As we learned in the previous article, systemic changes have been the dominant factors in admissions growth for this industry and will remain as such at least until 2017. Now we will peer inside this high-growth industry to learn how, at the turn of this century, the sails of a handful of companies were lifted by the confluence of disparate, but correlated, winds. Those leaders—especially our four publics, AFAM, AMED, GTIV and LHCG—are now positioned, more so than leaders from other industries within healthcare, to benefit greatly from consolidation, future healthcare reform and eventual demographic changes.
Congress initiated the Prospective Payment System (PPS) with hospitals in 1983, moved on to physicians in 1992, and concluded with outpatient services in 1998. When rolling out PPS, Congress did not impugn either hospitals or physicians, as it was generally pleased with the quality of their services. In fact, because of their political power, Congress had to tread lightly, initially offering generous reimbursements. Also, corporate debt levels were at low points in the respective economic cycles for both hospitals and physicians upon implementation. In 1998, outpatient service providers—especially home healthcare agencies (HHAs)—were identified as either blatantly fraudulent or short on quality; lacked any real political clout; and fell victim to holding excessive debt due to an irrational economic exuberance.
An inverted relationship existed with information technology—a critical tool for healthcare providers who store, share and analyze countless records, reports and diagnoses. Hospitals and physicians experienced their overhaul when I/T services were mired in decades-old conventions. By the turn of the century, surviving outpatient providers were streaming in a technological universe of overcapacity that was light years removed from resources available just a decade earlier. In regrouping and restructuring their businesses, the enterprising survivors capitalized on impressive, inexpensive and malleable software just as the dotcom bubble was bursting.
The Ugly State of Affairs: 1995 Through 2002
Retrospective fee-for-service remuneration was the problem for HHAs that led to industry changes a decade ago. By the late 1990s, driven in large part by financial incentives to bill for the most intense forms of care, or, at least, for increased frequency of visits, this unchecked industry was filled with excesses and fraud. Billing for excessive services was indeed common—more common than either identifying or performing such services. In “The New Face of Medicare”, Stephen Hedges of U.S. News and World Report details over a dozen sensational cases of fraud. He reports that during the 1990s, “many of the criminally inclined have moved out of the drug trade to start careers in Medicare fraud, a crime where penalties are low and rewards stratospheric.” Others, possibly lacking in criminal experience, were drawn into these new, easy-money careers by the thousands.
Not quite as newsworthy, but no less harrowing, were the countless frauds cultivated by those long-time Medicare providers who could not resist temptation. Hospitals, as discussed in the previous article, charged aggressively into the home healthcare business, often for the wrong reasons. What eventually brought down the most visible perpetrator of fraud, Columbia/HCA (which owned 351 U.S. hospitals in 1996), was the illegal shifting of costs from its PPS-remunerated in-patient facilities to its retrospective fee-for-service remunerated home health care agencies. But even with ethics intact, services performed by HHAs were more expensive than they should have been.
Congress’ original intent with PPS was to control inflationary medical costs. By the late 1980s, however, Congress’ primary use of PPS had become fiscal. Erstwhile budgetary gaps caused by spiraling Medicare fee-for-service reimbursements quickly turned—thanks to PPS—into unexpected windfall savings that Congress could apply throughout the federal budget.
In 1997, with federal revenues buoyed by the expanded economy, Congress clearly saw the stars aligned for the first surplus budget since 1969. The reprehensible actions and microscopic political voices of outpatient providers—especially HHAs—left them sitting ducks. When establishing reimbursement cuts to outpatient services, Congress, with a move that could hardly have been choreographed better, used its belt to discipline these execrable providers and then proudly squeezed that same belt tightly around the budget. Though representing only about one-eighth of federal spending, Medicare was squeezed for over half of the projected savings delivered by BBA ’97 (p. 328 here - pdf warning).
With focus on efficiency, cost and integrity, the home healthcare industry’s overhaul delivered some notable successes. The idea in 1997 was to cut HHAs’ fee-for-service reimbursements massively, and, with PPS, incent them to be inexpensive but valuable providers of healthcare. Even the most devout Libertarian would have to give Congress its due if measured only in financial terms: Though aiming for a $16B reduction in reimbursements from 1998 through 2002, the Balanced Budget Act of 1997 (BBA ’97) achieved $74B in cuts (see the charts on the last page here - pdf warning).
