Description
This idea has been posted over 2 years ago. I believe this is a good time to revisit it in light of several imminent catalysts. The dust stirred by MMA 2003 is finally settling and Rotech continues to trade significantly below its comparables. The stock was recommended at 14 in August 2002. Since then the market cap of the company has gone up by $300M, but most of the appreciation came from debt paydown using free cash flow generated - net debt has gone down by roughly $200M since then. That demonstrates the power of the free cash flow yield. FCF yield in 2005 should be about 9%. On an EBITDA basis, the company trades at 6.5x 2005E EBITDA, while the best comps Lincare (LNCR) trades at about 9x. So why does Rotech trades at such a discounted multiple?
You can go back to the August 2002 writeup for some background back in the days. Since then, the Company hired Phil Carter and his whole turnaround team that turned around Apria in the years between 1998 and 2002. Phil has spent the next two years cutting costs and fixing a plethora of operational issues. The results have certainly shown up in the financials. EBITDA margin has gone up from mid 20s to the 30s. What he hasn¡¦t spent much time on was growing the business. While Lincare was firing on all cylinders in growing top line and bottom line, Rotech has been having a broken growth engine. If Lincare has grown so much faster than Rotech, it¡¦s only fair to expect Lincare to trade at a higher multiple. However buying Rotech at a lower multiple allows you to benefit from the narrowing of valuation gap should Phil be able to reinvigorate the growth engine. If Rotech can reinvigorate the growth in their business, then there should not be more than one turn of valuation gap between those two companies. If Rotech trades at 8x 2005E EBITDA, the stock would be at 36, representing 30% upside. FCF yield could deliver another 9% return in each year. But even if Rotech can¡¦t achieve anything near Lincare¡¦s high-teens EBITDA growth, a FCF yield north of 9% is still nothing to sneeze at. Nevertheless, relative value argument is not the focus of this writeup. Even though the industry demonstrate highly attractive economics and above significantly above GDP growth, In order to determine whether Rotech is stock is cheap at these multiples, I would spend most of the time analyzing the number 1 risk factor ¡V Medicare reimbursement risk.
Business
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Home oxygen equipment provider such as Rotech provides respiratory therapy equipment for patients who suffer from breathing disorders. For example, if a senior is diagnosed with COPD (chronic obstructive pulmonary diseases), the physician or the hospital case planner will choose a provider such as Rotech from whom the patients rent the oxygen equipment. Typically a patient could be leasing a stationary concentrator and a few portable oxygen tanks a month. Medicare will then reimburse the provider at about $250/month. There is another 10% of patient co-pay on top of that, which sometimes is covered by seniors¡¦ supplemental insurance. Patients almost never switch from one provider to another. In addition, because pricing is determined by Medicare, there is no pricing competition in the business. Below is the economics for a typical patient:
Upfront investment: $1200
Average mortality duration of a patient: ~3 years
Average annual capital costs: $400
Cost of monthly visit by trucks: $50 (including cost for portable cylinders)
Total annual costs to Rotech per patient: $1,000
Average annual revenue from Medicare: $3,000 (not including patient¡¦s share of co-pay)
Gross Margin: ~67% (higher if patient co-pay is included)
As you can see, once a patient is assigned to Rotech, it becomes a lucrative annuity. How does a patient get assigned to an operator? What are the acquisition costs involved?
It turns out that physicians and hospital case workers play the biggest role in deciding where patients go for the equipment. Therefore, sales and marketing efforts are focused on the decision makers as opposed to be on the patients at the mass level. The relationship nature of the business makes barriers to entry extremely high. As long as an operator provides reliable service and minimizes troubles for the physicians, a physician has very little incentive to switch his primary provider. The bad news is if you don¡¦t have the relationship, it is very hard to break into a new market. Obviously the barriers to entry do more good than bad to the business. The business is competitive only at the decision maker level, and yet even at that level it is hardly a fiercely competitive business. Most of the time you only see two out of the three national operators in each market, and only Rotech and Lincare focus on the Medicare patients. There are usually a handful of regional mom-and-pops in each market, but national operators possess significant competitive advantages over mom-and-pop regional operators. For example, national operators can buy equipment from suppliers at a lower price. National operators, with their national network, can fulfill service delivery even when a patient travels outside the region (e.g. those who move to Florida or California during winter). Therefore regional operators have historically been one major source of growth as national operators roll them up at 3x-5x cashflows.
Rotech also cross sell respiratory drugs and other fringe products under Part B. In 2004, I estimate $135M of Rotech¡¦s revenue came from delivering respiratory drugs.
As you would expect, this business has been riding the tide of aging population and thus have been growing organically at a same-store rate of high-single digit. The future growth could only accelerate as baby boomers become Medicare eligible. Growth from CPAP and sleep apnea devices have also added fuel to the growth in recent years. Industry sources have informed me that they have been achieving as high as 20% same-store growth in some regions of the country.
