Description
Ticker: HRC; Recent Price: ($12.24); Mkt Cap: $4.8 B; FD Shares: 401.1 M; 52 Wk: $11.25 - $18.49
DESCRIPTION/OVERVIEW:
Healthsouth (HRC) is the nation’s largest provider of rehabilitative healthcare, outpatient surgery and outpatient diagnostic services. In HRC’s outpatient and inpatient rehab facilities, they provide rehab programs for patients experiencing disability due to physical conditions, such as stroke, head injury, orthopedic problems, neuromuscular disease and sports-related injuries. In addition to rehab facilities, HRC operates the largest network of outpatient surgery centers in the U.S. providing non-emergency surgical procedures. HRC is also the largest U.S. operator of diagnostic centers, performing diagnostic imaging, including MRI, CT, X-ray and ultrasound services. HRC operates almost 2,000 locations in all 50 states. On an LTM basis (ended 9/30/01), HRC generated revenues in excess of $4.3 billion and EBITDA of approximately $1.2 billion (EPS = $0.80).
INVESTMENT THESIS:
The implementation of a Medicare Prospect Payment System (PPS) has generated a great deal of skepticism regarding HRC’s future prospects. The conventional thinking regarding the impact of PPS on HRC appears overly pessimistic. At 6.4x EBITDA and 10.7x ’02 earnings, HRC is currently trading near its trough valuation as well as at a material discount to its peers.
HRC presents an attractive longer-term investment as well as a compelling risk/reward. At the current price, HRC should offer limited downside and meaningful future appreciation due to earnings growth, multiple expansion and improved market perception. The prospect of HRC failing to deliver on an efficient transition to PPS appears to already be discounted in the stock, thus limiting the downside. HRC is the dominant player in the rehab, surgery center and diagnostic markets as well as the low-cost provider. Over a 1-2 year period, HRC should realize the full benefits of a transition to PPS and, thus, significant appreciation in its stock at normalized multiples.
HRC MARKET POSITION:
HRC is one of the largest healthcare providers in the U.S. and the dominant player in the rehab/surgicenter market – the next largest publicly traded competitor has a market cap of less than $600 million. HRC’s size and scale put it in a unique position to realize economics of scale and to compete for national/regional contracts and referrals. Two of the primary success factors across HRC’s business segments are referrals and cost. HRC is the #1 provider in each of its segments:
Inpatient Rehab (41%/sales): HRC operates over 120 inpatient rehab facilities with almost 7,700 beds (22% mkt share). The inpatient market represents 35,000 beds, which is expected to grow at 4-5% annually. In 2000, overall utilization was 79.6%, which is in line with the industry. Competitors are primarily hospitals and other inpatient rehab agencies. Payor mix = 70% Medicare, 30% non-Medicare.
Outpatient Rehab (20%/sales): HRC operates over 1,400 outpatient rehab facilities (10% mkt share). The outpatient rehab market is $10B and is expected to grow at 5% annually. Healthcare reform is driving earlier discharge of patients from acute-care facilities. As such, most hospitals do not provide the intensity of services necessary to achieve full recovery and outpatient rehab plays a critical role in this process. Competitors include hospitals, private practice therapists and rehab agencies. Payor mix = 10% Medicare, 90% non-Medicare.
Outpatient Surgery (22%/sales): HRC operates over 220 surgery centers (16% mkt share) – 80% of the centers are located in markets with HRC rehab facilities. The outpatient surgery market is $6B. Growth is expected to continue at rates of 7-9% annually. Currently HRC surgery centers are operating at 50% capacity, which offers margin upside as incremental volume generates 40%+ EBITDA margins. Hospitals are the primary competitors but are disadvantaged from a cost perspective. Payor mix = 20% Medicare, 80% non-Medicare.
Diagnostic Services (8%/sales): HRC operates over 140 diagnostic centers (4% mkt share). The diagnostic market is $8B and is expected to grow at 8-10% annually. This market is highly fragmented with radiologists, hospitals and independent organizations offering services. This business is a significant source of cross-referral opportunities for rehab and surgery. Payor mix = 15% Medicare, 85% non-Medicare.
As of 2000, sources of revenue include: Managed Care (41%), Medicare (29%), Workers’ Compensation (12%) and all other (16%).
