Lincare Holdings: Heads You Win, Tails You Win Big

| About: Lincare Holdings (LNCR)
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I have followed Lincare Holdings (NASDAQ:LNCR) (38.69, $3.5 billion, S&P 400 member) for the past seven years. At my former employer, we owned the stock from 2001 until late 2002, when we sold it due to what we perceived as a major transformation in the industry that would negatively impact future earnings. The proverbial fan was hit with all sorts of things, the first of which was a change in the reimbursements for the drugs administered. Since then, the industry has seen competitive bidding crop up and yet another imminent reimbursement change (13 month cap on rental payments for equipment). I am confident that there isn’t much additional reimbursement risk left at this point. In fact, some of the analysts may be too pessimistic, as Congress could keep reimbursement level in this coming election season.

Lincare, based in Florida, is the leading provider of respiratory services in the home (out of 1000 locations). Their customer base typically suffers from COPD (emphysema, chronic bronchitis, asthma). The market has been consolidating for some time, though it remains somewhat fragmented. The second largest provider is Apria (AHG), which is also in other lines of business unlike the pure-play LNCR. Rotech (OTC:ROHI), teetering on bankruptcy, is another publicly-traded competitor, though substantially smaller. LNCR specifically provides durable medical equipment (oxygen concentrators and liquid oxygen for COPD, nebulizers for asthma and masks/CPAP machines for sleep Apnea).

The oxygen industry has some of the same characteristics as dialysis. A substantial portion of the customer base is covered by Medicare. Additionally, the condition is chronic with no cure (only treatment). Both of these industries have consolidated significantly as reimbursement has changed, as the remaining companies are more efficient and have a higher level of service. If the patients aren’t treated properly, then they end up an extremely expensive hospital patient.

LNCR is extremely well managed and maintains remarkably high margins relative to its peers. CEO John Byrne and CFO Paul Gabos have both been with the firm a while, having weathered the “AWP” pricing change (by reducing SG&A, though margins are still down) that hurt the industry so greatly in 2005 (check out ROHI), have expanded via acquisition and organically and been extremely straight-forward with the street regarding the impact of the changing landscape. The company has continued to internally expand while backing off of acquisitions for now. They have been repurchasing a significant amount of stock, leveraging the balance sheet perhaps a little more than I would like to see (but not unreasonably so at D/C of 38%). I would note that management, though, has been reducing personal holdings, not necessarily encouraging. Note, though, that Gabos sold a ton of stock in 2004 AFTER the bad news came out, pretty much bottom-ticking it at 31.62 on $8mm of exercised options.

Many investors have taken the position over the past several years that one should own LNCR once the bad news hits the market, as they will weather the storm better than the smaller competitors and gain market share. That remains the case now, as the industry is again facing a major change in reimbursement. The President’s 2008 proposed budget caps monthly rental payments at just 13 months. If it goes through, it could cut earnings by 1/3 evidently. A couple of long-term institutional holders bailed when this proposal became public. Will it actually happen? I would guess not. A few years ago, it came down to the wire, and Congress stuck it to the industry. The basic challenge has been how the industry prices – it bundles equipment, drugs and services. In 2005, they hit the industry hard with the slashes to the drug reimbursement component. At this point, if they tell the homecare providers that they will no longer reimburse after 13 months, then this chronically ill segment (more than 10mm in size) will not be serviced. This is unlikely to happen in an election year in my opinion.

If the cuts don’t happen, the stock is dirt cheap. If they do happen, as the leader, LNCR will ultimately enjoy higher growth off a reduced base. I believe that the current price reflects pretty much a worst-case scenario. It’s back to the old playbook of wanting to own this stock either right before the good news (no change) or just after the bad news. Look back to how the stock found support when the “bad news” came out in late 2003. This was somewhat of a different situation, as the stock had run up as political intelligence suggested right up until the last minute that there would be no change. The stock pulled back to support, failing to make a 52 week low. I believe that if the budget proposal is adopted, LNCR will hold its 32 spike low or 34 base low. I would expect the PE to jump to 20 if the bad news comes, which gets the stock to 40 in a “downside” scenario. I would expect the stock to rally substantially if there isn’t a reimbursement change, perhaps to 17X 2008 (about 50). Technically, the stock appears to be basing on the daily, weekly and monthly charts. The breakout will be confirmed if the stock clears 39.50. Support is at 38 or so.

1 year chart:


Longer-term chart:


Bottom line: LNCR, the industry leader in a business that ultimately saves the healthcare system money yet has seen its reimbursement hammered over the past few years, is poised to advance on either bad news (reduced earnings but higher growth) or the more likely good news (multiple expansion with removal of overhang) regarding the proposed 13 month cap.

Disclosure: I don’t own LNCR at the time of this writing, but I intend to establish a position on a break of 39.50.