Description

I believe that shares of HealthSouth Corporation (HLSH) are significantly undervalued at current levels, and offer an opportunity for very substantial near-term and long-term appreciation. For additional background information on HealthSouth, I refer you to this outstanding prior VIC write-up of the Company:
http://www.valueinvestorsclub.com/members/index2.asp?select=symbol&textfield=hrc&UserName=

OVERVIEW/THESIS

HealthSouth is the nation's largest provider of outpatient surgery, diagnostic imaging, and rehabilitative healthcare services. On March 19, 2003, the NYSE halted trading in HealthSouth’s stock, pending the results of a fraud investigation against the Company and CEO Richard Scrushy involving the alleged massive overstatement of earnings and assets.

Several days later the Company announced that its books could not be relied upon and that it was conducting a re-audit of the last several years of financial reports. The Company’s stock was halted and, while halted, was delisted by the NYSE and removed from the S&P 500.

HealthSouth resumed trading on the pink sheets a few days later, under the ticker HLSH. Massive forced selling by index funds ensued, along with tremendous selling by institutional and retail holders of the stock. The stock dropped to $.12 in its first trading session and bottomed out at $.08 a few days later. The Company had essentially been left for dead.

However, the rumors of HealthSouth’s demise had been greatly exaggerated. The Company soon announced that, although it could not currently make payments to any of its bondholders due to an injunction placed upon the Company by its lenders, those bondholders (whose debt was entirely unsecured) had granted the Company a temporary waiver rather than force bankruptcy.

HealthSouth then brought in the restructuring team of Alvarez & Marsal to streamline operations. Alvarez & Marsal did exactly that right out of the gate, quickly announcing that they had executed a 77 million dollar reduction in capital expenditures by targeting non-core operations and corporate waste. There were other encouraging announcements as well, including press releases indicating that the Company was cash flow positive and was current on payments to its vendors.

On July 7, 2003, the Company held a conference to update shareholders and the financial community on its status. That conference was extremely encouraging. The Company described its future as “solid”, and predicted approximately $4.1 billion in revenue and $650 million in EBITDA for the 12 month period beginning 6/03 and ending 6/04. HealthSouth predicted $328 million in free cash flow. Importantly, the Company also indicated that it might be able to realize an additional $80 million in EBITDA, through a 2% improvement in profit margins. It is also important to note that the Company made it clear that these projections were in no way contingent upon the results of the forensic audit or complete financial audit still underway.

The market learned in mid-September that the Fidelity family of mutual funds had purchased approximately 12% of HealthSouth’s outstanding shares in July and August (roughly 50.1 million shares). Fidelity had been the largest shareholder of HealthSouth stock in February prior to the scandal and delisting. When the fraud was disclosed and the stock began trading on the pink sheets, Fidelity dumped at least 90% of its holdings. For Fidelity to reestablish its investment in HealthSouth while the Company was still trading on the pink sheets represented a tremendous show of confidence in HealthSouth’s prospects, especially considering the major loss they had previously taken on this stock. Clearly, Fidelity felt extremely confident that the risk of bankruptcy was near zero, and that the stock price would appreciate considerably.

In addition, the Fidelity purchase might encourage those funds whose charters permit them to buy the stock of companies trading on the pink sheets to seriously consider taking a position in HLSH much sooner than might have otherwise been the case.

Given that Fidelity has held at least 25 million shares of HealthSouth stock going back to 1999 (often at much higher prices), it seems reasonable to assume that Fidelity intends for this to be a long term purchase. Fidelity’s acquisition therefore essentially removed 50 million shares from the float, which will make it that much more difficult for sector and index funds to acquire HealthSouth shares, as they will be seeking to do en masse once the Company is relisted next year (more on this point in the “Catalysts” section of the write-up).

In early October, HealthSouth announced that it had paid all interest due to its debtholders. After making these payments, HealthSouth remained in default only on the 3.25% convertible bonds which matured earlier this year. Those bondholders are still owed $354,150,000 in principal. The fact that HealthSouth’s lenders allowed these interest payments to be made, instead of seeking to extend their injunction against the Company making such payments, demonstrated their willingness to work with the Company.

HealthSouth had previously tendered a bond exchange offer to all of its debtholders. The Company has stated that it hopes to “come to a mutually beneficial agreement with banks and noteholders by the end of
the year.”

VALUATION

HealthSouth has projected $650 million in EBITDA for the 12 month period beginning 6/03 and ending 6/04, and also indicated that a 2% improvement in gross margins was possible. It is important to note that Alvarez & Marsal are decidedly in the habit of underpromising and overdelivering (to give just one example, they projected EBITDA in a range of only $400-$600 million just a few months prior to the 7/7 conference), and it is therefore safe to assume that the 2% margin increase referenced in the conference is very achievable.

