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"The broad filters that I apply for health-care investing in general is, No. 1: Does the health-care company deliver better quality of care than someone could get somewhere else?  No. 2: Does it deliver a net savings to the health-care system? In other words, is the total bill for U.S. health-care cheaper because of the efficiency the company provides?  And lastly: do you get a higher return on capital, predictable growth and shareholder-friendly management?"

~Berkshire Hathaway’s Ted Weschler in reference to DVA

YES, YES, and YES, but first thing first.  Like a lot of healthcare companies, HLS in the short term is subject to the vagaries of the government’s plans to reshape the cost structure of American healthcare.  I am by no means an expert here, but as Weschler recently intimated and as Buffet has stated in the past, at the end of the day the low cost producer will win.  HLS is the low cost producer here.

That being said, as I see it the main immediate risks to HLS are:

1. reduction in medicare reimbursement rates.  74% of revenues are tied to Medicare.
2. adoption of the “75% rule” which will require 75% of HLS patients to fit into one of 13 designated treatment buckets in order for HLS to qualify for reimbursements (currently it is a 60% rule).  On a national level HLS currently passes the 75% rule, but if adopted, the rule will need to be met on a unit level, which will require some adjustments by HLS.
3. changes in the 13 covered buckets that currently qualify for treatment at an IRF / patients getting routed to skilled nursing etc rather than to an IRF.

Any of the above can seriously impact HLS share price in the short term, however, at a ~12% forward free cash flow yield (OCF – maintenance CapEx) I believe these risks are more than priced in, and as the low cost provider of IRF services with a superior business model, on a longer time line HLS will actually benefit from any of the above changes as their weaker competitors will be disproportionately affected, allowing HLS to grow market share.

longer term, it is not clear what shape American healthcare will take in the future which is a risk.  that being said...

For the Elevator:

HLS is the dominant player in a niche segment of the healthcare complex.  The company is the nation’s largest owner operator of free standing Inpatient Rehab Facilities (IRFs) in terms of patients treated & discharged, revenues, and number of facilities.  IRFs serve patients that are admitted from acute care hospitals due to medical conditions that result in significant physical and cognitive disabilities such as strokes, hip fractures, and debilitating neurological conditions that are non discretionary in nature.  Patient care is provided by highly skilled nurses and physical, occupational, and speech therapists with the objective of returning patients to home and work. HLS benefits from meaningful competitive advantages on both the unit level and system level, which insulates them from the longer term threat of any change in the reimbursement/regulatory change.  Management is excellent, and has proven to be astute capital allocators.  The runway for growth is long due to the “graying of America,” unprofitable competitors seeking to exit the space, and a highly fragmented market.  An investment in HLS should be able to compound at a low to mid double digit rate for years to come.

Why Does the Opportunity Exist:

Seasoned investors likely think of HealthSouth in the same sentence as Enron and WorldCom.  In brief, the founder and former CEO famously bilked the company for billions of dollars while reporting wildly inflated revenue and EPS numbers to please sell side analysts as he assembled a healthcare megaopoly through aggressive M&A in the late ‘90’s early 2000s. For more background on the fraud, see previous VIC write-ups.   The company has only recently unshackled itself from the high debt and mismatched business models that were associated with old HLS, and the market is just recently realizing that HLS has emerged from the scandal as an efficient operator in a niche market.

In the more immediate term, the market is focused on the fact that a majority (74%) of the Company’s revenue comes from Medicare, and the potential for Medicare reform is an unknown.  This is a very real short term risk.  However, there are a number of reasons to suggest that the IRF section will be less affected than other segments of the healthcare complex in the event that the government is able to agree on spending reform.  If the IRF sector is greatly affected by spending cuts,  given that HLS is the most efficient operator (ie the low cost provider) it is unlikely that any proposed changes to Medicare will affect HLS longer term.  In short, any changes that hurt HLS and their wide margins will destroy the competition, leading to either 1) a national backlash by the important senior voting block and subsequent roll back of spending cuts or 2) competitors being forced out of the space, allowing HLS to scoop up (admittedly less profitable) market share.

