Description

This is the story of a healthcare company with declining SSS, deteriorating margins, a debt to EV of almost 80%, and a fraudulent billing investigation. I believe the market has overreacted to these factors and has created a buying opportunity for Hanger Orthopedic (HGR). With all of this bad news in 2004, HGR has fallen from a peak of $19 earlier this year to its current price of $6.50 and is trading at 7 times 2005 estimated EBITDA. For this price, you are getting the undisputed market leader in orthotics and prosthetics with 25% market share in an otherwise fragmented industry (next largest has roughly 2%).

The bear argument is that HGR will die a slow death as flat reimbursement levels and increasing materials costs cause GM to decline and the company suffers under a highly leveraged structure (HGR is levered both operationally and financially).

I will lay out the bull case by evaluating each of the factors that has led to this buying opportunity. First, a little about HGR’s business. HGR owns and operates over 600 patient care centers. They design, fabricate, fit and maintain custom made braces (orthotics) and artificial limbs (prosthetics) for its patients. HGR also has a distribution business which distributes private label and branded O&P devices manufactured by third parties. HGR’s products are technically advanced and highly customized. Here is how the patient life cycle works: a patient visits a physician who writes a prescription and refers them to one of HGR’s O&P centers. HGR’s practitioner designs a custom product for the patient, which are then fabricated by HGR’s technicians. The patient returns to the center and is fitted for the device as part of the final adjustments and given instructions on use. The patient then comes in periodically for follow-up visits, maintenance, and replacement.

On to the story. There are really 3 reasons that have caused the drastic price reduction of HGR: alleged billing fraud, A/R restatement, and declining operating performance.

1. Billing Fraud: on June 14th, an employee at Hanger’s patient care center in West Hempstead, NY alleged in a television news story that there were instances of billing discrepancies and other noncompliant conduct at that facility. HGR hired an outside law firm to conduct an investigation of this and other sites in the area. The US Attorney’s office in NY issued a subpoena for documents, and the SEC chimed in with their own informal investigation. In August 2004, HGR provided an update from their internal investigation saying that all improper practices were isolated to the West Hempstead location. Keep in mind that HGR has approximately 600 patient care centers, the West Hempstead location contributed less than $2 million annual sales to HGR’s revenue base of over $500 million, and the US Attorney’s office was only concerned about a 12 month period. It will take a while for the US attorney’s office and the SEC to report a conclusion on their efforts, but initial signs point to an isolated incident. I should also mention that billings and collections are done at each local O&P center, which makes it unlikely that this is a company-wide scandal. Think of the logistics of senior management orchestrating a company-wide billing fraud scheme involving 600 unique sites that were largely added through acquisition. It falls under the “highly unlikely” category in my book.

2. Accounting Restatement of A/R
HGR’s stock plunged from $9.5 to $4.4 as HGR delayed its Q2 earnings announcement to “complete certain accounting reviews.” This clearly spooked the market on the heels of the West Hempstead billing fraud allegations. It turns out that this delay was related to an overstatement of A/R and understatement of bad debt expense in prior periods that required restatement. On the surface, this appears to support a pattern of deception when taken together with the billing fraud. However, I am comfortable with this incident for a few reasons. 1: the restatement resulted in annual decrease of net income of only $1mm in each 2001, 2002, and 2003. I would not put this in the massive fraud category in terms of magnitude. 2: these adjustments were identified because of the new OPS system (a billing and collection system) that HGR is installing at all of its patient care centers. The overstatements were not identifiable prior to this system and came to light during the conversion.

As an aside, HGR delayed its second quarter 10-Q as it was trying to resolve this problem. In its notification of late filing, HGR estimated that its Q2 pre-tax would be $2.5 million vs. $15.8 million in 2003. HGR treated this A/R error as a change in accounting estimate to be as conservative as possible (a change in estimate requires a company to report the entire change in the current period rather than restating F/S for previous periods). It turns out that the issue was more properly categorized as a prior period adjustment (an error) that required restatement. When the Q was finally issued, pre-tax was $5.8 million. This whole episode caused quite a fluctuation in the stock price, and could not have come at a worse time on the heels of the West Hempstead situation.