Medicare Reimbursement Risks
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So you see this is a stable lucrative annuity business that has minimal churn and doesn¡¦t compete in pricing. Not only does it have very high barriers to entry, there is also favorable demographics due to aging population. Of course there is a catch to it - Medicare risk. If you have never looked at Medicare-related companies before, the knee-jerk reaction is commonly, ¡§Medicare risk too big a hurdle for any investment in the sector to be sound. Medicare can cut reimbursement rate at any time without notice and it would probably continue to do so in the next 10 years.¡¨ For sure, the Medicare factor has contributed to the extreme volatility of the stock price to the sector. Just take a look at the trading history of Lincare (LNCR) and Apria (AHG) in the past 10 years. You would have seen the most volatile stock price chart. So investment in this sector is not for the faint of heart. But this doesn¡¦t necessarily follow that the business is as risky as it is perceived, unless you believe in the business school theory of deriving risk from stock price movements. Below I will explain why I am comfortable with this risk.
I would safely assume that when you were reading the business description, the first risk factor that came to your mind would be the Medicare reimbursement risk. And it is the number 1 risk factor that people study when they look at these companies. No shareholders would have bought the stock without thinking about this risk factor. So one could argue that this risk is sufficiently priced in in the stock. I was taught that if I were to take a risk in an investment, make sure that risk is not ignored by the market. Better yet, it¡¦s always smarter to take risk that is widely recognized than taking one that¡¦s not, because a widely recognized risk is likely to have been overblown.
Recognizing this risk is priced in is at least priced in would be a good start. But it is still not good enough. The fact that the risk is priced in only means that the stock price is such that the upside from here justify the downside. I could still lose my shirt if things go the other way, however unlikely it is. To get comfortable with the risk, I would need a detail assessment of the downside scenarios and their corresponding likelihood.
Let¡¦s start with some history. Medicare Modernization Act dated December 2003 has brought forth a sizeable cut to the reimbursement rate for oxygen equipment and respiratory drugs. Reimbursement rate for respiratory drugs were going to be cut by 90% in 2005 while oxygen equipment (Rotech¡¦s main business) reimbursement was set to be cut by 15%. To understand the difference in cut, one needs to note that oxygen equipment provider is a business that requires substantial capital investment and specialized expertise while supply of respiratory drugs merely requires a mail-order pharmacy who knows how to deal with Medicare billing. Even so, when CMS came to realize the repercussion of this cut to the industry, the respiratory drug reimbursement cut was subsequently moderated to 50%, bringing gross margin down from 90% to 70%. The oxygen equipment has also been moderated from 15% to what is likely to be a 7-10% cut.
While the final details of the oxygen equipment have yet to come out, the good news is the new cut is just being put in place this year. Chances are we won¡¦t see another major cut until 2007. As Apria CEO Larry Higby put it recently in the JP Morgan healthcare conference, he has never had more visibility in the reimbursement rate than now. Lincare management are putting money where their mouth is by recently initiating a $250M stock buyback.
What about 2007 and beyond? Could Medicare cut the reimbursement rate so much that Rotech would go out of business? I don¡¦t believe so. The home care oxygen industry is still fairly segmented. Top 4 national players account for about 55% of the market. There is still 45% of the market accounted for by small regional operators, who have cost structure significantly higher than a national operator. If a dramatic cut forces too many of those out of business altogether, service disruption would be too rampant for the national operators to pick up the slack. To have patients dying of lack of oxygen supply so that the government can save several hundred million dollars a year while we are spending hundreds of billions on Iraqis is too politically foolish. Therefore I believe any future cut will be gradual like the 2005 cut, and should be overcome by the growth of the entire demographics as well as the consolidation opportunities.
If the baby-boomer doesn¡¦t make you feel good enough about the industry growth, then the consolidation opportunities might. Not only national operators like Rotech are poised to take share from regional mom-and-pops, the 3x-5x cashflows roll-up acquisitions have been quite accretive for the national operators. This is not the typical problematic roll-up story here. Roll-up growth is just the way business works for national operators due to the high barriers to break into an existing relationship. Smaller operators would sell at such a low multiple because they have a significant cost disadvantage. Moreover, ROE is so high in this business that most of the startups would have earned multiples of their investment if they were to sell out after several years. National operators not only get better pricing from suppliers, they have also been able to pass on much of the reimbursement cut to suppliers. My contacts with suppliers informed me that they leniently accommodate national operators but hold the line firm with regional operators. Because consolidation is such an integral part of the business, ability to integrate acquisitions is an important criterion for selecting good management in this industry. As long as the Medicare cut would not be sudden and drastic, I view Medicare cut as a growth opportunity. Counter-intuitive as it is, the Medicare risk is really not as big as it seems. In order for cashflows to be down 4 years from now, any future Medicare cut has to overcome both the demographics unit growth, as well as the consolidation opportunities.
