Back in February, Civitas Solutions (CIVI) plunged 23% after its fiscal Q1 report, touching an all-time low just above $11. (The company was taken public in 2014 after years of ownership by private equity.) A quarter that didn't look that bad raised serious questions about the viability of the for-profit health services provider; I wrote at the time that those questions offset what fundamentally looked like a quite attractive price.
Since then, however, the news has appeared much more positive. Better results in Q2 and particularly Q3 - with a 22% increase in Adjusted EBITDA - seem to show that early-year worries were overwrought. A report that the company was considering strategic alternatives spiked the stock earlier this month. From those lows, CIVI has rallied nicely:
But despite the 38% rise from the lows, I'm skeptical all that much has changed. Margin pressure continues. Civitas may be considering alternatives - but I'm not sure the company truly has that many options. The fiscal Q2 and Q3 numbers (CIVI fiscal years end in September) do look better - but the trend and the story look as concerning as they did in February.
Q2 and Q3 Change the Case...
The abridged version of the bear case (and potentially the short case, though few traders have taken that side: short interest is just 0.53% of the float, even though over 50% of shares are owned by P-E firm Vestar) here is pretty simple. Rates for Civitas' services - for individuals with disabilities, foster children, post-acute physical rehabilitation patients, and developmentally disabled adults - are going up slowly. Wages, more broadly, are going up quickly. And that's a huge problem for Civitas, whose labor-intensive offerings already rest on the back of underpaid staffers.
To be clear, that's an issue in the social work/'caring industry' space more broadly: the average hourly wage is below the national average despite the fact that many industry employees hold advanced degrees. Glassdoor reviews of subsidiary Mentor Network, however, feature numerous complaints about Civitas' wage levels. But at the moment, with unemployment low and state-level minimum wages rising, Civitas is under significant pressure. Pressured 10%+ EBITDA margins and a balance sheet that is nearly 4x leveraged (on a net basis) are a recipe for lower equity values, if not outright disaster.
That case was what drove the post-Q1 sell-off. But it would seem to be assuaged by the results of the last two quarters. Q2 EBITDA margins did compress 60 bps - but that was an improvement from a 90 bps shrinkage in Q1. Direct labor costs, as a percentage of revenue, were flat in the quarter, per the Q2 conference call. Civitas did pull down the top end of full-year EBITDA guidance, but the quarter was at worst better than feared.
Q3, meanwhile, looked downright fantastic. Revenue rose 8.6%; EBITDA margins leveraged 140 bps, with the absolute figure rising 21.8%. Direct labor dropped 100 bps as a percentage of revenue, per the Q3 call. Civitas actually bumped up full-year guidance by $2 million coming out of the quarter.
At worst, relative to the margin issue, the last two quarters would seem to suggest that the post-Q1 sell-off was an overreaction. (So, obviously, does the 38% rise in CIVI stock.) YTD EBITDA margins now are flat year-over-year. Civitas again appears to be grinding through, continuing a multi-year trend of growth:
source: author from CIVI press releases and filings. FY18 figures at midpoint of updated company guidance
...Or Do They?
But though the numbers look better, I'm truthfully not sure the story has changed all that much. Both quarters benefited from somewhat unusual items. Q2, per the Q2 call, saw an unspecified help from buying out vendor contracts for therapists a year ago. Health insurance reserves leveraged 60 bps, with expenses from the self-insured plan at all-time lows. G&A dropped 30 bps, due largely to cost-cutting measures.
Q3, meanwhile, benefited from "about $2.5 million", per that quarter's call, in "structural items" - the largest of which was a reduction in incentive compensation expense. Those items alone drove a quarter of the year-over-year growth in EBITDA (and note that full-year guidance was pulled up $2 million largely due to the quarter's outperformance) and the "majority" of the direct labor leverage. G&A deleveraged 60 bps in the quarter, further helping margins.
Civitas deserves some credit for managing through, and pulling the levers it can in terms of insurance, G&A, and cost optimization. But those levers now are pulled. And management, in particular, clearly has tried to lower expectations going forward. CEO Bruce Nardella said on the Q3 call that "our expectations for upcoming quarters are tempered by labor challenges that we expect will pressure our organic EBITDA growth". He noted in the Q&A of the call that retention remained a significant issue, and added regarding labor costs being flat as a percentage of revenue that "it would be, frankly, unrealistic to expect that to continue - certainly in the fourth quarter and, frankly, for quarters to come..."
From a broad, long-term standpoint, Q2 and Q3 don't seem to change the case much. Civitas was able to perform well for the two quarters - and again, deserves credit for doing so. But by management's own admission, that's unlikely to continue. The midpoint of full-year Adjusted EBITDA guidance suggests Q4 EBITDA should be ~flat (the midpoint is almost exactly zero growth), with margins compressing ~60 bps in the quarter. Come FY19, Civitas does get to lap an easy comparison in Q1 - but then has tougher comparisons following, with cost-cutting benefits likely gone and no room for error in areas like G&A and self-insured risk.
The Problems Continue
The core underlying mismatch between what Civitas has to pay and what state governments (and their voters and representatives) are willing to pay isn't over. Notably, on the Q3 call Civitas announced a surprising 7% rate cut in Minnesota - the company's most important state, driving 15% of revenue per a recent presentation. The cut comes despite the fact that the state finished its fiscal year with a $300 million surplus, as Nardella pointed out on the call.
