Description

Situation overview:

Encompass Health Corporation (EHC) presents investors with the opportunity to invest in a strong business at an attractive relative and absolute multiple in front of a near-term, value-creating separation event through the spinoff, sale, or merger of Enhabit, EHC’s Home Health and Hospice (HH&H) segment. 

Prior to the COVID-19 pandemic, the healthcare services industry was typically immune from traditional business cycles. The pandemic impacted healthcare in unique ways on the labor, referral, and mortality side. As a result, EHC is near a fundamental trough but is on its way to returning to an a-cyclical compounder. EHC shares provide an opportunity to buy a steady growth business in front of a fundamental recovery and experience multiple expansion as two business segments are separated and peer valuations can be appropriately applied. 

Business Separation: 

EHC recently concluded a 12-month strategic review of the HH&H segment which resulted in the decision to separate HH&H from EHC through a spin off during 1H’22. During 2H’21 while the strategic review was ongoing, EHC declined from $87 to $60 per share due to a Q3 miss and guide below consensus. EHC has risen to $67 per share since management announced their intent to separate EHC’s HH&H business from the IRF segment through a spinoff. More recently, on February 28, 2022, EHC announced the restructuring of their Board of Directors and noted management’s continued evaluation of value-creating opportunities such as a sale or merger of Enhabit, despite the impending spinoff. On March 4, 2022, Reuters reported EHC was receiving interest from private equity firms Advent and Bain Capital and noted the business could be worth up to $3B in a sale. While we still believe that the spinoff will take place at the end of Q2’22, the potential for an outright sale does give us further confidence that there is valuation- strong support for the HH&H business even amidst a challenging operating environment. 

Business Description:

Encompass Health Corporation (EHC) is one of the largest providers of post-acute healthcare services in the nation. EHC operates through two segments, in-patient rehabilitation facilities (IRF) and Home Health and Hospice (HH&H), with HH&H accounting for roughly 22% and 18% of consolidated revenue and EBITDA-NCI, respectively. Through the IRF segment, EHC owns and operates 145 hospitals across the nation.  EHC consolidates their home health business and hospice business under one segment with hospice accounting for roughly 20% of the HH&H segment revenues. 

The HH&H business is an HSD-LDD top line grower driven by aging baby boomers, based on a shift in demand from Skilled Nursing Facilities (SNFs) toward care in the home and consolidation opportunities. We see favorable secular growth drivers allowing this business to generate mid 20% margins.  

IRF is a stable MSD top line business with healthy 22%-25% EBITDA-NCI margins. IRF growth is primarily generated through de novo developments which EHC targets at 6-10 per year. 

Valuation: 

EHC currently trades at 9.5/8.7x FY22/23 Adjusted EBITDA less NCI, roughly 1.5 turns below its 5-year average. EHC also trades at less than 15x 2023 consensus earnings which is attractive on an absolute basis for a business with neutral or slightly counter cyclical attributes, healthy returns on capital, and strong demographic and industry consolidation tailwinds with the upside of a corporate event catalyst. We see strong potential for both segments to grow intrinsic value at attractive rates as independent public companies. 

The best comps for the home health business are Amedysis (AMED) and LHC Group (LHCG). 

AMED trades at 20x 2022 EBITDA and 29x EPS and LHCG trades at 18x 2022 EBITDA. We own both of these stocks, in addition to EHC, based on the strategic value in home health, where we believe healthcare is moving. Further, the tailwinds of organic demographic growth and industry consolidation of a highly fragmented industry should power attractive compounding returns. We think buying EHC is a chance to create a similar asset at a discount. 

As far as the IRF division, the comp often used is Select Medical which trades at ~10x 2022 EBITDA. I believe that IRF exposure is significantly better than LTAC exposure which is a much more significant part of SEM’s portfolio. As a result, I believe that EHC IRFS could be rewarded a higher multiple than SEM as a standalone public company. 

