Home Healthcare Industry: Looking Forward to Patient Growth

This is the fifth in a series of articles covering the home healthcare industry. See part 1 here, part 2 here, part 3 here, and part 4 here.

“…after a repetition of similar instances, the mind is carried by habit, upon the appearance of one event, to expect its usual attendant, and to believe, that it will exist.” (David Hume, An Enquiry Concerning Human Understanding)

With a level of epistemological humility suitable for any philosopher or economist from Scotland (especially those great thinkers whose use of commas perplexes modern-day readers), we will finally attempt to look into the future. The historical context of the home healthcare industry we have reviewed will hinder us if we rely on it too heavily when estimating future profitability. We can walk securely into the dense fog separating us from the future armed with conservative valuations, not trying to focus on imperceivable specifics, but instead targeting the more visible broad outlines.

After a discussion of our changing landscape, we will place AFAM on the foundation we built in the first four articles of this series, which will allow us in the next article to determine various intrinsic valuations-processes which can easily be projected onto the VN operations of AMED, GTIV and LHCG. While admission drivers will remain important, revenues and profits will become our focus in these next two articles.

Constants, Fluidity and Liquidity

In 2008, the odds-on favorite to take over as Secretary of Health and Human Services, Tom Daschle, released Critical, which became the call to arms for healthcare reform by the Obama campaign. The book’s mantra is simple: Extend healthcare to all, but lower overall costs by eliminating the unnecessary.

Even without Daschle in the cabinet, the message remains the same, as was made clear by Obama’s proposal to squeeze medical costs wherever possible. The good news is that if Medicare and/or other payors actually “trade-down,” home healthcare agencies (HHAs) will come out huge winners—at least in terms of admissions.

While I’m cheering heartily for Obama, it should be remembered that the Democrats’ commitment to overhaul our healthcare system is in many ways similar to the Arizona Cardinals’ commitment to win the Superbowl: Some years seem more promising than others, but after what seems an eternity, it hasn’t happened.

There is really no telling what will come from Obama’s reform efforts—and I am certainly not banking on magical and unexpected benefits—but good things could happen. In this fluid environment, home healthcare offers two obvious and overwhelming benefits that will not change. First, patients prefer care at home. Psychology plays a prominent role in a patient’s recovery, so it is no surprise that clinical outcomes from home healthcare episodes are superior to similar episodes from facility-based providers.

An analogy to Wal-Mart (WMT) may help further illustrate the second constant that we can depend on no matter what the future holds. When Sam Walton opened his first Wal-Mart Discount City store in 1962, he was competing with Mom-and-Pop retailers, various five-and-dimes, and the likes of Grants and Ben Franklin Stores. Wal-Mart’s cost-cutting formula allowed it not only to dominate its original field, but eventually to take on such other retailers as Toys ‘R Us, Circuit City (CCTYQ.PK), Kroger (KR) and Petsmart (PETM). Those retail fields were a long way from where Walton began. The world of home healthcare is quite different, but the analogy has some merit.

Medical facilities (hospitals, doctors’ offices, rehabilitation centers, skilled nursing facilities, nursing homes, etc.) incur immoderate expenses: property, overhead, insurance, equipment, waste, bureaucracies, security, etc. A day at the hospital might cost a few thousand dollars, while care at home is what a patient prefers and runs about $150 per day. Our healthcare system and society are best served when we can effectively move patients away from higher-cost surroundings to the home. As most of their bigger ticket services cannot be transferred to the home, medical facilities are not going away.

Similarly, Tiffany & Company (TIF) is not sweating Wal-Mart encroaching on its high-end big-ticket sales—but that did not stop Wal-Mart from more than doubling the legendary boutique’s jewelry sales in 2008. Home healthcare holds the unassailable position as the lowest cost provider of sub-acute care.

