AGB 2021.14 - Chemed (CHE)
Two Good Businesses + Capital Allocation
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“Capital deployment is probably the most underappreciated aspect of what a company can do to deliver real value to shareholders because that's about it. Creating value to shareholders by providing great care for our patients or services for our Roto-Rooter customers, that decides how well your stock is going to do and how much value you can create.” – Chief Financial Officer, David Patrick Williams at Deutsche Bank Health Care Conference May 2015
Chemed operates two distinct business entities. VITAS is the leading operator of hospice programs in the U.S. with 45+ programs across 14 states and Roto-Rooter is the leading operator and franchisor of plumbing and water restoration services covering 90% of the U.S. population and 40% of the Canadian population. There are very few synergies across the two businesses and each is operated separately for the most part. After doing weeks of research, the best explanation for why these two businesses are under one public entity is that management is aware that owning good businesses + prudent capital allocation drives stock returns in the long-run.
Chemed started off as a subsidiary of W.R. Grace and was spun out in 1971. At the time, the company owned a medical division, which eventually become Onmicare and a few specialty chemical businesses. The management team at Chemed came from Omnicare but felt that the business had many headwinds ahead and decided to spin out Omnicare in 1981. Just a year prior, Chemed had acquired Roto-Rooter and began repurchasing franchises when they came up for sale. After selling off the specialty chemical businesses (also considered to be not good businesses), Chemed was left with just Roto-Rooter. Chemed then identified the healthcare business they wanted to own, which was VITAS and acquired a 33% stake through preferred equity in 1991. The company acquired the remaining ownership of VITAS in 2004.
While the company owns and operates two businesses, the management team views Chemed as a healthcare company and would be willing to spin off or sell Roto-Rooter if the right opportunity came along. We’ll analyze both in detail here as they are both good businesses but given that the hospice industry has a steeper learning curve and it’s the main business, most of the write-up will focus on VITAS.
Hospice is when a terminally ill patient elects palliative care and gives up the rights to curative care for the remaining time they have left. Hospice is usually elected after curative measures for the patient’s terminal illness are exhausted and it’s an educational process for both the patient and family. The patient’s attending doctor must attest that the patient has less than 6 months to live if the illness runs its normal course. Some hospice patients outlive the timeline of their diagnosis, but that’s okay and they will still be covered for hospice care as long as they live. Patients are typically older, with 65% of patients that elect hospice care being over 80 years old, and more than half don’t live past a few weeks under hospice care.
Most patients are covered for hospice care under Medicare (due to the advanced age) and hospice programs are paid via a per-diem reimbursement structure (paid per day of care). For VITAS, 93% of revenues come from Medicare reimbursements, 5% from Medicaid and 3% from private insurance. Medicaid generally follows the Medicare rules for payments.
There are four different types of hospice care (for billing purposes) and the per-diem rates are different for each. Routine Home Care (RHC) is when hospice patients get care in their home or at a nursing facility and this has the lowest per-diem rates but the highest margins. There are two tiers to RHC reimbursement rates (after the change in 2016), higher for the first 60 days and lower for any days after that. Continuous Home Care (CHC) has the highest rates but requires staff to be onsite for long periods of time and has low margins. General Inpatient Care (GIC) is when the patient goes into the hospice facility to receive care. Similar to CHC, this also has higher per-diem rates but also has low margins. And lastly Inpatient Respite Care (IRC) is when the patient checks into a facility (up to 5 days) so that the patient’s main caretaker can take a break, and these are roughly double the reimbursement rate vs RHC. All per-diem rates are adjusted for cost of labor in different markets and increase with inflation annually.
Medicare reimbursement is complicated and there have been changes made in over the last decade. In 2013, after review of spending, there was a 2% cut to all Medicare programs including hospice. In that same year, “failure to thrive” and “debility unspecified” (15% of hospice admissions at the time) were removed as allowable diagnoses. In 2016, the two-tiered rate for RHC was introduced. In 2020, RHC rate was reduced 2.6% and the other higher acuity care increased by the same amount.
