Description

Thesis

SEM is currently undervalued as the market is still valuing it like an LTAC provider despite the segment shrinking to ~35% of revenue. LTACs are viewed very unfavorably given the recent reimbursement pressure. However, the company is getting back to its founders’ roots as a Physical Therapy provider. Additionally, after the most recent bout of pressure from CMS rate cuts, surviving LTAC providers will actually be in a favorable position to grow occupancy and profits.

I think SEM will be a $30 stock in 18-24 months based on 10x my 2020E EBITDA – NCI of ~$750M (2018 consensus of $652M). I’m assuming marginal multiple expansion with most of the value increase coming from US Healthworks integration and continued recovery in the LTAC segment that will begin to accelerate as reimbursement changes force competitors to exit the business (levered PE entities). Industry participants estimate that 25% of beds will be closed and every 1% occupancy for SEM is ~$8M EBITDA based on a 30% incremental margin.

Company Description

Select Medical (SEM) is a healthcare provider based in Mechanicsburg, PA. The company was co-founded in 1997 by Rocco and Robert Ortenzio who were both Physical Therapists. Shortly after, the company began providing long term acute care services in 1998. The company acquired other LTAC providers in the late 90s making LTAC patients the primary business driver. SEM was then taken private in 2004 by Welsh Carson in front of CMS legislation that would seek to prevent the number of patients an LTAC could receive from any individual hospital source.

SEM operates in 4 segments: Long Term Acute Care, Inpatient Rehab, Outpatient Rehab (Physical Therapy), and Concentra (Occupational Health). The company recently acquired US Healthworks from Dignity Health and combined it with the existing Concentra business to create the leader in Occupational Medicine and Urgent Care. USHW was acquired for $753M and Dignity was given a 20% interest in the combined Concentra business.

Segment Descriptions

LTAC (35% of revenue) – Hospital step down units for patients in critical but stable conditions (on a ventilator). Important differentiator for SEM is their Hospital within a Hospital (HWH) model where they lease space from a normal hospital. 42 beds on average per hospital. The facilities are significantly smaller than freestanding LTACs that Kindred would operate (75 avg beds). CMS did implement a rule that only 50% of admissions can come from the connected hospital, but that rule is currently sidelined until Oct 2019 and could be done away with entirely.

IRF (13% of revenue) – Also employs the HWH model. IRFs are basically physical therapy facilities that the patient stays in. Typically they are recovering from intense surgeries or something like a stroke where they must learn to perform basic human functions again like speaking or walking. The largest IRF provider is EHC. This is the fastest growing segment for SEM as they expanded relationships with their LTAC hospital partners to grow the IRF business. Notable partners include Cleveland Clinic, UCLA/Cedars Sinai, Baylor, Ochsner, Emory, U of Florida, among others.

Physical Therapy (20% of revenue) – Standard physical therapy business to help recover from basic injuries. USPH is a competitor in Physical Therapy that has been a monster stock. I won’t bother going through the STOP exercise as I believe there is a very low likelihood of an asset sale.

Concentra (32% of revenue) – Largest provider of Workers Comp related rehabilitation. Workers comp makes up 53% of revenue for the segment. SEM acquired Concentra from Humana in 2015 and subsequently doubled EBITDA margins.

Long Term Acute Care: LTACs are facilities that act as step down units for patients that are in critical but stable conditions. Kindred actually “invented” the business and is the other large LTAC player with about 40% market share based on number of facilities. SEM currently has ~30% of the LTAC market based on admissions.

Payment Structure: LTACs are paid at the “LTCH rate” set by CMS each year which is about $1650 / day as long as >75% of their patients stay for 25 days. This is expensive, but about 30% less than having the patient stay in the STAC hospitals. Cynics can immediately spot the incentive for profit seeking companies that could simply keep patients in the hospital for longer than clinically necessary in order to manage their average LOS and therefore reimbursement.

This happened in practice and the industry expanded as a step down setting for stable patients on ventilators and operators began taking other patients that should not be in their hospitals such a wound care patients waiting for their infections to heal. There are lower cost venues where those patients could be cared for which costs the government money.

Medicare spends about $5B on LTAC providers according to recent Medicare Payment Advisory Commission (MedPAC) data. A large sum of money no doubt, but it’s about 0.7% of Medicare’s total spend.

Reimbursement Changes: CMS was keen on this dynamic as the industry had greatly expanded since the 1990s. In response, they changed how the LTAC game was played by making the new reimbursement require the patient to either be in the ICU of a STAC for 3 nights OR be on a ventilator in the LTAC for >96 hours. If patients did not meet this criteria, the LTAC will be reimbursement at the “Site Neutral” rate which is the rate of a comparable Prospective Payment System (PPS) of a lower cost site (likely Skilled Nursing at $250 / day) or the Cost of Services, a rate far below the current LTAC cost structure.  These are the patients LTACs were originally meant to treat so CMS explicitly stated such in the new ruling introduced that went into place beginning on the hospitals cost report for the 2016 Medicare fiscal year (starts October of the previous year). The rule was originally meant to be phased in over 2 years to be fully implemented for the Oct 2017 fiscal year, but CMS pushed the rule out for 2 more years as to not meaningful impact access to care (bed closures).

SEM opportunity: This is an opportunity for SEM as they are a “good actor” in the LTAC industry and were predominantly accepting “Compliant” patients in the first place. The company proactively chose to strictly accept LTAC compliant patients beginning during the blended phase in unlike competitor LTACs which continued to accept Site Neutral patients as reimbursement remained attractive before a full phase in. The decision to strictly accept compliant patients explains the Specialty Hospital segment profitability hit in 2015/2016. As a result I think SEM will exceed their prior peak occupancy of 71% from the current level of 66% where every 1% is ~$8M of incremental EBITDA. Timing is less certain and the build was definitely pushed out when CMS extended the blended payment period, but I still believe it’s a when not if.

I will include more data in the comments as this is more of an overview of what’s taking place in the industry.

Risks

Like many healthcare providers there is a lot of leverage here and it will cut both ways

If CMS were reverse their reimbursement decision that would alter my estimate of potential upside from market share shift

Catalyst

Marginal LTAC providers close beds over the next 2-3 years and patients accrue to remaining industry participants

SEM integrates the recent USHW acquisition and expands margins to 15-16% from 11% today