Description

Thesis

AAC will file for Chapter 11 bankruptcy this year, wiping out shareholders.  With over 100% of its profits coming from over-billing insurers on drug tests and massive reimbursements cuts happening now, we see AAC’s EBITDA declining by 60%+ in FY16 and EPS turning negative.  We see AAC defaulting on its debt in the middle of this year, leaving the equity worthless.

While there has been a Seeking Alpha article written on this premise that AAC does excessive drug testing, the write-up was sloppy.  More importantly, it doesn’t take into account the recent updates to insurers’ reimbursement guidelines, nor did the author conduct the confirmatory channel checks with payors that we’ve done.  AAC’s top three customers, which account for 41% of its revenue, have each significantly changed their reimbursement guidelines in the last three months, with the impact to be felt starting in 1Q16.  Additionally, just last month, substance abuse providers in California (AAC’s second largest state) have begun to receive clawback notices from insurers for previously paid claims.

Background

AAC is the country’s second-largest chain of substance centers (think of a bunch of Betty Ford clinics but less posh).  A JOBS Act IPO, AAC came public in October 2014 at $15.00/share, quickly zooming up to $45 as sell-side analysts touted it as “the best growth story in small-cap healthcare,” as the company aggressively expanding its bed count through acquisitions and de novo openings.  The stock plummeted last summer on news that its President, co-founder and second largest shareholder (22% stake currently) was indicted by a California Grand Jury on 2^nd degree murder charges and elder abuse (in an unprecedented move, two of AAC’s subsidiaries were also indicted, as well as several lower level employees).  While obviously tragic and significant in other ways, the murder charges are ancillary to the short thesis.

The Bull thesis is predicated on several alleged secular trends, against which AAC is intending to execute an aggressive roll-up strategy.  One, the Affordable Care Act expanded insurance coverage for mental health treatment, of which substance abuse is one such area.  Two, culturally, there is less of a stigma for people to “admit they have a problem” and seek help in the form of going to a rehab center. Three, from the provider standpoint, the substance industry is highly fragmented, with many operators being not-for-profits; AAC is the second largest provider behind Acadia Healthcare (ACHC), due to its acquisition CRC Health Group in 1Q15.

Our thesis is that AAC is over-earning because over 100% of its profitability comes from excessively charging payors for unnecessary drug testing performed on its patients.  Ostensibly a chain of rehab facilities, in reality, AAC is an out-of-network lab in disguise, using the façade of a rapidly growing substance abuse provider as a loss leader to drive drug testing business to its lab. 

The insurance community has been talking about excessive drug testing claims over a year now, and began taking small steps to address the issue in late 2014, with AAC beginning to feel the impact in 3Q15.  Its 4Q15 pre-announcement last month shows the impact is continuing.  But a step-function change is now taking place, based on public updates from insurers, coupled with our channel checks, indicating that reimbursement changes are dramatically accelerating beginning in early 2016.

Business Economics

Using 2015 numbers (AAC pre-announced on Jan 26; I’m using the high-end of their range), AAC generated $212mm of revenue, $43mm of EBITDA and 91C of EPS.  Revenue is broken out accordingly:

Client-related revenue is revenue AAC receives for its core business of treating patients for substance abuse.  Other revenue is from an acquisition AAC did last year of behavioral health lead gen company.  Client-related revenue is bifurcated between Drug Testing and other ancillary services revenue, which are one-off services that AAC gets reimbursed/paid for on an a la carte basis, and the “Per Diem” revenue, which is the daily fee that AAC receives for patient staying in its rehab facilities (the Per Diem can be broken down further into different levels of treatment intensity, but for simplicity I list it as one item).

What does this $60mm of Drug Testing revenue equate to in terms of unit economics?  Last year, AAC treated 563 patients per day on average (this is disclosed).  Based on 365 days, this equates to $294/patient/day of Drug Testing revenue.  For a typical 30-day stay at a rehab facility, that equals $8,800 of revenue over that stay solely for Drug Testing.  Think about that for a second.  This company is generating $8,800 in revenue for having drug addicts pee in a cup during their month-long stay at an AAC facility.  Based on our conversations with current and former management, we estimate this breaks down to, on average, 2-3 drug tests per week at an average revenue per specimen tested of $700-1,000.

We believe this $60mm of revenue from Drug Testing earns 90%+ margins.  (Shockingly, management won’t quantify what the margin is, only to acknowledge that it’s high.)  This is because the incremental cost of running a drug test on a urine specimen is small, in the tens of dollars (patients literally pee into a cup and have it checked for cocaine, barbiturates, etc.), while AAC receives $700-1,000 in reimbursements per specimen.  For conservatism, we estimate the incremental cost to test a specimen is $50-75/test.  At ~92% margin on its drug tests, this $60mm of revenue translates into $56mm of EBITDA.  Accordingly, based on AAC’s FY15 EBITDA of $43mm, we can see that the rest of AAC’s revenue generates negative EBITDA.

