Let’s start by taking a look at the home health care business. In general, AFAM provides home health nursing services to elderly patients who are recovering from a period of hospitalization and need special nursing care. After their hospitalization, patients have three choices — they could stay in a long term hospital, move into a nursing home, or live at home and receive home health care from AFAM.
The choice for patients is pretty easy. They’d much rather live in the comfort and privacy of their own home than in a nursing home or hospital.
And the choice for Medicare is pretty easy too. Patients prefer to live in their homes, and the cost per day of providing home health care ($150 per day) is one-tenth the cost of living in a hospital ($1,500 per day) and less than half the cost of living in a nursing home ($325).
Cheaper, and more comfortable. Even the government has a hard time messing that choice up.
And that’s been the key to the home health care industry’s explosive growth over the past decade. Combine convenience and cost savings with a rapidly aging population, and you get an industry that grows at an absolutely explosive rate.
And with the baby boomers set to retire, increasing the senior population by 15 million (almost 40% growth!) over the next decade, there’s plenty of room for more growth in the future (That’s between 8,000-9,000 new customers per day).
In addition, while barriers to entry are relatively low, this is a “local” market business very dependent on referrals from physicians, hospital discharge planners, social workers, etc. The local nature of the business makes it very difficult to enter a market in size once several players have established themselves, so each market naturally forms something of an oligopoly, with two or three big players controlling a majority of the market and dozens of smaller players controlling a tiny fragment of the market.
Returns on capital
So just how great are AFAM’s returns? At their most recent quarter end, the company employed just under $115 million in tangible assets, and that might be overstating how much capital the core business actually employs.
Of the $115 million in assets, almost all of it consisted of cash ($55.4 million) and accounts receivable ($41.1 million), and with almost no debt and just $40.1 million in total liabilities, almost all of that cash can be considered excess. Of the $115 million in assets, only a fraction ($4.3 million) consisted of property plant and equipment. In other words, this is an incredibly asset-light business
So how much did AFAM earn on that $115 million? Employing just $115 million in capital, AFAM earned $48.7 million in operating income for a return on tangible capital of over 42%! If you adjust for excess cash, the return on capital exceeds 81%, and if you adjust for current liabilities (like the actual magic formula does) returns exceed 157%!!!!
To put those returns in perspective, it puts almost every other business on earth to shame. Dell (DELL) is no slouch, and their return on capital is below 20%. Aeropostale (ARO) has one of the best returns on capital of any company in the world, but (even after adjusting for their excess cash) their returns on capital are only around 75%. Among the few companies whose returns can match or exceed AFAM’s are dominant tech companies with huge moats and little to no marginal cost of production such as Google (GOOG), Microsoft (MSFT), and Apple (AAPL).
At its current price of $27.23, AFAM trades for a market cap of ~$255 million. With over $55 million in cash and just $1.5 million in debt, their EV comes in at about $200 million. With trailing twelve months EBIT coming in at $48.7 million, the company currently trades for just 4.1x EV / EBIT.
That level of valuation would be more consistent with a business in terminal decline like Earthlink (ELNK), a pure play dial-up Internet company, not a business with huge demographic tailwinds and outstanding returns on capital like AFAM. As a matter of fact, Earthlink’s current EV / EBITDA of 3.98x is almost exactly AFAM’s current 3.99x.
So why the overhang on the stock?
Two reasons — first, reimbursement rates for home healthcare services were cut by about 5% this year under the new healthcare budget, and the outlook is for them to be further pressured in future years. While it looks like future cuts in payments will be much smaller, Wall Street hates uncertainty, and it’s certainly weighing on the stock.
However, remember this — it’s in the government’s best interest to let these companies continue to make a profit. If they cut all of the profit out of this business, then the elderly will be forced to stay in hospitals, where they will be less comfortable and cost the government 10 times as much. It behooves the government to let these companies maintain healthy profit margins, because then they can actually expand and save the government money!
The other overhang stems from a federal investigation into certain home healthcare companies (including AFAM) resulting from a Wall Street Journal article exploring the relationship between the companies and some of their reimbursement and utilization rates. Obviously, the lawsuit is a very serious risk.
The headline risk from these two regulatory concerns is very serious and very scary. But this is exactly the type of opportunity a basket of magic formula stocks is supposed to take advantage of. While anything is possible, it’s doubtful the lawsuit results in a penalty that permanently impairs AFAM’s long term earnings power, and it’s in the government’s best interest to allow AFAM (and the other home healthcare companies) to continue to profitably grow.
Wall Street hates uncertainty and avoids this stock like the plague because of these two risks. Anything can happen, but if you invested in a situation like this (a high quality, high return business facing regulatory risks that have almost no bearing on the long term value of the business) one hundred times, you’d almost certainly significantly outperform the market.
Valuation, part deux
The first time we looked at AFAM, we just established they were trading like a dying business, not a business with huge growth tailwinds. Now let’s take a harder look at how much they’re really worth.
First, let’s take a look at what AFAM trades for compared to its peers. (Note — EV / EBITDA represents this year’s estimates from Bloomberg. All data as of business close June 7, 2011).
Despite returns on capital at the top of their peer averages, AFAM trades for the lowest valuation of any of its direct peers. And that’s not AFAM’s only advantage over its peers. AFAM also employs the strongest balance sheet and derives 50% of its revenue from Florida, the state which should have the fastest growth in senior citizens (and thus, the fastest growth in demand for home health care services).
Let’s take a look at AFAM from an acquisition angle. Gentiva made one major acquisition last year, purchasing Odyssey Health in August in a deal that made them the largest home healthcare company. The deal valued Odyssey at 1.29x EV / Sales and 10.23x EV / EBITDA. Amedisys just closed a buyout of Beacon Hospice for $125 million that valued Beacon for over 1.5x EV / Sales. Applying those multiples to AFAM would imply a target price of at least $50 per share, almost a double from today’s prices. And with the company’s CFO recently admitting the industry is ripe for consolidation, AFAM could be an acquisition target sooner than later.
So there you have it. Almost Family. There certainly are some risks, but as part of a magic formula basket, it makes an incredible addition that is likely to significantly outperform the market over the next year.
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