Description

Situation Overview

I recommend shorting Hanger (HGR), the nation’s largest orthotic and prosthetic (O&P) practice management company.  As the biggest player in an industry with a long history of fraud and abuse, HGR has been dramatically overearning for the last several years.  Recently, Medicare and commercial payors have begun to respond aggressively, increasing their focus on billing practices and payments.  With the industry under renewed scrutiny, we believe HGR is likely to find itself squarely in the crosshairs of investigators, with long term negative implications for the Company’s volumes and margins.  While the latest industry data suggests almost half of all O&P claims to be illegitimate, a 15% decline in HGR’s volumes implies 50% downside to its stock from current levels.

HGR operates 740 O&P clinics with 1,350 licensed clinicians treating over one million patients annually, representing ~20% of the market.  From 2009 to 2013, HGR’s business was firing on all cylinders.  Sales and EPS grew at CAGRs of 8.6% and 14.6% respectively owing to positive same stores, accretive tuck in acquisitions, and steady margin expansion.  Over this period, the stock almost tripled, peaking at $41/share in early 2014 – a valuation of 10x EBITDA. During this run-up, the regulatory environment was relatively stable, with flat pricing in 2010/2011, 2.5% price growth in 2012, and 1% growth in 2013. Beginning in 2014, the bloom began to come off the rose.  

Increased Regulatory Oversight

According to CMS’s 2013 Improper Payment Rate Report, a stunning 48% of lower limb prostheses and 44% of lower limb orthoses payments were deemed improper.   (A copy of the report can be found here: http://www.cms.gov/Research-Statistics-Data-and-Systems/Monitoring-Programs/Medicare-FFS-Compliance-Programs/CERT/Downloads/November2013ReportPeriodAppendixFinal12-13-2013_508Compliance_Approved12-27-13.pdf). On HGR’s two most recent conference calls, management highlighted a litany of increased payor scrutiny, ranging from greater procedure pre-authorization requirements, declining payment appeal win rates with their largest customer, slowing collections, and rising bad debt.

Over the last 9 months HGR’s fortunes have reversed dramatically under increased regulatory scrutiny. The company has generated negative 13 million of FCF, failed to file financials, replaced its CFO, scrapped a new practice management system, breached its financial covenants, and had its revolver frozen. In light of this quickly deteriorating industry environment, HGR’s valuation looks absurd, with a $1.4 billion enterprise value and $800 million market cap for a company that is free cash flow negative and whose prospects are getting worse.

While (based on numerous channel checks) I believe HGR to be one of the best actors in  the industry, I believe the Company is virtually certain to serve meaningfully fewer patients as payor scrutiny of the sector increases. The recent spike and aging of A/R , a declining Medicare appeal win rate (from 95% to 88%), and a recent $38M bad debt charge, all suggest that the Company is over treating patients and under reserving for bad debt.  I believe Hanger’s sales and margins will materially decline in the new regulatory environment. Growth is impacted as fewer patients are approved for treatment, more patients are treated with less expensive, less profitable care, and increased bad debt (which is a contra revenue account) weighs on reported net revenue. Margins will be impacted given higher bad debt as a % of sales and negative operating leverage.

Starting in Q1 2014, same store sales turned negative for the first time in years, declining 1.8% and sending the stock down 15%. Management guided to 3% - 5% SSS, attributing the quarterly weakness to bad weather.  Additionally, management mentioned that Center for Medicare and Medicaid services (CMS) slowed payments due to greater Recovery Audit Contractor (RAC) scrutiny and highlighted that their historical challenge win rate declined from 95% in Q1 2013 to under 90% in Q1 2014.

On the Q2 call, SSS declined 1.5% and management commented on “increased pressure and a slowdown in payment authorization from both government and commercial payors.” HGR cut sales guidance to down 1% to 2% and cut EPS guidance from $2.01- $2.11 to $1.60 - $1.70, sending the stock down 35%. The Company blamed a number of other new issues for the sales softness including (1) a spike in Medicare pre-pay audits, (2) reduced demand do to more high deductible health plans, (3) more frequent treatment authorization requirements from commercial payors, (4) a slowdown in collections in practices with the newly implemented Janus practice management system, (5) a further decline in the RAC challenge win rate to 88%. Despite the multiplicity of new excuses, I still don’t believe management has fully come clean on what is happening.

I think the key phrase from the Q2 call occurs at the end of the call when the ex-CFO states, “There also is some impact on the numbers because our AR built for the reasons I discussed.  I have to put reserves - $0.14 of reserve in every $1 I put on the balance sheet in A/R. So since that goes against sales for the most part, that had some impact as well on the sales decline.”

Accounting Restatement

To exacerbate the soft Q2 results, Hanger eventually restated its first half results, lowering PBT by 8% in late February due to five accounting errors:

1.       Cost of Materials – Absence of elimination of certain intercompany profit amounts between segments and other computational errors;

2. Education Fair – Timing of in year expense recognition related to the Company's annual employee education conference;
3. Depreciation – Delayed commencement of depreciation expense related to the Company's new clinic management system;
4. Lease Accounting – Incorrect application of GAAP accounting requirements for lease accounting; and
5. Other Recurring and Non-Recurring Errors.

The company has a long history of material accounting weaknesses and has still not reported Q3 14, Q4 14, or Q1 15 results.

Current State of Play

On March 17^th, the Company’s revolver was frozen and downsized from $200M to $146M with a 3^rd waiver granted, giving the Company until May 31^st to finally report financials. Additionally, the Company disclosed that its cash collections have been negatively impacted by their roll out of new practice management software, Janus. (As an aside, CGI the contractor behind the disastrous ACA exchange rollout was the brain behind HGR’s Janus implementation.) The Company also disclosed that they increased their bad debt allowance by $38 million, $29 million of which relates to second half of 2014. A $29M increase in bad debt is ~5.2% of last year’s second half sales which is 40% of the Company 13% EBIT margins.

Based on their cash and revolver balances, we now know that the company has burned $13M of cash over the last nine months and is very likely in violation of their 4x debt to EBITDA covenant. 

While their last 8-K includes an excuse de jour in Janus practice management system, I believe the A/R write off is the first proof point of the key issue impacting Hanger. While the Company has blamed weather, high deductible plans, new Janus software, bad inventory management, and poor lease accounting, I believe the key issue impacting their SSS and cash collections is that payors , particularly the government which accounts for 40% of sales, have stopped reimbursing unnecessary procedures. The company still has to pay its employees, suppliers, and lenders which explains why a Company with purportedly 1.60 - $1.70 of EPS is cash flow negative and raising liquidity red flags.

Lost Volume and Margin Sensitivity

If sales decline by 15%, and margins contract due to negative operating leverage, EBITDA could fall from 200 million projected by analysts in the beginning of 2014 to 125M and the stock would be worth $12.82 at 8x EBITDA.  Every 1% margin erosion from increased bad debt reserve wipes out ~10% of EBITDA, which makes it challenging to accurately model the full downside potential.

Risks

·         The stock is down 40% and could recover if the current issues prove transitory

Catalyst

Release of financials prior to May