Home Health Agencies - Buy a Dollar for 80 Cents
If someone offered to sell you a dollar for 80 cents, what would be your reply?
For me, it would be "How many can I buy?!"
Even the stock market, as psychotic as it can be, rarely offers this opportunity. It is a highly unusual to be able to purchase stock in a company below its tangible net asset value (not including accounting assets like goodwill and acquired intangibles). It is rarer still to be able to do so in a firm that is solidly profitable and relatively predictable. It is ultimately rare to be able to buy a debt-free company with zero insolvency risk at that kind of value.
Magic Formula Investing (MFI) has dug up two companies in the home healthcare sector that now sell well below tangible net asset value: Gentiva (GTIV) and Almost Family (AFAM).
This is not a wildly volatile industry with 50% revenue swings peak-to-trough. It is not an industry facing secular demand destruction - quite the opposite, considering the aging U.S. population. It is not a business model saddled with massive fixed costs - the majority of expenses are to health care workers, the levels of which can be adjusted to meet demand. And it is not a business with razor thin margins - AFAM, GTIV, and their primary public competitors all sport operating margins of 10% or above.
So what kind of drastic risks have led to unbelievably cheap valuations? Easy - the federal government. Both Gentiva and Almost Family generate about 80% of revenues from the federal Medicare program. Unfortunately, home health reimbursement rates have been a focus of spending cuts. For 2011, Medicare reimbursement in this sector was cut by 5%, and the 2012 proposal calls for another 3.5% cut. New "face-to-face" doctor referral rules went into effect in April, placing a higher burden on physicians to refer patients to home care. And there is significant fear that home health will be a further victim in upcoming budget cut proposals.
Given those risks, we certainly don't expect these stocks to sell at high multiples.
But why should a profitable company sell below the level of their net assets? Gentiva has a net tangible book value of about $8.38 per share, but trades at $6.00 per share. That's buying a dollar of net assets for 72 cents! Almost Family is similar, with a tangible book value of $19.30 per share but a stock price of $15.76, 81 cents on the dollar.
Of the two, Almost Family is by far the better choice. Gentiva has company-specific risks in addition to those mentioned above. The company is experiencing indigestion from their $1 billion purchase of hospice provider Odyssey Healthcare last year. As a result, Gentiva carries over $1 billion in debt, with a harrowing debt-to-equity ratio of 155%. Even more concerning are interest expense coverage ratios. For the trailing twelve months, Gentiva is covering its $87 million in interest expense only about 1.9 times over - far below the minimum of 5 times I consider acceptable. Worse still, Gentiva is in real danger of breaking its debt covenants. Moody's rates the firm's debt at Ba3 (three steps below investment grade) and has it on watch for a potential downgrade. This is not a good position to be in when Medicare is slashing payments. So in some respects, Gentiva's valuation is understandable.
The same can not be said about Almost Family. This is not a company in any financial danger - it carries a miniscule $2.5 million in debt, vs. $56 million in cash. It is so financially solid, in fact, that it recently announced the purchase of Cambridge Health for $32.5 million in cash. Margins are getting squeezed a bit, but Almost Family has not embarked on any kind of cost cutting program yet. This is a firm taking advantage of weakness in competitors to grow its business. There seems to be little justification for this stock selling below net tangible assets. This is why Almost Family is one of my top picks in the Magic Formula screens at current.
Disclosure: Steve owns AFAM