As advances in medical technology continue, more pre-acute and sub-acute services can be provided in the most cost effective and comfortable setting—which is exactly why more services will be provided in the home. The moats that our publics have created within home healthcare could easily be extended outside the industry. In fact, they already have been.

In the second article of this series, we discussed how home healthcare has already expanded its footprint impressively. As a reminder, about 60% of this industry’s referrals come from hospitals, about 30% from community-based physicians, and the remainder from various assisted living facilities.

Earlier this century, AFAM, AMED and GTIV ran fairly close to that 60/30/10-referral ratio, but these trailblazers’ referrals from community-based physicians account for about half of their admissions these days. Such admissions appropriate physicians’ referrals from competing providers in other industries: rehabilitation centers; skilled nursing facilities; outpatient facilities; and, increasingly, hospitals.

This internally driven systemic change (which helps explain how I have broken down the various growth elements detailed below for AFAM) is the cause of most of the organic admissions growth for these companies and appears to offer tremendous opportunities going forward; value-oriented business models routinely avail themselves of such benefits.

LHCG has also increased its percentage of referrals from physicians (about half), but it has simultaneously targeted that most obvious referral source: hospitals. One eventually comes to understand why a well-provided-for dog—even on a full stomach—begs for food: it is simply in the dog’s nature.

A newcomer to this market might wonder why hospitals do not dominate home healthcare. The reader may recall that MedPAC estimates recent net margins for this industry (sans facility-based operations) in the teens. Newcomers to this industry come to understand how hospital-based HHAs—even with an inherent unfair referral advantage—net rather embarrassing negative 4.5% margins (see page 178 here): it is simply in the nature of these famously inefficient dogs.*

LHCG has identified this incredible opportunity—and with the best balance sheet of the publics is capitalizing on its increasingly co-dependent relationship with hospitals. LHCG teams up with hospitals by managing their in-house HHAs through joint partnership agreements. This value-creation technique offers an abundance of both profits for shareholders and endorphins for fans of efficiency.

Here is how Medicare’s $447B of outlays is to be split up in 2009:

• Hospital Inpatient... 29%
• Medicare Advantage... 24%
• Physicians and Other Suppliers... 17%
• Outpatient Prescription Drugs... 11%
• Hospital Outpatient... 8%
• Skilled Nursing Facilities ... 5%
• Home Health... 4% (about $15B)
• Hospice... 2%

(Source: CBO Medicare Baseline, March 2008)

When contemplating where Medicare dollars are going, which of the above players should be most concerned about reform dictated by economics? Medicare Advantage and Outpatient Prescription Drugs have already been earmarked, but cuts will be felt everywhere. The other most obvious pieces of the pie are Hospital Inpatient and Physicians.

The recent trends of HHAs receiving patients from the other “upscale” Medicare players “sicker and quicker” could easily accelerate. Let’s dream for a moment and go a step further in cutting medical costs: How many more patients can be handled by HHA’s before they even leave their house for the hospital or doctor’s office?

A step further: HHAs aren’t limited to Medicare and Medicaid. Whatever form of universal healthcare we potentially get may seek out HHAs to replicate their rock-bottom pricing and offer new or different services in the home.

A party-pooping reminder that the government is in charge of these outcomes brings us back to reality all too quickly. Congress’ historical attitude of allowing more than minimal profits for Medicare providers might offer a false sense of security. Its ultimate decision-making ability could quickly lead to irrational and unprofitable outcomes—especially in the short term.

Over the next two years, as the effects of Obama’s reform efforts become more visible, it is wise to keep some liquid funds available to capitalize on what could be ridiculously low share prices.

Needless to say, bears today are more wealthy and powerful than they have been in decades, and—if inclined to do so—may afford us even greater buying opportunities in short order. In the long run, though, the shorts will lose interest and power, and our fleet-of-foot publics will profitably adjust to whatever situation emerges.

