Description

Description:

Enhabit Home Health and Hospice is a deeply obfuscated stock that has been beaten down since its spin-off from Encompass Healthcare a couple of months back. Enhabit stands to benefit from an umbrella of demographic tailwinds that should materialize in increased investment into the home health and hospice industry within the United States. Uniquely, Enhabit is trading at a steep discount relative to other home health and hospice peers that share similar market penetration and dynamics.

Labor constrictions associated with the current economic environment have led to overall patient in-flow slowdowns across the entire industry, increasing CPV (cost per visit) costs by LSD/HSD depending on the respective operators’ servicing mechanics and dependence on contractual labor. Based on contractual labor trends and FTE rates, most labor constrictions are expected to normalize in 1H23 with Enhabit being able to materialize its acquisition portfolio and understated budget (both of which I will get into later).

I believe that Enhabit Home Health and Hospice represents a great way to capitalize amidst these market conditions while also putting your money behind a company with great referral dynamics, cost minimizations strategies, and a strong hospice deal pipeline that is unrivaled in the home health and hospice industry. The introduction of VBC (value-based care) and PDGM (patient-driven grouping model) adds another variable that makes this investment all the more interesting relative to its peers.

Brief Preface: 

Oldyeller and SanQuinn both wrote up Encompass Healthcare in 2020 and early 2022, so I would recommend reading those write-ups and their supplementary information on Encompass’ HH&H division (pre-spin) for some additional information on Enhabit’s previous operations if necessary for your DD. htm815’s write-up on Cross-country Healthcare and byronval’s write-up on Option Care are nice insights on the overall industry as well.

Additionally, I will be describing some personal anecdotes I’ve experienced from the home health and hospice industry (not as a patient) which should complement some of the other pieces of evidence that I will provide.

Business Description:

Enhabit Home Health and Hospice is a leading home health and hospice provider based in the Southern and Northwest regions of the United States. Their 252 Home Health locations and 100 hospice locations cover 34 states, nearly 70% of the U.S. CMS expenditure market. Enhabit is a top two leading home health provider in 11 states and a top five home health provider in 18 other states. With this framework, Enhabit has managed to become the fourth-largest home health provider in the United States and the 12th-largest provider of hospice services in the United States. While Enhabit’s home health market share has remained steady for the past couple of years, the hospice division has seen accelerated growth going from the 51st largest in 2019 to the 41st largest in 2020, leading to the relatively sizable market share it enjoys today.

Enhabit Home Health and Hospice was spun off from Encompass Healthcare (the largest IRF operator in the United States). The spinoff share distribution was 1 EHAB for every 2 EHCs. Contingent on the spinoff agreement, Enhabit entered into a 500M term A loan and a 350M revolving credit facility with Encompass. This, paired with the overall notion of the HH&H industry constantly being in the crosshairs of the CMS and Enhabit being the seemingly less consistent part of Encompass’ segmented revenue led to the indiscriminate selling from $25 to ~$13 a share. 

 The general sentiment of Enhabit being the orphaned spin has resonated pretty deeply within the investing community even with the great prospects it provides. I too was pretty skeptical of the stock, but recent experiences after talking with some home health and hospice operators have shown the materialization of my thesis. The markets, in my opinion, have every right to be skeptical of Enhabit: constant earnings guidance revisions and initial referral sourcing problems have led to over-extrapolated distrust in a stock that is set to outperform in its industry.

If you want an example of the general sentiment I’ve seen towards Enhabit, here is a question asked to Encompass’ 's CEO during their Q2 earnings call: “Hey. Good morning. So, Doug, you won't like this question, I'd tell you, but it's the one I'm getting, so I got to ask it. So, the whole Enhabit process, I think, has – kind of at least at this point look a little disappointing. And so within the bounds of what you can tell us, how is it that the vanilla spin ended up being plan A and some type of spin/merger/sale couldn't have resulted? I mean, I think it's around 8.5 times EBITDA now and numbers have come down a couple of times, as you know. So, just what can you tell us to say, hey, this was the best option and other things either weren't forthcoming or we just – for tax reasons or other reasons, we decided to go the route we did. Thank you.”

