Home Healthcare Industry: Short Explanation

This is the fourth in a series of articles covering the home healthcare industry. See part 1 here, part 2 here and part 3 here.

The first three articles in this series should have served to contextualize the emergence and maturation of the “Prospectivized" home healthcare industry. Along the way, we took a meaningful peek at stock prices through the end of 2008. In this article, we will get a close-up view of how the prices of our four publics (AFAM, AMED, GTIV and LHCG) came to be so cheap at the beginning of this year.

On January 8, MedPAC continued its annual ritual—begun in the late 1990s—of officially recommending Medicare reimbursement cuts to home healthcare (see pages 173-224 here). Everyone familiar with this industry expected 1) the recommendation to reprise their traditional stance; 2) Congress to leave things alone until 2011; and 3) reimbursements to be ratcheted back in coming years. In other words, MedPAC’s recommendation was worthy of about as much attention as the advertised “blowout sales” being held at local car dealerships every weekend.

Then, in his first primetime address to the nation on February 26, our new President fervently affirmed his commitment to universal healthcare—a movement begun by the Progressive party a century ago, reticently adopted by FDR in the 1930s, and finally articulated overtly by Harry Truman in 1945. Obama’s initial proposal called, at a minimum, for significantly squeezing Medicare and Medicaid for down payment monies. Many of us did not expect these sacred sheep of the Democratic Party to be fleeced. Worse yet, despite Obama’s vague rhetoric and confusing numbers, there was some specificity regarding this niche industry: HHAs could experience cuts—much deeper and sooner—than industry insiders expected. The more pessimistic owners (or borrowers) of these stocks saw the sky falling and sold quickly. Of course, such selling pressure begat more selling pressure.

The table below shows a fairly static short interest in our publics prior to MedPAC’s recommendation—nothing unusual. It also shows a general decrease in short interest immediately after the President’s budget proposal—a development to be expected for two reasons. First, that official pain point drove prices down quickly, making them less attractive to bears. Second, on March 9, Congress proposed legislation to block Obama’s proposed cuts to home healthcare—one of many back–and-forth steps in the budget process. But in the weeks after MedPAC’s boy-who-cried-wolf recommendation and before Obama proposed his sizable cuts, there was an astonishing increase in the number of short sales of our publics.

Short Interest as a Percentage of Outstanding Shares

Ticker	15-Dec	31-Dec	15-Jan	30-Jan	13-Feb	24-Feb	27-Feb	13-Mar
AMED	41.12%	40.06%	44.08%	50.49%	53.32%	53.80%	53.53%	43.06%
AFAM	12.05%	11.56%	15.46%	18.84%	22.33%	22.98%	22.83%	29.34%
LHCG	8.96%	9.19%	11.92%	15.41%	15.92%	15.15%	17.27%	11.13%
GTIV	4.40%	4.46%	5.41%	6.42%	7.45%	9.28%	9.24%	4.95%

(Sources: Nasdaq and AOL Finance)

These percentages—which, quite significantly and for whatever reason, were high to begin with—translate to a $200M+ increase of borrowed shares sold on these companies immediately prior to Obama’s proposal—not the result of a smattering of small-time speculative operators. Some big money chose to short, which was a remarkable decision. To pass on an investment risks lost opportunity; to buy risks loss of invested capital; but to short risks everything a trader is worth. A review of the risks, rewards and guidelines of short selling is in order.

Borrowed Time and Suspicious Minds

Last October, the folks at Porsche gave bears around the world an attention-grabbing reminder of how extreme the liabilities can be for short sellers—even in such an unlikely market as the down-and-out automotive sector. Within just a few days, shares of Volkswagen erupted from about 200 euros to over 1,000 euros after Porsche made its unexpected announcement that it had, in effect, increased its ownership (from 35% to about 75%) of the world’s third-largest auto maker. About 12% of Volkswagen’s shares were on loan to short sellers when the announcement was made. When bulls started to bid the shares higher on the news, many of the shorts were forced to cover margin calls on their paper losses. As the price continued to rise, those calls became pricier and pricier, forcing shorts to clear broker demands by buying the stock—an extreme form of fiscal sado-masochism. While this short squeeze—effected predominantly by market machinations—cost bears about $38B and put many of them out of business, it could have been worse as shorts (by their design) carry unlimited liability.