For hospice programs, there are also two caps that Medicare places. The first is the 80-20 rule, which states that inpatient care can only apply up to 20% of the total days of hospice care. This is to prevent unnecessary inpatient care on hospice patients at higher per-diem rates. The second is the cap on overall payments. The total reimbursement payments per admission can’t exceed $30.7k for 2021. This impacts areas with higher cost of labor.
VITAS’ hospice programs vary in size according to the eligible hospice candidates in the area (high in states like Florida) but are scalable due to the fact that most hospice care is provided in the patients’ homes. The company offers all forms of hospice care and operating facilities are necessary for inpatient care. VITAS’ hospice program had over 90k+ patients in 2020 totaling almost 7M days of care.
The hospice market has grown ever since the hospice election was offered by Medicare in 1983. Initially it was mostly cancer patients, but now patients with other illness like neurological, cardiovascular and respiratory diseases all elect hospice care. Annual Medicare spending on hospice benefits were above $20B in 2019, which was ~3% of all Medicare spending.
The hospice market is highly fragmented with VITAS leading with 7% market share. Other healthcare companies and private equity firms have acquired hospice assets in recent years to somewhat consolidate the industry. Kindred is the #2 player with ~5% share and Amedisys is the #3 player with ~3% share. Roughly a quarter of the industry is comprised of non-profit hospices, which have much lower margins. Many hospice programs do not offer all forms of care. Chemed states that 92% of hospice programs in the U.S. don’t offer continuous home care and rely on the patient going back to the hospital to get curative treatment (and revoking their hospice election) if there is an acute care episode.
Roto-Rooter is a simpler business to understand. The company offers plumbing and water restoration services across North America through its company owned locations, independent contractors and franchisees. As of 2020, Roto-Rooter has 127 company owned branches and 369 franchise locations. Core services like plumbing, drain and sewer cleaning and excavation services make up most of Roto-Rooter’s revenues. These jobs are short-term and typically are last minute jobs, many of which come through the customer calling a call-center. 2/3 of the business is residential customers and 1/3 commercial. Similar to Rollins in pest control (you can read our write-up from June here), residential customers tend to offer higher margins because commercial customers have more negotiating leverage and require more complicated jobs. However, commercial customers tend to do more repeat business and there are fewer companies bidding for commercial jobs, which is where size and reputation becomes a big factor.
Water restoration is fixing water damage after a flood incident and typically are longer-term jobs (3-5 days). This is a newer offering from Roto-Rooter (since FY13) and has grown to over $125M or 17% of total Roto-Rooter revenues. The gross margins for the core services is higher than water restoration but because both services are provided out of the same branch location, the increased utilization leads to higher operating margins. 90% of the water restoration business is residential (10% commercial) and are typically paid out by the customer’s insurance company. This business tends to be more recession resistant.
Franchisees and independent contactors own rights to certain territories in exchange for payment. Independent contractors typically pay 20%-25% of weekly revenues to Roto-Rooter in exchange for the right to use the trademark and also receive back office support and benefit from national advertising. Franchisees pay a monthly fee based on the population of the coverage area and are typically under 10 year agreements. These terms are only cancellable by Roto-Rooter at the end of each term with a 60 day notice but the franchisee can cancel it at any time. The initial franchise agreements are very favorable to the franchisee and it’s rare for franchisees to actually sell their businesses.
As for the company operated branches, they are typically the best run. This is why Roto-Rooter has been acquiring franchisees over the past 40 years. Roto-Rooter isn’t as recession resistant as VITAS but the company can quickly scale down its cost structure if needed as technicians are paid mainly on commissions. Roto-Rooter commands 2%-3% of the same day plumbing market.
Why is it a good business?
The hospice business is a good because it’s recession resistant and it has many tailwinds, even with the regulatory setbacks that happen every few years. The demographic breakdown in the U.S. implies there will be more 65+ year olds that qualify for hospice care should they need it. More people are aware of the hospice option (vs. curative care) now and are starting to realize the benefits of hospice care. Furthermore, hospice tends to be higher margins than many other areas in health care due to almost all of the reimbursement coming from one insurance payor, Medicare.
