When a single industry becomes heavily represented in the Magic Formula Investing (MFI) screens, you know that industry is highly out-of-favor with investors. Right now, there are a few sectors that match this description. For-profit education firms and consumer apparel retail are two examples right now.
But the one I want to look at today is almost fully represented in MFI - home health agencies (HHAs). Let's take a look at the industry, the qualities that make it an attractive investment, the challenges that have led to low valuations across the sector, and then a comparison of the 3 publicly traded stocks currently in MFI.
Home health agencies provide visiting nurses to patients who have been released from hospitalization and wish to undergo rehabilitation and recovery at home, as opposed to at a hospital, rehab center, or nursing home. Most also offer private care services, where employees provide services like grooming, medication, meal preparation, and so forth for elderly patients, many of which live alone at home.
The federal Medicare program is by far the largest source of revenues here, accounting for 75-90% of sales depending on the firm. A large part of the remainder is paid by state-run Medicaid programs, making these companies almost entirely dependent on government funding.
Home healthcare is a very attractive business to be in. The age demographics of the U.S. population ensures patient growth. The number of citizens over 65 is expected to grow 3% per annum over the next 10 years. In that period, senior citizens will grow from 13% of the population to over 16%, an increase of 14 million people. With age, unfortunately, comes the higher risk of medical problems. Over 83% of people who die of heart disease are over 65. The risks of stroke are double at 65 what they were at 55. These sad facts nevertheless will drive enrollment and episode growth for all home health providers.
What's more, over 80% of seniors understandably prefer being treated at home to being treated in facilities. It costs the government much less on average to provide home services as opposed to a hospital or facility stay. The services provided by these firms offer significant advantages to everyone involved in the rehab and recovery equation.
The industry is enormously fragmented, with anywhere from 9,000 - 11,000 providers. This leaves a lot of room for consolidation, which will be led by the public firms. We've already seen a large deal this year, with Gentiva (GTIV) buying out Odyssey for $1 billion, a significant premium to the market value at the time.
Finally, the business model is a good one. There is very little capital spending required to maintain the business (cap-ex is usually only around 10-20% of net income). Revenues are almost entirely recession-proof. Price competition is non-existent as everyone is paid through Medicare.
With such a strong investment case for the industry, why are all the major players selling at enterprise value to earnings (EV/E) ratios below 9 (most below 8)? The major risks to the stocks have always been their reliance on government, and health cost cutting is in the crosshairs. The Centers for Medicare and Medicaid (CMS) recently published proposed payment changes for 2011. While there are various pieces to it, the net effect is about a 4.75% decrease in Medicare payments to home health agencies next year, with a similar additional reduction in 2012. These changes, if enacted, will significantly slow down industry revenue growth rates, which have averaged nearly 25% for the large publicly-traded companies over the past 5 years.
Some headline risk has further hurt these stocks. In late April, the Wall Street Journal published an article questioning rehab appointment practices, where HHAs were scheduling to capture Medicare bonus payments for specified cutoffs (at 10 visits). This led to the announcement of a Senate Finance Committee investigation in May, followed by an SEC inquiry into all of the major players.
The government is putting its foot on the neck of the industry, and valuations have constricted as a result.
There are 4 publicly traded HHAs. However, only 3 of these are currently Magic Formula stocks (Gentiva is not currently a MFI stock). Here is a quick overview of each, in the order of attractiveness for investment (in the opinion of MagicDiligence):
- Revenues: $321.7mm (ttm)
- Op Margin: 15.2%
- Cash / Debt / Current Ratio: $31.4mm / $3.0mm / 3.18
- MFI-adjusted Earnings Yield: 22.4%
- Return on Equity: 17.3%
The key advantage for Almost Family is the firm's concentration in Florida, where 50% of revenues originate. Florida remains the most popular retirement destination in the U.S., which bodes well for AFAM growing their same-office sales, the lowest-cost way to grow. The company also has one of the best balance sheets in the biz, providing plenty of capital for acquisitions.
- Revenues: $552.5mm (ttm)
- Op Margin: 13.0%
- Cash / Debt / Current Ratio: $17.3mm / $4.4mm / 1.57
- MFI-adjusted Earnings Yield: 18.5%
- Return on Equity: 18.8%
LHC is a well managed company in the sector, with strong returns on equity and capital. They have been aggressive in responding to the investigation news, even going so far as to re-affirm guidance. Still, the stock is not as cheap as AFAM, the balance sheet is not as strong, and LHC's geographic concentration, while fine, is not as favorable.
- Revenues: $1.59b (ttm)
- Op Margin: 15.5%
- Cash / Debt / Current Ratio: $82.0mm / $203.4mm / 1.09
- MFI-adjusted Earnings Yield: 26.1%
- Return on Equity: 18.6%
By far the largest and most aggressive player in the space, Amedisys is the market leader. With drastically lowered guidance, a history of rumored accounting issues, and a centralized operating model (i.e. higher liability), there may be more risk here than in the other two. This is mitigated somewhat by the cheapest stock price of the bunch.
Disclosure: Steve owns AFAM