Launching Pad and Language

We will next use AFAM as a case study to apply the knowledge we have gained thus far. We will hold a commanding advantage if our education enables us to assimilate the dynamics affecting AFAM so that we can do a better job of estimating its intrinsic value than can the overall market. In the next article, we will review highlights of four intrinsic valuations I created.

The home healthcare admissions process is intuitive. A patient comes into the VN operations of AFAM by referral of a physician or another designated healthcare provider. (We are simplifying matters here by lumping in non-Medicare admissions—which generate revenues close enough to those of Medicare and are of small enough impact to allow such liberty.) Once it receives an admission, AFAM is paid on an episodic basis by intermediaries of Centers for Medicare and Medicaid Services (CMS).

An episode is a 60-day period in which AFAM performs its services (see here). Patients who clinically merit home health services beyond 60 days are recertified. Recertification rates have been increasing in recent years, and are now pushing 40% for AFAM, though it is unusual for patients to be recertified more than once.

Higgledy Piggledy Growth

In the first two articles of this series, we focused on the drivers of the 6.25% Medicare admissions growth the industry experienced from 2001 through 2006. As admissions increased even more through 2007 and 2008, we can safely estimate annual growth this century at 8%, which can be fairly broken down as follows:

• Systemic

• Externally driven “trade downs” (more than half of total growth)
• Internally driven “seek, teach and preach” (more than a quarter)
• Demographic (less than a fifth)

In the third article of this series, we jumped inside this industry to learn how its leaders are devouring more than their fair share of this expanding pie. AFAM’s admissions growth this century is a stunning 23% CAGR: 7,737 in 2001; 8,895 in 2002; 9,481 in 2003; 11,540 in 2004; 14,494 in 2005; 18,921 in 2006; 29,338 in 2007; and 39,666 in 2008. Subtract the industry growth, and AFAM shows about 15% growth due to increased market share, which, based on reported data during that time, can be fairly broken down as follows:

• M&A (about half of the 15% growth)
• Besting Competition
  • “Medieval style” competitive victories (more than a third)
  • Post-modern government deployed “weapons of mass destruction” (less than a tenth)

The Medicare base episode payment started off as $2,339 in 2001, and is $2,272 this year, but over the years AFAM has consistently increased its revenue per episode: $2,226 in 2001 (estimated 30% recertification rate) and $3,171 in 2008 (verified 38% recertification rate). Operating profits per episode have gone from a loss of about $8 in 2001 to a profit of about $560 last year. Net margin per episode is estimated at just less than $300 in 2008—which translates to a bit more than $15M net profit on approximately 53,000 episodes.

Of significant note, AFAM had some one-time costs in 2008, so, other things being equal, the bottom line would be slightly better going forward.

This relatively detailed snap-shot of AFAM is helpful; however, we are watching a full-length suspense film. The intrinsic value of a company is simply the discounted value of future cash flows that company will produce—simple to understand, difficult to determine. In the next article we will review the highlights of four meditations I completed, and their resultant intrinsic valuations.

*In fairness to these hulking facilities, home healthcare is very low on their list of priorities. As anecdotal evidence, there was once an executive meeting between LHCG and a regional hospital to discuss the potential of the former managing the latter’s home healthcare operations. The meeting was temporarily interrupted as the hospital’s CEO and CFO had to conclude their argument as to whether or not the hospital even had a home healthcare operation.

Disclosure: Long AFAM, AMED, GTIV, LHCG; Short GTIV

Comments

[User 411682:]

Daryl
This is really fascinating work. I work in the industry and would love to speak with you directly. If you are interested, I can be reached at [e-mail]
Thanks
Michael

May 11 10:59 AM

[Anthony B:]

Great work, I'm eagerly awaiting your AFAM valuation. I've been watching it since last Fall. Thought it was a steal below $20, but wussed out. I couldn't get a feel for what future earnings would be because of the uncertainty surrounding the budget cuts for Medicare (which is why it was priced so low).

May 11 02:59 PM