If projected reimbursement cuts would have been painful but necessary, then actual cuts were flat out cruel. But the final torture, which could hardly be seen at the time, was administered by the economic cycle. An epidemic of confidence had caused companies around the country to employ excessive cheap debt in the late 1990s. Before the end of the dotcom boom, it was quite common to see balance sheets with long-term debt at five or six times an expanding EBITDA. Thanks to BBA ’97, over 10,000 HHAs went in the opposite direction of the overall economy when their debt obligations expanded as their top lines shrank. Combined, these forces were horrific. Almost unbelievably, by 2000, a third of all the agencies that made up this industry had shuttered their operations (see here).
This rare industry extremity brought with it an equally rare outcome for its conservative CFOs. Usually, directors and officers find the vigilant finger wagging of these debt-averse worrywarts to be a necessary annoyance. After this cataclysm, directors and officers of the surviving HHAs, staring at a relatively empty playing field, embraced those same CFOs with unabashed joy. Those CFOs still around today understandably hold their chins high when wagging their fingers, commanding respect and appreciation that their peers in other industries—holding their chins equally high, as a matter of course—can only dream of.
Front-end economizing is only part of the equation. What about the outcome for the healthcare system? In the previous article, we reviewed compelling evidence that clearly demonstrates HHAs are performing their roles nicely, as payors and providers more frequently prefer their services. Economically speaking, payors are “trading down” patients to the least expensive medical venue “sicker and quicker.” Medically speaking, referral sources are wising up. An additional testimony: Centers for Medicare and Medicaid Services (CMS) concluded that overall patient outcomes did not diminish from 1996, when visits per patient were 74, to 2002, when they had been whittled down to 29.
The Few, the Proud, the Ubermenschen
That which didn’t kill an HHA made it stronger. Survival was founded on shoe-string budgets, conservative leveraging and superior services. And those executive teams in this industry who made it through the storm, generally speaking, have achieved black belt status in broad cost cutting.
For better or worse, there is no pricing power in this industry: pre-determined Medicare reimbursements almost single-handedly determine the top line of VN operations. Efficacious agencies with the lowest cost per episode win. As there are some variants in reimbursement rates (e.g., rural add-ons, wage indexes and a range of 160 HHRGs), there is an important addendum to that dictum: Agencies with the wherewithal (i.e., technology, training and/or enterprising nature) to seek out and find the extra profits win more quickly.
A decade after BBA ‘97, the lowest cost providers are the ones that not only survived but now thrive in this environment. These days, an AMED or AFAM can spend $2.5M to open a new agency and have that money returned via operating profits in 18 months! These industry leaders have followed Congress’ marching orders to be efficient, technologically advanced and malleable. They have no real capital expenditures; there is no property, plant or equipment. They have no pensions. Their operating costs per episode of care are much lower than those of smaller HHAs, and a fraction of the costs incurred by other groups in healthcare. These companies can turn on a dime. They have tailored their technologies and operations to mesh with an ever-demanding and ever-changing bureaucratic morass. The technology and know-how of these leading HHAs enables them to go beyond the obvious. When a skilled nurse from AMED performs his independent and thorough analysis using his secure Point-of-Care software in a patient’s home, he may detect other clinical needs that weren’t originally cited upon referral. And if he misses something, AMED’s home office—with immediate access to the analysis—will likely catch it. At the beginning of 2008, when CMS doubled the number of HHRGs (the critical factor in determining reimbursement rates), it took GTIV less than eight weeks to integrate and adjust its technologies. Mom-and-Pop HHAs (some of them paper-based) simply cannot change that fast—if at all. One wonders how long it would take a hospital to adjust to an even smaller change.
Any competitive industry affords participants the opportunity to buy market share or earn it. Because of tremendous disparities in profitability, HHAs are afforded such Darwinistic growth opportunities in abundance. A very intuitive analogy for the competitive forces of the classical economic model is that of medieval warfare. When watching a superior business squelch out less desirable competitors, it is quite easy to romanticize about Scottish warriors advancing their line slowly and inconsistently across a battlefield—though, with an occasional bum-rush opportunity, still analogous to macro market cycles—winning against a weaker camp, then another, then another. That analogy certainly has its place in home healthcare, but a more unique and telling wartime analogy is postmodern: Periodic (and sometimes arbitrary) Medicare reimbursement reductions—substantially devoid of market forces—are like weapons of mass destruction.
