Description

Overview

Hanger is the dominant player in the $4 billion orthotics and prosthetics (O&P) industry – a business that has high recurring revenues (devices need replacement every 3-5 years), 40-50% incremental margins, limited capital requirements, produces solid cash flow, and is acyclical. This is a business where scale provides a competitive advantage as back office infrastructure can handle billing, reimbursement, and procurement, and allow clinicians to focus on patient engagement, experience, and sales. Given the majority of the market are mom & pops with lower margins due to lack of scale, an M&A strategy has significant advantages.

Why Does the Opportunity Exist

Hanger is in the final innings of emerging from a 6-year dark period stemming from a 2012 accounting deficiency that morphed into a systemic failure on multiple fronts requiring a complete rebuild of entire systems, controls and processes. During this period, the company did not file financials, was de-listed, and had no access to credit. While the company produces good free cash flow, all of it was directed towards rebuilding the infrastructure (ie. revenue cycle management, electronic health records, claims processing, etc…). The company is nearly complete with the process (there is still a material weakness which the company expects to rectify this year) enabling it to focus on the core business. As a testament to the success of these initiatives, disallowed revenue peaked at 9% of 2014 revenues and now is running at 4%.

Investment Thesis

Hanger finally has the reigns to direct its cash flow towards growth initiatives – both same store sales and acquisitions – producing 10%+ annual EBITDA growth given the high incremental margins in the business. As growth accelerates, sentiment should shift somewhere from untenable to GARP and improve the multiple on rising EBITDA estimates. We think in 18-months, we could be looking at $150mm in EBITDA (vs. $122mm in 2019E) which would produce a $32 at a 12x multiple.

This is a longer-term thesis but we believe two recent events have created an attractive entry point:

1.       On May 8, HNGR reported Q1 results which missed estimates, sending the stock down 8% despite Q1 being a seasonally soft quarter and management reiterating full year guidance. We found that the company’s annual clinician summit was three weeks later this year than in prior years, which likely pushed sales from Q1 to Q2. This can be corroborated by observing a $1.2mm increase in inventory on the balance sheet, which equates to $4.3mm in lost revenue, nearly identical to the amount of Q1’s shortfall. The stock recovered as its inclusion in the Russell 2000 led to some index buying but that rally was short-lived.

2.       On July 2, Morgan Stanley traded a 1.7mm share block, which was priced poorly during a week when many were away for the July 4 holiday. HNGR is still well under the radar of most institutional investors given its history so when the stock broke price, new/uninformed investors began selling sending the stock down 7%. The stock has declined 15% mostly due to these events, in spite of its addition to major indices during the June rebalance. We believe this will also serve as a catalyst as new investors become familiar with the company.

Brief Company History

Hanger is a roll-up of companies built mostly during the 90s. In 2004, the company blew up from a lack of integration and brought in a restructuring expert to stabilize the business. The lead consultant ended up becoming the CEO and focused his attention on paying down debt. The company completely neglected investing in systems or people. Supposedly the finance/accounting department consisted of only a few people despite generating $1bn of sales (today the department has over 100). In early 2013, accounting issues began to surface mostly due to WIP and inventory. This was primarily due to a culture that was focused too much on beating short term Wall Street targets and not having the appropriate systems, people, and procedures. From our understanding, the CFO and CAO essentially guesstimated certain line items in the quarterly numbers. In 2014, material deficiencies were recognized and financials dating back to 2009 were deemed unreliable. In 2016, the stock was delisted.

An internal investigation found the CFO/CAO at fault and they were dismissed. A highly respected fix-it CFO, Tom Kiraly, was hired early in 2015. Since then, the company has made significant progress remediating material weaknesses, investing in infrastructure, implementing centralized revenue management and electronic health record systems, and getting the financials current. The SEC concluded its investigation without any charges and except for one minor material weakness, the company has fixed all of the prior problems.

Key takeaway: for 15 years, Hanger has been hamstrung from using its cash flow to grow its business…that has all changed now.