Beyond simply covering a short position with a long position (i.e., owning an equal number of long and short shares), there are guidelines that short sellers follow to avoid any short squeeze. A nay-saying bear may find reason to pause if a company exhibits just one of the following characteristics: 1) a solid balance sheet; 2) explosive earnings potential; or 3) a low PE ratio. A company with two of these three traits becomes exponentially more avoidable. A company with all three should cause even a dumber-than-your-average bear to pass, as the market power is held by the company and a universe of unpredictable bulls. Also, stocks already with very high levels of short interest—irrespective of business fundamentals—should be avoided, as they are sometimes targeted by speculators who attempt to drive the price high enough to make the weakest bears capitulate, which can cause a chain reaction of increasingly stronger bears to follow suit. To “clear” his position, each short has to buy a long position—which creates upward pressure on the stock. Whether by pain threshold or broker mandate, as the price goes up more and more clearing takes place.

AMED offered a stunning exception to all these guidelines when an unbelievable 54% of its outstanding shares were on loan—four and a half times the percent detailed above for Volkswagen. For a company which has collected over 97% of its acquired receivables since it began acquiring receivables, AMED’s balance sheet was (and remains) excellent. Earnings had increased by leaps and bounds for several years, and anyone with a calculator and half the industry education afforded by our first three articles could clearly see that Q4 ’08 earnings (up 58%) were going to continue that trend. The PE was below 10. And yet there it was: An incredible majority of shorts tempting fate on a stock that had demonstrated in recent years (as detailed in the previous article) a propensity for multi-bagger price increases.

An even more absurd, if not generally visible, circumstance existed with AFAM. Though its PE was not quite as low as AMED’s, its balance sheet was even stronger, and its earnings (up 151%) were sure to have grown the highest percentage of the bunch. But it had two other very significant bear deterrents. After the market closed on February 13, the S&P 600 announced that AFAM was to be added to its distinguished list on February 20. Unlike other indices, the S&P 600 selections are subjective (outsiders can’t anticipate which companies will actually be chosen), so when such announcements are made, a sudden wave of buying usually follows as index funds and others adjust their holdings (see here). If a stock has significant short interest—and AFAM certainly did—all that copy-cat buying can easily cause a short squeeze which could destroy numerous bears. Most shorts would have stepped back from the ledge, but our preternatural shorts offset the increased demand by shorting more—an action that would not have been taken by an investor simply pursuing a neutral position.

AFAM possessed a special power that posed the final, very distinct, jeopardy for bears. Significantly, this deterrent was distinct from the others detailed above in that not a single share would have to be purchased to exert a tremendous upward pressure on the price of the stock. This power resided squarely in the hands of 12 insiders—who bristled at short sellers dragging the share price through the mud to begin with. Because some of those insiders did not appreciate this power until notified by the author, a detailed explanation might be helpful.

Of the three types of brokerage accounts, those of wealthier and active traders are generally designated as margin or option. Traders usually prefer these accounts because they offer more trading choices and because the traders’ securities* act as collateral to borrow against—an easy way to create leverage. More important for our purposes, brokerages universally prefer these accounts as they are profitable: When the trader designates her account as margin or option, the broker has the legal right to take securities out of her account (without advice) and loan them for fees to other customers or dealers. This is how shorting is legally performed: Broker B takes securities out of Investor I’s margin or option account, loans them (and charges interest) to Speculator S who sells them with hopes of buying them back at a lower price before returning them. Most small accounts, and all tax-advantaged accounts, are designated as the third and most basic type of brokerage account, cash, wherein the investor simply uses her cash to trade securities that must remain parked in her account.

The following information regarding AFAM’s shares owned by insiders comes from its Schedule 14A Proxy Statement filed September 5, 2008 (8,129,024 total shares outstanding):

Insider	Shares	% of Outstanding
William B. Yarmuth	613,294	7.50
C. Steven Guenthner	183,320	2.30
Steven B. Bing	1,805	<1
Donald G. McClinton	90.307	1.10
Tyree G. Wilburn	37,125	<1
Jonathan D. Goldberg	114,195	1.40
W. Earl Reed, III	145,679	1.80
Henry M. Altman, Jr.	21,125	<1
Patrick T. Lyles	80,962	1.00
Anne T. Liechty	25,555	<1
Phyllis D. Montville	2,250	<1
John B. Walker	2,250	<1
Total of 12 insiders	1,319,117	16.50

All of these investors would have qualified as wealthy by brokerage standards, but certainly not all of these shares would have resided in margin or option accounts. Of these 1.3M shares, the Proxy details that 5,924 reside in a family trust (tax-advantaged), and 87,706 are only phantom shares (see here). Also, from the filing of that Proxy through the end of January, 82,000 shares had been sold in open market transactions. So by February, the largest number of shares that could possibly reside in margin or option accounts held by these insiders was 1,143,487. Even if a quarter of those shares were located in margin or option accounts, it would still mean, of course, that the insiders’ very own shares were loaned by their brokers (without advice) to various short sellers who used them to pummel the share price.