From Medicare’s perspective, while there are instances of hospice providers abusing the reimbursement system and certain misrepresentations of care, fewer dollars go out the door during the last year of a patient’s life who is on hospice care vs. non-hospice care. So while there are still areas of improvement for the reimbursement system, Medicare sees the financial advantages of hospice care.
Hospices are asset light because most of the days of care are provided in the patient’s home. Aside from facilities necessary to provide inpatient care (which VITAS leases) and medical equipment, the incremental costs to service a new hospice patient are mostly variable. The business scales with size, but not in the traditional sense.
Large hospice programs get more “shots on goal” to care for patients that end up having long lengths of stay. While most providers lose money or break-even on acuity care, the profitability of a hospice program will be driven by the number of higher margin routine home care days. For VITAS, 12% of the company’s patients live beyond six months and the costs to service these patients are very low. So the holy grail in hospice is to find more of these types of patients and larger programs just get more shots at it.
Large hospice programs get large by having better referral networks. Typically an established operator like VITAS can offer all forms of hospice care and delivery on better quality to appeal to hospitals and nursing homes. Over 50% of VITAS’ new admissions comes from hospitals and these patients tend to have a higher acuity mix, meaning there would be a need for continuous care for the first few days. Many times, these patients arrive into a hospice during their last few days, and require lots of personnel and machinery to help them through the period.
Hospitals care about their patients’ well-being but they also care about readmissions. A live discharge is when a patient revokes their hospice election and goes back onto curative care through Medicare. This usually means a trip back to the hospital. Because there are penalties for readmissions, hospitals want to avoid this situation. Studies have shown that hospices that can provide good acuity care tend to have a lower live discharge rate (VITAS is 3% below the industry average of 17%-18%). Sometimes patients are just unsatisfied with the hospice care provided or are uniformed of what hospice care entails and end up revoking their election. Either way, hospice programs that can provide quality acuity care usually end up higher on the list of recommended hospices from their referral sources.
For Roto-Rooter, the business is more dependent on the state of the economy but its water restoration business tends to be more recession resistant. Scale advantages stem from national and digital advertising capabilities and the ability to offer services to commercial customers. Smaller plumbing and water restoration companies wouldn’t be able to compete for these deals. Roto-Rooter also has three different call centers that are open 24/7, which is where a lot of the inbound leads come from.
The Roto-Rooter business scales better than the hospice business because increasing utilization of technicians (adding ancillary services like water restoration) leads to much higher margins. And while there is little disclosure and research done on this segment of Chemed, Roto-Rooter does have pricing power due to its brand and the fact that customers that have a water emergency just want the issue fixed, rather than haggle on the price of the job.
Over the past 10 years, Roto-Rooter has outpaced VITAS in annual revenue growth by almost 4% (7.7% vs. 3.9%) and EBITDA growth by 6% (12.7% vs 6.6%).
Returns on capital?
Over the past 10 years, Chemed has spent 2/3 of its capital on capex and 1/3 on acquisitions, most of which were for the Roto-Rooter segment in FY18 and FY19. Capital expenditures are mostly related to medical equipment and plumbing related + water restoration equipment purchases. The company has stated that medical equipment returns are in the 30% range and water restoration returns are over 100%.
While Chemed would like to do tuck-in acquisitions within hospice, it hasn’t made too much strategic or financial sense as of late, except for an $11M acquisition in 2018 of a Florida hospice program. When a hospice is acquired, the buyer gets the brand and the infrastructure necessary to run a hospice organization. There are no contracts with referral sources or list of potential customers that are transferrable. So in that sense, a large established player like Chemed would find hospice acquisitions less attractive than a financial buyer looking to make its first hospice acquisition. Regulation can also be an issue in certain states like New York, which don’t allow for-profit hospices to acquire non-profits.
