Encompass (“EHC”) is on the right side of trends both before and after Covid-19.  It’s also unimpacted by the economy and trades at an unwarranted discount versus historical and peer valuations.

Business Overview

EHC has two businesses. The largest is specialty hospitals called Inpatient Rehabilitation Facilities (“IRFs”) where EHC has 134 facilities, $3.5 billion in annual revenue, and is the 800-pound gorilla in the industry with no close peer. The second business at Encompass is home health, which has natural synergies with IRFs and where EHC is the 4th largest player in the United States. This business has 245 home health locations, 83 hospice locations, and $1.1 billion in annual revenue. The vast majority of company revenues are from Medicare or Medicare Advantage and both benefit from baby boomers and the continued aging of the US population.

IRF Background

In 2018, Encompass served 31% of Medicare patients who went to an IRF.  To further put EHC’s size into perspective, EHC had $3.5 billion in IRF revenue in 2019, and the next largest player, Select Medical Holdings Corp. (Ticker “SEM”) had $671 million.  For-profit providers like EHC and SEM represented 56% of Medicare discharges in 2018 and have much higher margins than non-profit players. In 2018, Medicare disclosed that all for-profit IRFs had aggregate margins of 24.6% compared to just 2.4% for non-profits. This makes it difficult for Medicare to cut rates further without driving more non-profits out of business. While EHC IRFs have higher margins than non-profits, Medicare also pays EHC less per discharge even with EHC treating higher acuity patients. EHC also drives better outcomes than the rest of its peers. This is possible because most competing IRFs are small units in larger hospitals and not core to what the hospital focuses on. EHC also benefits from scale and the sharing of best practices and equipment across its facilities.

It is a misconception to think of IRFs as rehab facilities for weekend warriors on VIC who get knee replacements at 45 years old. Unless they have other complicating conditions, they are unlikely to qualify for an IRF.  More likely at an EHC IRF would be a senior who is diabetic and could have both knees replaced at the same time. The average age of an EHC IRF patient is 71 years old. About 50% of people admitted have severe brain dysfunction, neurological conditions such as Parkinson’s Disease, and/or have recently suffered from a stroke.  These people have conditions too severe to be able to go directly from an acute-care hospital to the home. Most come to the IRF through medical transport (i.e., an ambulance) and they need 24/7 nursing care while also receiving intensive rehab that is provided at an IRF. It is physical therapy on steroids for people where it is medically necessary. After an average stay of about 13 days, patients are ready to be discharged. About 60% of patients are not ready to be on their own yet and receive home health as the next part of their recovery journey.

Home Health Background

At the beginning of 2015, the company (then known as HealthSouth Corporation) significantly expanded its home health & hospice business by acquiring Encompass Home Health, and subsequently changed its name to Encompass. This was a great acquisition for Encompass as the combined company now had the potential to keep a larger number of patients being discharged from its IRFs and ensure the continuation of care from a patient perspective. The acquisition also made sense because both entities had best-in-class management teams with industry-leading service and margins.  

The Encompass Home Health management team, led by April Anthony, joined the merged company after the acquisition. The praise we have heard in the field for April Anthony ranks up with the best of management reference checks we have done.  In addition to running the Home Health business, April Anthony created Homecare Homebase, the predominant software tool used by the entire industry. Encompass has among the highest home health margins in the industry, which can be attributed to April being among the best operators in the entire industry, including her and Encompass knowing how to take advantage of the software better than anyone. It is also noteworthy that in February and March 2020 April Anthony invested a total of about $55 million in EHC stock.

There is a lot of potential to drive further synergies (aka “clinical collaboration) between EHC’s IRF and home health businesses (as well as from home health to hospice). In 2019 EHC IRFs had 186,842 discharges, with ~59% or about 110,000 being discharged to home health. However, only 24,560 or 22% of those discharges went to an EHC home health agency. EHC has the potential to drive outsized growth in home health as it captures a much greater percentage of those discharges over time. Part of this will be through additional M&A to increase overlap. Of EHC’s 134 IRFs, 89 have an EHC home health location within that service area. A second part is driving increased referral rates in regions where there is overlap. In those markets, the clinical collaboration rate has increased from 18.5% in 2015 to 35.6% in 2019. Company guidance is for this to increase to 40% in the near-term and to 60% over the long-term.

The home health industry is extremely fragmented.  Encompass has just a 4% market share and the four largest home health companies have just 20% market share. The remaining 80% of the market consists of about 12,000 providers. Our contacts support our view that a “perfect storm” of events and regulatory changes leaves the larger players well-positioned to grow organically at accelerated rates through market growth and by capturing market share from smaller players.

 Currently, less than 10% of Medicare beneficiaries receive home health services, even though caring for patients in the home is the most cost-effective version of healthcare and has been shown to drive better outcomes. Elderly people also prefer to receive care in their homes which makes home health a “win-win” for both the payer and patient. Part of the reason for low penetration is antiquated regulatory restrictions. Such restrictions include (1) home health only being able to receive referrals from doctors (i.e., not nurses), (2) only being able to treat people who cannot physically leave their home on their own (i.e., the homebound requirement), and (3) restrictions on providing telehealth services.  The CARES Act that was implemented due to Covid-19 has removed or loosened each of these barriers.

