Daryl Davis'  Instablog

This is the sixth in a series of articles covering the home healthcare industry. See part 1 here, part 2 here, part 3 here, part 4 here, and part 5 http://seekingalpha.co....

In the last article, we used AFAM as a case study to assimilate the dynamic drivers of VN admissions growth we reviewed in the first four articles. AFAM had 7,737 admissions in 2001, of which almost 60% were referred from hospitals, about 30% from physicians and the remainder from various assisted living facilities. It had 39,666 admissions in 2008, of which about 45% were referred from physicians, 35% from hospitals and the remaining 20% from assisted living facilities. That 23% CAGR in admissions over eight years can be broken down as follows:

Industry growth accounts for about 8 points of that 23%

·   &... Systemic

o   &... Externally driven “trade downs” (more than half of those 8 points)

o   &... Internally driven “seek, teach and preach” (more than a quarter)

·   &... Demographic (less than a fifth)

Market share growth accounts for about 15 points of that 23%

·   &... M&A (about half of those 15 points)

·   &... Besting Competition

o   &... “Medieval style” competitive victories (more than a third)

o   &... Post-modern governmentally deployed “weapons of mass destruction” (less than a tenth)

In this article we will review the highlights of four meditations through which I attempt to predict the financial future for AFAM. Each of these four abstract processes will be somewhat quantified with models facilitating the formation of intrinsic valuations. The challenges inherent in these efforts cannot be overstated. Throughout this series, we have briefly reviewed a limited number of variables that played roles in this industry’s history. An infinite number of variables that could have played roles were disregarded- -variables that still exist going forward.

It would be unwise to hope that I could choose the one correct approach to determine AFAM’s exact intrinsic value; so, instead, in the four meditations below I have created a spectrum of valuations which, in aggregate, should provide some advantage in gauging the various prices that Mr. Market might offer. I figuratively donned specific hats to affect the desired attitude prior to each meditation. The specific pieces of headgear can be thought of as a frameworks designed to constrain and enable certain kinds of thinking.
Each of the meditations below will be named after the particular hat donned for the occasion.

There will be some constants in each valuation even though the outcomes will differ significantly. As AFAM’s 2009 results are relatively easy to predict (barring any acquisitions), they will be exactly the same in all four valuations; changes will register themselves in 2010. Similarly, while the demographic data we reviewed in the first article could buck expected trends, for practical reasons we will leave its contribution to admissions growth unaltered in each valuation (which is zero through 2016, then from 3-7% annually through 2023).

AFAM has a Personal Care (PC) segment which has become much less significant this century, generating about $40M in revenues and a bit more than $1M in net profits in 2008. In order to more easily project the below results on the VN operations of the other publics, we will focus on AFAM’s VN operations and simply add in its PC business at the end of each valuation.

AFAM has no significant capital expenditures (i.e., no ersatz earnings caused by depreciation), so net income will be used to calculate intrinsic value. We will discount that net income 6% annually. Shares outstanding will be our final constant, left at the current level of 8.3M in each valuation. Quite significantly, even though there are none detailed below, losses (and write-downs) should be expected after major cuts in reimbursements.

Ushanka (a la Nikita Khrushchev)- -Ultra Conservative

It is all too easy to imagine that Khrushchev was wearing his ushanka when he gave orders to destroy various churches.  His fashion choice in 1962 left nothing to the imagination as he stormed the United Nations wearing this traditional Russian headgear in the midst of the Cuban Missile Crisis.  When I wore this hat, made of bear fur, my mental approach to the world was similar to that of a Skeptic or Minority Whip—an approach which affords the opportunity to say “I told you so” the instant anything happens that was not specifically predicted.

I immediately questioned the validity of any intrinsic valuation, and, with an over-the-top frown, pointed out how an epidemic or escalated global stalemate—possibly the Lybian Missile Crisis—could easily change our global economy.

Interestingly, from this perspective I found it perversely rewarding to imagine draconian cut-backs that killed off 90% of the industry players. This left our publics with paper thin margins that were more than offset by incredible volume and power: AMED had a 20% market share, GTIV 15%, LHCG 10%, and AFAM 5%. I made myself do better (worse) than that.
 

