Home Healthcare: Towards Wise Exuberance

With the possible exclusion of Philadelphia Eagles fans, there is not a more fickle group of people than Wall Streeters. Certainly there are exceptional Wall Streeters who bring much needed value to our economy—who facilitate beneficial transactions and even add intrinsic value to the companies we invest in. But those people aren’t seeking our attention. The Wall Streeters who are anxious to get our attention usually are gifted in appearing to have long ago identified the newest bandwagons. When changes in trends are just becoming obvious, these folks can ditch a heretofore-favored-but-now-defective ride and jump on the next hottest thing in a New York minute—without looking the least disheveled. “Financials? Paaashaaa. Oil stocks? Of course! Who didn’t see that coming? I’ve owned Exxon since it was called Standard.” They don’t share their doubly regrettable sale of Bear Stearns at $5.

Within the resilient healthcare industry we will find a sector that has also become a Wall Street darling recently: home healthcare. Over the past 13 months this sector’s increase in market capitalization is somewhat commensurate with its increase in stock analyst attention. I offer data on four companies below  - Amedisys, Inc. (AMED), LHC Group (LHCG), Almost Family (AFAM) and Gentiva Health Services, Inc. (GTIV) - as a sort of stock market snapshot of the sector.

Need I remind you that we are in a bear market?

Note: This article focuses on Visiting Nurse-oriented home healthcare companies.

Home healthcare companies, both public and private, will play an increasingly critical role in our economy for the next few decades. Fewer workers supporting increased seniors means that we will be greatly impacted by how well these companies are able to economize quality home healthcare—irrespective of the vicissitudes of Wall Street.

So what are the analysts writing? “Baby Boomers” is a common catch phrase. You’ll also see “recession-proof,” because:

1. the services these companies provide are non-discretionary; and
2. the vast majority of these companies’ revenues come from Medicare.

You’ll also be wowed by recent “organic” growth of many of the public companies. And while the word “consolidation” is used frequently enough, I have yet to see an adequate explanation of its importance for would-be investors.

I hope to shed some much needed light on what is happening, and what one might expect, in this sector—with minimal focus on stock prices.

(Aware of the significance of Medicaid—and of the various roles it might eventually play — I will follow the precedent set by many of these companies and only mention it in passing.)

Speculators Promoting the Long-Term

Question: How much impact have the Baby Boomers had on this sector?

Answer: Virtually none.

We’re not due a new census until 2010, but can use the 2000 Census to see what the U.S. population was by age in 2000:

Note: There are 3.86% more 72-year olds than 73-year olds, and 7.26% fewer 34-year olds than 35-year olds.

Reading the above from youngest to oldest, bear in mind the incrementally greater role death plays in thinning these numbers. We can simply add eight years to the above ages and get a pretty helpful current picture, especially by changing the population column to percentages to see what type of patient growth these companies might expect.

Note: This guestimation shows there are 3.86% more 80-year olds than 81-year olds, and 7.26% fewer 42-year olds than 43-year olds.

Working backwards from today’s 81-year olds through today’s 67-year olds, the average annual growth is 2.35%--nothing special. Those born in 1942 and 1943 make up that largish band of today’s 65- and 66-year olds (many of those 1942 conceptions were timed in correlation with drafting policies for WWII). But the post-war “births” started in earnest in 1947, and those people are now about 61 years old. Once that plateau of procreation was reached in 1947, it was maintained for quite some time: there was no consistent diminution in births until 1966, represented by our current 42-year olds (see here). There is a tremendous difference in size between the two generations on either side of today’s 62-year olds.

The demographic data I’m presenting clearly shows that the Baby Boom generation (or, even more vaguely, our aging population) has not yet made, nor will make for a while, a sizable impact on these companies. Today, the average age of patients within the home healthcare sector is close to 80. The members in that pre-cursor group of people born mostly in 1943 will have to be in their 70s before they make a real splash on growth. Then there will be three years to go before the tidal wave rolls in. That means that while preliminary trickles may be noticeable in 2012 or so, the ultimate benefits for this sector with respect to the Baby Boomers begin somewhere around 2017. Factor in lengthening life spans and believe you me, the future growth will be tremendous for these companies. There is no way to get around that.

But this timeline has not been made clear in any of the articles I have read. Might we have some Johnny-come-latelys who are now promoting these companies by ambiguously pointing to an easily identified demographic, irrelevant to gross demand for another 5-10 years? I wonder how many of these promoters will hold shares in this sector ten years from now…or even three years from now.

Freebies, Recessions and Consolidation: A Seller’s Market?

Check out AFAM’s incredible “internal growth” stretch of Medicare-oriented revenues on a year-over-year basis: Q3 ’06 17%; Q4 ’06 29%; Q1 ’07 27%; Q2 ’07 27%; Q3 ’07 27%; Q4 ’07 27%. The other companies show similar trends.

How can all these publics claim such growth without an increase in demand?

This sector is at the mercy of Medicare reimbursements, so the 3.3% increase on January 1, 2007 certainly offered a nice tailwind. But that didn’t account for the half of it. Since early 2000, reimbursements in relation to costs have increased by a multiple of “infinity,” which begins to explain things.