3. Decrease in SSS and margin deterioration
HGR has had a weak year in terms of SSS and profitability. SSS in Q2 were down 1.6% and Q3 was down 1.2%. HGR also saw GM% decline from 53.7% to 51.9% yoy in Q3. At the same time, SGA increased dramatically. Given that this is largely a fixed expense business, decreases in GM% is a slippery slope. There are a few reasons why SSS will turnaround:

--replacement cycles in prosthetics: HGR recommends that prosthetics be replaced every 3-5 years. These devices are expensive, however, and on a $10,000 price a patient may need to cover $1k - $2k out of pocket. The company has seen a recent tendency of customers to delay replacement, mainly in geographical areas that have been hit hard with job losses (primarily the Midwest). Either patients are out of work, accepted new jobs with lower health benefits coverage, or are just delaying the purchase because of general economic concerns. HGR estimates that SSS decline in the Midwest is 4% and is dragging down positive results in other areas of the country. HGR insists that prosthetics are part of a cycle and we are in a downturn due to poor economic conditions in the Midwest. They believe a recovery in prosthetics units is directly correlated to job creation and economic improvement in the Midwest (and the rest of the US). I’m not sure when meaningful job creation will take hold in the Midwest, but even if it doesn’t take place for a while, there is only so long these patients can hold off before replacing what is a very meaningful component in their daily life.

Prosthetics also carry a higher GM than orthotics. The materials cost of orthotic devices are 300 basis points of sales higher than prosthetics. When prosthetics units rebound, GM will rebound as well.

--Favorable demographics: this is more of a long term macro trend, but diabetes is one of the largest contributors to prosthetics patients. Given the rapid increase in diabetes and with the baby boomers aging, HGR is anticipating a significant long-term boom in demand for prosthetics.

--Insignia: HGR has rolled out new technology to its O&P centers which replaces the plaster casting technique used to model a patient’s residual limb with the generation of a computer scanned image. This move is designed to increase capacity at its O&P centers to better leverage the fixed cost structure in place.

--Linkia: this is a major initiative by HGR to develop national contracts with major managed health care providers. HGR would in essence serve as an outsourced provider for these clients. HGR is projecting an incremental $40-$50mm in sales in 2005 and $4-$7mm EBITDA.

--Investment in sales team: HGR has invested $5mm for the first 9 months of 2004 building a business development staff of 20+ staff. Their sole mission is to work with the practitioners at a local basis to source more referrals. While HGR has invested $5mm to date, the benefits will not likely be seen until 2005.

Outlook
The Company expects revenue in 2005 to be between $610-$615mm without any significant acquisitions. Backing out $50mm in incremental Linkia sales from $615mm gives us $565, which would be flat on a SSS basis in 2005. Things appear to be getting better: in the last quarter, SSS were down $1.5mm or 1.2%. HGR estimated that $1mm was lost due to the hurricanes in FL during the quarter. Without this disruption, SSS would have been down $0.5mm, or only 0.4% down. This is significant improvement over Q2.

HGR announced in Q3 a profit improvement plan, whereby they would be cutting headcount in corporate, reduce G&A spending, squeezing vendors and reducing bad debt. HGR estimates it will increase EBITDA by at least $10mm in 2005 through these efforts. HGR gave guidance for 2005 EBITDA in the low to mid $80mm’s.

The company has said that it will focus on using cash flow to pay down debt and has no plans to grow through acquisition.


Summary
I would not characterize this as a full turnaround situation, because I don’t think HGR is broken. I think an upswing in the prosthetics replacement cycle and the benefits of the company’s revenue generating efforts will improve SSS. At the very least, HGR’s cost cutting initiatives will add $10mm to EBITDA in 2005. For a price of 7 EV/EBITDA on 2005 estimates, you are getting a market leader that is focused on improving operations.

Catalyst

--improvement in SSS through company initiatives.
--resolution of informal SEC inquiry and US Attorney investigation
--traction on the Linkia program.
--improvement in prosthetics units, either through economic improvement in Midwest or aging of baby boomers.