New administrative hurdles curtailed referrals from physicians, and hospital budget strains led to an increase in apathetic or ignorant discharge planners. This translated to a severe shrinkage in systemic admissions in the near term, and subsequent industry growth fell from 8% to a mere 2% through 2016, augmented thereafter by demographics.

Further, MedPAC—using bad math—convinced Congress to adjust reimbursement levels so that thousands of Mom-and-Pops struggled to break even, but resiliently stayed in the only business they knew. The powers-that-be pulled back average revenues per episode (putting AFAM’s around $1,900) with a slight allowance for inflation, and CMS instituted new restrictions that cut recertifications in half. This left the scaled operations with net margins in the 3-4% range, with much smaller revenues per patient. Profits were so small and capital structures so weak that there was not much desire or capacity for M&A activity (1% growth). AFAM’s “medieval style” competitive victories still dominated (5% growth), with freebies coming in relatively small waves each time rates were tweaked back (though anywhere from 0-5% in a given year, I used 1% annually below).

ushanka table goes here.

The discounted cash flows from the VN segment through 2023 come to about $111M. Of course, from this perspective the environment in 2024 is not conducive to selling, so we value the sales price of the VN segment at $59M, or about eight times AFAM’s 2023 net income. The intrinsic value of AFAM’s VN operations is thus $169M ($111M + $59M). In this painful scenario, AFAM’s PC segment adds a not meaningful amount to that total, translating to an aggregate intrinsic value per share at just over $20.
 
Ideally, we want to buy a share of such a company (in an industry with limited barriers to entry and constantly subjected to unpredictable political winds) on the stock market at a third or less of the intrinsic value ($7 and under here). Based on the Ushanka extremities, however, half off ($10) would be a satisfactory price even for a very grouchy bear.

Fedora (a la Tom Landry)--Conservative

Tom Landry—one of the most successful football coaches in the history of the NFL—almost always wore his fedora when in the public spotlight. Even though he was categorized as an old-school conservative, he demonstrated an uncanny ability to think independently (e.g., he invented the shot-gun formation; he revolutionized the game by inserting an untested Olympian sprinter, “Bullet” Bob Hayes, at wide receiver; etc.).
 
With this hat on, I saw MedPAC successfully lobby Congress to significantly curb the profitability of the scaled HHAs. Using some complicated efficiency formula, HHAs which met certain size criteria received a maximum episodic rate as long as recertifications did not exceed 30%.
 
AFAM’s average revenue per episode was around $2,000 under this system by 2010 (with an inflationary increase). At the same time, budgetary pressures led to decreased hospital care and even more expeditious discharges, continuing current admissions trends for HHAs. Referrals from other sources slowed down as a result of various bureaucratic verification requirements. After an initial and significant decrease as a result of lost physician referrals, there was 8% systemic admissions growth through 2015 and 5% growth thereafter, augmented, again, with the demographic constants as of 2017.
 
Admissions growth due to besting competition was about 3.5% annually as freebies became a bit more prominent due to rate cuts, which somewhat mitigated “medieval style” victories. Admissions from M&A growth stayed the course through 2014 and then fell back to 5% annually.

fedora table goes here

With several years of demographic growth remaining in 2023, it would be quite conservative to assume a sales price of $234M (10 X 2023’s discounted earnings). Add to that figure the discounted cash flows of $187M of VN earnings through 2023 for a subtotal of $422M (slightly improved by a PC segment), which translates to an aggregate intrinsic value of around $54 per share—meaning anything less than $18 is a buy.

Detroit Tigers Baseball Cap (a la Magnum P.I.)—Moderate

The flocculent Tom Selleck burst into public consciousness in the 1980’s as the protagonist of the television series Magnum P.I. His character, Thomas Magnum (frequently wearing his signature Detroit Tigers baseball cap), contrasted sharply with Landry in that he answered only to himself. When contemplating new information regarding any case, Magnum could change direction immediately without discussing his decisions or managing any expectations. Clearly, this sort of character deserves significant space in my consciousness.
 