Home Health: Patient Driven Grouping Models (“PDGM”)

Before Covid-19, the smallest players in the home health industry were already reeling from the January 1, 2020 implementation of PDGM, which fundamentally changed the way home health is reimbursed and when payments are made. Our contacts told us that this is the biggest change to the industry in 20 years and many mom & pops are overwhelmed as they weren’t well prepared for it. Many were losing money or had razor-thin margins to begin with and relied on upfront funding that is going away. The Centers for Medicare & Medicaid Services (“CMS”) estimated that 30% of providers would leave the market as a result of PDGM alone.

One big change with PDGM is that there is also a very large reduction in the reimbursement rates for therapy services. The highest rates are now paid for more acute areas where patients tend to be critically ill. So, like in IRFs, the focus is less about therapy for a 50-year old getting his knee replaced and more about referrals of elderly patients from acute settings like hospitals and IRFs.

PDGM makes having both the IRF and Home Health business even more complementary and valuable together. While many providers are struggling to shift both their referral sources and mix of therapists and nurses to provide home health services and stay in business, you can argue that PDGM was a gift to EHC. It’s home health business already has natural referrals from the IRF and with smaller players leaving the market as a result of PDGM, EHC will have an easier time gaining market share.

Home Health Covid-19 Impact

On its 1Q20 earnings call Encompass highlighted that “the effects of PDGM have been greatly exacerbated by the Covid-19 pandemic”.

Home health referrals have slowed due to lower overall activity in the hospital. About 10% of EHC home health business relates to elective procedures This is compounded by volumes slowing as many elderly patients who are at high-risk for Covid-19 are refusing all or part of their treatments. Costs are also up, including the need to secure protective equipment (PPE). This is more of a body blow to the smaller and less sophisticated providers who were already hurting from PDGM.

The CAREs Act stepped in and provided loans and funding to smaller players, essentially acting as a temporary lifeline. Once many of these loans need to be repaid, many smaller providers will be in a worse situation than before and look to sell (at reduced multiples) or exit the business entirely, which will benefit Encompass and the other large home health providers.

The remaining players will also benefit from the CARES Act removing or loosening regulations, many of which have a good chance of sticking in at least some form going forward, and will help drive volumes to rebound from lows seen in March. The CARES Act has increased the number of potential referral sources by permanently allowing nurses and physician’s assistants to certify and recertify home health plans. Before only doctors could do this and created large bottlenecks. The potential pool of people who are eligible for home health has also been increased due to a loosening of the homebound requirement, which previously dictated that providers could only treat people who cannot physically leave their homes on their own (i.e., the homebound requirement). CMS has not fully given the go-ahead for telehealth services to replace in-person visits. However, they have opened the door to allow for fewer visits and increased conversation regarding telehealth going forward.

We see catalysts going forward as the regulations are permanently changed or loosened.  All of them make sense in a post-Covid-19 world and as people get used to something they like it is hard to take it away. Big picture, Covid-19 is also driving more of a focus and preference towards care in the home which will benefit the industry. 

IRF Covid-19 Impact

The vast majority of people at IRFs are not there for elective procedures. Less than 4% of the patient mix is for replacement of a lower extremity joint such as a knee replacement – and those would be in elderly patients who have other medical problems. It is medically necessary for the patients to receive treatment and the reason they are at an IRF is that they can’t be treated at a home. For instance, if you are 76 years old and had a stroke and can’t walk or speak properly, you didn’t control the timing of when this happened to you and you need to go to the IRF before being released to the home (where you will receive additional but less frequent service).

Even with this, EHC’s IRFs saw an initial hit due to Covid-19 as everything slowed. In early March, EHC reported seeing a 35% drop in patients with neurological conditions and a 20% decline in stroke patients. Part of this could be because hospitals had extra room and were keeping patients longer, but otherwise, those declines aren’t at all sustainable and should quickly bounce back.

One area where EHC is seeing lower volumes is related to accidents as people shelter in place. “Fractures of lower extremities” and “other orthopedic” (typically other fractures) account for about 16% of the patient mix and saw declines as a result of fewer falls as people stay on their couch.

As part of the CARES Acts, CMS has waived several requirements that previously limited the number of people who could qualify for stays at IRFs. For example, CMS temporarily suspended the requirement that patients be able to tolerate at least 3 hours of therapy per day.

On its 1Q20 earnings call, Management indicated that the IRF business was rebounding quickly and dynamics could return to normal soon. Importantly, Management said that absent a 2nd or 3rd Covid-19 wave, we could see 2021 levels consistent with previous expectations.

Growth Expectations

The average age of EHC patients is 76 and the population group ranging in ages from 75 to 79 is expected to grow at approximately 5% per year through 2026. Also, one would expect EHC to continue gaining share in both businesses, including continuing to add new beds to the IRF business and continuing to take advantage of secular shifts to home and hospice care. So absent rate cuts by Medicare, EHC seems like it should be at least a mid to high-single-digit grower going forward.

