Description

Long EHAB:  We believe it is time to revisit Enhabit (EHAB) ahead of an improvement in fundamentals combined with likely strategic interest in mid-2024.  We see close to 100% upside as EHAB trades closer to its strategic value ahead of the 2-year spin window ending next June.  

Dr. Ridgewell did an excellent write-up of EHAB on Oct 24th, 2022, and we would refer you to that write up for an in-depth overview of the business. 

To briefly rehash the situation: EHAB was spun from EHC in mid-2022 and has been cut in half from its initial spin prices.  It has faced several headwinds from labor costs to mix shifts that have caused EBITDA estimates to be lowered on a levered equity.  Strategic interest remains in the space though as EHAB’s only remaining public peer is being acquired in a bidding war for 14x EBITDA forward EBITDA vs EHAB’s sub 9x multiple currently.  Shareholders are frustrated at the lack of performance and persistent valuation gap.  This likely catalyzed an activist investor, AREX Capital, to publicly send a letter to the board on June 13^th. 

Pressure is on the company to optimize its cost structure as well as be open to strategic alternatives when the tax window opens.   Combined with a likely improvement in its fundamental environment we believe this is an ideal entry point for this highly discounted company. 

Improving Fundamentals After Multiple Setbacks:

EHAB’s results have been pressured by several factors over the last two years.  This has masked an attractive long-term opportunity in the industry as the population ages and payors look for ways to lower the cost of care.  Absent these headwinds, we believe the business should grow sales organically in the high single digits. There is also ample opportunity to grow thru tuck-ins given the fragmented nature of the industry. 

The headwinds started with a pandemic driven nursing shortage that resulted in significant wage inflation.  Then more of the business mixed to Medicare Advantage (MA) which has much lower reimbursement rates.  Wage inflation has already begun to subside, rising a more normal 2.2% in the 1Q23 after increasing 7% in 2022.  The mix headwind of Medicare Advantage will also start to lessen as MA naturally becomes a larger part of the business combined with new contracts at more favorable rates.  For example, MA mix shift was a $22mln EBITDA headwind in 2022, in 2023 its forecast to be a $14mln headwind.  $5mln of that was in the first quarter, implying a large sequential improvement as we go thru 2023.  The forecast improvement is being driven by new MA contracts signed with payors at improved rates.  This will begin to offset the negative mix to MA as we progress though the year.  This is the driving factor behind management’s confidence in their 2023 guidance, despite the below trend Q1 results.  Better labor and improved contracts should alleviate the two largest headwinds that have been facing EHAB and allow the natural growth of the business to resume.  

There is also the potential to optimize the corporate cost structure here.  EHAB is currently burdened with $15mln of public company costs on an EBITDA base of $130-140mln.  Simply taking the company private would yield a nice uplift to a buyer.  EHAB’s corporate cost as a percent of revenue is about 200bps higher than AMED.  While some of this is due to size, we believe the spin has burdened the company with duplicate costs that can be rightsized over time.   

Last Public Provider with Proven Strategic Value:

EHAB will be the only public home health care provider once UnitedHealthcare finalizes their purchase of Amedisys at a 5 turn premium to where EHAB currently trades on 2024 EV/EBITDA.  This deal comes after another home health care provider, LHC Group was also acquired by UNH last year for ~20X EBITDA.  Amedisys was the subject of a bidding war between UNH and Option Care Health.  This in our view is a sign of the strategic value of assets in this space, especially to large strategic acquirors.  UHC’s interest in this industry is driven by its ability to lower its total cost of care via ownership of home health assets.  We believe other payors are likely to have interest in EHAB once it reaches its 2-year spin off date next summer. 

Depressed Sell-Side Expectations:

Expectations are also low, with current sell side estimates at the low end of management $125-140mln guidance for 2023. This is logical given the company’s limited track record as a public company and recent earnings headwinds.  Recently a sell-side analyst published a report expecting EHAB to struggle to generate more than 100mln in EBITDA for the next several years. We believe his expectations are overly punitive, but even if he is right the downside from here is minimal on a fundamental basis while there is upside on a strategic basis. 

Financial Forecast:

We assume that the new MA contracts begin to roll in later in 2023 and we begin to see more of the impact in 2024.  Combined with a modest amount of G&A optimization in 2024 we see EBITDA of 135mln in 2024.  We incorporated the latest CMS rate announcement in our home health forecast for 2024, which is about a $10mln EBITDA headwind.  In response to activist pressure, we would not be surprised to see material improvement in corporate costs into 2024.  However, we only model $5 million of cost improvement.  We think the business will be much closer to a normal operating environment later this year and believe a more on trend growth algorithm will emerge in 2024.   We are not assuming any CMS claw backs, though if those did occur, they would be likely in 2025 on and should be viewed as a 1x item in our view.  While the recent CMS announcement on home health rates for 2024 was mildly disappointing, we note that their long-term outlook shows home health care as the fastest growing health care  submarket at 7.4% per year.  This is another supportive datapoint to the long-term growth potential in the industry. 

Valuation Gap

We believe the re-contracting efforts offset by lower home health rates will support modest EBITDA growth in 2024, with EBITDA of $135mln next year.  Fundamental stability should help valuation recover.  As the table below shows EHAB has significant upside to the recent transaction multiples in its space.  Our base case relies on a 12.5x EBITDA multiple, as we think this would trade with some discount to the AMED deal given its smaller size. One can assume a lower multiple though and still have significant upside from today’s depressed price.

Note: Table assumes a 6/30/24 capital structure with net debt of 495mln.

Catalyst

Expiration of 2yr spin window next June.