Not long after donning this cap I successfully snooped out Landry’s impressive estimates and made some changes: AFAM’s average revenue per episode bottomed out no lower than the Medicare home healthcare base rates used during the industry’s first decade of PPS. I therefore estimated these rates at $2,300 for AFAM on a per episode basis by 2010, allowing a 2% inflationary increase thereafter. I was not surprised to see a bundling concept introduced by Congress, which called for hospitals to be reimbursed one time for both acute and post-acute care, which forced AFAM to copy techniques similar to those currently employed by LHCG. This bundling change motivated hospitals to improve their home healthcare operations enough to at least achieve profitability, resulting in more referrals for the hospitals, and fewer for AFAM.
 
Also, while Landry’s visualization of a bureaucratic muddling of referrals from non-hospital sources seems like a safe approach, his admissions cuts were too severe. I instead used a 5% static systemic admissions growth.
 
I saw a continuation of the strong companies in this industry getting stronger, which caused 8% admissions growth from M&A. Besting of competition netted 5% annual growth as the expansion of this arbitrage brought with it an increase in medieval victories, coupled with fewer freebies in this more hospitable environment. Industry consolidation eventually saturated, which squelched both of these growth engines by 2017.

tigers table goes here.

Fetching a sales price of about 13 X 2023’s earnings ($678M), plus the $367M in discounted cash flows from the VN operations through that year, plus a more meaningful valuation of the PC business equals an intrinsic valuation in today’s dollars of just over $1B, which translates to about $145 per share. A $100 margin of safety whittles the high-end of potential purchase prices down to about $45.
 

Dr. Seuss Hat (a la Arts Student at Lollapalooza Festival)--Aggressive

Since 1990, Lollapalooza has been the premier alternative rock festival in the U.S.—at least as famous for its opiate-caused mass euphoria as for its legendary artists. At each festival can be found random liberal arts students wearing the vertically extended red-and-white striped Cat in the Hat hats. While these intoxicated patrons sometimes get beaten up for no other reason than wearing such conspicuous hats, they are almost always blissful. Say! I like home health and AFAM! I do! I like them Sam-I-am! They are so good, so good, you see! So I will buy them here, and I will buy them there. Say! I will buy them anywhere! I do so like home health and AFAM! Thank you! Thank you, Sam-I-am.
 
From this rosy perspective, I saw AFAM’s revenue per episode decrease significantly by 2013 ($3,200 X .85 = $2,700), but the company adjusted—as it did at the turn of the century—with net margins in the 8% range by 2015. This left the smaller operations in the industry netting less than 5%, which allowed M&A activity and medieval victories to continue on similar trends through 2017 (with scant freebies).
 
Congress claimed to focus on the critical issues of healthcare reform and simultaneously outsourced its decision-making authority to a massive central cost monitoring agency—given the euphemistic Orwellian acronym NICHE (National Institute for Clinical and Health Excellence). This agency created a unique form of bundling and bureaucratic muddling, but also looked for reasons to increase as many admissions as plausible to our cheapest form of pre-acute and sub-acute care, resulting in systemic growth of 10-15% annually through 2015, with a slow drop-off thereafter, and—due to increased acuity levels-- recertification rates over 40%.

dr. suess table goes here.

To be sure, there will be no cheery consensus on this outcome anytime soon. In this scenario, AFAM’s intrinsic valuation is about $2.7B (($897M discounted cash flows through 2023) + (15 X 2023 discounted income) + (a meaningful valuation for the PC segment))—or $325 per share. Because of how aggressive these estimates are, I will create some extra margin of safety with a maximum purchase price 75% less than that intrinsic valuation ($80).
 
As Benjamin Franklin once said, “The most exquisite folly is made of wisdom spun too fine.” The above four models could easily be misinterpreted as a fine spinning of any wisdom garnered in previous articles. In the next article, therefore, we will undo some of that damage, as well as conclude this series on home healthcare.

Disclosure:  Long AFAM, AMED, GTIV, LHCG; Short GTIV.