Description

Rotech Healthcare Inc., (ROHI - $14.00) is a post-bankruptcy security with $190 million in EBITDA trading at 4.5x EV/EBITDA, which is a 50% discount to its closest peer. Rotech equity was distributed to Integrated Health Service (IHS) debt holders this spring as part of the Chapter 11 reorganization of IHS. Rotech is the number three player in the home health care business behind Lincare Holdings (LNCR - $34.30) and Apria Healthcare Group (AHG - $25.00). These companies provide three specialized services: respiratory therapy, home medical equipment and infusion therapy. The business generates solid free cash flow which has been used by the large public companies to make small, highly accretive acquisitions.

Lincare Holdings trades at a healthy 20 times 2002 eps and 10.0 times 2002 EV/EBITDA. You could easily argue that the valuation is appropriate given the company’s stellar track record. The top line has grown at 18% CAGR over the last five years with a steady 30% operating margin and 40% EBITDA margin. Rotech has a business mix that is similar to Lincare in terms of payer mix (60% Medicare/Medicaide) and is exposed to similar demographic trends and acquisition opportunities. Rotech would also argue that being in rural areas creates a less competitive environment and more opportunity for tuck-in acquisitions (offset by some loss in efficiency). The margin at Rotech is considerably lower than Lincare, as a result of the rapid acquisition led growth of the company which has yet to be fully consolidated because of the distraction of the IHS bankruptcy. Lincare also has a higher percentage of respiratory therapy than Rotech at 90% as compared to 75% for Rotech. Rotech finds that providing DME (durable medical equipment) in rural markets enhances its referral network.

Rotech is traded on the pink sheets (CRT is the axe) as a result of the recent distribution and the lack of SEC filed financials (which will be filed shortly). The company will perform a secondary to distribute shares owned by the debt holders by the spring of 2003. The new capital structure is as follows:

$200 MM six year term loan
$75 MM five year revolver
$300 MM 9.5% sub notes due 2012
25 MM shares of common stock

The stock is trading at $14.00 and the revolver has not been drawn so the enterprise value is approximately $850 MM. The company should do $190M in EBITDA in 2002 for an EV/EBITDA multiple of 4.5 times.

So, why the huge discount to Lincare? Rotech announced on July 3, 2002 that an independent contractor defrauded the company by fabricating documentation for nonexistent sales of medical equipment in bulk to the Department of Veterans Affairs (The VA was never billed for these sales). This fraud affected $21 MM in revenue and $11 MM of EBITDA for the 2001 year, and $4 MM of revenue and $2.5 MM of EBITDA in Q1 2002. The company notified authorities, announced the matter to stakeholders and hired Latham & Watkins and Navigant Consulting to conduct a comprehensive internal investigation of the company and its internal controls. The company then announced on August 13, 2002, they were going to be late in reporting the Q2 2002 financial results pending the completion of the investigation and KPMG finalizing the 10Q. This delay put the company into a technical default on the sub notes that they have 30 days to cure. Finally (as if that was not enough!) on August 20, 2002, the company announced the resignation of the CEO and the departure of the COO at year end. The board took an aggressive stance with management in order to put this issue behind them as soon as possible by placing the blame of the lack of earlier detection on senior management. The company is being managed by Guy Sansone who is a director of the turn-around interim management firm of Alvarez and Marsal, which managed the Company until its emergence from Chapter 11 on March 26, 2002. The company has hired the executive search firm Spencer Stuart to assist in identifying a new CEO.

So now you are getting the picture. A pink sheet post bankruptcy equity in the hands of distressed players, in technical default, discovering fraud during the summer of Worldcom and Adelphia. That is why the stock dropped from $30.00 to $14.00.

So what is it worth? I believe the answer is that the business is worth at least the 6x EBITDA multiple it was trading for prior to the announcement of the fraud. It is important to emphasize that the fraud was isolated, identified by the company, and has a very small one time financial impact. The investigation is largely complete and has not uncovered any other issues in the company’s financials, accounting or internal controls according to management on their August 14th conference call. The business has the same growth opportunities and efficiency opportunities that existed prior to the news. The 10Q should be filed in time to cure the technical default as KPMG appears to be close to putting together the data from the consulting studies which they supervised.

The company is capable of producing $190 MM in 2002 EBITDA and we estimate $220 MM conservatively for 2003. Lincare is trading at 8.5 times 2003. My target for Rotech is 5.5 to 6.5 times 2003, or $28.40 to $37.20 per share assuming no debt pay down or share repurchase. Subtracting $46 MM in annual interest, $60 MM in capital expenditures (maintenance plus growth) and $20 MM in cash taxes (my estimate) from 2003 EBITDA projections results in the generation of $94 MM in free cash flow. The enterprise is currently trading at an 11% FCF yield. At $30.00 per share the free cash flow yield would be a more appropriate 7.5%

Risks: There are two primary risks to the story both of which are regulatory in nature. (1) Reimbursement of respiratory drugs could be cut once again (it was last cut by 25% in 1998). My Washington contacts think the chance of passage this year is very low (there is no consensus in Washington and the legislative year is coming to a close)and that there is the potential for service charge increases to offset and revenue lost from drug reimbursement if the AWP (average wholesale price) method is revised. Rotech’s exposure is roughly $120 mill in revenue (with high gross margins); And (2) competitive bidding for Medicare home health contracts. Rotech has performed very well in a test market Arizona study of competitive bidding. The large players will likely benefit from efficiency that smaller players lack. There is no consensus for how to phase in competitive bidding or what minimum standards would be required. Contacts in Washington suggest that as part of a Medicare Provider’s Bill (that will address the “SNIF cliff”) to be pushed in September competitive bidding will be raised again. Rotech experienced a 10% margin hit in the Arizona study, so overall you could see a 5% reduction in EBITDA (50% Medicare) as competitive bidding is phased in over a three year period (1.66% per year).

Both of these risks can be hedged by shorting Lincare. I generally am not a fan of pairs trades, or shorting great companies, but Lincare would be hit much harder than either Rotech or Apria because of its business mix,the nature of its investors, and its “priced for perfection” valuation.

Catalyst

I see four potential catalysts for Rotech: (1) The filing of financial statements over the next few weeks will ease the concern that there is more bad financial/accounting/fraud related news. Investors have been hurt by being early in these situations and will wait to see the final restatements and/or charges. (2) announcement of new leadership will be an important catalyst for the stock which will be followed by more visibility with “vanilla” investors through analyst coverage, and (3) a secondary offering of shares to redistribute from debt holders and reduce the over hang from the bad technicals in the distressed market. (4) Rotech is a possible takeover candidate and would be an accretive acquisition to both of their competitors (e.g., Lincare) or an industrial gas company that is looking to diversify into higher margin, less cyclical businesses. With the management vacuum and the concentrated, short term performance driven shareholder base, a buyer may have an opportunity to acquire this franchise cheaply.