CUSTOMERS/COMPETITORS:
HRC markets its services directly to patients, payors, physicians, case managers and other referral sources through national, regional and local programs. Referrals are a critical component of the business and HRC focuses on “cross-referrals” across its rehab, surgery center and diagnostic facilities. HRC has also placed a major effort on the development of contractual relationships with managed care organizations and major insurance companies. HRC has national pricing arrangements with CIGNA, United Health and with national HMOs such as First Health and Multiplan as well as with national employers such as Delta Airlines, Marriott, Federated, Goodyear and Winn-Dixie.
Competition tends to vary based on the healthcare providers in a particular area and by segment (as described above). Some of the publicly traded competitors are highlighted below (based on Jan. 22, 2002 closing info):
MKT CAP TEV/EBITDA P/E ‘02 P/E ‘03
Surgicenters/Rehab:
Amsurg (AMSG) $0.5 7.3x 25.9x 20.8x
Hanger Ortho (HGR) 0.1 11.3 39.1 n/a
Rehabcare (RHB) 0.4 6.0 13.5 11.3
United Surgical (USPI) 0.5 13.3 36.5 28.6
US Physical Therapy (USPH) 0.2 9.8 21.6 17.2
Average: $0.3 9.5x 27.3x 19.5x
Acute Care Hospitals:
Community Health (CYH) $2.4 12.2x 36.2x 27.0x
HCA Inc. (HCA) 21.1 8.6 19.1 16.2
Health Mgmt (HMA) 4.7 11.5 20.6 17.7
Lifepoint (LPNT) 1.4 12.9 32.0 26.1
Province Healthcare (PRHC) 1.1 14.9 27.0 21.2
Tenet Healthcare (THC) 21.1 10.6 18.5 n/a
Triad Hospitals (TRI) 2.1 14.0 22.0 16.7
Universal Health (UHS) 2.2 7.8 16.9 14.4
Average: $7.0 11.6x 24.0x 19.9x
Healthsouth (HRC) $4.8 6.4x 10.7x 9.4x
BACKGROUND/COMPANY STRATEGY:
Leading up to 1998, HRC pursued a strategy of rapid growth through acquisition, merging with or acquiring 12 companies over six years. In such, HRC assembled a franchise of significant scale with market leading positions in each of its three segments.
In 1997, however, Congress passed the Balance Budget Act, which caused the Medicare reimbursement of certain healthcare services to change from a cost-based reimbursement system to a flat-fee Prospective Payment System (“PPS”). In a short period, services went from cost-plus to fixed fee. A number of providers with highly leveraged balance sheets and undisciplined management teams were driven out of business, particularly in the nursing home, home health and institutional pharmacy sectors.
HRC experienced a material deterioration in its profitability during the 1998/1999 timeframe (see Exhibit I) and its stock was severely penalized. In 1999, HRC shifted its management focus from growth to profitability. HCR reorganized its management and has placed a new emphasis on enhancing profit margins and maximizing cash flow. Since the 1998/1999 timeframe HRC has started to demonstrate the benefits of its operational initiatives evidenced by: (i) improved EBITDA margins; (ii) a return to 15% EPS growth rates; (iii) improved days receivable and (iv) reduced capex as a % of revenues. Operationally, there should be opportunity for additional margin and cash flow improvement in the next few years.
CURRENT SITUATION:
Medicare begins implementation of PPS in the inpatient rehab sector starting January 1, 2002. Inpatient rehab subject to PPS accounts for roughly 1/3 of HRC’s total revenue. The implementation of PPS has generated a great deal of skepticism regarding HRC’s future prospects, which has caused its stock to trade near its historical lows. The conventional thinking in the market regarding the impact of PPS on HRC seems overly pessimistic.
In contrast to other segments that have experienced PPS, the implementation of inpatient rehab PPS should be beneficial for HRC in two ways. First, the advent of a fixed fee system is likely to cause many acute care hospitals to exit the business because these facilities will not be profitable under PPS. This should cause a reduction in competitor capacity. Second, the PPS Medicare reimbursement rate of $11,200/discharge is higher than HRC’s average cost per discharge of $9,600. Previously, HRC received the lower of cost or charge. With 70,000 annual discharges, HRC should generate over $100M of incremental EBITDA or incremental EPS of approximately $0.15-$0.20/share when fully implemented. HRC has stated it expects approximately $0.07 of incremental EPS in ‘02 (and the remainder in ’03), which implies that approximately 40% of its units will be transitioned to PPS in ‘02. HCR’s ability to manage through PPS and generate additional income should not be a question of if, but a question of over what time frame.