Here is a recent report from UBS, which I have borrowed to illustrate their sum of the parts model. Where I would disagree is that I believe the HH&H segment should get at least a 15x multiple, if not higher, given where LHCG and AMED are trading as well as the significant strategic and financial buyer interest in the segment. Additionally, I think the IRF segment could get 10x EBITDA in time. 

Why does this opportunity exist?

Activist investors and management believe that EHC is not being awarded value for its higher multiple HH&H segment due to that value being obfuscated by the larger and less strategic IRF segment. Additionally, EHC HH&H segment has experienced some significant management turnover over the past year due to the departure of founder April Anthony and the appointment of IRF veteran Barb Jacobsmeyer as CEO. I believe this management turnover is concerning and partially explains EHC’s recent lackluster organic growth metrics compared to peers; I believe these issues are fixable over time and are more than discounted in valuation. 

Additionally, the Delta and Omicron waves of COVID during the past 9 months caused topline pressure to healthcare services operators who were already battling industry-wide labor pressure; EHC was not immune and saw admissions in HH down 1% YOY due to lower elective procedures, lower occupancy levels, and access constraints at elderly facilities. While COVID-related headwinds continued through the Omicron wave, we believe that in the post-Omicron period, absent another wave, financial metrics should improve meaningfully, leading to improving organic growth as well as margin expansion for both businesses through 2022 and into 2023.

Further, due to Medicare sequestration and the lag between CMS wage rate adjustments and recent labor inflation, 2022 is a year of challenging financial comparisons for the industry; however, I believe this is short term and should alleviate in 2023, as we expect a larger Medicare wage rate adjustment in 2023 and the comping of the sequestration benefit to be less of a headwind.  

Why fundamentals have bottomed and EHC is cheap:

We view the current price of $67 per share as an attractive entry point considering the secular growth in home health coupled with short term labor and topline headwinds resulting in moderate pessimism around the stock. We believe the implied valuation of Enhabit is currently ~10x FY23 EBITDA-NCI of $255M, with IRF segment receiving multiple of 8x FY23 EBITDA-NCI of $1,077m, which discounts Enhabit’s strong fundamentals and path to improved margins as COVID-related labor headwinds abate exiting FY22. 

We think the underlying secular growth in home health is going to continue at an MSD pace and any cost pressure seen in the industry is a net benefit to a larger operator like Enhabit. Topline growth in the DD range with ~20% EBITDA margins (with a path to 22-23% post-COVID) generally receives a mid-teens multiple, and we believe Enhabit will see a re-rating as we approach the separation date.

EHC’s IRF business outperformed during Q4, with record average daily census, 9.6% discharge growth, and 6% same store growth YOY, resulting in topline growth of 11.7% YOY and EBITDA-NCI growth of 8.4% in Q4’21. While management called out some cost headwinds in FY22, the business should maintain low 20% EBITDA margins next year followed by expansion in FY23/FY24. 

We view the IRF business as being capable of sustainable MSD-HSD top line growth with stable EBITDA margins in the low-to-mid 20% range, as a 10-11x EBITDA-NCI business. 

How do investors get paid owning the stock?

I think the UBS sum of the parts upside of $82 is not an unreasonable base case. For a blue-sky upside bull case, we assume 11x and 17x FY’23 IRF and HH&H EBITDA-NCI of $1.077m and $257m, respectively, resulting in a 72% gain or $49 of upside. 

In our downside case, we assume 8x and 12x for the IRF and HH segments, respectively, which seems attractive. 

Risks:

• Medicare Reimbursement Concentration  

• Pandemics and unforeseen health crises 

• Wage inflation spiral 

Catalysts:

• HH&H separation 1H’22 

Disclaimer: 

This write-up contains certain opinions of the author as of the date written. Before investing, do your own work. The author or his employer may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaim any liability for investment losses that you may incur under any circumstances.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Business Separation

Healthcare Labor Market Normalization