Lincare Holdings Inc (NASDAQ: LNCR) provides respiratory therapy services to patients with chronic obstructive pulmonary diseases such as emphysema, bronchitis and asthma. The company has approximately 750,000 customers in 48 states being serviced through 1,090 operating centers. As we will see in a moment, LNCR is a free cash flow machine, generating an average of $247 million in free cash flow annually for the last decade. The company’s shares have traded down nearly 30% in recent months, such that its equity is now valued around $2 billion, for free cash flow yield of about 12.5%.
Lincare Holdings Inc - Cash Flows, 1994 - 2Q 2011
Here we see in graphical form the company’s strong free cash flows and cash flows from operations. However, rather than focusing solely on cash flow from operations and free cash flows, I added a new metric to this chart: free cash flow after acquisitions. I’ve done this because LNCR has been particularly acquisitive, making an average of $70 million in purchases annually for the last seventeen years. Acquisitions are an integral part of the company’s strategy. According to its recent 10-k (emphasis added):
Our strategy is to increase our market share through internal growth and strategic business acquisitions. We achieve internal growth in existing geographic markets through the addition of new customers and referral sources to our network of local operating centers. In addition, we expand into new geographic markets on a selective basis, either through acquisitions or by opening new operating centers, when we believe such expansion will enhance our business. In 2010, Lincare acquired six local and regional companies with operations in multiple states.
I am usually not a fan of growth by acquisition as a strategy. In most cases, companies overpay for acquisitions. This strategy results in a significant amount of goodwill and other intangibles on the balance sheet, which is difficult to value. This is certainly the case with LNCR, which carries $1.35 billion of intangibles on its books, or 64% of total assets (130% of equity, meaning negative tangible equity). As such, this won’t be an investment based on asset value, but rather earnings (really, free cash flow). This requires an inquiry into how the company’s growth by acquisition strategy has been performing to date.
Lincare Holdings Inc - Historical Returns, 1994 - 2Q 2011
It is apparent from this chart that there is a definite negative trend in many of the company’s returns metrics over time. However, the key metric to watch here is the company’s Cash Return on Invested Capital, or CROIC. The CROIC tracks free cash flow as a percent of invested capital (book value of equity + book value of debt – cash). LNCR has a relatively high amount of non-cash expenses (depreciation being the largest by far), which largely account for the persistent excess of cash flows over earnings (and hence the CROIC over ROIC and other earnings based measures). Ultimately, free cash flow drives investment valuation, so CROIC is an important metric. The continued strength of the company’s CROIC suggests that management is doing a good job executing on its growth by acquisition strategy.
The company’s ROE has also stayed relatively high, but unfortunately this is largely the result of increasing leverage, as the next chart indicates.
Lincare Holdings Inc - Capital Structure, 1994 - 2Q 2011
Increased leverage means increased risk, so the company’s increasing use of leverage is not a good sign for investors. Especially in relation to the next chart:
Lincare Holdings Inc - Revenues and Margins, 1994 - 2Q 2011
Leverage reduces a company’s operational flexibility as fixed debt servicing payments increase and siphon money away from operational demands. In this chart, we see that the company has been suffering from margin contraction beginning with its gross margins and only getting worse as we work down the income statement. A large portion of this appears to be related to lower reimbursement levels from Medicare and Medicaid (and associated reductions in private insurance reimbursement). Further cost control efforts in these health programs are likely to continue to punish the company’s margins. The Patient Protection and Affordable Care Act (PPACA) has only recently been signed into law and includes sweeping changes, the effects of which are yet to be determined. As such, LNCR’s future performance is unlikely to look like its past, despite the stability of its past performance.
LNCR is a cash flow machine, and its declining earnings-based returns metrics ignore the whole story. Unfortunately, the company is experiencing a real decline in its gross margins. Combine this with increased leverage and extreme regulatory uncertainty (though, given the pressure to reduce medical care costs in the United States, in all likelihood things are going to get worse for medical service providers), and it becomes difficult to determine whether the company will be able to continue earning such strong free cash flows. I doubt it. For someone intimately familiar with the workings of the new legislation and how it might affect this company’s revenues and cash flows, this might still be a good investment. I am not that person, so I will stay away.
What do you think of LNCR?
Disclosure: No position