Although HRC will undoubtedly face challenges in transitioning to PPS, it has had three years to prepare. In contrast to the healthcare companies that were severely damaged by PPS in 1998/1999, HCR has had time to prepare for the transition and, perhaps more importantly, benefits from a lean cost structure. Interesting lessons can be learned from examining the home health (HH) and institutional pharmacy (IP) sectors. Companies in these sectors were damaged as a result of PPS. A few of the companies in these sectors (Lincare in HH and Omnicare in IP) have emerged stronger than ever. The companies such as Lincare and Omnicare that have been able to thrive in the new reimbursement environment are those that have dominant scale in their markets and management teams focused on driving lean operating structures.
HISTORICIAL FINANCIALS: (See attached)
Management and directors own of 7% of HRC.
BALANCE SHEET HIGHLIGHTS:
HRC currently has $3.1B of debt, which represents a multiple of 2.6x LTM EBITDA, interest coverage of 5.8x and a debt/cap ratio of 45%. HRC has $1.2B of debt maturing in 2003 (credit facility and convert debt w/ $36/share conversion price) but should not have a problem refinancing based on current ratios. HRC is carrying $2.7B of goodwill.
HRC has stated an annual debt reduction goal of approximately $250-500M that should help drive additional equity value. HRC has stipulated that capex will not exceed $400M/year and all new projects will be subject to a 20% ROE threshold.
Q3/YTD 2001 REVIEW:
For the most recent quarter (9/30), HRC’s revenues, EBITDA and EPS were all in-line with estimates. During ‘01, contracts with seven of HRC’s largest managed care contract were renegotiated, with an average increase of 11%. In the past year, HRC has favorably renegotiated 35% of its contracts with the balance remaining flat. The outpatient and diagnostic units have showed slight volume improvements with all other units remaining flat. In general, volumes appear to be flat but pricing appears to be strong, generating top-line growth (4.7%). Same store revenues are up 6.5% YTD. EBITDA and net income margins improved year-over-year in each of the three quarters. The balance sheet was relatively stable with days receivable increasing by 3 days in Q3 as a result of September 11. Debt reduction for the year looks to be approximately $150M, which is about $100M below management targets.
HRC recently announced that the DOJ was joining a pre-existing lawsuit claiming that the use of physical therapy aides violates certain Medicare restrictions. Fraud and abuse lawsuits are not uncommon in this industry. This suit relates to less than 1% of HRC’s business. The stock dropped $1-1.50 on this news. Based on a $400-$600M loss in equity value, the stock appears to be discounting the risk.
VALUATION:
HRC is currently trading at less than 6.4 times its trailing EBITDA. On a cash flow basis (EBITDA), HRC is trading at a 32% discount to the average multiple of the surgicenter/rehab comps and a 45% discount to the acute-care hospital comps. Given HRC’s #1 market position and improving EBITDA margins/growth rates, the valuation appears attractive.
On an earnings basis, HRC is expected to earn $0.82 in ’01, which represents a P/E multiple of 14.9x trailing earnings. The Company has officially raised its ’02 EPS guidance to $1.14 from $0.94 reflecting a $0.07 increase for the impact of the new inpatient PPS and a $0.13 increase for the impact of reduced goodwill amortization under SFAS 142. On a forward basis, HRC is trading at 10.7x ’02 earnings and 9.4x ’03 earnings. Excluding the impact of the accounting change, HRC should increase earnings in ’02 by 23% and 20% in ‘03.
HRC’s earnings estimate for ’02 assumes they will convert 40% of their inpatient rehab centers to PPS. There is some risk to this assumption; however, it appears that the market has already discounted for this potential outcome, thus limiting the downside to HRC’s stock in the event it disappoints. Should HRC fail to deliver on any of its incremental PPS earnings, the stock would still trade at less than 15x next year’s earnings (roughly equal to its anticipated 15% earning growth).
Catalyst
Demonstration of a successful transition to PPS in ’02 should expand earnings and reduce negative perceptions associated with HRC.