they wrap around that reimbursement that can result in some gaining of the system, so a demonstration project utilizing that actual proposed change in reimbursement to see that potential gaining and the unattended consequences is critical to make sure Medicare beneficiaries have access to quality hospice.
Brendan Strong – Barclays Capital
All right, great, that’s great. One other question I wanted to ask was about leverage, I mean you guys have always been under-levered, for as long as I’ve known you. I guess how do you see that changing, I mean how do you see leverage coming up overtime? I mean it doesn’t sound like it will come from a big deal, it sounds like it will come from buybacks, maybe an increase in the dividend, but just take us through that? And I guess, I don’t remember you talking as much about increasing leverage in the past, so I am wondering what’s changing here?
A good question. Actually I’ll only do a slight correction of leverage as it uses, and there are times when a company finds itself highly leveraged. We were extremely high leveraged in 2004. We basically borrowed more than our market cap at the time to buy the two-thirds of VITAS we didn’t owned when it became available. And then we scrambled and worked like heck over the next three years to generate a lot of cash flow to de-lever because the last thing – if we did this deal in 2007 and all of a sudden then in early 2009, you are highly levered environment that would have been a very dangerous situation.
So there is a time where you can deliver significant value to shareholders would been highly levered, but to perpetually highly levered we think is a very, very dangerous game. But it is a fair question novel. Well I think it’s safe to say we’re highly under-levered certainly with the current quality companies have access to very low cost capital. So we think we could be comfortably levered at three times EBITDA. Actually I would even argue I’d be comfortable at four times EBITDA, because we have very little CapEx in the business. We have a little under $30 million based on $1.4 billion plus in revenue, $1.4 billion in revenue and it only takes $30 million of CapEx which about approximates our depreciation and amortization, so we could afford to be levered.
The really questions is to what end. And so if you lever what do you do with the debt? We think the best use of debt in general is for acquisitions, but the acquisitions have to deliver shareholder value. And again as we talked about earlier, acquisitions have been valued at 10 to 12 times EBITDA, decent sized acquisitions. At 12 times EBITDA, even in the stable reimbursement environment we estimate it takes about 20 years for you to get your capital back. And that's in a stable reimbursement model.
If it’s in a declining reimbursement or you’re challenged on margin, it’s going to be a lot longer. So from that standpoint, we don’t think acquisitions are the answer today. I’d be more comfortable doing acquisitions at five times EBITDA. So really now its share repurchase. We could lever off and do share repurchase, we could have done a fair amount of leverage and bought stock at $55 a share and bought all we wanted. But the issue really is again we’re waiting – we think consolidation in hospice is inevitable, we don’t want to lever up by our shares and then see the fact is, there is some great acquisitions out there but we can't take a risk of expanding our debt to buy them because of what we’ve done our share repurchase.
So we’re prepared to buy. We would borrow up to a $100 million to do share repurchase that was opportunistic based on where our stock is trading at. And the only magic of that is, it’s about one year’s cash flow. So we would take a little bit more risk for one year of free cash flow and buy shares but not much more than that. So leverage is available when we can do acquisitions. And until that happens, we think a pristine balance sheet gives us a competitive advantage, and we could ride out a lot of bad things in a government reimbursement program and be a survivor because the one thing I am 100% confident on, hospice is the best answer for patients who are terminal where curative care won't cure. It’s crazy to have terminal ill patients going in and out of a hospital, receiving curative care that won't care at a tremendous cost, when hospice, 97% of which is delivered to the patient in their home is a low cost alternative, better for the patient, better for the patient’s family, better for the payor.
So the fact is, hospice is one of those unique place that it needs to be more utilized, since 30% out of every Medicare dollars spent is spend on Medicare beneficiaries in the last 12 months of life and a significant portion of that 30% within the last six weeks of life, hospice is the answer to free up resources, dollars within the Medicare system where we’ll do the most good for patients who can’t be cured and have quality of life for multiple years.
So hospice isn't going away, it’s to be more utilized and you just want to make sure our company is positioned to take advantage of that.
Brendan Strong – Barclays Capital
All right, on the acquisition side. Is the focus simply on hospice acquisitions or much expand into things that maybe related to home health for example?
It’s not just focused on that, but if – people ask third leg of the stool, you got hospice, you have Roto-Rooter, would you have a third leg? We’re not opposed to it, but we think there has to be significant synergies with our existing – one of the existing businesses to give us a competitive advantage. If it’s a just a standalone business, quite frankly there is so much private equity out here, there is so much capital. Capital at a very, very cheap price at today’s variable cost.
For something to hit my desk and take a look at, it had to be passed on by so many other eye balls who carefully study this. It’s unlikely that we’re going to find a diamond in the rock on a pre-standing basis, that private equity hasn’t looked at and rejected for probably good reason, so we look at a lot of potential things but quite frankly, of my nine years as Chemed’s CFO, I haven't seen a – I’ve looked at a lot, I haven't seen a single thing that made sense for our shareholders in terms of us to go into. So unlikely it’s going to be Roto-Rooter acquisitions and hospice acquisitions.
Brendan Strong – Barclays Capital
All right, maybe just one last question here. I was looking at slide 20 in terms of the breakdown of people who use hospice and who don’t use hospice, and 34% of people that as a way still don’t hospice. How is that been changing overtime, what do you think brings that 34% number lower overtime?
Yes, actually I love this chart. Our CEO Kevin McNamara, he thinks it gets too complicated because it brings up a lot of issues, but your point is actually good one. The starting point is market penetration based upon, did – was the patient in hospice when they passed away, we actually come up with I’d say fairly high penetration, but if you look at the market penetration relative to days of care available, then I consider the market only about really around 30% to 35% penetrated. Industry-wide half of all the hospice admissions in the United States, they pass away in about 20 days or less. So they’ve actually exhausted their cure of care option and entered hospice really at the last possible moment, 50% of these admissions.
These Medicare beneficiaries should have entered hospice weeks earlier and stopped going to the emergency room and stop receiving very expensive curative care. So if you turn around to make the assumption the median life of stay for a hospice patient should be 50 days, the average length of stay of 110 days, is then like we’re only at about 35% penetration. Now how is this changed over the past decade? The median length of stay hasn’t changed hardly at all. It seems right now our culture – people just want to chase curative care as long as possible. As long as someone is willing to pay for it, they are willing to chase it, so that half hasn’t changed.
We’ve seen an expansion in the other half. So that median length of stay in the other half, actually the length of the stay over the last 10 years has gone from the low 50s to the low to mid-70s in average length of stay. But that’s primarily as a result of going – of including non-cancer Medicare beneficiaries in there, non-cancers tend to have more episodic and crisis events. They have on average a longer length of stay than cancer. So if you factor out the change in disease safety, expansion of disease safe, they utilize hospice, quite frankly it hasn’t changed much at all.
Brendan Strong – Barclays Capital
All right, great. I think we’ll leave it there and take it to the breakout room. Thanks.
Thank you very much.
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