Here are some key financial metrics :

Key Financial Metrics (10/11/2022)

Stock Price (USD):                                               $13.47

Shares Outstanding:                                             49.62M

Market Capitalization                                        $668M

Cash                                                                      $50.2M

Total Debt                                                              $567M (Term loan)

Equity Value                                                          $855M

Enterprise Value                                             $1184.8M

Revenue Segmentation by Service Q2’2022

Home health net service revenue:                 $220.2 (82%)

Hospice net service revenue:                         $47.8   (18%)

Consolidated net service revenue:                 $268  (100%)

TTM Multiples and Operating Statistics (10/14/2022)

PE                                                     6.72x

EV/EBITDA                                    6.40x

Net Income Margin                       8.90%

EBITDA Margin                            15.8%

Comparables (Amedisys & LHC Group)

PE                                (21.12x & 69.64x)

EV/EBITDA                   (12.6x & 26.3x)     

Net Income Margin     (6.33% & 3.2%)

EBITDA Margin           (11.9% & 7.3%)    

Demographic Tailwinds:

I’m going to keep this section as brief as possible because I believe that most people already know that the senior citizen population in the United States is skyrocketing as the Baby Boomer generation is getting to the point where they are at the highest need for home health and hospice care. Paired with this are the increased CMS expenditures that have been essentially tied to the hip of the growing elderly population. CMS expenditures are expected to grow from $124B in 2020 to $201B in 2028, representing a 6.3% CAGR. Although it naturally makes sense for there to be a positive correlation between CMS expenditures and the demographic transitioning of the elderly population, there is a large fragment of the picture that must not be missed.

The Demographic Transition Model is often what I like to cite when asked about the state of demographic shifts in America and historical precedence with regard to the net increase and decrease in population dynamics. Historically, countries have gone from one stage to the next based on an integrated factor that changes the input of the natural increase (birth rate or death rate). The model is broken down into five stages with the five stages being described below:

I am not a human geographer, but the one commonality that countries experiencing stage 4 and 5 dynamics is increased home health and hospice spending due to the lack of working-aged adults that can provide for the elderly. As countries enter stages four and five, the number of elderly individuals is disproportionately higher than the amount of corresponding working adults, requiring increased spending to compensate. The United States has operated under this backdrop with Japan going through a more accelerated route of the model due to a lack of net-in migration that has led to them being classified as a possible stage 5 country.

Stage 1: 1400s–1600s

• Death rates: high

• Birth rates: high

• Growth rate: slow/stable increase

Stage 2: 1760-1870 (Industrial Revolution)

• Death rates: falls rapidly

• Birth rates: remain high

• Growth rate: increases rapidly

Stage 3: 1870-1950

• Death rates: falls slowly

• Birth rates: falling (contraceptives and labor participation)

• Growth rate: slows down

Stage 4: 1950-Present (America)

• Death rates: low

• Birth rates: low

• Growth rate: slow/stable

Possible Stage 5 (Japan)

• Death rate: very low

• Birth rate: low

• Growth rate: net-decrease

Let’s approach this from another lens: the dependency ratio. The dependency ratio is often seen as the ratio of the dependent (0-15 & 65+) to the providers (15-64), but I’m not pitching a daycare so my analysis is going to be negating the 0-15 age cohort. With this in mind, both the United States and Japan have seen pretty significant increases in the dependency ratio due to the increased life expectancies of the elderly population. Regardless of whether net-in immigration stops to the point where we can classify the U.S. as a stage 5 country with a natural population decrease, CMS expenditures will continue to increase pretty far into the future. For reference, here are two charts depicting the respective dependency ratios of Japan and the U.S:

“What Matters” Chasm by Dr. Robert Iyer

When you dig even deeper into the world of home health and hospice and the current spending allocated towards it, you are starting to see a significant shift in efficacy-based spending rather than rudimentary numbers. Anything from volume-based care switching to value-based care or allocating money towards hospice and palliative care training is the current trend that has been seen due to the necessitation of things like sequestration and other cost initiatives to combat the budget deficits the U.S. has been running paired with the depletion of the social security fund. The “What Matters” chasm can be represented by the fact that 70% of U.S. adults express the desire to die in their homes while only 30% end up doing so. Now, why does this chasm exist in the U.S? Post-Covid HH&H operators have seen intense labor constrictions in the realm of at-home nurses, a lack of early palliative care expertise among operators that create transitionary difficulties, and many operators currently don’t know how to deal with patients who may have high onset of needs.

Although this seems to be an abysmal picture of our current HH&H state, strides are being made in the right direction via legislative action (Palliative Care and Hospice Education and Training Act.) and increased realization of the cost efficiencies associated with home care relative to other forms of care. All of these are added incentives for the CMS and U.S. government to balance the perspective of HH&H operators within the discussion to meet this high demand for care.

