Through its hospice brand Vitas, Chemed (“CHE” or the “Company”) is one of the nation’s largest providers of hospice services in a market dominated primarily by small, non-profit, community-based hospices.  Management believes it is the largest provider of hospice services for patients with severe, life-limiting illnesses with approximately with approximately 7-8% share of the U.S. market.  The hospice segment comprises ~75% of the Company’s total revenue.  Approximately 90% of VITAS’ revenue is from the U.S. government through the Medicare program.  Over 33% of all hospices are not-for-profit.  Relatively few barriers to entry exist in the majority of markets served by Vitas.  Chemed also owns Roto-Rooter Group, a national drain cleaning and plumbing service company.

I advocate CHE as a short primarily based on the recent allegations asserted by the Department of Justice as described below.  

On May 2, 2013, the Department of Justice (“DOJ”) claimed that Chemed and its subsidiaries, VITAS Hospice Services and VITAS Healthcare, knowingly submitted false claims to Medicare for crises procedures that weren’t required, weren’t actually performed, or weren’t performed in accordance with Medicare requirements.  As a result of the conduct alleged in the complaint, the government contends that Chemed and VITAS violated the False Claims Act and misspent tens of millions of taxpayer dollars from the Medicare program.  Although the claims asserted against Chemed and VITAS are allegations only, and there has yet to be a determination of liability, I am convinced by enough anecdotal evidence that Chemed’s business practices were highly questionable and therefore the Company’s outlook in the near-term is vulnerable. 

The DOJ claims Chemed set goals for the number of crisis days billed to Medicare and pressured its staff into increasing crisis claims.  The government alleges that Chemed used aggressive marketing tactics and pressured staff to increase the numbers of crisis care claims submitted to Medicare, without regard to whether the services were appropriate or were actually being provided.  For example, the complaint contends that VITAS billed three straight days of crisis care for a patient, even though the patient’s medical records do not indicate that the patient required crisis care and actually reflect that the patient was playing bingo for part of the time.  According to the complaint, Chemed paid bonuses to staff based on the number of patients enrolled in the program and based on patients who were admitted for longer lengths of stay.  Furthermore, the Company took adverse employment actions against marketing representatives who did not meet monthly hospice admissions goals. 

The Company’s aggressive business practices resulted in the admission of patients who were not eligible for hospice care.  For example, Chemed’s subsidiary VITAS admitted a patient who showed no signs of a terminal condition and was described in the Company’s records as “very healthy given her age.”  In short, Chemed apparently has been receiving taxpayer dollars for some relatively healthy patients who didn’t need end-of-life care.

One employee commented on Glassdoor that the Company’s “motto is sign every referral, worry about whether appropriate for hospice later.  Literally walked into the hospital as patient expired and when I reported the death to my manager both her and the Rep showed no compassion and had the audacity to ask me if I had the family sign consents before the patient expired! Unbelievable....why do they want consents if no services provided...hmmm maybe Medicare should look into that.”

However, more relevant than the employee comment above is a whistleblower suit filed by Dr. Charles Gonzales, a physician previously employed by Chemed’s VITAS from 2004-2011.  Dr. Gonzales is a licensed physician, Board Certified in Hospice and Palliative Care.  Palliative care is aimed at relieving the pain, symptoms, and/or stress of terminal illness and includes a comprehensive set of medical, social, psychological, emotional, and spiritual services provided to a terminally ill individual.  Medicare recipients of palliative care agree to forego curative treatment of their terminal illness.  The suit was under seal and only recently made public by virtue of the government complaint described previously.  It is possible that Dr. Gonzales’ filing, made on January 26, 2012, prompted the DOJ to engage in their own information gathering which led to their filing on May 2, 2013.  Regardless of whether his filing served as the catalyst for the DOJ’s allegations, the substance of the filing made by Dr. Gonzales is enlightening in regards to abusive business practices by Chemed.  Below I highlight some of the specifics described in the filing:

• Over the course of at least the past seven years, Vitas Los Angeles has defrauded the government by systematically falsely certifying that a large number of its patients are eligible for hospice care, when they are not.
• During his tenure he received constant and strong pressure from Vitas Los Angeles’ management to certify and/or rectify patients as eligible for Medicare hospice care who were not eligible under the pertinent regulations and industry standards.
• Hospice providers in Los Angeles currently receive approximately $5,300, per patient, per month (moreover, if a patient is deemed to require “Continuous Home Care,” i.e., 24-hour care, the Medicare hospice reimbursement rate for Los Angeles is over $1,000 per day).  A false certification or recertification is thus very costly to taxpayers, and very profitable for Vitas Los Angeles.  Patients who should not qualify for hospice are especially profitable, because they typically require less care, and the expenditure of fewer resources.
• Vitas Los Angeles knew, deliberate ignored, or recklessly disregarded that the claims it submitted to Medicare falsely represented the medical condition and hospice eligibility of the beneficiaries.
• If a suggestion was made that a patient no longer qualifies for hospice, the Team Managers would fabricate a rationale for keeping the patient on hospice or instruct the Team Doctors to do so.  If there was continued disagreement, the case was referred to the Patient Care Administrator for Los Angeles who then applied further pressure on the dissenting team member, and instructed the Team Doctors what to state in the physician notes in order to ensure that the patient continues to qualify for hospice, no matter how untrue.  Notably, neither the Team Manager nor Patient Care Administrator is a doctor.
• Many of Vitas Los Angeles’ patients remain on hospice for years, with little or no decline in health, and requiring little in resources from Vitas.
• Vitas Los Angeles frequently uses the amorphous diagnosis of “dementia” to falsely certify and re-certify patients who do not have any diagnosis that meets the appropriate criteria.
• Dr. Gonzales summarizes thirty-four specific claims of patients who were improperly certified, and repeatedly recertified, as patients qualifying for Medicare hospice benefits, when they did not in fact qualify.  Despite hospice care having been intended to provide for care during the last six months of life, the hospice stay of the described patients averages approximately two years and seven months.  (For some context, note that the average length of stay (“LOS”) for Amedisys, the fourth largest hospice industry participant, was 88 days in 2011, 99 days in 2012, and 103 days for the quarter ending March 2013.  Based on data from CMS, the average LOS in 2008 was 71 days and for the top twenty diagnoses in 2008, the average LOS ranged from 28 days for chronic kidney disease to 105 days for Alzheimer’s disease and other degenerative conditions.  Amid scrutiny from regulators and researchers about potential abuse of the Medicare hospice benefit, data released in January 2012 showed that patient LOS in hospice fell in 2010.  Although Chemed’s average LOS in Q1’13, at 77.4 days, can be characterized as being relatively consistent with the broader CMS data, the specific claims elevated by Dr. Gonzales pertaining to specific abuses in Los Angeles does raise numerous red flags.)   
• Each patient thus had to be certified and recertified by Vitas Los Angeles an average of at least fourteen times.  Thus for just these thirty-four examples, Vitas Los Angeles submitted approximately 476 false certifications or recertifcations.  Each of those cost Medicare—and therefore taxpayers—at least ten thousand dollars.

On the day following the DOJ’s filing of the False Claims Act Lawsuit, CHE’s stock traded down intraday by over 24%.  From that intraday low, CHE has rebounded by 22% as of the close on July 12, 2013.  In response to the allegations, the Company issued a press release the day after the DOJ’s filing; there was never any disclosure of the Gonzales filing until after the DOJ filing.  Not surprisingly in the press release, management cites that Chemed and VITAS intend to defend the lawsuit vigorously.   In an interview, CEO Kevin McNamara said he takes the allegations seriously, especially because a doctor is involved, but that based on preliminary information doesn’t think they have merit.  In the Cincinnati newspaper, the CEO said his company isn’t engaged in fraud and that a short seller who is targeting the firm is engaged in “wishful thinking”.  McNamara is presumably referring to Citron Research which issued a report on May 10^th called “Chemed:  Game Over” with a $15 price target.

As the allegations are further investigated by the government, the Company knows it is subject to increased scrutiny.  This will force CHE to more carefully certify each hospice enrollee and the process will most likely moderate enrollment and re-certification.  As described by Citron Research, the regulatory scrutiny and an open investigation will chill the enthusiasm of CHE’s referral network of physicians, nursing homes, and other health care providers. 

The allegations regarding Chemed’s subsidiary VITAS are heightened by the overall investigations addressing abuses to curb Medicare fraud, especially in the hospice industry since Medicare pays for almost 85% of all hospice care.  Medicare is intensely focused on improving the integrity of hospices by cracking down on the industry’s growing habit of embracing those whose deaths aren’t imminent.  In fact, the government, through the Office of Inspector General (“OIG”) has recently raised a number of concerns about Medicare hospice care for nursing facility residents.  OIG found that 31% of Medicare hospice beneficiaries resided in nursing facilities in 2006 and that 82% of hospice claims for these beneficiaries did not meet Medicare coverage requirements.  The increased scrutiny by the OIG is evidenced by the more than $3.4M spent in the past three years (2010-2012) by CHE associated with “legal expenses of OIG investigation.”  This level of legal expense compares to only $859,000 for the prior three years (2007-2009).  It’s worth noting that management adds this legal expense back in calculating “Adjusted EBITDA” and “Adjusted Net Income” despite the fact that the increased regulatory scrutiny has inherently made the legal expense a recurring cost of doing business for CHE.