In fact, I would go so far as to say that a 2% increase in margins is very likely a conservative projection. Gross profit margins in the industry typically run about 3-4% higher than HealthSouth’s current profit margins. There is every reason to believe that HealthSouth can make up most of that difference now that the Company has attained a focus upon efficiency and profit-maximization that was very much lacking under the Scrushy regime. Still, I will assume EBITDA of 730 million for 6/03-6/04, to be conservative. On that basis, HealthSouth has an
Enterprise Value/EBITDA ratio of just 5.1 (compared to a sector average of approximately 7.7).

Even using the lowball $328 million free cash flow number which assumes no margin improvement, HealthSouth’s price/free cash flow ratio is just 3.50 (approximately 1/4th the average price/free cash flow ratio of its sector, which is about 14).

The composite Wall Street 2004 EPS estimate for HLSH is $.63. I feel that
this number is conservative- but even using this conservative $.63 estimate, HLSH still trades at a forward PE of only about 4.60 (the average P/E for the industry is approximately 15, and that multiple is depressed because the sector is currently out of favor).

RISKS

1) Possibility of debtholders attempting to precipitate a bankruptcy filing-

As mentioned previously, HealthSouth is in default on the convertible debentures that matured earlier this year. This default also renders the Company in technical default on their other outstanding bonds. HealthSouth’s bondholders could therefore conceivably seek to force the Company into bankruptcy. I believe that this possibility has suppressed the stock price by at least 20%. However, the chances of HealthSouth’s creditors forcing bankruptcy are virtually nil, in my opinion, for the following reasons.

First, all of the Company’s bonds are trading at extremely high levels. Some of these bonds were hovering in the $.20 range following the crash. Now they are all trading at least in the low $.90’s (several are in the mid .90’s). In fact, the bonds are uniformly trading at higher than pre-crash levels. This is a very strong indication that negotiations between the Company and its bondholders are going smoothly, and that the market expects the Company to avoid bankruptcy. In addition, the elevated bond prices provide HealthSouth with significant leverage, because the debtholders can not attempt to force bankruptcy without hurting themselves by driving down bond prices precipitously.

However, these points are really moot because, although HealthSouth would no doubt prefer to use their cash in other ways, if necessary the Company could resolve the default simply by paying off the ’03 convertible bonds.

2) Possibility of indictment-

There is a remote chance that the Department of Justice could indict HealthSouth and cause the Company to incur penalties severe enough to force it into bankruptcy. However, this risk is extremely minimal in my view, for several reasons. First, the DOJ has never sought the death penalty against a company that has committed corporate fraud. Even in the case of Arthur Anderson (which was a very distinguishable situation both because Arthur Anderson has no shareholders and because they actively concealed evidence in connection with the Enron fraud) the “death penalty” was not sought. Rather Arthur Anderson was prohibited from auditing public companies, and even that was only after the company rebuffed the government’s offer to settle the case via plea bargain. The most severe penalty imposed to date upon a corporation guilty of corporate fraud has been a fine. For example, RAD was fined only $20 million, despite the fact that the company was initially uncooperative with the government. PRGN received no fine at all.

Indicting HealthSouth would also be contrary to the memorandum promulgated by the Bush administration to guide the DOJ in prosecuting cases of corporate fraud. That memorandum states that consideration must be given to the effect of indictment upon the indicted company’s shareholders and employees. In this case, the “death penalty” would lead to substantial layoffs among HealthSouth’s 51,000 employees, and wreak devastation upon HLSH shareholders (many of whom have already suffered large losses due to the misdeeds of the Scrushy regime).

Even more importantly, the memorandum also states that the offending
company’s cooperation with the DOJ should be a key factor in determining whether indictment is appropriate. HealthSouth has cooperated fully with the DOJ, as the DOJ has acknowledged in numerous press releases. In fact, Alice Martin (the lead prosecutor for the DOJ in the Healthsouth investigation), was reported to have said, at the end of August, something to the effect that “HealthSouth's cooperation since March, when the investigation began, could help it to avoid criminal charges.” This is a very telling statement, considering that it is not reasonable to expect the DOJ to let the Company completely off the hook until they have established their case against Scrushy and thus no longer need HealthSouth’s cooperation. It is also interesting to note the following statement from Martin, made back in April “The way we are handling this investigation is going to be an assistance to HealthSouth in trying to avoid bankruptcy. We have made an extensive effort to try to assist a corporation that is cooperating in this investigation." Most importantly, indicting the Company would set a self-defeating precedent for the DOJ because the result would be that similarly situated companies would have no incentive to cooperate with them in the future. It should also be noted that, even in the extremely unlikely event that the DOJ did attempt to indict HealthSouth and seek the death penalty, the Company’s ultimate fate would lie in the hands of the judge hearing the case against it. It is doubtful that a judge would grant the death penalty, for all of the reasons given above.