The Medicare risk is a direct result of having a concentrated customer accounting for 87% of the firm¡¦s revenue. On the other hand, notice how this risk is the other side of the coin of the industry¡¦s pricing stability. It is also because Medicare sets reimbursement rate that the industry uniquely experience no pricing competition. To me the Medicare risk is no more a risk than the eruption of irrational price wars in some industries or the cyclicality of some other. At least we know patients need to breathe whether the economy is strong or not, and it is no more likely that we find a cure for chronic pulmonary disease than finding a substitute to wearing shoes. However investors are generally averse to unfamiliar risks like this one but accustomed to owning businesses with other kinds of more usual risks. After all, there are plenty of companies who have very concentrated customers. Perhaps the fat margins of Rotech imply downside in pricing, but it just happens that Rotech is the low cost competitor relative to the regional operators. Besides, if a business were to have a concentrated customer, the government is the best customer you can hope for. It is not as price sensitive as a typical commercial or retail customer. There is minimal credit risk. It pays a uniform rate to everybody and only revises it once in a long while. Putting all the fundamentals in context, I find this business to be superior to most of the others I¡¦ve looked at. The annuity nature, barriers to entry, lack of price competition and its growth potential more than makes up for the Medicare risk.
Respiratory Drugs Reimbursement Cut
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Uncertainty surrounding the respiratory drug reimbursement cut has been plaguing the industry for the past twelve months. The impact is now relatively quantifiable. My estimate is that the revenue impact would be close to $50M, much of that dropping thru the bottom line. But my industry contacts have given me clues that point to a much milder impact. Don¡¦t take my word for it. If you can¡¦t come up with at least $140M for 2005 EBITDA projection, you shouldn¡¦t feel comfortable investing in this company.
Competitive bidding
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Competitive bidding won¡¦t be fully rolled out before 2009, if it ever gets implemented at all. Should it happen it would still benefit low cost producer such as Rotech.
Management
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This management team might be the best part of the story. Rotech continues to be a turnaround story and CEO Phil Carter had a terrific track record turning around Apria (another major national oxygen equipment provider) from May 1998 to Feb 2002. Since he joined Rotech in late 2002, he had done an equally impressive job cutting costs and rationalizing operations. The next phase of the turnaround is about how he can jumpstart the salesforce to get new business and how he can identify and integrate roll-up opportunities. You might not find the same kind of stellar track record in this respect but having a capable industry veteran/turnaround specialist on the CEO seat is as much margin of safety as I need for owning this business 2.5x lower than Lincare. It should also help that Phil got a team of his former lieutenants to join him from Apria.
The CFO Barry Stewart wasn¡¦t from Phil¡¦s Apria turnaround team. But I¡¦ve heard good things about him at Community Health, where he was involved in business acquisitions.
Conclusion
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My view is that despite the obvious Medicare risk, the oxygen homecare business is such a superior business that it should trade north of 10x EBITDA. Due to its superior salesforce, Lincare might just outperform Rotech significantly. However buying Rotech at 2.5x EBITDA multiple lower provides better downside protection. With about 2x of leverage, I find Rotech¡¦s 9% free cash flow yield attractive. On an absolute value basis, I believe the right FCF multiple should be about 15x, implying over 50% upside. On a relative value basis, Lincare is trading at 16x 2005 P/FCF, which I also believe is undervalued.
Financials
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Mkt Cap: $700M
Net Debt: $290M
2005E EBITDA: $150M
2005E Capex: $45M
2005E FCF: $63M
Catalyst
- The release of final MMA 2003 details
The big picture is that MMA 2003 has been keeping Wall Street¡¦s heads spinning for much of the past 12 months. No one was sure what 2005 EBITDA would look like until recently. But as the dust settles down, the industry multiple should gradually expand. The industry used to trade at 9x-12x EBITDA when there were more near term visibility. Final details of the oxygen equipment cut are expected to come out in 1Q05.
- Potential stock repurchase
The company has been paying down debt with the substantial free cash flow generation. However, the Company has indicated to me that they think the company is close to the tail end of deleveraging and major acquisitions are unlikely. That leaves either dividend or stock buyback as possible outlets for the future free cash flow.
- NASDAQ stock listing
Although Rotech emerged from bankruptcy over two years ago, it has yet to get listed. It has been reasoned that the listing was not timely until the big distressed holders have exited. I don¡¦t know if it makes a lot of sense to me. But in any case, it is expected that NASDAQ listing would be a 1H05 event.
- 2005 guidance
The management is expected to release 2005 financial guidance as soon as the final details of oxygen reimbursement come out. This along with the NASDAQ listing should encourage Wall Street sell-side to pick up coverage over the next 12 months.