To be sure, the more traditional type of labored economic warfare to gain market share has been the order of the day for some time in this industry. But the exponentially more potent and patently visible force in this market “vaporizes” entire swaths of less efficient operations, affording survivors freebies (the no-longer-served referral sources we discussed in “Towards Wise Exuberance”) in abundance. The last time we saw a significant rate reduction was 5.3% in late 2002, and the damage was notable. The most cataclysmic of these reductions, of course, occurred between 1998 and 2001. In February, our Commander in Chief proposed firing another bombshell in 2011, governmentally proscribing marginal providers. This is not your father’s free market (though, considering the monumental shifts our economy has taken lately, it may be more like your daughter’s).
Because over 85% of this market is private, there is debate regarding the current aggregate levels of profitability. MedPAC claims aggregate operating margins are in the teens. But its “logic” mocks the scientific method as it excludes the very substantial impact of unprofitable facility-based (predominantly hospital-based) agencies, presenting quite an expedient sample. In similar fashion, the National Association of Home Care and Hospice (NAHC), offers numbers that appear too dire (use this link to see their percentages of the HHAs “underwater” in the current reimbursement system - pdf warning). Wherever the truth lies, the question is not whether weaker HHAs will be destroyed, but how many? A slight cut might cause less than 5% of the over 9,000 agencies to shut their doors. A major cut could crush a majority of providers.
In any circumstance, however, our industry leaders will almost certainly continue to increase their share of this expanding pie at the expense of their weaker—or “vaporized”—competition. All of this is quite clear within the industry; which explains its intense M&A activity, again running counter to our current economic cycle. Operations that turn 5-10% net margins are selling out to those scaled companies which turn 10%+ net margins. Most operations with less than 4% net margins will likely be left to die. Incoming investors anchored to our recession might find it curious that in such a tempting environment executive teams, 1) balk at acquiring what appear to be decently profitable and growing companies, and 2) shudder at the notion of exceeding long-term debt of 2.5 times EBITDA. If those investors hang around through 2011, they too will sing the gospel. Our industry leaders are destined to benefit further from systemic and eventual demographic changes. Their only real challenges are neither to overbid nor to over lever.
Things calmed down significantly after the tumult of BBA ’97. Sensible Medicare reimbursements for this industry had evolved into something like their current form in 2001—and have been periodically tweaked ever since. The desired result is that HHAs cut their costs and expenses to keep as much of their allowance as possible. When considering how and why Medicare reimbursements are what they are, simply think of the following players and their roles: 1) Congress legislates what the monstrosity called Medicare is to accomplish; 2) the White House, in addition to executing it, has significant influence in the passage of that legislation; 3) MedPAC is the “unbiased and knowledgeable” group from which Congress is supposed to seek guidance; and 4) CMS administers the program—with significant influence on policy as well.
The reader with only a cursory understanding of the stock market would expect the prices of these public companies’ shares to have performed quite well this decade. In reality, the results have been extraordinary. From the beginning of 2000 to the end of 2008, the S&P 500 was down almost 40% while GTIVs share price increased by 500%, AMED’s 3040%, and AFAM’s 3580%. (LHCG was not a public company in 2000, but its share price increased 250% from its IPO in June 2005 through 2008). And it would be quite easy to argue that these companies’ shares at the end of last year were reasonably priced, with LHCG trading at less than 18 times very reliable 2009 earnings, GTIV at less than 17, AFAM at less than 16, and AMED at less than 10.
These first three articles should have provided us with an adequate foundation to think about the business of home healthcare. Next, we will discuss what caused these share prices to go from what I deemed a “pass” last summer to a “buy” today (though I would recommend keeping some money handy over the next few years). After that, we will shift our focus from the rearview mirror to the road in front of us, with revenues and profits playing a more visible role.
Disclosure: Long AFAM, AMED, GTIV and LHCG