For comparison, we’ve spoken with former executives at CRC Health – the largest player in the substance abuse space, which was bought by ACHC last year – who told us their revenue from drug testing is < 5% of total; the simple reason is twofold:

a)       AAC’s 2-3 tests per week compares to a standard testing frequency of 2-3 tests per 30-day stay,

b)       At $700-1,000 of reimbursement per specimen, AAC is massively over-billing, as most Drug Testing claims aren’t reimbursed on an a la carte basis like AAC’s (who is almost entirely out-of-network), but rather are simply considered a cost of doing business which is implicitly reimbursed for in the Per Diem revenue

Moreover, besides speaking with CRC Health, other checks with smaller providers and industry consultants corroborate that AAC is an egregious abuser of drug testing claims.

So what…AAC is over-earning / over-charging today, what’s going to change that?  What’s changing is that the largest insurers are all making significant changes to their reimbursement guidelines, which will lead to massive declines in the amount payors reimburse substance abuse providers for drug testing:

·         Anthem (Blue Cross California and Blue Cross Colorado are 11% and 16% of revenue):

o    https://www.anthem.com/medicalpolicies/guidelines/gl_pw_c166612.htm (guideline number: CG-LAB-09)

·         Blue Cross Blue Shield Texas (13% of revenue): 

o    http://www.medicalpolicy.hcsc.net/medicalpolicy/activePolicyPage?lid=ifojvj2i&corpEntCd=TX1 (guideline number: MED207.154)

·         UnitedHealth (likely high-single digit % of revenue):

o    https://www.unitedhealthcareonline.com/ccmcontent/ProviderII/UHC/en-US/Main%20Menu/Tools%20&%20Resources/Policies%20and%20Protocols/Medicare%20Advantage%20Reimbursement%20Policies/Q/QualitativeDrugTesting.pdf (guideline number: QDT12182013RP)

Blue Cross California and BCBS Colorado (subsidiaries of Anthem) and BCBS Texas are named customers accounting for 41% of all AAC’s reimbursements, (we estimate UnitedHealth is in the HSD %).  We’ve spoken with multiple payors who say that such changes will reduce drug testing reimbursements to substance abuse providers by 90%.  While our checks varied on the timing of these changes – with one suggesting this 90% drop is happening now and another expecting 30-40% annual declines in reimbursements over the next several years – the impact to AAC is catastrophic.

We conservatively assume that these reimbursement cuts play out over several years.  Our estimate is that the $294/patient/day of Drug Testing revenue that AAC received in FY15 will decline ~50% to $148 in FY16.  Note that this still means that in FY16, 18% of AAC’s total revenue will come from Drug Testing (vs < 5% for CRC Health), equating to over $4,440 of Drug Testing revenue per 30-day stay.  See below for how FY15 results would look, adjusted for the change in Drug Testing reimbursements:

Our actual FY16 results call for $19mm of total EBITDA on $286mm of total revenue, given growth in bed count (both de novo and acquisition), but the punchline is the same.

Importantly: these changes to reimbursements haven’t hit reported results yet.  The above policy updates have effective dates ranging from 11/01/15 to 01/01/16, meaning that they are not yet in the FY15 results pre-announced last month.  (Even the November updates didn’t impact 4Q15 reported results as there is a lag between when a provider submits a claim and when it eventually gets denied by the payor.)   So this will be all incremental to FY16 results.  While there has been some initial pressure on Drug Testing reimbursements beginning in 3Q15 that impact is actually based on older, less stringent medical guideline updates that pre-date the ones linked to above. 

Finally, last month, Health Net, a large-California based insurer started sending notices to multiple substance abuse providers in the state seeking to clawback previously paid claims that it now believes were fraudulent (see here for background: http://www.behavioral.net/article/health-net-looking-fraud-among-treatment-centers).  California is AAC’s second largest state, with 19% of its beds.  While we don’t know whether or not AAC is being targeted by Health Net, it wouldn’t shock us if at some point the company was a target.  This is, after all, the state where AAC and its former President are on trial for murder.  AAC is also cited multiple times in a scathing study by the CA state legislature (see http://sooo.senate.ca.gov/sites/sooo.senate.ca.gov/files/Rogue%20Rehab%209_4_12.pdf for mentions of AAC subsidiary “A Better Tomorrow”)

Valuation and Leverage

On FY15 EBITDA, AAC trades at 13x (which compares to the 10x that ACHC paid to acquire CRC Health last year).  However, on our FY16E EBITDA of $19mm, it trades at 32x (we have negative EPS given the high interest expense).

AAC ended FY15 with 3.4x of leverage relative to its max allowable leverage of 4.5x (on gross debt of $145mm).  Given the steep drop off in EBITDA, we have leverage going 9x by the end of FY16 (their leverage covenant also steps down to 4.25x in 2Q16). 

Accordingly, we expect AAC to default on its debt this year.  With the decline in EBITDA being structural (and drug testing reimbursements getting worse in subsequent years), we see no residual value to the equity in a bankruptcy. 

Note that last October, AAC got $50mm in commitments from its sponsor, Deerfield Management, with $25mm coming in the form of a 2.5% note convertible at $30/share and another $25mm from a 12.0% subordinate note – hardly a vote of confidence in AAC’s prospects.  

Catalyst

Catalysts

·         FY16 guidance (expected on 4Q15 call on Feb 23)

·         Default on its bank debt (expected middle of 2016)

·         Chapter 11 bankruptcy