Current HH&H Industry Breakdown and Forecast:

I’ve already made it clear why healthcare spending and its importance will be imperative in the future, but I will also make the case for the HH&H industry as well. The homecare providers business is expected to do $122B in revenue by YE2022 with a projected CAGR of 7.93% from 2022 to 2030 ($660B revenue forecast). Additionally, the amount Medicare beneficiaries are also expected to increase by nearly 50% from 2022 (54M) to 2030 (80M).

The overall HH&H industry is very fragmented with over 15,000 homecare facilities providing care to nearly 58.6M eligible Medicare beneficiaries. Regarding market share, the top 10 home health providers comprise 29.6% of the national market share while the top 10 hospice providers comprise 19% of the national market share. The best way to describe the market presence of a lot of these different operators is similar to Monopoly: the best way to capitalize in a market is to build a stronghold and develop more facilities in contiguous states (collect the same color) while also building strong payer preferences and referral sources within each of those states to constrict smaller operators into leaving (houses and hotels). 

To better understand why the home health and hospice industry is so fragmented, the best thing to do is to look at overall startup costs relative to the average revenue of a home care facility startup. For the past couple of years, we have seen a neutral correlation between the two variables with exponential revenue increases being paired with stable costs for staffing. The one thing that I’ve realized about healthcare staffing since COVID is that the amount of players willing to operate in a field is a determinant of the labor environment at the time. Fixed cost structures are often pretty inelastic until it comes to labor. Most of the now-shut-down vaccination clinics and dialysis centers I have talked to have left the industry on the premise that the marginal utility isn’t worth pursuing in eyes of labor constrictions and increased compensation demands from employees. Pair this with the fact that referral sources have been getting tough on quality, and the recipe for a small operator exodus aligns nicely. 

I visited plenty of home health and hospice facilities and some very similarly ran vaccination clinics and saw what I thought to be antithetical to high quality: a small facility often hidden behind some fast food joint that doesn’t even have enough room to house its employees. Looking through their referral sources, you often saw small facilities run by friends and family referring them patients on an arbitrary basis. All-in-all, not a good look in the eyes of payers and “actual” referral sources. I’m not trying to slander some of the smaller operators that I’ve seen first-hand, but I just don’t think they are the most optimized cohort of the HH&H market for VBC and PDGM.

To summarize all of what I just said: when the main incentive mechanisms of both high start-up revenue and low start-up cost both take a turn for the worse in this labor environment, smaller operators will leave the market and prospective operators will be disincentivized to enter. Most of these operators are family-owned or independent ventures that aren’t backed by some large financial institution.

Just recently, I talked to a home health and hospice operator I know at a local conference who was based out of the Midwest. He talked about how his main incentive for leaving the home health and hospice market was labor retention and staffing bonuses that weren’t feasible for his facility with the lack of familiar referral sources that were willing to give him patients. It’s a sad phenomenon, but it's a natural mechanism of what is going to happen in the near future.

Unit Economics of a medium-sized homecare facility (Initial Investment)

$5,000 minimum - Business license, accreditation from the local health department, and utility deposits.

$20,000 minimum - Hardware set, patient management software, and medical equipment/supplies

Leasing office space costs $1,500 per employee depending on amenities and location - $7,500 

Furniture and signage - $10,000

Online promotion & website development - $100,000 (Average Franchise Fee)

Unit Economics of medium-sized homecare facilities (monthly working capital)

Personnel ($30,000)

Utilities ($1,200)

Insurance ($500)

Transportation ($300)

Supplies and disposables ($10,000)

Marketing ($500)

Contingencies ($200)

Franchise fee (if applicable) (5% to 10% royalties)

Now that I’ve set up the backdrop of my investment thesis, I’m going to lay out my thesis. My apologies for the long write-up. I know that I’ve received comments in the past regarding the length of my write-ups, but I hope the length is a product of benefit rather than of other reasons.

Thesis

Enhabit benefits from the same secular industry and economic tailwinds that are associated with the most well-known home health and hospice, public operators, but it comes with a significantly lower valuation and idiosyncratic growth & cost-minimization factors that make it more attractive than its peers.

1. Enhabit’s referral and servicing model is more well-protected and sustainable than other home health and hospice operators.