For those who may not remember, home healthcare companies were pummeled beginning in the late ‘90s due directly to changes in Medicare affected by the Balanced Budget Act of 1997. From 1998 through 2000, our Wall Streeters turned their backs en masse on this fragmented sector. Amedisys's market capitalization in July of 1999 bottomed out around $2.6M (that’s not a typo). Write-downs were enormous while operating losses were guaranteed—what a combination! Medicare administrators could hardly use the term “reimbursement” and keep a straight face. Home healthcare companies were left in turmoil, holding on to modestly profitable Medicaid reimbursements for dear life.

A much more subtle but still critical aspect of this paradigm shift involved technology. There were both exogenous (e.g., HIPAA and PPS reporting requirements) and endogenous (technocratic drive for efficiencies—e.g., AMED’s Point of Care) drivers requiring continuous investment in hardware and software. Even without the Medicare overhaul from BBA ’97, this technology “ante-up” would have eventually destroyed many smaller agencies with poor cash flow. In a sense, BBA ’97 put many companies that were on life-support—whether they were aware of their morbid condition or not—out of their misery.

That perfect storm was a stomach-churning demonstration of Social Darwinism. Saying that environment was very difficult would be like saying that movies tailored for junior high-school kids are bad: both are feeble understatements. But by 2001, many of the survivors were able to euphorically use black pens for bookkeeping more often than not. While CMS (Centers for Medicare and Medicaid Services) has helped create a more stable reimbursement environment in which profits can obviously be had, the process has been anything but liquid. “One step forward and two steps back,” appears to be the theme.

Battle-tested owners of home healthcare companies are still getting out as the future is far from clear. Mom-and-Pops are hoping to sell if they haven’t already shuttered their doors. Many of the non-profits that made the cut have since lost market share. Who knows how many regional hospitals (hospitals that may have garnered no more than 1% of profits from their home nursing facilities earlier this decade) have closed those operations with no fanfare just to get out of the turmoil? This is what has caused the mouthwatering “organic” growth. No baby-boomers—just the beauty of being at the right place at the right time. Freebies. And it is worth noting that the companies still around in the middle of the next decade will experience a deja-vu of sorts, when the Baby Boomers finally increase gross demand at…gulp…levels similar to those detailed above for Almost Family, Inc.

The mass exodus is not nearly over as this sector remains extremely fragmented. However, freebies are thinning out, and future growth will be more and more dominated by M&As. Today there are over 8,000 home healthcare agencies nationwide. In June, at the Jefferies Second Annual Healthcare Conference, Larry Graham, President and COO of AMED, offered this gem of a stat: “If you take the other…three publicly traded companies that are presenting at this conference, all combined we make up less than 7% of the national market share in Medicare home nursing.” (The other companies were LHCG, AFAM and GTIV - recall our stock market snapshot above.) That stat is incredible. AMED is the market leader by size (publics), and the other companies are in the top ten. 7%? That’s it?!

Small agencies will certainly struggle. It is fairly clear in this sector that efficiency, scale and technology are required going forward—merely the clarity of this fact has contributed to this positive feedback cycle. But while we are beyond the tipping point, this consolidation will take some time. And though M&As are not nearly as profitable as either the diminishing freebies or the impending rising demographic tide, they are still very significant and immediate.

But how profitable is it to buy these operations for 7.5-8.5 times ebitda?

“Probably” it is reasonably profitable. Ostensibly, CMS is trying to create a rather efficient and non-sexy world of home healthcare providers that plods along with net profit margins in the 5% range. If that is the goal and if CMS can affect reimbursement schedules that achieve this goal, then, indeed, larger, more efficient companies will do O.K. to buy out the smaller ones at such prices. But government budgets are always under review—and their revenues don’t look to be growing anytime soon; in fact they have already begun shrinking due to our slowing economy. What happens when companies like AMED get headlines touting 6 and 7% net margins while Congress pushes through a new “BBA of 2010”? (Though I’m focusing on Medicare, many would argue we have more reason to suspect upheaval with our comparatively underfunded state governments and Medicaid.)

This sector is not recession proof. At best it is recession resistant, and more likely it is recession delayed. The folks in Washington will make budgetary decisions with fewer tax dollars based on many motivating factors, and, obviously, special interest groups will play a pivotal role. Home healthcare is severely lacking in this category—due in large part to its historical fragmentation.

So how does “probably” fit into that?

A whimsical analogy using a children’s game will help illustrate my point. If pharmaceuticals are “paper,” doctors are “scissors,” and insurance carriers are “rock,” then home healthcare can be thought of as a microscopic insect unwittingly destroyed at the onset of the game. Compared to other players impacted by Medicare, this little sector has a lot of ground to make up on the lobbyist front. To be sure, there are no guarantees even with focused voices in Washington, but without them our current world of profitability seems very precarious to me. A sudden reversion in reimbursement philosophies could cause our “friendly” Wall Streeters to jump ship yet again.

