Seeking Alpha
Hedge fund manager, long/short equity, healthcare
Profile| Send Message|
( followers)  

With this article Seeking Alpha introduces Paul Nouri, the manager of Noble Equity Fund, LP, a healthcare focused hedge fund he founded in January of 2008. In addition, he manages Noble Advisors, LLC, a Registered Investment Advisor. Paul also has sell side experience at both Sidoti & Co. and Deutsche Bank covering various industries. He welcomes your comments and feedback.

Providers of healthcare, including home health entities and hospitals, have come under attack of late for overbilling. Collectively, these institutions attain approximately half of their revenues from the government. At a time when budget discussions are constantly in the headlines, investors are nervous that healthcare services will be one of the first places that the government will reduce reimbursement.

Most recently, the Senate Finance Committee, issued a report prompted by an article in the Wall Street Journal in May 2010, with its findings of utilization trends of three of the largest home healthcare companies. The report found that when Medicare issued a bonus for companies when they visited their patients 10 times in each health “episode”, the companies worked towards that ten-day goal. Similarly, when it set bonuses at 6 and 14 days, the companies worked towards these goals. The journal article, as well as the Senate findings, purported that the practice of companies working towards these goals “at best represent abuses of Medicare”. Since when did people or companies working towards bonuses become labeled as abuse?

Medicare’s stated purpose of the bonuses was to drive the acuity of care. This is one example of how the government has begun to sharply criticize healthcare. This kind of rhetoric has driven down stock prices and multiples at healthcare service providers over the past three months (see chart below).

Home Health Providers

Forward PE Ratio*

Gentiva Health Services, Inc. (NASDAQ:GTIV)

2.5x

Amedisys, Inc. (NASDAQ:AMED)

8.0x

LHC Group, Inc. (NASDAQ:LHCG)

8.2x

Almost Family, Inc. (NASDAQ:AFAM)

9.5x

*Using Price end of Day October 28, 2011 EPS Estimates from Thomson One

As the table above illustrates, stocks in the home health industry are trading well below their long-term average of 12x-13x forward earnings per share. While investors are staying away from the names out of fear, the fundamentals tell a much different story. Starting with home health companies, while they have a barrage of headwinds facing them, from negative press to reimbursement challenges, their services still represent an astounding savings to institutionalized post acute care settings.

Meanwhile, continued growth in admissions, supported by continued growth in the Medicare count as well as people’s preference to be treated in the home, should help to offset a negative reimbursement environment. Also, most home health companies have moved away from paying their employees on salary and towards pay-per-visit. This variable cost model is beneficial in an uncertain reimbursement-rate environment. Finally, specialty programs in the home, such as orthopedic care, are becoming more popular. These programs typically come with a higher reimbursement rate. While the story for home healthcare is not without its challenges, valuations have become increasingly attractive, making it difficult for investors to ignore the names.

Overall hospital admissions growth continues at an anemic pace, and reimbursement growth has been called into question. At the end of 2010, the largest public hospital at the time, Community Health Systems (NYSE:CYH), initiated a hostile bid for Tenet Healthcare (NYSE:THC). Initially, CYH management approached THC management for amicable discussions, but Tenet management felt strongly that it did not want to sell. The bid immediately increased valuations in the industry as investors began to position themselves for consolidation and the benefits that it would bring.

On average, stocks in the sector rose 30% from December of 2010, when the company announced the offer, until April of 2011, when, in an effort to thwart off an unwanted takeover, Tenet initiated a lawsuit against Community alleging the company of boosting one day admissions from the ER, amounting to allegations of Medicare fraud. While Community later came out with a presentation over 100 pages in length to counter these allegations, valuations fell precipitously and still have not recovered.

Meanwhile, Tenet’s share price is 25% below CYH’s final take over bid. Putting further pressure on valuations were volatile discussions over the debt ceiling in July and August. Some investors are convinced that hospitals will not be able to manage current reimbursement challenges while others do not want to participate in any future volatility in these shares. These conditions have left valuations at the bottom of a range that has typically been between 10x-15x forward EPS estimates. Again, the fundamentals tell a different story from the current valuations.

Hospitals

Forward PE Ratio*

Community Health Systems, Inc. (CYH)

5.2x

HCA, Inc. (NYSE:HCA)

7.0x

Health Management Associates, Inc. (NYSE:HMA)

9.7x

Tenet Healthcare Corp. (THC)

11.2x

LifePoint Hospitals, Inc. (NASDAQ:LPNT)

11.5x

*Using Price end of Day October 28, 2011 EPS Estimates from Thomson One

One of the reasons I have been interested in the hospital industry since I started my fund in 2008 is because I believed the larger the large hospitals groups became, the more pricing power they would garner on everything from heart monitors to medical waste. Also, there are great opportunities for treatment center synergies by owning multiple hospitals in the same region. Management and administrative functions are streamlined and there is a better process for dealing with non-payers. Of the companies that have reported earnings so far this season (CYH, LPNT & HMA), they have all guided at or above expectations, proving that even in a difficult admissions environment, the management teams have strategies to continue to grow earnings.

What I find particularly interesting about the space, with valuations at trough levels, is that admissions are at a trough as well. Assuming admissions advance at some point in the next 24 months, there should be incredible earnings leverage. While some investors feel comfortable in their assumption that reimbursement is a significant risk, I have a different view.

First, for-profit hospitals only make up 18% of hospitals in this country. 62% of hospitals are not-for-profit and many of these hospitals have been struggling in the face of weak economic growth. If reimbursement rates were cut significantly, it would force more not-for-profits to either sell or close the doors, which would decrease the quality and accessibility of care, clearly not a desirable outcome for either political party to be responsible for.

Second, profits from publicly traded hospitals, compared to both other sectors of health care as well as other industries that get reimbursed from the government, is fairly meager. For example, WellPoint (WLP) and United Healthcare (NYSE:UNH), respectively, earn more money than the 6 largest publicly traded hospital names combined. Similarly, profits at Lockheed Martin (NYSE:LMT) tied to government reimbursement match the profits of the publicly traded hospital sector.

My point here is that there is a lot more fat to cut on the budget of other entities that get reimbursed from the government before basic care is cut significantly. In 2014, when the goal is for the entire country to have insurance coverage, while Medicare reimbursement will likely be cut, the hospitals should benefit significantly from a reduction in bad debt expense.

Names in both the home health space and the hospital space tend to be volatile, so if you decide on a name, my advice would be to dollar cost average in your position.

Disclosure: The Noble Equity Fund, LP has holdings in GTIV, CYH, HMA, HCA. I personally own GTIV, CYH HMA.

Source: Healthcare In The Penalty Box