1. The natural synergies between Encompass and Enhabit’s acute-care referral sources are yet to be realized due to the recent spin-off that separated their revenue and cost structure and the current state of the healthcare, and labor market.

2. The natural synergies present in Enhabit’s referral sources will benefit Enhabit with the resumption of the Patient-driven Grouping Models that will cause many smaller operators to leave the industry on the premise of weak referral sources.

3. Enhabit’s use of these natural synergies has led to superior EBITDA margins and an exceptional EBITDA profile relative to peers with a larger stock price.

2. Enhabit’s hospice acquisition pipeline is severely underlooked by the growth prospects it presents.

1. Enhabit has the strongest hospice acquisition pipeline in the industry with an acquisitional budget that management has historically sandbagged to make investors underestimate its hospice growth prospects.

2. The success of their hospice pipeline has led to them gaining unprecedented market share in the hospice industry without sacrificing their position in the home health markets.

3. Enhabit has yet to realize the probabilistic hospice TAM that would exponentially increase its referral network.

4. Takeout multiples compressing will allow Enhabit to fully capitalize on its acquisition budget and appetite.

3. Other reasons why Enhabit is an excellent investment thesis:

1. Most of the management are former Encompass executives that have deep experience in capital allocation and unlocking shareholder value.

1. Management has also purchased significant amounts of stock with compensation being heavily reliant on bottom-line growth and targets.

2. Labor normalization in FY2023 will help accelerate Enhabit’s recovery and EBITDA expansion catalyzed by patient in-flow normalization/Frontier HH&H synergies.

Concerns over U.S. HH&H Operators’ Cost Management

My main reservation concerning a majority of public home health and hospice operators is either the experienced margin deterioration pre-2022 labor constrictions or their current battle with servicing costs in 2022. The two main public market competitors of Enhabit (Amedisys & LHC Group) have seen either form of margin deterioration. Amedisys saw a -2.3% in Gross margins by YE2021 while LHC Group’s net income margin decreased to 1.8% in Q2’22 from an already low 3.4% in Q1’22. Enhabit has been able to expand its operations into different addressable markets while ensuring that its margins were superior to its peers. Before 2022, Enhabit was en route with increasing its EBITDA and net income margins in the LDD/HDD range. I fully expect Enhabit to continue down this path once labor starts to normalize in 2023, making them a key, accelerated beneficiary in the HH&H market.

The way Enhabit will maintain this operating success is through the cost minimization associated with Encompass’ IRF facilities. Of the 134 IRFs that Encompass Health has, 89 are co-located with a respective home health location that is present within its servicing region. Decreased servicing and communication costs will all fall to the bottom line once they fully start to materialize. Oldyeller specifically talked about how Enhabit’s clinical collaboration rate with Encompass increased from 18.5% in 2015 to 40% in the current day with guidance to 60% in the long term. The fact that most of the discharged patients from the IRFs are going to be acute-care-based patients that require intensive care makes increased referrals a small benefit of this collaboration. Acute-care pay rates are the most coveted in the industry under the PDGM model that gives the highest reimbursement to referrals out of acute care that are terminally ill. The more Enhabit can increase its acute-based-care source concentration relative to traditional therapy services, the better reimbursement it will receive from the PDGM (will delve into this later).

Homecare Homebase Integration

One of the best cost minimization strategies that Enhabit has utilized is its Homecare Homebase software program which was created by former Encompass Health and Hospice CEO April Anthony. April Anthony created Homecare Homebase and deeply integrated it into Enhabit via physician training programs and a unique licensing agreement that allows for increased data collection and software testing from both parties. The best way to describe Homecare Homebase from experience is like a mixture between Slack and Amazon AWS in the sense that it pairs with information acquisition and optimization. With Homecare Homebase, there is constant communication between every level of the home health and hospice experience. HCHB allows for a single platform for all members of the facility to exchange notes and upload documents with added features that can map clinician routes and see different patient notes and referral networks. Enhabit has integrated this pretty heavily within its Care Management Division where nurses can dictate the best course of action for a patient based on the information they provide.

I’ve seen smaller software startups try to pitch similar software products, but HCHB is deeply inoculated within the HH&H market. Nearly 30% of HH&H operators in the United States use HCHB. The constant software updates and additions have made it significantly harder for other players to jump in. I know I’m not supposed to be pitching HCHB, but its business model is pretty spectacular in that it operates under the Adobe model (repackage different software and service tools and make consolidated purchasing agreements for the whole package). It’s very similar to when you buy a package of Gatorade and you only like two of the three flavors, but you have to pay for all three. All of these seemingly minute factors play into why I believe this HCHB advantage will continue for Enhabit with HCHB’s increasing market share.

