In some respects it may seem like a good thing to have the government as a major customer for your healthcare services. After all, hospitals like HCA (NYSE: HCA) and Health Management Associates (NYSE: HMA) have to wrangle with the fact that they must treat all comers irrespective of ability to pay and bad debt expense is a major issue here. Unfortunately, Medicare and Medicaid are looming as major problem areas in the U.S. federal budget and reimbursement cutbacks threaten to limit Skilled Healthcare's (NYSE: SKH) ability to grow and prosper.
A Deceptively Good Third Quarter
Skilled Healthcare's third quarter results hint at what the company can do. Revenue was up a little less than 4% on flat occupancy. The company's core business, long term care, was down very slightly this quarter, while therapy services and hospice revenue were both up better than 20%. While Skilled Healthcare has stood out a bit from rivals like Kindred (NYSE: KND) and Sun Healthcare (Nasdaq: SUNH) on the basis of a higher mix of skilled services, the skilled mix was a little disappointing this quarter at less than 23%.
Despite an unimpressive top line, SKH delivered solid profit growth. Operating income jumped nearly 15%, while adjusted EBITDA rose nearly 11% and the margin expanded by one full point. This was achieved despite a three and a half point reduction in rehab margins - a byproduct of more individual and less group therapy.
Now Comes The Sticky Part
Reimbursement adjustments have done no favors to major device companies like Johnson & Johnson (NYSE: JNJ) and Medtronic (NYSE: MDT), but it has been even worse for the service providers. As in-home service providers like Lincare (Nasdaq: LNCR) and home care providers like Amedisys (Nasdaq: AMED) have been targeted for cuts, now the skilled nursing space is in for it as well.
Medicare announced an 11% cut that went into effect on October 1. Skilled Healthcare management estimates that this will hit them to the tune of $45 million, with certain mitigation strategies possibly recouping about one-third of that. Unfortunately, more could be on the way - due to the debt ceiling deal, another 2% cut is possible and that could hit forward earnings by 10% or more. Making matters worse, there is only so far that the company can push cost savings - nurses are not so plentiful that they'll take poverty pay just to have a job.
But wait, there could yet be more. As an industry, skilled nursing facilities still have some of the highest margins of major Medicare/Medicaid recipients, second only to home health providers (like the aforementioned Amedisys). That could make them a target of opportunity for further federal budget wrangling- especially as long-term acute care providers like Select Medical (NYSE: SEM) have had to take less and yet still survive.
A Trend That May Be No Friend
On one hand, you would think that Skilled Healthcare should be looking at the early years of some pretty positive market developments. Boomers are getting older and it is only a matter of time before they start showing up in skilled nursing facilities in numbers not seen before. As at least some of these will have long-term care insurance, that would seem like a lucrative opportunity. At the same time, this is still a very fragmented industry and growth-by-acquisition should be in the offing.
Skilled Healthcare may not see so much benefit from that, though. For starters, the company's high debt load is already an issue and may preclude further acquisitions. Then there's the aforementioned Medicare issues - the federal government simply doesn't have the money to pay for Boomers' healthcare without significant changes to the entire system (likely including further reimbursement cuts).
Don't count out Skilled Healthcare; this is a well-run company with a record of good margins and still more opportunities to squeeze profit out of the existing system. That said, don't make the assumption that the U.S. government will make it easy for them to grow.
The Bottom Line
Despite Skilled Healthcare's sizable debt load, these shares look too cheap by many metrics. Unfortunately, investors are so troubled by the uncertainty around Medicare/Medicaid that it is hard to see how sentiment will let this stock work in the near term. Patient investors who believe rational heads will prevail and that politicians will realize they shouldn't squeeze this sector out of business could well be rewarded in the years to come, but don't expect an easy ride.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.