Revenue Growth Should Accelerate

Over the last three years, revenues have been essentially flat as the company has focused entirely on rebuilding its infrastructure. We think top line growth can accelerate to mid-single digits by 2020/21. Given the operating leverage in the business, this would translate into 10%+ EBITDA growth. Several factors have impeded growth over the last several years, one of which has been rectified and the others should reverse course in the near-term.

The biggest issue has been the distraction and resources associated with the company’s prior issues (at a cost of $30-45mm annually). From a simplistic standpoint, this cash flow can now be re-directed towards M&A. The company has already made two acquisitions this year that are expected to add over 3-points of revenue growth. It should be noted that M&A when executed correctly can be a large value driver for Hanger. As you can see from the graph below, Hanger is the dominant player with the majority of the market being small groups or mom and pops. Hanger is typically the only buyer for these small clinics making the purchase price fairly reasonable (3-5x EBITDA from our research). Additionally, those multiples are further inflated since small clinics operate at a subscale basis and Hanger can typically get increase margins. Finally, clinicians at acquired locations can spend less time on operations and more time servicing customers providing for further revenue synergies.

We believe the company is going to favor acquisitions with its $50mm of annual FCF. Our base case assumes the company uses around $30-40mm a year for acquisitions, which should equate to $35-45mm in revenues and $6-8mm of EBITDA. This alone adds about 3-points to revenue growth and 6-points to EBITDA growth.   

Additionally, management has started to focus on patient engagement and outreach initiatives that should drive SSS growth. While it is hard to quantify the benefits of these initiatives, we would note that the company had roughly flat revenues for a few years during a period of under-investment and no initiatives so we think it could only be incremental. The market is growing 1.5-2.0% annually and we believe the company should do at least this given its renewed focus.

There are two offsetting factors, which should improve in the near term:

1.       Therapeutics business declining (6% of total revenues). This business sells rehabilitation technologies and clinical programs to skilled nursing facilities (SNFs) and post acute providers. The business has been declining fairly significantly for several years due to challenging conditions and the reimbursement environment in SNFs. The company estimates further declines of $5-7mm this year, which is a 50 bps headwind to top line growth. We think the business should stabilize in the next year but to be conservative, are projecting one more year of declines. We actually think this business can be sold once it finally stabilizes so could see some upside if that occurs.

2.       De-emphasized business lines winding down. In the Patient Care segment, there is $160mm of products lines that the company is slowly winding down. It is split fairly evenly between off the shelf orthotics and shoes for diabetics. These products generate minimal ROI as they occupy floor space, tie up working capital, and consume time of the clinician, all at very little margin. While the products contribute minimal margin dollars, they will provide a headwind to top line growth as they are wound down.

Operating Leverage Should Drive EBITDA Growth

Given the fixed cost nature of operating 900 locations (including 800 patient care facilities) any improvement in SSS growth or improving clinic efficiency has a profound effect on the bottom line. At a 1.5-2% growth rate, margins stay relatively flat. However, every 1-point of organic growth over that should drop significantly to the bottom line. Cost of materials represents 30% of revenues while personnel costs represent 36%. We believe incremental margins are 40-50% as organic growth surpasses 2%.

As discussed in the prior section, the acquisitions the company makes are typically mom and pop locations that do not have the purchasing power, back-office, and infrastructure of Hanger. This provides both cost synergies as well as revenue synergies as clinicians can focus more on the customer instead of the back-office.

EBITDA margins historically were in the 15-16% range and have been in the 11-11.5% range the last few years. It is too optimistic to suggest they could get back to 15-16% as those were generated in years where the company had no infrastructure (hence, the accounting shenanigans). However, we do believe that 13% is achievable both due to operating leverage and a positive mix within Patient Care.

Risks

1.       Reimbursement: Healthcare companies always have the risk that Medicare will cut reimbursement. Since Hanger’s clients are politically sensitive classes (amputees and veterans) we do not view this as a high risk.

2.       Leverage is high at 4x.

Catalyst

1. Acquisitions

2. Accelerating revenue growth