Addus HomeCare Poised For Growth In An Expanding $92.8 Billion Market

|
About: Addus HomeCare Corporation (ADUS)
by: Mihir Gonsai
Summary

$74.45 price target based on a Free Cash Flow to Equity Model representing a 21.55% upside.

A key driver to our valuation is strong growth with penetration into the East Coast.

An estimate of Addus' monthly value at risk was shown to be lower than industry competitors'.

Editor's note: Seeking Alpha is proud to welcome Mihir Gonsai as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »

Our recommendation is a Buy for Addus HomeCare (NASDAQ:ADUS) with a 1-year price target of $74.45 per share, as derived from a Free Cash Flow to Equity model. This valuation represents a potential 21.55% upside based on February 2, 2019, close price of $61.25. The key drivers to our valuation are strong growth with penetration into the East Coast, a strong balance sheet which provides a competitive advantage, and numerous acquisitions which create synergistic benefits and increase market share.

Valuation Date:

2/2/2019

Target Price:

$74.45

Upside:

21.55%

Recommendation:

Buy

Industry:

Home Care Provider

Addus HomeCare is a growth stock in the rapidly growing U.S. home care providers industry. The company provides personal care services across 24 states to individuals at risk of either hospitalization or institutionalization. It earns revenue from payor clients such as governments, private individuals, and commercial insurers. Many families choose retirement communities for aging family members. However, these communities are becoming more expensive, and, as a less expensive alternative, in-home care services, like ADUS, have steadily gained market share.

Economic Analysis

We are bullish considering the medium-to-long-term growth prospects of the U.S. economy. While recent market trends have been volatile and not quite as strong as previous years, we believe that a series of leading economic indicators support a relatively stable growth in the foreseeable future. Such indicators include Real Gross Private Domestic Investment, Real Gross Domestic Product, and Real Retail and Food Services Sales - all of which tend to flatten or decrease preceding a recession. We also examined unemployment adjusted for part-time workers, which consistently flattens or increases prior to a recession. Most importantly, the 10-Year and 2-Year Treasury Spread have not passed zero, which signifies a buffer of likely more than a year between now and the next recession.

TD Ameritrade Thinkorswim - Real Gross Private Domestic Investment

TD Ameritrade Thinkorswim - Advance Real Retail and Food Services Sales

TD Ameritrade Thinkorswim - 10-Year/2-Year Treasury Spread

TD Ameritrade Thinkorswim - CPI for All Urban Medical Care Services

TD Ameritrade Thinkorswim - Consumer Discretionary ETF

Industry Analysis

Retrieved from IBIS World

This industry is in its growth stage, and it’s characterized by relatively low revenue volatility, capital intensity, and barriers to entry. Major players in the industry are currently looking to treat and manage chronic diseases for their patients, thus expanding and competing directly with institutional care providers. The annual growth rate of adults aged 65 and older is currently around 3.25%, and it is expected to stay above and around 3% through 2024 - exemplifying an expanding target market. Moreover, commercial insurance companies have been encouraging customers to pursue home care due to its lower costs. Unemployment has been trending downward, which suggests more individuals are covered by insurance. Additionally, disposable income has been rising, as indicated by the strong performance of an index of discretionary spending relative to an index of staple good spending. Higher employment and disposable income both boost the likelihood of individuals being covered by insurance or paying out of pocket for medical services. This is supported by the consistent growth of the consumer price index for medical care services over the past couple of decades.

The industry does, however, have high regulation and competition levels. The industry is also suffering a shortage of skilled personnel - on which it relies. Over 10% of this industry’s revenue comes from people with private health insurance, which, in the U.S., is subject to a combination of economic and political factors - especially considering the industry’s poor political representation. Additionally, there exist larger market players in the industry that can threaten smaller firms, though they are rarely incentivized to seek economies of scale due to the industry’s need for labor rather than capital. The depletion of reimbursements for home healthcare services under Medicare and Medicaid, despite their federal funding increases in recent years, has consistently damaged industry profits.

Retrieved from IBIS World

As for the industry’s outlook, the number of mergers and acquisitions is expected to increase as profits are diminished from reimbursement cuts. Services catered towards patients with chronic diseases is expected to increase and provide a wider market for home healthcare services. Similarly, the Patient Protection and Affordable Care Act, amended by the Health Care and Education Reconciliation Act, is expected to further increase the industry’s long-run growth by providing additional support for people who want to continue living at home and avoid institutional care. However, as previously mentioned, the industry is expected to suffer from a shortage of qualified employees - especially considering the industry’s extremely high employment growth rate. Such a labor shortage is expected to increase employee wages and benefits - further reducing profits. While the industry has unique barriers, increased demand should perpetuate increased revenue growth over the foreseeable future.

Competitor Risk

The biggest risk to ADUS is competitors, namely LHC Group (NASDAQ:LHCG), Amedisys (NASDAQ:AMED), and BioScrip (NASDAQ:BIOS). LHC Group is one of the smaller competitors whose Chairman and CEO recently sold $7.9 million of shares on February 4. The company has also announced a joint venture agreement in Arkansas with Unity Health and in Newport with Harris Medical Center Home Health. The company is expanding in States where ADUS is currently not located, so future growth into these States could be difficult due to stiff competition. However, LHC Group has begun to focus on hospice and palliative care, while ADUS focuses on traditional home care. Amedisys, on the other hand, is the largest competitor in the PCS industry. The company is completing a $340 million acquisition of Compassionate Care, a hospice care company, in New Jersey - bringing the total number of States it has locations in to 38.

LHC Group

BioScrip Inc.