Admittedly, the cut is due to bureaucratic issues between the CMS (Centers for Medicare & Medicaid Services) and the state regarding rates for waivers that cover home- and community-based treatment. But the cut itself will negatively affect EBITDA by ~$4 million - implying a 3-4% decrease in annual normalized cash flow ($65-$70 million by my numbers) on its own. And it's of a pattern with similar issues elsewhere, whether rate cuts or a waiver redesign in West Virginia that cost Civitas several million in annual profit. (It is possible the decision will be reversed by the legislature next year; a request for an injunction was denied according to the Star Tribune.)
The broad issues haven't really changed here. Both Nardella and CFO Denis Holler repeatedly tried to make clear on the last two calls that pressures, on labor in particular, aren't abating. Civitas already closed 39 programs in Q3, with more likely to come in Q4. The disconnect between wage inflation and modest rate increases made those programs unprofitable - and are pressuring the remainder of the business. Nardella cited "modest rate increases in about a dozen states" - that's not nearly enough. Direct care workers in Minnesota, according to the Star Tribune, make $12.50 an hour, with annual turnover of 40 percent. That is not going to work in this labor environment when Amazon (AMZN) is going to $15 and even entry-level employers like Walmart (WMT) and McDonald's (MCD) are moving into the double digits.
And it's not like revenue growth can offset margin compression. Organic revenue has risen 1.5% YTD, per figures from the 10-Q. Civitas continues to acquire smaller providers, but that's what's driving basically all of the profit growth here over the past few years. And those acquisitions are eating up free cash flow: over the last fifteen quarters, Civitas has spent $263 million on acquisitions (not including two consumated after the end of Q3) and generated $197 million in free cash flow. Even giving credit for working capital that should reverse in Q4, it's likely that the cash generated over the four years - and then some - will go solely to buying growth.
Does This Model Work?
Even with the seemingly better quarters, and particularly with the higher share price, there's a short case here. CIVI shares have been headed in the wrong direction since the beginning of 2016. EBITDA margins compressed 51 bps in FY17, 16 bps (at the midpoint of guidance) in FY18 - and could take a big step down next year if labor pressure doesn't abate. (The Minnesota cut alone takes out a 20 bps bite.) And I'd note that Nardella said on the Q3 call that labor challenges would pressure "organic EBITDA growth", not organic EBITDA margins.
Given the leverage on the balance sheet, that compression can have a substantial effect on the equity. Cut EBITDA margins 100 bps, and hold the current 7.3x EV/EBITDA multiple (again, using midpoint of guidance) steady, and the fair value of CIVI shares drops almost exactly 20%. With retention still disappointing, and overtime still too high, the risk of problems in the company's facilities seems to increase as well.
It's possible that Civitas can continue to grind higher, adding business through M&A and keeping EBITDA growth intact. Labor issues may ease at some point as well; an investor might argue that CIVI is not only somewhat defensive (89% of revenue comes from public payors) but countercyclical, and is at the worst part of its cycle from a labor standpoint.
But a strong economy also has notably strengthened state-level budgets and balance sheets - and yet Civitas (and its peers) still can't get appropriate rates through. If the economy weakens, perhaps labor shortages are alleviated - but then more budget-conscious legislators start taking a red pen to state-level contracts.
As for the strategic alternatives process, I'm not sure what exactly Civitas is looking for. A sale to another P-E firm seems highly unlikely given the existing debt and a rising-rate environment. Strategic acquirers don't make a ton of sense; G&A here isn't that high (10-11% of revenue) so synergies would be limited. Similarly, I'm not sure there's a buyer for a specific unit, and the areas where Civitas is focusing its growth investments - the SRS rehab business and adult day health - represent just 22% and 4% of YTD revenue, respectively.
That said, between limited downside potential and the possibility of some major move, there's probably enough to forestall a short case, particularly with the stock pulling back from $17 to $15+. I'd add too that I don't think management here is doing a poor job. In fact, for the most part, I'd argue they're doing a pretty good job, at least from a financial standpoint.
But while CIVI bulls might frame the heavy proportion of government spending as a positive, given its stability and the likelihood that key populations unfortunately will grow, from here it looks like a negative. Governments do not want to pay for what they get - because their voters don't either. And Civitas' for-profit status likely doesn't help much either: why should taxpayers fund its higher margins? (That's a rhetorical question, by the way.)
As noted, Civitas took about $4 million of its tax savings and put it back into the business. Nardella was asked on the Q2 conference call whether that might help turnover, and his answer is worth considering:
Well, it’s not nearly enough and I know you guys have been tracking the company closely, it’s not nearly enough. but at least it’s something. So we have used it for example to target some of our worst areas. For competitive reasons, I’m not going to say exactly, where, but for example, there is one state where we gave a substantial increase to our direct service professionals ranged between 5% and 11%, but it was only for perhaps about a third of the state operations, because that particular geography was hardest hit. So, we have to be very targeted with it, because there’s just not nearly enough money.
I think Nardella is right: there's just not nearly enough money. And I'm not sure what Civitas can do about it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.