A Growth Play In A Bad Neighborhood
It would be an understatement to say that home healthcare providers like LHC Group, Amedisys (AMED), Gentiva (GTIV), and Almost Family (AFAM) have been beaten up since 2010. Not only has the industry had to absorb cuts in reimbursement, but the entire industry has been under a regulatory cloud caused by accusations that these companies have fraudulently and illegally billed for unnecessary treatments.
Compared with its rivals, though, LHC arguably has a cleaner path to many years of growth. Though LHC Group is far larger than the thousands of glorified mom-and-pop operators that make up the bulk of the home healthcare industry, it is still a fairly small company operating a little over 300 facilities in 19 states. Focused largely on the Southeast region of the country, LHC Group has yet to target markets like the Northeast (New York, Boston, Philly), Upper Midwest (Chicago), or California.
LHC Group may also have a somewhat cleaner regulatory slate. In October of 2011, LHC Group settled a qui tam lawsuit with the U.S. government for about $66 million covering claims from 2005-2008. Although there is a risk that the government may demand additional monies for years outside that agreement, and LHC will have to abide by new regulations designed to curb similar wrongdoing in the future, the company has still largely left this matter behind.
Tighter Purse Strings Versus Growing Opportunities
Just as Johnson & Johnson (and other drug and device companies) have had to deal with pricing pressures tied to Medicare reimbursement, so too has LHC Group and the sector as a whole. Rate cuts have come in around 3% in recent years and it looks like regulators are pushing for similar ongoing cuts.
There's next to nothing that LHC Group can do about reimbursement; Medicare comprises 80% or more of revenue for most of this entire sector. What LHC Group can do, though, is offset that pressure with enrollment growth and expansion. Thus far, Medicare reimbursement has been relatively more favorable for hospice care and LHC Group is growing its exposure to this business. At the same time, LHC Group is also looking to take advantage of the fragmented home healthcare market to grow by acquisition.
As time goes on, I expect that investors will see much the same in home healthcare that they have seen in managed care providers like UnitedHealth and WellPoint (WLP). There has been enormous consolidation in managed care as larger companies cannot only eliminate redundant G&A expenses, but also avail themselves of more sophisticated healthcare information systems and volume pricing. If Medicare wants to continue to push price cuts across the sector, more and more small operators are going to get squeezed out and into the arms of consolidators like LHC Group.
Consider that UnitedHealth's operating margins are actually lower than LHC Group's, but still generate double-digit returns on capital and healthy cashflows. I'm not suggesting that the two companies will follow identical paths; I'm simply saying that the arguments for size and scope in managed care can also apply to the incredibly fragmented home healthcare sector.
Differences That Matter
LHC Group also has a few other attributes that stand out from comparables like Amedisys or Gentiva. For starters, LHC Group addresses a more rural population set (about 50% of its client base) and Medicare has usually granted small (but still significant) premium adjustments for rural providers.
LHC Group is also well-placed to benefit from a new trend in hospital reimbursement. Hospitals like HCA have seen a significant change to Medicare reimbursement - a penalty applied when readmission rates rise for so-called preventable hospitalizations. This penalty should incentive hospitals to work with home care providers to create a more effective chain of continued care with lower readmission rates. Although this is a new idea, LHC Group already has partnerships with hospitals covering most of its facilities.
The Bottom Line
Certainly LHC Group is going to have to absorb the headwinds created by lower Medicare rates and new regulations aimed at curbing past abuses (like the requirement of face-to-face physician consultations to determine patient eligibility for home healthcare). As such, nobody should expect a banner year in 2012.
Longer term, though, LHC Group looks like it could be one of the survivors who thrive. Not only is there significant geographical expansion potential, but also growth potential from increasing its exposure to hospice care and leveraging those partnerships with hospitals.
With tens of millions of Americans becoming eligible for Medicare over the next 20 years and increasingly needing home healthcare services, a 10-year compound free cash flow growth rate below 5% is arguably conservative even with ongoing Medicare cuts. That sort of free cash flow can power a target fair value well into the $20s, making this a stock worth serious consideration by patient value hounds.