There is also the issue of valuation. Hospice assets are being acquired for as much as 20x LTM EBITDA which would imply very little returns unless the asset improves dramatically over time. The company has stated that a hospice asset would need to be meaningful (have an established presence in certain geography that the company isn’t in already) and sell for 7x EBITDA for it to make sense financially for Chemed. We’re very far from that valuation target, so it’s safe to assume that Chemed won’t be acquiring large hospice assets any time soon.
Acquiring non-profit hospices could work out better financially since on average, non-profit hospices have much lower operating margins compared to for-profit hospices (5% vs. 17.7% in a 2015 MedPac report). The disparity is mainly from the differences in average length of stay (66 days vs. 106 days), but as we mentioned before, there is greater regulatory scrutiny and/or rules against acquiring non-profit hospices.
For Roto-Rooter, the acquisition opportunity still remains attractive. Franchisees have a favorable agreement with Roto-Rooter (the original franchise fees are very low and can’t be adjusted) that hasn’t been changed since the ‘40s/’50s. Typically Roto-Rooter gets the opportunity to acquire a franchise when the 2nd generation is retiring. Many of the larger franchisees operate it like a family business, with many of the members employed by the company. Chemed acquires these franchisees for 4x-6x EBITDA (though it’s more like 6x-8x as of late), which implies a pre-tax return of 17%-25% prior to any efficiencies gained.
The large Roto-Rooter acquisitions over the past three years include:
These deals are highly accretive to the company if you assume that steady state EBITDA margins for the acquired businesses will increase to 25+%. At a 25% EBITDA margin, the deals above come out to 6.5x-7.7x EBITDA, which implies a pre-tax return of 13%-15%. The returns get even better (and the implied multiple is lower) because Chemed will be able to increase revenues in the acquired territories. The revenue/population range between $1.7-$2.9, whereas company owned branches typically bring in $4-$4.5+ in revenue/population.
As an example, Chemed has stated that HSW had 10% lower gross margins and 18% lower operating margins than company operated branches. HSW didn’t market over the Internet and so the residential business was significantly smaller than the average company owned branch. The customer mix was heavily skewed towards commercial at 2/3 of the business, which makes sense given the lack of digital marketing on the residential side of the business. The company plans to take 18-24 months to ramp up KPIs, increase necessary marketing and hiring and improve response times for inbound leads. Chemed will also add water restoration services to these regions.
Chemed management views capital allocation as a big driver of long-term value creation. So when doing these Roto-Rooter deals, they believe that it’s a better use of capital than spending more on capex or buying back shares. With the remaining capital, Chemed has chosen share repurchases as the next best use since hospice assets sell for a higher EBITDA multiple than where Chemed trades. Over the past 10 years, the company has generated $1.6B in FCF and has allocated almost 2/3 of that to share repurchases. Chemed does pay a small dividend (0.3% yield) and that is to just expand the universe of potential shareholders.
We estimate that Chemed has achieved a return on incremental capital between 45%-55% over the past five years, netting out any impact from litigation and government investigations. The returns have recently improved as (1) margins for VITAS have increased since 2017 after settling with the OIG and for Roto-Rooter as water restoration services have contributed more + large franchisees were acquired and (2) passing of the Tax Cut and Jobs Act in 2017. These high returns in recent years make sense because incremental capex for both VITAS and Roto-Rooter has very high returns.
We recognize that netting out the fines may not be correct, and it may be the case that Chemed has to pay more fines in the future, but they weren’t that material except for 2017 when Chemed settled with the OIG for $75m ($52.5M net of taxes). There is also some volatility year to year to the return numbers because Medicare reimbursements generally happen every other Friday and ~$35M in cash flows can fall into the next fiscal year depending on the calendar.
Chemed expects VITAS to grow on the top line by ~2% due to the annual increase in the national reimbursement rate and another ~2%-4% from admissions growth. If the company can also increase average length of stay from getting more patients into hospice care earlier, that’s also additive to growth. For Roto-Rooter, annual price increases are usually tied to inflation and should partially help with wage pressure and most of labor costs is from commissions.