Competitive Advantage, Unit Level:

The IRF space is a fragmented industry.  80% of all IRFs are tied to acute care hospitals, while 20% are freestanding.  HLS is the largest player in the freestanding market with their ~100 hospitals making up ~42% of the free standing market and ~9% of the total market.  The next largest freestanding competitor operates 12 hospitals.  The trend has been away from acute care based IRFs and toward freestanding IRFs due to the simple fact that the freestanding units benefit from economies of scale on the unit level.  Acute care based IRFs draw patients from one hospital, while freestanding units are able to draw patients from several area hospitals resulting in higher utilization rates for skilled staff.  HLS further capitalizes on this larger patient pool by running more beds – the average HLS facility houses 68 beds, versus the average acute care based IRF with 23 beds.  The larger bed base and higher utilization rates allow HLS to maintain ~20% EBIT margins, while hospital based facilities are typically EBIT negative.  Importantly, according to a 2011 MedPac review of IRF practices, there is statistical evidence showing that freestanding IRFs cost the government less money in terms of cost per discharge.  Essentially HLS’s less profitable competitors attempt to pass the higher costs of their less efficient business model on to the government.  Their inability to operate profitably is causing acute care based IRFs to exit the space.

 In addition the previously mentioned advantages vs acute care based IRFs, HLS benefits from unit level economies of scale versus their free standing competitors.  As mentioned previously, the average HLS facility houses 68 beds, vs 52 beds for free standing competitors, contributing to 7-8% EBIT margins for free standing competitors.  Once again, there is statistical evidence that there is a negative correlation between the number of beds in an IRF and the amount that that IRF passes on to Medicare on a per patient basis, meaning that HLS patients cost the government less money.

Competitive Advantage, System Level:

As the largest and most profitable operator of freestanding IRFs, HLS is able to dedicate significant resources to training of staff, operational efficiencies, and procurement.  Each of these factors contributes to a lower cost for HLS reinforcing their dominant position.

• Training – Before being admitted to a HLS facility, all patients are examined to make sure they are eligible for medicare reimbursement by trained staff.  The result is lower “slippage” in the form of denial of reimbursement claims and associated audits, which contributes to the previously mentioned lower discharge cost per patient. (note: like most companies in this universe, HLS is being audited currently.  So far so good however.)
• Operational Efficiency – HLS has a proprietary system that collects data from individual hospitals and tracks metrics such as patient volume, labor productivity, variable expenses etc.  This allows management to appropriately staff facilities w/ flex hours, as well as monitor inventory levels on a national level.  The result is better management of flexible costs, which contributes to the previously mentioned lower discharge cost per patient.
• Procurement – as mentioned above, the company is able to manage their inventory on a system wide level, resulting in bulk discounts for consumable items.  The result is once again lower discharge cost per patient.

Supply Cost Per Discharge:

Competitive Advantage, Patient Outcomes:

The industry standard for patient outcomes is the Functional Independence Measure, or FIM score, which measures 18 physical and cognitive skills and abilities. Patients are scored on their arrival day, and again shortly before dismissal. HealthSouth has a proven record of producing significantly above average FIM score results, which likely makes them a preferred destination for referring physicians. 

Competitive Advantage, Real Estate:

HLS owns the real estate associated with 73% of its IRFs.  From a balance sheet perspective this provides some downside protection in the event of a sell off.  More important however is the fact that owning their real estate gives HLS more control of their own destiny in the event of a change in reimbursement rates.  While competitors will be subject to the dual threat of increasing lease rates and lower reimbursements, HLS with be largely protected from increasing fixed costs. 

Barriers to Entry:

49% of HLS facilities are in geographies that require the local governing authority to issue a “certificate of need” before licensing an IRF.  Obtaining this certificate can take up to 3 years, and importantly, incumbent service providers can object to new entrants, giving HLS a first mover advantage in these geographies.

Additionally, as mentioned previously, HLS has an above average record of patient results.  New entrants to a HLS geography will have to convince referring physicians to take a chance on the new entrant, rather than sticking with the proven solution.