The industry is highly-fragmented with VITAS’ 7-8% share being the largest (according to management).  According to MedPac, 50% of hospices have negative margins and the average operating margin is 4-8%.  The fact that VITAS has generated an operating margin of 10.3-13.5% in each of the past nine years versus the average of just 4-8% provides additional context for the allegations made by the DOJ and Gonzales.  The Company’s share is not significant on a RMS basis nor are there many benefits from economies of scale that enable a margin that is approximately double the industry in what is essentially a locally-driven, personnel-intensive business model.

The Company and other publicly-traded, for-profit peers are assertive regarding favorable industry dynamics.  The main arguments typically relate to demographic trends coupled with consolidation opportunities and benefits that will accrue from a fragmented industry.  According to data described by Amedisys in their investor presentation, the estimated industry mix of Medicare hospice-driven revenue breaks down as follows:  publicly-traded peers (13.6%), other for-profit (45.2%), non-profit (33.4%), and hospital-based (7.8%).  Medicare hospice spending has grown at a 17% CAGR from 1999-2010 but the growth rate moderated significantly in more recent years at 8.1% CAGR from 2007-2010.  Medicare reimbursement for the hospice industry increased in each of the past three years, by 1.4% in 2010, by 1.8% in 2011, and by 2.4% in 2012.  The trend is reversing this year with a decline of 1.1%.  Numerous industry experts believe the hospice industry is likely to continue incurring an ongoing annual decline akin to the Medicare reimbursement trend within home health which witnessed Medicare reimbursement declining by 5.2% in 2011 and by 2.4% in 2012, and is expected to decline by 2.0% in 2013.  Furthermore, several publicly-traded home health companies recently declined by over 10% on the day pursuant to the announcement from CMS proposing Medicare reimbursements to home health providers will fall 1.5% in 2014. 

Roto-Rooter has substantial brand recognition.  It has been around since 1935.  I have not allocated significant time to evaluating Roto-Rooter but I will make a leap of faith that it’s a strong business.  The business model, primarily a franchised focus, is low capital intensity.  In the past two years, its capital spending was less than 3% of revenue.  Here are some highlights as described by management in the Company’s investor presentation.  Roto-Rooter provides plumbing service to approximately 90% of the United States and 40% of the Canadian population.  There are more than 110 company-owned territories and over 400 franchise territories.  The estimated share of the drain cleaning market is 15%; the estimate share of the same-day service plumbing market is 2-3%.  In 2012, revenue declined by 1.8% to $363 million and EBITDA declined by 9.3% to $58 million.  EBIT was $49 million and capex was approximately $10 million.  Since 2004, Roto-Rooter’s EBITDA margin ranged from 15.3-20.1% for an average of ~17%.  The business benefits from abnormally high precipitation and from an abnormally high magnitude of freezing temperatures.  In my simple valuation framework, I ascribe EBITDA multiples of 7.5-11.5x to Roto-Rooter’s LTM EBITDA of $61.6M, as of Q1’13.

I do not want to engage in spurious accuracy to forecast VITAS as my thesis is predicated on questionable business practices that have enabled the Company to over-earn at both the revenue and the margin line.  If the DOJ’s allegations are indeed accurate, the overarching regulatory challenges would escalate such that revenue, margin, and multiples will all be adversely impacted.  For simplistic purposes, I assume 10% lower revenue at VITAS and a much lower EBITDA margin of 10% to LTM results, as of Q1’13.  LTM revenue was reported as $1.08B and after applying a 10% reduction to revenue and a 10% EBITDA margin, I assume EBITDA of $97M for my simplistic valuation framework (note that LTM EBITDA for VITAS was reported at $158.4M so this is obviously a substantial cut but my thesis is predicated on significant hospice-related abuses that enabled CHE to over-earn within its hospice segment). 

Selected peers like Amedisys, Gentiva, Kindred, and LHC Group trade at an average multiple of ~0.5x LTM revenue and an average multiple of 5.7x LTM EBITDA.  The range for revenue is 0.3-0.6x and one might argue that those multiples are consistent with the lower margin profile of the peer group but I think the lower margin profile of the peer group calls into question the sustainability of the margin profile for Chemed’s VITAS business.  The simple valuation framework below is based on Roto-Rooter being ascribed a value based on EBITDA at 7.5-11.5x and VITAS being ascribed a value based on EBITDA at 5.5-7.5x.

Benjamin Franklin said, “There is no kind of dishonesty into which otherwise good people more easily and frequently fall than that of defrauding the government.”  In recent years, we have witnessed the increasing intersection between federal largesse and corporate interests resulting in widespread incidents of corporations dictating public policy, systemic abuse and outright fraud.  The situation at Chemed seems to be another potential candidate.  Insiders might agree as evidenced by the more than $10 million sold by insiders since August 2012 and almost $25 million sold since the beginning of 2010.