Amedisys

Market Cap

3,474M

488.48M

4,416M

Forward P/E

26.49

-18.17

34.19

Peg Ratio

1.69

-0.97

1.76

EPS

2.5

-0.385

2.58

Financials

Chart Created from Revenue Forecast

Financially stable growth is projected for the next five years with revenue growing at between 9% and 11% per year. Historically, ADUS has grown revenue by 12.63% per year on average. Our growth rate for the forecast period is lower than historical growth because when factoring out 2014 and 2016 acquisitions, ADUS’ growth rate was roughly 6%. We have increased that rate considering the industry’s growth, ADUS’ recent growth, and the possibility of future acquisitions. In fact, ADUS is in the process of acquiring VIP Healthcare, a predominantly New York-based home healthcare company. ADUS has also recently opened a revolving credit facility with Capital One - allowing it to grow further organically. Such strategic investments allow ADUS to further grow and gain market share in a highly competitive and fragmented market.

Created from Forecasted Revenue Model

The pro forma financial statements represent the historical financials from 2013-2017, and the projected financials from 2018-2022. The yearly sales are grown per the revenue model, and the income statement and balance sheet line items are projected as a percentage of sales, with a 5% perpetuity growth rate for the terminal year (2023). We used a Free Cash Flow to Equity model to calculate our price target.

From our revenue model, we calculated total revenue to grow at an average of 10.40%:

Retrieved from ADUS 10K

From fiscal years 2018 to 2022, we estimated average billable census to grow at an average 4.34%, while average billable hours per census per year grows at an average 4.23%. These two key metrics multiplied together equal total billable hours per year which, when multiplied by revenue per billable hour, produce total revenue.

From Forecasted Revenue Model

We calculated total expenses growth at an average of 8.49%:

Chart From historical 10K and forecasted modelFrom fiscal years 2018-2022, we estimated total operating expenses to grow at an average rate of 8.49%. Historically, expenses grew at an average of 13.76%; however, our forecasted figures are lower due to expected operating synergies. The above graph shows the gross profit, total operating expenses, and net income from 2013-2022.

EPS estimate for 2018 is $1.45:

This estimation is based on the belief that ADUS will generate more revenue as it expands into new markets in the U.S. through the VIP Healthcare acquisition. Additionally, due to the company’s growth, we continued to increase operating revenues and operating expenses at an average rate based on the revenue model.

Using the FCFE method, we valued ADUS to be $74.45:

From Model

The risk-free rate is the yield of the ten-year Treasury note. Beta was found from Infront Analytics as the 3-year levered beta. This number makes sense, as the home care industry is generally less volatile than the market. The market return was generated from Yahoo Finance. ADUS is valued through the FCFE model using a cost of equity of 7.98%. Our perpetuity growth rate was 5%, which is in line with IBISWorld’s estimate for the industry.

Football Field:

A football field graph shows the valuation of a company according to different methodologies. Our graph shows a variety of valuation ranges based on different methods. We use 2 enterprise comparable valuations, 2 equity comparable valuations, and a DCF valuation. The competitors used for the comparable valuations were Amedisys, LHC Group, BioScrip, Chemed (CHE), and U.S. Physical Therapy (USPH). The highs and lows in our football field are the maximum and minimum price per shares found in each valuation. Our DCF Valuation derived a price of $74.45, which is the horizontal line in the football field. The target price runs through the ranges of most of the other valuation criteria - making it an adequate 2018 price target.

Graph from Calculated Football Field

Volatility Analysis:

We decided to forecast ADUS’ volatility as well as estimate its value at risk at 1% and 5%, which first requires determining ADUS’ normality. ADUS’ returns are distributed around a mean of -0.0008481 and with a standard deviation of .0305. To test the curve’s normality, we have run a Jarque-Bera (JB) test on its returns, from which we have proven ADUS’ distribution to be non-normal.

Retrieved from Matlab output

Knowing that returns are non-normally distributed, we needed to find an appropriate univariate conditional volatility model from which we could forecast volatility. We tested the beta parameter in the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model, which we found to be statistically significant. We then tested the leverage parameter in the GJR-GARCH model, which we found to be statistically insignificant – meaning ADUS’ volatility is affected similarly after both positive and negative shocks. We then ran an additional JB test on GARCH’s residuals and determined that its residuals are not normally distributed - indicating we must use the Student-t GARCH to forecast volatility.

Retrieved from Matlab output

By running an aicbic test using Student-t GARCHs, we have determined that 140 lags is the optimal number of lags when estimating future volatility. In doing so, we’ve modeled future volatility and unconditional innovation variance based on the last 140 days of data.

Retrieved from Matlab output

We utilized violation ratios to test value at risk (VaR) under several models including historical simulations (using sorted returns and quantile functions), parametric VaR, and VaR Exponentially Weighted Moving Averages, and Expected Shortfall. In doing so, we determined Expected Shortfall, which considers fat tails in its estimation, as the most accurate VaR estimator. Using Expected Shortfall, we’ve found that, on a monthly basis, there is a 1% chance of losing 27.89% of value and a 5% chance of losing 15.03% of value when investing in ADUS. The average 1% and 5% monthly VaR of three large ADUS competitors - LHC Group, BioScrip Inc., and Amedisys Inc. - are 28.06% and 19.86%, respectively. VaRs of competitors were calculated in shorthand utilizing each firm’s standard deviation of returns since January 2000.

Retrieved from Matlab output

Retrieved from Matlab output

Conclusion

ADUS is a growth stock in a growing industry. This is a long-term investment opportunity that is expected to offer medium-term stock appreciation for both fundamental and speculative investors. ADUS has strong revenue growth coupled with future synergistic benefits arising from expected acquisitions. ADUS only makes up 1% of the home care service, indicating it has a large amount of room to grow. Despite ADUS' position as a growth stock, its relatively stable and low volatility showcase the appreciation opportunities of a growth stock combined with the steadiness of a mature stock.

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.