The Base Case Is Bullish For HealthSouth

HealthSouth Corporation (Ticker: HLS) operates post-acute rehabilitation centers across the country, with locations more focused in the southern U.S. Their business model is quite simple, they provide physical rehabilitation services based either in their facilities or at an individual’s home. As of December 31, 2014 they acquired Encompass, which broadens their care base to both home health and hospice. Home health provides assistance for individuals at home who require aid in their daily lives, while hospice care is for individuals with terminal diagnoses.

HealthSouth’s business model is extremely dependent on their employees, and as a result they have limited economies of scale. Margins are also pretty standard, as Medicare only gives a ‘market basket’ price increase and HealthSouth itself gives their employees an equivalent increase in salary. The business model is extremely dependent on the quality of people they have interacting with and treating patients. HealthSouth understands the importance of their workforce and as a result they have given a 2.75% and 2.25% wage increase for non-management employees in 2016 and 2015 respectively. Management recognizes where their core competencies lie and invests in their human capital. While they do not overleverage their employees, they do focus on increasing efficiency in realistic ways. They are not ignorant to technological trends, and are actually quite advanced in their adoption of analytics software as I will touch on later.

Healthsouth’s expansion model is really quite simple, focus on operational excellence and efficiency wherever possible and acquire new treatment centers with capital raised either from equity, debt or operating cash flows. ‘Operational excellence’ is an easy term to use for a multitude of companies, so how can we quantify their alleged operational excellence?

To start, we have their return metrics, which show their ability to allocate and invest capital effectively.  Their five-year average return on invested capital is still 14.64%, even though has been decreasing recently as a result of higher premiums being paid for acquisitions. HLS targets specific patient densities in the markets they acquire, which aids in their lower cost per patient than the industry average. They utilize proprietary data analytics software to analyze trends and create custom reports allowing them to quickly identify problem locations and other issues. Encompass also utilizes a proprietary software they developed to serve the same purpose. Finally the combination of post-acute rehabilitation with their acquisition of the in-home health care provider encompass allows them to see a patient through the entire recovery process, maximizing revenue per patient.

Post-acute and in home health care is an extremely segmented market, and HealthSouth’s size allows them to make investments in their analytics, along with their supply chain, giving them an advantage that smaller companies and individual providers can not afford to make. The company specific advantages I outlined combined with the unavoidable demographic trends and healthcare spending increases we have seen in the U.S. make HLS a strong operator in a market poised to catch multiple tailwinds.

If HLS is such a glaring buy, then why isn’t it already priced in? I think there are two main factors keeping HLS from being efficiently priced. The first is uncertainty surrounding healthcare reform. There have been multiple efforts to repeal and replace the Affordable Healthcare Act. With the failure of the most recent effort, I believe this uncertainty is past us. HLS derives 82% of their revenues from Medicare and Medicare Advantage, so it would make sense that this risk was being discounted. The second aspect that I believe investors are discounting is Healthsouth’s debt-load. They have roughly $2.9 billion in debt compared with a market cap of $4.6 billion. While this is a significant amount of debt, management has been very savvy in how they handle it. They recently refinanced their senior notes from an average coupon payment of over 7% to just over 5%. Their acquisition of Encompass for almost $700 million was done using debt from their revolving credit facility with a coupon rate of less than 3%. When money is cheap, they are not hesitant to take advantage. Furthermore, while their debt is rated B+, bond investors seem optimistic about HLS’s ability to pay, as the debt is trading above par. Lastly, they have pretty robust coverage ratios, for example their EBITDA coverage ratio is 4.9.

HealthSouth is currently trading below their 5 year average P/E, P/B, and P/Free Cash Flow and in line with historic EV/EBITDA. My discounted cash flow valuation which assumed roughly 2-3 acquisitions of inpatient rehabilitation hospitals per year (in-line with historical acquisitions) and moderate growth in their home health and hospice segment (equal to inflation + projected growth in Medicare subscribers) arrived at a 20% upside. This valuation utilized their current EV/EBITDA ratio as an exit multiple and a conservative 10% WACC, as I felt their actual WACC of 5.7% did not adequately represent the risks I outlined. This base-case modeling scenario demonstrates why HealthSouth is ready to realize its true value.