Enhabit’s Co-location Strategy has gone Unappreciated by the Market

Most investors that I’ve talked to have a preference for the segmented version of Enhabit rather than the consolidated revenue between the home health and hospice segments. Although Enhabit’s hospice division has seen fluctuations in growth because of COVID and the current status quo of labor constrictions, the asymmetrical market penetration between their home health and hospice divisions presents an optimal environment for Enhabit to operate in based on their acquisition strategy. Enhabit’s acquisition strategy can be summarized as followed:

1. Identify markets in which there is an asymmetrical presence between home health and hospice agencies.

2. Buy out smaller hospice operators that surround Enhabit home health facilities.

• Remove the barrier between the synergy

• Work with local payors and insurance companies to inoculate themselves within a given area.

• Constricts local operators with no payor reimbursement and referral preference.

3. Materialize the cost and revenue synergies by building referral networks between the Enhabit-backed home health and hospice sources

What about very dispersed networks in states like Idaho that may have larger servicing ranges?

• Joint ventures or large buyouts are the preferred routes for Enhabit.

• Saint Alphonsus Health System joint venture with Enhabit in January 2022.

• Shared cost structure and referral preferences.

• Allowed Enhabit to become the number one home health provider in Idaho by leveraging the fixed cost structure of already established systems like Saint Alphonsus.

Frontier Home Health and Hospice’s Acquisition in 2021 is a Masterclass on Enhabit’s Acquisition strategy.

• Already strengthened Southern home health and hospice market with Alacare acquisition 2018 (became 4th largest provider in Alabama)

• Focus on new geographies that either already has friendly referral networks or lack competitive referral networks.

• The Rocky Mountain region is a pristine example of a lack of competitive referral sources.

• Target agencies that use Homecare Homebase for integration and have a heavy contiguous state presence (Frontier had a great health system presence with the Saint Alphonsus Health System in Idaho)

• Strengthen recently integrated acquisitions and leverage them for an introduction into other contiguous state systems.

Based on this acquisition strategy, the best way to address Enhabit’s potential TAM is to look at states that have asymmetrical home health to hospice presence and to see the market size in such states. Overall, Enhabit’s stronghold in the Southern Half and Western Half of the United States is favorable for the future of CMS expenditures projections in the future. Currently, the South and Mountain West are both the most common places for retiree migration while states like Florida and Texas (leading Enhabit provider states) are the largest recipients of CMS payer payments per patient relative to other states in the U.S.

Additionally, as I’ve already stated previously, Enhabit has remained disciplined in venturing into new markets while ensuring that they don’t sacrifice their quality of care and margin profile. Even with the Frontier Home Health and Hospice acquisition in 2021, Enhabit managed to increase its margins whilst also increasing its servicing area and market penetration as a leading HH&H provider in states like Idaho.

Florida, Arizona, and Massachusetts all have a top-five home health presence with no corresponding hospice presence. 

Management is Understating its Hospice Acquisition Potential Relative to its Actual Prospects

The most contentious part of Enhabit’s recent spin-off was its hospice potential in the HH&H market and how it would collect market share as a separate entity. Enhabit, under Encompass and as a stand-alone company, has had a history of ramping up acquisitions during very distressed times to take advantage of the compressed takeout multiples and industry headwinds that made most operators shy away from any sort of expansion activity. Even with this methodology in mind, I believe that Enhabit’s already aggressive acquisition budget of $50-$100M every year from 2022-2026 is an understatement for what Enhabit can do. Firstly, this acquisition budget is the same one that was utilized under Encompass Home Health and Hospice from 2019-2022. This budget, during 2019-2022, was constantly overridden due to the pressures of PDGM that compressed the takeout multiples of smaller operators. Once the PDGM was implemented on January 1st, 2020, Encompass bought Alacare Health for $217M, beating the budget significantly.

April Anthony even spoke about it at the time: “When you have these big [acquisitions], it’s great, but you hate to promise that you’re going to catch a big fish when you’re just not sure what the opportunities are going to look like,” Anthony said. “So we’re always pretty conservative in that acquisition profile.”

