Last night, I was reading this compilation of value investing articles by Bruce Greenwald while watching the Sugar Bowl. Two paragraphs from the article really stuck out to me.
HMOs are a good example of this sort of value stock. They once had a very positive financial story,and were seen as socially progressive too, a force for good. The idea of integrated healthcare that isan HMO, with doctors and hospitals and patients all members of one health organization, was firstdeveloped by the industrialist Henry Kaiser. He thought this would lead to healthier and happierworkers, and he offered a type of HMO to workers building his Hoover dam. It was a successfulexperiment by every measure. Today, HMOs are seen as a force for bad. Their perceived function is to deny healthcare. They were attacked in Michael Moore’s film, Sicko. A reformed U.S. health system could someday eliminate them. Needless to say, with their uncertain future and unpleasant present, HMOs have become a value stocks.
Finally, people are over-confident. For Greenwald, the link to value stocks is the fact that investors are overconfident a certain scenario will occur, and this applies to both the upside and the downside.We think a growth stock will continue to grow and a value stock will only continue to go down.Possible scenarios are interpreted as certain scenarios. When people think stocks are going to do well, they overbuy those stocks. And stocks that look bad, that might be facing trouble, are priced as if that trouble is certain.
Those paragraphs got me thinking about a sector similar to the HMO’s: the home healthcare providers, specifically Almost Family (AFAM), Gentiva (GTIV), LHC Group (LHCG), and Amedysis (AMED).
Before we dive into these stocks, let me start off by saying I’m no expert on the industry, and I investigated these stocks more as a basket just for general knowledge about the companies than the deep dive through the financial statements I would normally do.
That in mind- until a couple of years ago, these stocks were the growth darlings of Wall Street. They enjoy secular tail winds from the aging population and the fact that, in general, they are both cheaper and better than staying in a hospital. However, in 2011, Medicare cut the payment rates recieved by the companies by 5% and plans on another cut in 2012. Combine that with some accounting issues and rumors of gaming the reimbursement system, and the stock have become multi-year dogs.
Now, however, these are some of the cheapest stocks I’ve ever seen when looked at on a trailing basis- all but LHC are on the magic formula list and have been so for quite a while. GTIV has the highest multiple of the group, trading for just over 4.5x EV / EBITDA and just over 1x book value, though that’s likely because the company is incredibly leveraged. Most of the others trade ~3x EV / EBITDA and well under book value.
However, I don’t even think those metrics show quite how cheap these stocks are. Instead, consider this- most of these companies trade for less than the value of an acquisition they did within the past two-three years. AMED, for example, has an EV of ~$450m. In 2008 alone, they paid out over $475m for acquisitions (including one massive ~$400m acquisition). GTIV trades for just over $1b but spent just under $1.1b in a 2010 acquisition of Odyssey. Most of the acquisitions I’ve seen have been on the higher end of a 1.0-1.5x sales range. To put that in perspective, it would mean AFAM would have to ~3x in order to approach the low end of that range. Due to its leverage, Gentive would see about 5x in its stock with a return to the lower end of those levels.
So why are these companies so cheap right now? They’re undergoing three big problems. First, Medicare rates declined 5% in 2011 and are set to decline again (by ~2.5%) in 2012. Given the ongoing budget woes for the U.S., it wouldn’t be surprising to see further cuts in the future. Second, they’ve all had a cloud hanging over them from an on-going investigation into wrongful billing practices. It looks like most of the companies are settling, so the cloud should go away…. but they’re settling at huge costs, and there’s no guarantee that it doesn’t happen again in the future. Finally, results for the year are flat out coming in weaker than expected, even factoring in the reduced expectations due to reimbursement cuts. Perhaps this is related to new competition entering the relatively low moat arena, or maybe mgmt distraction from the on going court cases.
One interesting thing that I do think has been overlooked in the general melt down of these stocks is the potential to buy each other out. There are real synergies to be had from merging- mainly through cutting out overlap in markets and consolidating back office functions, though my understanding is bigger companies also have an easier time getting reimbursed by medicare (though I don’t know if that’s true or not). While it might be difficult for them to find the financing for a deal right now, given they’ve historically used quite a bit of leverage in deal making, it’s not completely off the table.
Most of them also have a pretty strong history of repurchasing shares. As the clouds over the industry lift, they could start to buy back large amounts of shares, leading to a nice appreciation in the stock price.
Overall, this is a high risk/ high reward play. You glance at the industry and your first reaction is “ewwwwww. No way.” But remember the Greenwald quote- that’s exactly the type of reaction you want when you investigate an industry. It means there could be value hiding somewhere. And it’s really not hard to project a scenario where medicare makes a couple of further light cuts and all of these companies are massively undervalued compared the their cash flows.
I really wish there were some LEAPs available on these companies so we could make a LEAP play similar to last week’s with Radioshack (RSH). Unfortunately, the longest call available is AMED’s Jan. 2013, which trade for a very wide spread and aren’t long dated enough for me to be comfortable with. Instead, I think the best approach is to either 1- short puts close to today’s price to take advantage of the ridiculously volatility in the stock prices and go long them if they drop a bit further or 2- just take a basket approach and by a bit of all four companies. That way, individual noise from settlements and other bad things go away and you’re just investing in a basket of super cheap stocks in a hated industry. Either way, good luck!
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