The uncertain regulatory environment acts as an impediment to entrants without scale

Why IRFs are Less at Risk for Reimbursement Cuts:

It is impossible to predict how any medicare reform will impact various segments of the healthcare complex, but there is reason to believe that IRFs are not a "high value target."  Options for post acute care can be broadly summarized as IRF, Skilled Nursing Facilities (SNF), and Home Health Services (HHS).  The highest acuity patients are referred to IRFs.  SNFs and HHSs have a higher concentration of for-profit ownership, higher profit margins, higher historical medicare growth rates, and higher overall spending vs IRFs.  All of these factors make these segments of the healthcare complex more natural targets for reimbursement cuts than IRFs.  In fact, IRF spending currently accounts for 1.2% of total medicare spending, and this percentage has been declining for more than 10 years while almost all other segments have been growing. 

Management:

CEO Jay Grinney was thrown in the fire as he was brought on board in the depths of the previously mentioned accounting scandal.  For more on how he expertly navigated the ship through this period, please see previous VIC write-ups.  Of note, management has a long track record of under promising and over delivering, having beaten EBITDA guidance by an average of ~7% over the last 5 years.  Grinney personally owns 2.9% of the company (~$85M worth) and management collectively owns 5%, aligning their interests squarely with shareholders.

Recent Performance and Future Opportunity:

HLS has strong growth potential for three important reasons. 

1. The “graying” of America is increasing the pool of seniors that are likely to need treatment in an IRF facility.  This trend will not revert any time soon.
2. The entire medical complex is dealing with uncertainty tied to reimbursement cuts from insurers and the government.  IRFs are typically cost centers in hospitals, which is causing hospitals to seek to exit their captive IRFs and refer patients to free standing IRFs.  HLS has a proven track record of developing de novo hospitals to fill the vacuum left by exiting acute care hospitals.  Additionally, they have been JVing with acute care hospitals to develop new facilities.  In my view this positions HLS well in the event that a coordinated care model becomes the norm in the future.
3. The freestanding IRF market is fragmented, with many small players operating a small number of facilities.  Increased compliance costs tied to Obamacare record keeping initiatives are forcing smaller IRFs to sell themselves to larger competitors in order to spread these costs over a wider base.  As the biggest player in the space with only 9% market share (based on facilities) HLS is an obvious acquirer.  The opportunity for acquisitions will be even greater if reimbursement rates are cut as their status as the low cost provider insures that they will be the last man standing in this scenario.

Capital Allocation:

In recent years, the company has been focused on internally funded growth via de novo construction, M&A, and bed expansion, but perhaps more importantly in paying down debt associated with their scandal laden past.  As debt has been paid down, FCF has of course grown, allowing the company to think more clearly about capital allocation.

In March of 2013 the company repurchased 9.5% of shares outstanding via a $234M tender offer.  Another $26M worth of stock was repurchased in Q1’14 under a current buyback authorization of up to $250M (8.5% of shares outstanding).  Additionally, the company initiated a $.18/share quarterly dividend in October (2.1% current yield).  Management has indicated they would like to stay below 3x levered subject to opportunities to maximize shareholder value.  I would interpret this as management keeping themselves open to possibly taking the business into adjacent healthcare sectors, but am confident based on their past track record and public statements that this is not something they will do haphazardly.  Interestingly, Grinney has also indicated he sees buybacks as an opportunistic pursuit, not an obligation, implying that he would be an aggressive buyer in the event of temporary dislocation attached to headline risk (ie reimbursement cuts).  In addition to further debt management and return of capital to shareholders, management plans to continue to grow the business through de novo expansion, M&A, and bed expansion.  They have a stated 15% IRR hurdle on any move along those lines, and a long runway.

Valuation:

I view HLS as a moated company that will grow revenue, widen margins, and buy back shares for years to come, allowing an investment to compound at low to mid double digits for the foreseeable future, and thus consider putting a dollar value on what the company is “worth” to be mostly useless.  However, for purposes of discussion I will submit that the company can do $680M in adjusted EBITDA in 2017, and is deserving of a conservative 8.5x multiple on that number (note they will largely not pay cash taxes in this period).  Allowing for some share repurchases along the way that gets you to ~$54/share in 2017 or a 15% IRR pre dividends.

For reference, acute care hospitals trade at ~9.2x EV/EBITDA

Other:

The HLS investor reference book is excellent.  http://www.sec.gov/Archives/edgar/data/785161/000078516114000016/q42013investorreferenceb.htm

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