3) Shareholder lawsuits-

Shareholder lawsuits will be brought against the Company, as a result of the fraud and ensuing decline in the Company’s stock price. However, I consider these suits to be virtually a non-factor. First, such actions are usually settled for pennies on the dollar. Moreover, any shareholder suits which were not settled would not come to trial for several years. By the time these cases were tried, the Company’s stock price would likely be higher than it was prior to the crash (indeed, the stock price is already closing in on pre-crash levels).

4) Possible Medicare exposure-

There is an unresolved Qui Tam (whistleblower) suit which was brought
against the Company several years ago. Prior to the crash, the government made a settlement offer of $200 million. HealthSouth countered by offering $150 million and that counter-offer was rejected. I do not view this suit as a major concern. Even if HealthSouth were to settle for $200 million, this would be a one-time charge that would not unduly affect the Company’s prospects. However, given that HealthSouth currently lacks access to the capital markets, it is probable that the Company will take the case to court in order to conserve cash in the near-term. Qui Tam suits tend to drag on for several years. Thus, even if a judge were to find against HealthSouth in this matter (which would by no means be a foregone conclusion, since Qui Tam cases are generally difficult to prove) that wouldn’t happen until several years from now, when the Company’s recent difficulties will have long since been forgotten.

There is also the remote possibility that the fraud perpetrated by the Scrushy regime might have resulted in the submission of fraudulent cost reports to Medicare. However, this is a very minor concern in my opinion because the Company 1) said several months ago that the fraud did NOT impact Medicare cost reports; and 2) indicated in the July 7th conference that the forensic audit was 90% complete and that no material Medicare reimbursement issues relating to the fraud had been found.

CATALYSTS

1) Valuation

2) Relisting following completion of financial audit next summer- Many mutual funds are prohibited by their charters from owning stocks that trade on the pink sheets. Once HealthSouth’s stock is relisted, institutional accumulation will be very intense. Before the delisting, HealthSouth was 81% institutionally owned. Now, the percentage of institutional ownership is below 30%. One can conservatively assume that the level of institutional holdings will increase to at least 60% (and possibly much higher) shortly after relisting. By way of comparison, the Company’s four top NYSE competitors have institutional holdings as follows: HCA- 83%; THC- 82% (in spite of its problems), HMA-94%, UHS- 92%. These numbers are largely explained by the fact that there are relatively few “blue chip” companies in HealthSouth’s sector. However there are a number of funds that must hold weightings in the sector. In addition, index funds will be REQUIRED to buy when HealthSouth rejoins the S&P 500. If, as I expect, HealthSouth’s stock is relisted next summer, there will be a huge amount of technically driven buying that should take the stock to surprisingly lofty levels compared
to its underlying value.

3) Refinancing of debt/ resolution of default- Judging from the current bond prices, it would seem that a resolution of default on the 2003 convertibles (and possibly even refinancing of all debt) is likely to happen sooner rather than later.

4) Completion of forensic audit by November- HealthSouth has stated that the financial projections made in the 7/7 conference will not be affected by the results of the ongoing forensic or complete audits. The conclusion of the forensic audit (which the Company indicated should occur “by November”) can therefore only be good news for the Company, as it will reduce fear of the unknown (which may in turn help to increase institutional accumulation of the stock.)

5) Closing of Coral Gable hospital sale- HealthSouth announced on August 18th that it had reached agreement with Baptist Health for the sale of the Company’s acute care hospital in Coral Gable. Baptist Health indicated that the sale was expected to close within 60 days of that announcement. While the exact sale price is not yet known, it is anticipated to be at least $115 million.

6) Possible tax refund- HealthSouth is legally entitled to a tax refund from the IRS, since the Company’s fraud resulted in it paying greater taxes than it should have. The amount of the potential refund could be as much as $250- $300 million. There is also a chance that the refund may wind up taking the form of a credit against future taxes. It is also possible that the government could impose a fine upon HealthSouth in an amount roughly commensurate to what the Company is owed in back taxes, to prevent the Company from “profiting” from the fraud.

7) Announcement by DOJ that it will not indict the Company- Such an announcement could easily spur a 25% increase in HealthSouth’s stock price.

8) New CEO/CFO/Directors- Appointment of new management should boost HealthSouth’s stock price, because it will represent a return to “business as usual” and further distance the Company from the incompetence and dishonesty of the Scrushy regime.

Catalyst

see above section on catalysts