Historical IRF guidance has been for same-store growth of about 3%. However, at the March 4th investor day, the company raised its long-term growth guidance through 2025. The company sees opportunities to add more beds in existing facilities to meet demand resulting in IRF discharges growing at 4-6%. Same-store growth in January and February 2020 was right there at 5.4%.

EHC also gave long term guidance that home health admissions were expected to grow annually at 10+% and hospice admissions at 10 – 15%. Given that medium and long-term dynamics have improved since then due to easing of regulations, more pressure on smaller competitors, and an overall increased desire for people to receive care in their homes, we think that these estimates could be quite conservative. 

EHC guides for annual tuck-in home health & hospice acquisitions of $50 - $100M per year. EHC says that it can go above that for larger deals. EHC has leverage of 3.6x EBITDA, which is above the historical leverage target of 3.0x.  Therefore, if EHC pursues much larger deals above its target range, it potentially risks taking leverage to levels not perceived well in today’s market where strong balance sheets are key. However, there are several mitigating factors.

EHC doesn’t have any significant debt maturities until 2023 and it has no economic risk given that the government is the main payor. It also owns about 70% of its IRF real estate which gives the company additional flexibility. Before PDGM and Covid-19, on an EBITDA basis, home health providers that are profitable can typically be acquired at 8 – 10x EBITDA and it is likely to decrease going forward in a buyer’s market. So EHC will be able to make cash acquisitions that could still be accretive and not raise the leverage profile. Finally, a lot of smaller players have been closing or will close, which will allow for the natural absorption of market share to EHC.

Even its higher-valued pure-play competitor Amedisys (“AMED”) says that it still wants to focus on hospice acquisitions as it feels like there will be a lot of natural absorption of market share in home health.

Valuation

There are no great comps for the IRF business at EHC. As a result, to value the IRF business one is left looking at the historical valuation of EHC combined with your expectations of where it should trade at going forward.

If we look at 2021 (which would be after things are normalized), after allocating SG&A and SBC to both segments, we see $838M of IRF EBITDA and $220M of home health EBITDA for a total of $1.06 billion of EBITDA, which is above consensus of $997 million after deducting an estimated $30M of SBC.

If you value EHC’s home health & hospice business at 19x, which is the average of AMED and LHCG valuations, it implies that EHC’s 2021 IRF business is trading at 7.3x EBITDA. EHC has historically traded at about 9x NTM EBITDA. Given that the economy looks like it is headed towards a prolonged downturn, we think there should be an increased flight to safety and particularly to companies that are unimpacted by the economy and with trends in their favor like EHC.

Therefore, we think the multiple for the IRF business should increase to at least 11x, with the potential for multiple expansion in home health as well. Also, given the impact of PDGM and Covid-19 to smaller players, EHC will very likely make more accretive acquisitions that will drive additional value. Put this all together and we have a 2021 price target near $100 for EHC.

Conclusion

There are many factors in EHC’s favor going forward. Baby boomers continue to age and are a tailwind regardless of what the economy does. While PDGM is a major tailwind for the large home health players, EHC is especially well-positioned for it given that referrals from IRFs to home health are now among the most valuable. Covid-19 adds to the pain of the smaller providers which will make it a lot easier for EHC to pick up share organically and via acquisitions, which will help EHC expand its presence in markets where it doesn’t currently have overlap with its IRFs. Finally, Covid-19 is another positive catalyst for the home health industry that is increasingly being accepted as the ideal place for care while some important antiquated regulations that held back the industry, such as doctor referrals, the homebound requirement, and telehealth, were either permanently changed or likely to be remain loosened in some form going forward.  

Risks

IRF Rate Cuts: EHC’s guidance is for pricing to be flat to up 75 bps in 2020 and then for 2021 and 2022, the best info suggests on average 2% rate increases. As noted above we feel the risk of major cuts is limited because non-profit competitors have such tiny margins and would fold. Also, if there was a large rate cut, the outcome could be like the PDGM impact in that it would drive a lot of smaller players out of business (or make them acquisition targets at depressed prices).

A Covid-19 Outbreak at an IRF: There have been several news articles about Covid-19 outbreaks and deaths at nursing homes and long-term care facilities. So far, we have not heard of major outbreaks at EHC IRFs resulting in shutdowns though this is clearly a short-term risk. If an IRF does have to shut down, it is likely to be temporary. The average stay is 13 days so it can start back up quickly if it has to be shut down for an outbreak. If the stock does decline as a result of outbreaks at IRFs we would likely see it as a buying opportunity.

Labor Shortages: The availability of labor is critical, and nurses are in high demand which could be made worse due to the challenges of Covid-19 and high needs in other settings such as acute care hospitals. Unemployment payments are currently high and can also exceed what some labor receives working for EHC. A shortage of nurses or much higher costs for nurses could lead to EHC coming up short of its growth goals.