Under the status quo, Enhabit is experiencing a similar situation to the one that yielded Enhabit’s best acquisitional profile relative to the industry. The resumption of sequestration, HRRP restrictions, and the impact of PDGM in the current market environments will allow Enhabit to get more “bang for its buck” with its acquisition budget. Barbara Jacobsmeyer supplements this when she stated: “We’re starting to see multiples both for home health and hospice come down a little bit, pretty much in line with what the markets are doing,” Jacobsmeyer told Hospice News.”Maintaining a constant acquisition budget for four years while also acknowledging that takeout multiples are going to compress relative to the market lowers hospice pipeline expectations in the public markets.

PDGM and Enhabit’s Capitalization

Oldyeller went into great detail describing the impact of the PDGM on the IRF and HH&H segments of Encompass, but I’m just going to expand on this point slightly because recent earnings have echoed the importance of this point about referral sources and payer preference.

Firstly, the PDGM. In previous years, the CMS would give a base rate for a standard 60-day episode. The base payment would then be adjusted based on the patient’s specific situation and the expected services that will be provided to the patient. On top of this, providers could file a Request for Anticipated Payment (RAP) and receive up to 60% of their base pay upfront. What’s changed under the PDGM is that the CMS varied the base pay into 432 groups that were classified on referral sources, functional level, and the presence of comorbidities.

What were some of the byproducts of this?

Providers of traditional therapy sources were hit as the pay rates for their services saw a huge reimbursement decrease, acute-care patients became preferable due to the higher reimbursement rates, and smaller operators who couldn’t secure proper referrals (good reimbursement rates)/couldn’t keep up with the servicing requirement such as the filing of the various services left the business. The CMS estimated that 30% of small operators will leave the market because of PDGM. Pair this with the current labor environment, and we could see takeout multiples reverting to 3.3x in 2023 compared to the ~5.1x average in the current market. Enhabit stands to benefit from these regulatory actions because of the natural IRF referral synergy that provides them with a significant amount of acute-care patients combined with their aggressive acquisition history in similar environments.

I know a lot of healthcare investors don’t like to pay too much attention to KPIs and other metrics, but I want to graze over them quickly just to dispel any future remarks about it. Enhabit’s QPC rating of 3.7 and its hospital readmissions rate of 15.3% are lower than the national average. Although Amedisys and LHC Group generally are within the 4 range for the QPC star rating, I think the most beneficial factor is that Enhabit is above the most smaller operators who were forced to sacrifice quality to ensure their facility was above water. A notable example of this in smaller operations that I’ve seen from some operators that I’ve talked to is the training of DONs to become administrators and office managers to cut the cost burdens of employment while also trying to keep a pulse on the VBC filings and documentation. As long as Enhabit maintains this standard while remaining aggressive on acquisitions, they will be able to pick up a lot of smaller operators that were starved of referrals due to payer non-compliance.

Enhabit has a pretty significant amount of traditional FFS patients relative to other public competitors. Traditional FFS provides a cushion for Enhabit to use while transitioning over to Medicare Advantage patients. Many payers aren’t letting operators work in certain servicing areas if they aren’t compliant with/willing to treat MA patients. Although a lot of people have a general sense of dismay towards the profit potential of MA relative to traditional FFS, it is a sign that must be regarded within the current transition to VBC. The payer structure is the most optimal setup for the future of CMS regulations relative to other operators that work primarily with Medicaid or have a primary functioning base of MA patients.

Normalization of Home Health and Labor Constrictions

Htm815’s write-up on CCRN does a great job describing my overall thesis on the future of labor constrictions within the home health and hospice industry. Overall contractual labor dependence over in-house staffing isn’t a sustainable model for a lot of care providers that have to compensate for labor and housing + living expenses of the contractual laborers. The contractual labor obligations have been a burden for a lot of operators that depend on caregivers being on call during the late hours of the night and early in the morning. FTE rates have seen an overall peak-on-peak trend with a lot of contractual staffing agencies seeing COVID spikes in EBITDA and revenue. 

Home health and hospice usually have a small lag in labor normalization relative to IRFs and hospitals that don’t have to deal as directly with the notion of traveling labor and a caregiver being able to travel to various locations at various times. A lot of the data and quotes on normalization are currently from hospital and IRF operators, but it should seep into the HH&H market by 1H23 once QT initiatives hopefully get realized with staffing initiatives within HH&H companies. 

