Description

The Chemed investment thesis is pretty simple. The company is an underfollowed, recession-proof compounder with high returns on invested capital, a net cash balance sheet, and an underrated management team that I expect to be buying back tons of stock here. The shares are currently priced for double digit forward returns at 25x 2021E FCF.

Chemed consists of two businesses in totally different industries: VITAS, which provides hospice services; and Roto-Rooter, which provides plumbing services. Chemed (named after ‘chemicals’, ‘medicine’, and ‘education’) was spun out of W.R. Grace in 1971 via a partial IPO. The company purchased Roto-Rooter in 1980, and by 2003, consisted of only Roto-Rooter and a partial stake in VITAS. When VITAS received a buyout offer, management decided they were a buyer rather than a seller at the bid price. The company purchased the remaining 2/3 of VITAS they didn’t already own.

VITAS overview

Today, VITAS represents about ~60% of company revenue and ~55% of adjusted EBITDA. The hospice business is 91% Medicare pay, 5% Medicaid pay, and 4% private pay. One thing that stands out to me about hospice is that the entire ecosystem is generally quite positive towards it. The government likes it because it saves a substantial amount of money (30% of Medicare is spent on the last year of a person’s life), nurses like it because they run the show and have more autonomy relative to a hospital environment, and families/patients generally have a good experience (considering the circumstances) since there’s no insurance to deal with/no deductible and they engage with caring people throughout the process.

The market is highly fragmented with thousands of hospice providers and the top 10 making up about 20% of the market. The age 75+ population is expected to increase at a greater than 4% CAGR from 2018 through 2030, compared to a growth rate of 1.7% from 2010 through 2017. The outsized growth is driven by baby boomers, the oldest of which are hitting 75 this year. Add in reimbursement rate growth of 2-3% and I expect VITAS to grow its topline 6-7% for the immediate future. Plus I think you can add in some expectation that the average length of stay will increase over the long-run as people choose hospice earlier, but I don’t know how to quantify that trend so I consider it potential upside. I also expect VITAS to continue expanding its EBITDA margins relative to the 2019 pre-COVID base.

Roto-Rooter Overview

Roto-Rooter represents roughly ~40% of consolidated revenue and ~45% of adjusted EBITDA. Roto-Rooter’s relative value prop to customers is essentially that it’s a professionally run organization in a sea of independent contractors. Anyone that’s dealt with home service providers understands the pain points there. Roto-Rooter is one of the oldest franchises in the country, with a history dating back to the 1930s. This segments revenue is not discretionary. People are going to pay to unclog pipes before they pay for just about anything. The water damage remediation business has been a great part of the story, growing from $18 million of revenue in ’14 to $126 million in ’20.

The company has historically purchased its franchisees for low multiples and improved the margins/operations dramatically. At this point, the acquisition strategy there has largely played out with about $75mm of franchisee ‘street revenue’ remaining. I estimate this business can continue to grow organically at 5-6% (mostly by taking share) and at ~35% incremental EBITDA margins.

Under-rated management

Chemed’s CEO and CFO have been in their roles for 20 and 17 years, respectively. The CEO is 67 and owns roughly $60 million of stock while the CFO is 60 and owns about $10 million. Over the CEO’s tenure, the stock has produced an 18%/year total return. Management repurchases shares when they believe the stock is undervalued, and they’re pretty good at it. In the last 10 years they’ve retired about 30% of shares outstanding.

They also understand that the company could be subject to a conglomerate discount given hospice and plumbing making strange bedfellows. To help combat it they provide quite a bit of segment detail. Management has also been open about the potential for selling or spinning one of the divisions if it makes financial sense. I think they truly do aim to increase per-share intrinsic value, as evidenced by a lack of empire building and tons of share repurchases.

The only other mention of Chemed on VIC is a short recommendation from 2013 (and a winner nonetheless). The short thesis centers around the DOJ’s allegations from 2013 that Chemed submitted false claims to Medicare to inflate the number of high acuity services (these would be the hospice segment’s continuous care and inpatient care- both require more intensive oversight of the patient). At the time, continuous care carried a billing rate roughly 4.5x regular care. The government noticed that Chemed was responsible for about ½ of all continuous care administered, despite having only 8% market share, and concluded that there must be some wrongdoing.

Obviously this calls into question the integrity of management. Their response at the time of filing was that continuous care is low margin and therefore not profitable enough for other hospice providers to offer it. Chemed management noted that only 8% of hospices provide any continuous care at all. In late 2017, Chemed finally settled with the government for $85 million with no admission of wrongdoing.

Eventually, the government got around to studying the issue. Their conclusion in mid-2019 was that continuous care costs $54.49/hour to administer while their reimbursement rate was $41.57. CMS increased the reimbursement rate for continuous care by a whopping 40%. To me, this is a tacit admission that Chemed was right and a vindication of management.

Valuation

Putting VITAS and Roto-Rooter together, I expect Chemed to grow its top line at a rate of 5-7% a year and to grow its FCF at a 7-8% a year relative to my 2021 FCF estimate of ~$280mm. This puts the forward FCF yield at 4% and the total return at 11-12%. In addition, the company is going to have $500 million of cash available for share repurchases this year without taking on any leverage (7% of the market cap), all of which I expect them to deploy. Finally, I think selling VITAS to a strategic could make a ton of sense. Hospice providers need referrals to acquire patients. It’s illegal to offer any payment for referrals, but VITAS employs sales people that call on potential referrers to highlight their service. An entity earlier in the value chain could essentially tack VITAS on to their business, cut the sales expense, and refer patients they’ve already acquired. For example, a hospital system can transition patients to hospice, and potentially also avoid the additional costs of readmission. Or a company with homecare services could acquire a hospice provider. Self-referrals for hospice from a care provider that’s already regularly in your home probably results in a fantastic retention rate. Upper management is reaching retirement age and a large corporate transaction could be on the horizon.

Catalyst

Time, and potentially a corporate transaction.