Without spending one penny, the insiders could have quite simply and legally retarded such subversion had they switched all margin or option accounts to cash, which would have required their brokerages to return all outstanding securities to the insiders immediately. Had this happened, some short sellers would have been mandated by their brokers to clear enough shares to return to the insiders by buying AFAM on the open market—even if those short sellers had extremely well capitalized brokerage accounts AND had covered their short positions. As only about 400,000 shares were trading daily, those servile short sellers would have had a very difficult time locating extra shares quickly at normal market prices—a short squeeze could have quite easily ensued. Of course, that would have been the shorts’ problem. How many shorts actually saw this subtle but potentially bankrupting risk? The question is not rhetorical. Small-time operators, generally speaking, most certainly did not. Well-heeled, well-connected, professionally trained money managers could easily have seen it.

So here we had almost every possible warning sign to scare bears away from financial mauling. Yet they stood united, with ultimate resolve, awaiting a vague budget proposal—though with specifics on home healthcare—from a Democratic president who would unexpectedly fleece the Medicare program. It would take more—much, much more—than suspicion, hope or a gut feeling to stand in the face of such overwhelming odds. It would take knowledge. But how many shorts actually knew the specifics of our President’s confidential budget proposal? The question is even less rhetorical.

Once Bitten Twice Shy

We owe to those short sellers this buying opportunity. To be sure, by itself Obama’s proposal would have caused significant selling pressure on these stocks. But these incredible price dislocations were really created by the added momentum of our short sellers. Through the first 45 trading days of this year, AMED shares were down 37%, LHCG 52%, GTIV 56% and AFAM 67%. Importantly, many of those longs scared away by the bears won’t be coming back to the home healthcare camp any time soon. Traders—and even investors—don't forget such pain quickly. This buying window will likely be open for a while.

A well executed value investment plan can easily benefit from such short selling. All we have to do is determine reasonable intrinsic values for these companies and buy at significant discounts. Because of how precarious both business fundamentals and stock valuations are in this industry, we should respond to ridiculous share price fluctuations not by worrying about them, but by capitalizing on them. In the final articles of this series, we’ll use AFAM as a case study to determine various intrinsic valuations—a process which can easily be projected onto the VN operations of AMED, GTIV and LHCG—which will allow us to talk sensibly about market valuations.

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* The term “securities” is used as a matter of simplification. In reality, these are security entitlements (http://www.cato.org/pu...).

Disclosure: Long AFAM, AMED, GTIV and LHCG

Comments

[909:]

What about the negative piece on AMED by Citron Research -- the short-seller? Any take on that?

Apr 30 10:38 AM

[tc1:]

Thanks, Daryl, for yet another really insightful article about this home healthcare segment, and for beginning to zero in on my great concern about the short-sellers who have pounded this sector's leading companies' stock-prices.

I'll await your next article on this topic.

Meanwhile, it's really quite a mystery to me as to who are these short-sellers and naked short-sellers who, for instance, pounded AFAM's stock price from $49 (where i bought it in early Dec. when the Fall-Winter rally was starting to take off) all the way down to $16 / share.

For you wrote:
>"So here we had almost every possible warning sign to scare bears away from financial mauling. Yet they [the big short-sellers] stood united, with ultimate resolve, awaiting a vague budget proposal—though with specifics on home healthcare—from a Democratic president who would unexpectedly fleece the Medicare program. It would take more—much, much more—than suspicion, hope or a gut feeling to stand in the face of such overwhelming odds. It would take knowledge. But how many shorts actually knew the specifics of our President’s confidential budget proposal? The question is even less rhetorical."

Apr 30 02:39 PM

[tc1:]

P.S.--I finally sold out of AFAM (at slightly over $31) in late January upon doing some digging and finding this article by Devon Rackle:

"Almost Family Almost Makes the Cut" January 27, 2009

silobreaker.com/Documw...

(This negative article was also posted at fool.com )

Apr 30 02:45 PM

[deep research:]

wonder why the short interest in this industry, because of relatively low number of shares outstanding and low volume or shares traded?
this HH industry will be around for a long time, in aiming to cut health costs a strong case can be made to increase investment in hh by the government in favor of much more expensive institutional care, the four companies mentioned in the above articles have the infrastructure and business models to carry out consolidation and expansion adding efficiency and effectiveness - making a strong case stronger for home health.
Smart money is pushing the share prices up and there is no doubt that private equity will be jumping in once the credit markets open up. As usual the small investor can get squeezed short term, but long term these four companies look very attractive.



On Apr 30 02:45 PM tc1 wrote:

> P.S.--I finally sold out of AFAM (at slightly over $31) in late January
> upon doing some digging and finding this article by Devon Rackle:
>
>
> "Almost Family Almost Makes the Cut" January 27, 2009
>
> silobreaker.com/Documw...
>
>
> (This negative article was also posted at fool.com )
>

May 08 12:14 PM