A quote from Mark Tarr, CEO of Encompass Health, in the recent earnings call, summarizes the overall labor normalization pretty nicely: “We responded to the challenging labor market conditions for skilled clinical resources in several ways, including adding substantial resources to our talent acquisition team. We have built a centralized recruitment function now comprising over 60 professionals. This strategy is gaining headway. Same-store net new RN hires were 276 for the first half of 2022 as compared to 117 in the same period last year. For the second half of 2022, we expect sign-on and shift bonuses to remain elevated as we continue to hire more RNs and use existing staff to fill in gaps. This will facilitate a decrease in our utilization of contract labor. Assuming normalizing industry conditions, we expect agency rates to decline further. However, the pace of the decline remains uncertain as agency rates remain highly variable, and the extension of the public health emergency may prolong the duration of elevated rates.”

Management Carry-over

Enhabit’s board of directors is loaded with individuals who draw from various medical and administrative pathways that could help build Enhabit’s core values. Jeffrey Bolton, a board member of Enhabit, was the highest-ranking non-physician member of Mayo Clinic as their Chief Administrative Officer. He helped spearhead the international acquisition team that led to the first Mayo clinic sites in London and Abu Dhabi, including the famous joint-venture buyout of Oxford University Health Clinic in 2020. Leo Higdon was a member of Encompass’ Board of Directors since 2004 and eventually became their Chairman from 2014 to 2021.

Compensation at Enhabit is heavily aligned with company objectives. 65% of executive compensation is performance-based while 43% of NEO compensation is performance-based. The base salary portion only makes up 23% and 47% of the CEO and NEO pay respectively. The management team’s PSU package was based on ROIC and the normalized EPS of Enhabit. Enhabit management regularly beat expectations and was able to yield a lot of compensation incentives based on Enhabit’s EBITDA growth.

Enhabit is Significantly Cheaper than its Peers on an EBITDA Basis

• To simplify the above information, it shouldn’t be that a top leading home health and hospice provider with advantageous cost minimization and patient referral sources are selling for less than $20 a share when its peers with similar market reach are >$100 a share. 

• With debt service payments of around $10 million, Enhabit should make well with the sizable interest coverage ratio (17x)

• With Enhabit’s EBITDA performance, it sets the path for an exponential recovery post-labor constrictions amidst weak, industry volume flows due to labor shortages.

Base Case Model Valuation

Key Assumptions:

- Enhabit will execute on five de novo locations per year from FY2023-2026. Three of which will be hospice and two of which will be home health. Enhabit will also execute 13 acquisitions per year from FY2023-2026

-Materialization of revenue synergies from Frontier transaction will result in a ~7% revenue turnaround in FY2023 and a continued organic growth rate of 6.25% from FY2024-FY2026

-Enhabit’s G&A is fixed, but I assume employment scalability from payroll and marketing.

         -Steady HDD EBITDA margins.

-13x FwD PE multiple is used based on similar revenue segmentation with Amedisys.

-Hospice’s share of consolidated revenue will increase 3% YoY, leading to an FY2026 share of 27%

Risks to My Thesis:

Regulatory: 

• Added regulatory pushback against home health and hospice CMS expenditures from Congress such as CMS Sequestration resumption.

• Mitigant: Sequestration and most CMS regulations are asymmetrically weighted. Enhabit’s cost minimization paired with the necessitation of HH&H services should disincentivize Congress/help Enhabit prosper.

Economic: 

• Labor constrictions don’t normalize/take time to normalize

• Mitigant: firstly, there is empirical evidence towards labor normalization (FTE rates) but even with this unfairly extrapolated bearish perspective, Enhabit is trading at a unique discount relative to its peers that are experiencing the same labor problems but with higher multiples.

• A rare opportunity where bearish expectations still provide a Margin of Safety for Enhabit’s valuation.

Financial: 

• IRF Synergies don’t materialize and adequate ROI isn’t delivered in future TAM.

• Mitigant: Historically, Enhabit has increased referral diversity while also increasing clinical collaboration to ~40% with Encompass. Enhabit has seen steady EBITDA margins while entering into the newly penetrated Rocky Mountain region.

Finally, thank you all for putting up with my long write-ups. If you have any comments or questions regarding my rationale, please let me know. I’m trying to make it a habit to check VIC more often, but you can also DM my Twitter @DrRidgewell if you want to ask me more about the company or any other similar plays.

Catalyst

Labor normalization in the HH&H market

Realization of synergies between Encompass and Enhabit

PDGM and other CMS regulations compressing smaller operators' takeout multiples