Description

Summary

M&A in the DME/HME industry should yield ROICs of ~8% for big strategic deals and 20% for smaller deals (cash on cash returns). I estimate that Adapt’s past deals average a > 15% ROIC.

Organic growth should be ~8.5%. The diabetes market is growing > 15% and sleep is growing ~9%. 40% of Adapt’s revenues come from sleep and 20% from Diabetes. The rest come from markets growing on average 3% a year. Plus Adapt should be able to take market share from mom and pops.

Valuation – the company has a $4.3bn EV. Compared with $4.7bn in total capital ($4.0bn in goodwill). This implies an EV of 0.9x capital deployed in M&A. the market is assuming the company is worth less than what they paid for existing deals. I believe the market is also underestimating the value of future deals.

Why is there an opportunity

The bear thesis is that the Adapt rollup was undisciplined and went too far, to the point where the acquired businesses started falling apart. In this case, most of acquired businesses are permanently impaired and it suggests ROIC on future deals will be low. Furthermore, given the former CEO, Luke McGee, was involved in personal tax fraud, there could be more skeletons hiding in the closet. Short sellers also believe there are actually revenue declines post transactions as acquired companies lose top sales people. Short sellers believe that Q4 2020 saw -15% organic revenue declines. I agree that organic revenues declined, but not by that much. In addition, Adapt did not include “immaterial” M&A in pro forma numbers making it hard to estimate organic growth.

In 2021 and 2022, they’ve shown MSD organic growth, below expectations of HSD growth. They are also missing on FCF margins at 5%-6% versus 7%-8% long term targets.

In 2020, I estimate organic revenue declined 10%. At best, I think they declined 5%. I cannot know for sure because Adapt did not disclose one key piece of information: the revenues of “insignificant” acquisitions. In 2019, Adapt spent $21M on “insignificant” M&A, that is not material. However, in 2020 they spent over $200M. If the businesses were acquired at a cheap EV/Sales multiple of 0.4x, they could have contributed $180M to reported revenues in 2020 (with a further $335M contributing to 2021 reported revenue growth). The difference between buying small deals on the cheap vs a high price is more than $130M in reported revenue. Given that proforma revenue in 2019 was only $552M, the $130M represents a more than 20% swing in organic growth.

What explains all these red flags and why is Adapt a good investment today

It’s clear to me that things went wrong for Adapt in 2020 and that impacted 2021. I conclude that almost all of the problems occurred in the businesses Adapt owned prior to 2020. I tried to estimate organic growth three different ways. They all point to declining revenue.

My research concludes that the vast majority of the shortfall in growth stems from a mis-execution on M&A. they grew too fast, in an uncontrolled manner, and that led to operational problems beginning in 2020.

2020 was a record year for M&A at Adapt. They did too many big deals that were too complex to pull off in one year.  4 of their 2020 deals were bigger than any deal done before. And 2 of them involved entering a new market (diabetes). This was simply too much. This led to a lack of focus. In Q4 2020, many employees learned that Adapt would merge with Aerocare and they pre-emptively quit, expecting to be fired once the deal closed in early 2021. The departure of these employees led to a brutal Q4.

In 2020, they acquired PCS, formerly owned by McKesson. The ROIC on this deal was great because the business needed restructuring and had to shrink massively. It was a money losing business that had to exit many product lines. The PCS deal was a huge time sink and contributed to the execution problems.

Since then, Adapt has transformed itself. They merged with Aerocare, a company that has a 20 year record of as a disciplined rollup, and now Aerocare management are in control. 60% of revenue now comes from Aerocare and the high growth diabetes business. Aerocare’s management is great. They should be able to improve the rest of the business, resulting in a high single digit organic growth rate.

Aeerocare’s management is excellent. Every one of their locations is a local leader with strong customer reviews, as measured by google reviews, yelp BBB complaints and my checks with competitors. Aerocare’s margins are also outstanding. ~600 bps higher than Adapt on a like-for-like basis. My research indicates this management team has the best reputation in terms of operations, integrity and disciplined acquisitions. Steve Griggs is now CEO of the merged company (Adapt and Aerocare). He bring his COO and CTO to the C level management team at Adapt. My research indicates Aerocare is taking over the company and most management roles. Adapt had better technology and I believe there is potential for the merger to bring together the best of both companies.

The businesses Adapt acquired in 2020 are actually quite good and grew nicely – While they created huge execution problems, the assets acquired are very good. Adapt reports 10.9% organic growth on these businesses. I disagree with this number but I do think HSD growth is likely. The two most important deals are Solara and Pinnacle. Both are high growth diabetes. My research indicates Solara did poorly immediately after it was acquired. First, Solara likely lost $15M in annualized revenue from Tricare resetting to Medicare rates. Second, my research indicates that customer churn increased following the deal. Shortly after that, I believe that both Solara and Pinnacle grew more than 20%. The PCS deal, formerly owned by McKesson, should have shrunk massively in 2020. It was a money losing business that had to exit many product lines.

