SEM

Publicly traded companies mentioned herein: Encompass Health Corp (EHC), Humana Inc (HUM), Select Medical Holdings Corp (SEM), US Physical Therapy Inc (USPH)

Highlights

Select Medical Holdings (SEM) stock appears to be meaningfully undervalued in the high teens ($18 - $19; an 8% FCF yield). The presenter is long at this time and based on either a sum-of-the-parts model, or a fair multiple to earnings, the risk/reward setup favors bulls. The company has an established history of providing LTAC (long-term acute care) and rehabilitation services across the continuum of care, and with its business exposure and payer mix both shifting in favorable ways, the upside for shareholders could be material. The acquisitions of Concentra (2015) and US Healthworks (2018) have helped with this mix shift, and while the company is somewhat of an “orphan,” its valuation discount to US Physical Therapy is striking. If SEM’s earnings can grow in line with Street expectations, the stock should trade up to the mid-$20s over the next 12 months. Longer-term, the SOTP math points to a fair value that is at least in the $30 - $34 range, assuming a 10x - 10.5x multiple to EBITDA-NCI, and there could be optionality around US Healthworks deal synergies.    

• The presenter briefly described SEM’s history, and its close ties to private equity firm WCAS (dating back to 1997). WCAS took SEM private in 2004, and exited via an IPO in 2009; however, the private equity firm was also involved in the acquisition of Concentra from Humana, a $1.05B 2015 deal. Over time, its business mix has shifted from an “overweight” in LTAC, a controversial niche of the market, to a more balanced combination of LTAC, rehab (inpatient and outpatient), and workers comp (aka occupational health).

  • SEM is the largest player in three of its four markets. LTAC has been more controversial due to Medicare exposure and reimbursement rules/changes. However, its overall payer mix has shifted from ~50% Medicare to just 25% over recent years, with more commercial insurance offsetting the risk/ lower government reimbursement rates.

  • The current business mix is roughly 35% legacy LTAC, 14% inpatient rehab, 20% outpatient rehab, and 31% workers comp.

  • In the presenter’s opinion, the management team, led by CEO David Chernow and CFO Martin Jackson, are good operators that have done a great job diversifying the business via opportunistic acquisitions of workers comp and inpatient rehab assets; “These moves have repositioned the company favorably.”

• Following the acquisition of Concentra, the presenter noted that SEM “massively beat [synergy] expectations (+$160MM of EBITDA vs +$90MM expected).” if management is able to repeat this feat with US Healthworks, it would provide an excellent tailwind for the company, and financial results would exceed current expectations.

  • Based on the presenter’s numbers, SEM can boost inpatient rehab from a $650MM business to $1B, and its outpatient business is 3x the size of USPH’s.

  • The company should see EPS grow at a 25% CAGR from 2016 - 2020, and this year he thinks adjusted EPS will be $1.13, slightly ahead of Street estimates.

    • In 2019, EPS should rise to $1.25 - $1.30, for ~15% growth.

• While a SOTP model may not be the best/most accurate way to analyze SEM’s stock, presumably because the value is unlikely to be unlocked, it does suggest that the stock is meaningfully undervalued when compared to pure-play peers that trade at noticeably higher multiples (using peer-based multiples would put SEM’s fair value at $44, said the presenter).

  • The presenter gets to a $30 - $34 value range using “reasonable” 10x - 10.5x multiples to EBITDA-NCI.

• SEM’s Q3 is usually difficult due to seasonality, so the entry point heading into Q4 and Q1 (both seasonally stronger) is good. Additionally, private equity interest in healthcare services has been “off the charts” recently due to the defensive nature of the industry, real estate values, etc. For example, with SEM the SOTP model looks attractive, as if the legacy LTAC business is “free” (if valuing the other three segments at market multiples).

• On the regulatory/reimbursement side, the presenter noted that nuanced changes are more favorable for SEM. There used to be a rule that only 25% of admissions could be from the host hospital, and operators can go above this level now. This helps increase volumes with its strong hospital partners. Also, SEM has lapped a change to an alternative payment model.

• A participant asked what happened to the stock after Q2 earnings, and the presenter explained how the aforementioned nuances of reimbursement in the LTAC business can lead to changes in payments (based on number/% of patients admitted, length of stay, and other factors). The mix of patients can skew payments, good and bad. In Q2 ‘18 it was bad, and it’s a risk investors must deal with as it is impossible to say it won’t happen again.