Many would call this a buyers’ market, and certainly it appears as such wearing today’s intoxicating goggles. A decade ago (the “morning after” BBA ’97), however, the much more sober view was far from attractive. Maybe today’s sellers know more about their market place than we credit them for.

To be clear, I’m no gloom-and-doom dude…I just have some viscerally painful memories from ten years ago. And for the record, I’m heavily invested in this sector. If CMS steers this reimbursement system to reasonable levels (leaving profitability mostly unharmed), then the future is bright indeed. If the reimbursement environment gets notably worse, then shareholders will have essentially paid too much to those very happy and retired sellers.

(On that note, because issuing equity has been the predominate method for buyouts, I do truly appreciate any and all help we have received to raise the value of our remittance to more reasonable levels. And we can count on that continued support from Wall Streeters—promoted especially by M&A beneficiaries—as long as deals can be made.)

A Cheery Consensus Would Create Far More Expensive Shares

It is quite possible that my investment hero, Warren Buffett, would never buy companies saddled, as such, with governmentally predetermined revenues.  However, I can’t help but rely heavily on his guidelines when analyzing any investment.  As such, I’ll conclude with a some Q&As for this sector based on some of his most famous tenets geared for companies.

Does the Business Fall Within My Circle of Competence?

While it takes trained professionals to administer these services, a teenager could easily understand the basic mechanics of home nursing.  Even with revenues complicated by state and federal governments, this is an easy “yes” for me.

Is the Operating History Consistent?

“Yes.”  Although a cogent argument could be made that Medicare reimbursements have been anything but consistent since 1998.  While that is critical information, it can be compartmentalized within the much broader history of home nursing.

Are Long-Term Business Prospects Favorable?

Emphatic “yes!”

Is Management Competent and Trustworthy?

Circumstances are the ultimate litmus tests for this question.  Remember that almost all public companies in this sector remain alive today because they have already been through the fire.  Beyond that, I tend to lean towards management teams with very conservative accounting and those less spellbound by our Rico Suave Wall Streeters.  Caveat emptor.

Is the Price Fair?

I’ll use my favorite of these companies, AFAM, for illustrative purposes.  While the variables would change (e.g., AMED’s size deters it from growing as quickly; LHC is more diversified; GTIV uses more leverage), the basic logic and trends would be similar for all of these companies’ Visiting Nurse operations.

• Assume a perpetual 5% net profit margin starting in 2009
• Assume AFAM’s 2009 net profit is $12M
• Assume a 6% annual discount
• Assume a six-tiered profit-growth chart:  2010-2015: 12% annually; 2016-2021: 18%; 2022-2037: 3%; 2038-2043: -4%; 2044-2072: 0%; 2073 and beyond: 3%

(I make it point to avoid false precision, and would agree that, at first blush, a six-tiered growth chart just seems silly.  However, in this instance, with the population data so accessible, it is not inappropriate.)

Those assumptions give us, in 2009 greenbacks, intrinsic enterprise value for AFAM of almost $900M, which translates to $108 per share (8.2M shares outstanding and counting). 

Such views from the stars are always fun.  Before we leave this ephemeral perch, I’ll point out how fleet of foot these companies are:  capital expenditures are minimal (no ersatz earnings); no pensions to speak of; goodwill and unrestricted earnings abound.

Now back to earth: I was offering what I believe is a reasonable hypothetical intrinsic value, not market value.  While companies usually trade below their intrinsic value, stocks in this sector should trade well below theirs as long the specter of a potentially-irrational-but-always-regulated reimbursement system looms.  By simply changing AFAM’s net profit assumption to a much more conservative 3% (which would be greater than aggregate Visiting Nurse profit margins were in 2000) the per-share intrinsic value plummets to below $60—solidifying “no purchase” status in Buffettology at current prices.

Ironically, the reality won’t be known until about the time I’ll be in need of quality home care.  I’ve been long, and will remain long.  I’m just cautious about our new “friends.”  I won’t speculate on where either reimbursement rates or share prices will be three years from now.  But I’m fully vested in the outcome of home healthcare in the long run.

Comments

[guliamo:]

Hi Daryl,
Thanks for a great post.
Amedisys Inc posted second-quarter results that beat market estimates and said its integration of TLC Health Care Services was ahead of schedule.
Net service revenue rose about 85 percent to $312.7 million.
As I have written before I simply love this company - it has all the makings of a fantastic growth story - here's why:
1. It's a small cap. At under 2 billion valuation these guys can multiply 5 fold in value before reaching any kind of market saturation.
2. AMED is on an aggressive buying spree - bought two old age facilities since the year began and still retain a reasonable ROE of 16%
3. This whole sector is racing up - take a look at the industry chart compared to the S&P - like a mirror image.. Old age care is breaking out in a sprint:
www.m?arketguru.com?/h...
4. The one thing you can count on in this market is that baby boomers are retiring, getting old and in dire need of these services.
Hope the run continues.

2008 Jul 29 10:48 AM

[guliamo:]

sorry - the link came out wrong..
www.marketguru.com/opi...

2008 Jul 29 10:49 AM