Since then, organic growth has been in the MSD range. I try and estimate sequential organic growth (QoQ) because I feel it is more reliable. You only have to estimate seasonality and what the recent deals contributed. I’m confident they grew modestly in 2021 and in Q1 2022. Their explanation for their shortfall is also straightforward, Phillips had a massive recall of CPAP sleep apnea products that hurt everyone’s sleep business.

Evidence supporting a 15% ROIC on future deals and > 8% organic growth

The overall DME TAM is projected to grow at a 7% CAGR out to 2025. This is due to an ageing population, rising obesity and the cost effectiveness of home care vs hospitals ($1,500 per day) and nursing facilities ($500 per day). Covid should provide a bump for home care as well.

Adapt is more heavily exposed to the fast growing diabetes market. based on their revenue mix, I would expect a > 8% CAGR in their TAM. they should be able to gain market share from mom and pops and maybe grow 10% a year.

ROIC on future small and midsized deals should average ~15%

·         Adapt paid a high price on 2 strategic deals. Solara and Aerocare. I estimate both at an approximate 5% ROIC on run rate revenue with a path to 8% ROIC over time. I think that is acceptable for large transformative deals.

·         ROIC on Adapt’s other deals. Other deals are mostly done for < 1x revenue. PCS McKesson was 0.1x revenue because it was a turnaround. There are several at 0.7x revenue. If you assume a path to a 10% FCFF margin plus HSD organic growth, you have a path to a 15% ROIC on acquisitions made at 0.7x sales. The historical financials support this analysis.

·         We can estimate Adapt’s ROIC on deals by annualizing pro forma EBITA each quarter. I get 13% to 24% ROIC in each quarter of 2020 with an overall ROIC > 15%. That drops in 2021 due to the Aerocare acquisition. Excluding that, I estimate the ROIC at > 13% 2021. With HSD organic growth, I believe deals will average > 15% ROIC over time.

·         Aerocare makes up 40% of the business and has a fantastic track record.  Aerocare tried to go public in 2014 but there was no demand due to fears that the industry would get beaten down by regulation. They disclosed enough information in 2014 to get a sense for how the company performed between 2002 and 2020.  Between 2002 and 2014 they grew revenue 31% and then did another 30% through 2020. They took EBITDA margins from 20% in 2014 to 26%. I estimate a minimum of 15% ROIC on deals.

Forecasts and Target price –

Adapt should grow HSD organically and improve EBITDA margins to 24% from 21% currently. By 2025, they should generate $300M in FCFE organically. If they manage to deploy $2.1bn in deals over the next 7 years ($300M per year), at a HSD ROIC, they have a path to $5 EPS in 2028.

In a bear scenario, regulation hurts margins and ROIC on future deals is low now that the company needs to make large deals to move the needle. Organic revenues grow 5%, EBITDA and FCF margins stay low. It is still hard to justify the share price under these assumptions as there should be a clear path to a $3bn market cap vs $2.2bn today (but they will have to use FCF to reduce debt along the way)

Risks

1)      My thesis is wrong and past mistakes at AdaptHealth have impaired the existing Adapt business

2)      Regulatory risk is always a concern.

However, the last decade saw harsh regulations damage the industry and harm consumers. ~8k DMEs went bankrupt and service levels dropped materially as competitive bidding allowed unserious entrants to win contracts that they later failed to deliver on. I believe regulators have learned that they must allow mom and pops to earn a profit, which should protect Adapt’s margins. My research indicates that large national DMEs have a > 1,000bps margin advantage versus regional DMEs, let alone mom and pops (due to scale purchasing of COGS). This suggests that a HSD FCF margin is sustainable in the long run.

Diabetes should face reimbursement pressure. Margins are fat for that value chain. Offsetting that is massive growth and expansion of CGMs into type 2 diabetes. As scripts move to the pharmacy channel, which is lower reimbursement rate, Adapt is poised to get a lot of market share because of Solara’s national pharmacy license.

3)      New entrants – Walmart, Amazon etc

Walmart is building out its walk in health clinic business. Nurse practitioners (NP) are eligible to sign scripts for CPAP, oxygen etc. Walmart could staff their clinics with NPs and compete directly with DMEs. However, they already compete in the cash pay market, with minimal risk or operational burdens. To succeed with payers and medicare, Walmart will have to deal with billing, compliance and collections processes. My research suggests this is a very hard skill to master. Walmart considered acquiring their way into the industry long ago for this reason. In addition, I believe a majority of the market would not trust a Walmart nurse practitioner to prescribe oxygen, CPAP or CGM devices. If Walmart employs doctors, I believe the economics will not work due to the increased salary and low utilization of the doctor.

4)      They could lose a payer overnight

5)      Industry rivalry – Apria bids aggressively to win contracts

Apria’s margins are half those of Adapt, which itself is much lower than Rotech. There isn’t much room for Apria to lower prices even more.

Catalyst

Earnings and future deals