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Home Oxygen, Home Health & Rotech Healthcare

|Includes: AFAM, AMED, GTIV, LHCG, LNCR, Rotech Healthcare Inc. (ROHI)
Rotech Healthcare Inc
April 2010
Recommendation – Buy
Rotech (OTC:ROHI) is a levered equity investment. With $456m in net debt, and an EV of $481m, any improvement to EBITDA should create stock price appreciation. ROHI operates in the home oxygen supply industry, and has been plagued by two issues: an onerous debt burden and government forced reimbursement cuts. Below are different case scenarios.  Provided the company can get beyond the aforementioned issues, current valuation suggests an opportune entry point. However, I place a bankruptcy at 30%, so apply probabilities appropriately.
(In mil)
Mkt. Cap.
Share price
Share price
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% upside
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ROHI is one of the largest providers of home medical equipment and related products and services in the United States, with a comprehensive offering of respiratory therapy and durable home medical equipment and related services primarily to older patients with breathing disorders. Most of ROHI’s revenue is derived from reimbursement by third party payors, including Medicare, Medicaid, the Veterans Administration (NASDAQ:VA) and private insurers. 54% of the market is made up of Lincare, Apria, American Home Patient, Praxair and ROHI.
Former parent company, Integrated Health Services (IHS), filed for chapter 11 in 2000. ROHI was divested and assumed the balance sheet of a failed company under the IHS umbrella (see 10k). The result was over $300m in net debt, of which servicing was manageable until reimbursement rate cuts trends began in 2005 (see below). 
Valuation and price target
Lincare is the best of breed in the industry and trades at a 7.4x 2011 EBITDA multiple. Apria, bought by Blackstone in 2008 at 6x EBITDA, is also another major player.  My analysis uses a 5x multiple, a discount to the market leaders for obvious reasons, and my best case assumes ROHI can make up half the distance between current EBITDA and peak EBITDA from 2004.
Issue #1: Reimbursement cuts
While the traditional home health industry, which includes AMED, GTIV, LHCG and AFAM, have only started to feel the reimbursement cut pain, the home oxygen industry has been under the government thumb for more than 5 years. The larger players have adapted, evolved and survived. Valuations in 2005 were hit due to the passing of several acts, such as the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. Subsequent years also included new acts; 2006 saw the Deficit Reduction Act of 2005, which included a 36 month rental period cap for oxygen equipment, and 2008 saw the Medicare Improvement for Patients and Providers Act of 2008, and the Medicare, Medicaid and State Children’s Health Insurance Program Extension Act of 2007 (“SCHIP Extension Act”) which cut rates on various categories in home oxygen.
However, in what I think is a sign that reimbursement cuts are over, CMS has implemented a competitive bidding process where suppliers compete for the right to provide items to beneficiaries in a defined region. For sure this will hurt margins, but it will separate the haves and have nots, leaving a much more consolidated industry. In exchange for lower margins, volumes and visibility will increase, and the fraud and abuse practice will be better monitored. Lincare sees competitive bidding as largely value added for the major players.
Issue #2: Balance Sheet
ROHI currently has $515m in debt outstanding
·         Senior Secured credit facility: expiring in Sept 2011 paying Libor plus 6% or Base rate plus 5%.  Originally, this debt was payment in kind, but beginning in October 2009, ROHI elected to pay in cash accrued interest on the principal.  I believe this in an effort to signal cash flow strength to the investment community (and to Highland Securities, see below).  The loan from this facility was used to repay a former credit agreement. As of last quarter, ROHI was in compliance with covenants.
·         Senior Subordinated: expiring in April 2012 paying 9.5%.
·         Highland Securities owns a majority amount of both debts.  The debt trades by appointment with large spreads. It has been suggested that Highland wanted ROHI to file for bankrupcy in an effort to take over the company, and then merge it with American Homepatient (currently in default), of which they also own a significant credit piece.
·         It would make a lot of sense to restructure the credit given the risk appetite surrounding the distressed credit markets of late.
Other tidbits
·         Management: CEO has a mixed reputation. He has experience and is regarded as a turnaround expert, but has alienated investors in the past. The CEO has stock and lots of options. Recently, ROHI replaced well out of the money options with common stock. While somewhat dilutive, this effort should incentivize and retains management due to the correlation to stock price performance and vesting time table. Look at recent insider buying unrelated to the replaced options.
·         Apria, owned by Blackstone, recently issued debt at approximately 9% in order to pay its equity holder a onetime dividend. This illustrates a lender’s willingness to participate in this industry, albeit under the Blackstone halo.
·         Watch the bonds. Recent equity move should be considered noise. If the bonds trade near par, it’s a signal to focus on the equity. The bonds trade by appointment. Institutional investors on the credit side have been sniffing around. ROHI has not participated in the recent upside within the distressed credit strategy.
·         Recent development: The stock has appreciated from $0.50 to $1.00. Nothing has really changed.  But the market could be revaluing due to: a) the possibility of a debt restructure, b) off the Apria dividend news, c) investors are seeing the risk/reward potential, d) recent insider buying, e) increased chatter among institutional distressed investors and/or, f) health care reform transparency (home oxygen was absent from the bill). If there wasn’t a firming of credit markets, I would have considered a planned bankruptcy as a possible outcome.
As the industry moves towards competitive bidding and an exclusion from the current health care reform bill, I am assuming the worst of the rate cut push is over. As such, I believe Rotech can generate enough cash flow to fund debt obligations and get back to focusing on operations. Larger acquisitions will come with time. This isn’t a top line growth thesis, it’s a leverage to equity thesis. There is significant upside potential, and ROHI management are well positioned to take advantage of the tide turning.

Disclosure: long ROHI