Because the hospice segment will likely not have any meaningful acquisitions in the near future and the Roto-Rooter acquisitions are lumpy, it’s reasonable to expect capex spend to be the majority of reinvestment dollars. We do want to note that the reinvestment rate has been low at Chemed for these reasons. As hospice admissions grow the company needs to acquire more medical equipment. For Roto-Rooter most of the capex spent will be on plumbing and water restoration equipment.
Roto-Rooter will have certain franchisees that want to sell their rights back to the company and there is still a lot of white space in certain western, mountain and midwestern states. The overall TAM for the plumbing market is north of $20B.
Chemed has also started new hospice programs but hasn’t had that much recent success. However, there should be regions that VITAS can open new locations if management felt that it would be a good return on their time and capital. The math on the patient side goes like this. There are an estimated 2.6M annual deaths in the U.S. and 2.1M are appropriate for hospice care. The total industry cares for about 1.1M-1.2M patients per year and there are almost 5,000 hospice programs in the U.S. (an operator can have multiple programs). Chemed cared for 90k patients in 2020, so there is more room to grow.
With a reinvestment rate between 20%-30% and a return on incremental capital of 45%-55%, we estimate that Chemed has increased its intrinsic value 11%-13% over the past 5 years. The reinvestment rate has increased recently due to the franchise acquisitions at Roto-Rooter, but as mentioned before, these tend to be lumpy.
What else is important?
Risk of carve in for Medicare Advantage
Carve in for Medicare Advantage is a potential risk for the way hospice care is reimbursed. Currently, it’s covered under original Medicare under a fee for service model. The reimbursement rates, while they adjust from time to time, generally get paid and the per-diem model is profitable for hospice providers that have the right mix of RHC vs. acuity care.
However, there has been talk of a hospice carve-in under Medicare Advantage for a few years now. And while most hospice programs will either say it’s unlikely to happen or that it would create a conflict of interest problem, there is still a chance that this outcome does occur. And the worry is that Medicare Advantage would pay hospice providers less and/or change the reimbursement model from per-diem to per visit, which would make profitability in the hospice industry almost impossible.
CMS proposed a voluntary demo starting in 2021 as part of the Value-Based Insurance Design model in several states. This will be tested and studied by many agencies before a decision would be made as to the efficacy of the program.
Office of the Inspector General (OIG) investigations
Similar to other areas of healthcare, there have been many government investigations into abuse and fraud within hospice care. The industry has paid over $400M in settlements and fines over the past 20 years. Chemed is not immune to these investigations and had one large settlement in 2017.
Chemed settled an OIG investigation for improper billing related to claims from 2002-2013. The lawsuit claimed that VITAS used aggressive marketing tactics and pressured staff to falsely increase the volume of claims. As a result of the investigation, Chemed ended up settling with the government and paying $75M or $52.5M net of taxes. The company also entered into a Corporate Integrity Agreement with the OIG that lasts 5 years. The agreement ensures compliance and documentation of procedures related to claims, and a breach of this agreement would result in fines.
Both of Chemed’s businesses were deemed essential during the lockdown period of 2020. However, Covid-19 did impact both businesses in different ways. For VITAS, at the start of the pandemic, many patients ended up delaying hospice election due to worries about infection from the virus and family members that wouldn’t be able to see the patients during acuity care. There was also worry that hospitals would look to free up beds for Covid patients. Routine home care was fine as people were at home anyway, but the average census at nursing homes was down -11% since these facilities were hit the hardest by the virus.
For Roto-Rooter, the company saw a strong increase in demand from residential customers as people were confined to their homes. Furthermore, when there was a shortage of toilet paper, people started to substitute it for other paper products which ended up clogging many drain pipes. From an article in the San Bernardino Sun, a technician in Orange County stated that,
“Before the virus, our average calls a day, for clogs, were probably four a day, and now we’re doing 10 to 13 calls a day.”
The unit-for-unit (similar to same store sales) residential revenue growth for Roto-Rooter in FY20 was:
Commercial revenues were hit hard but rebounded after the country started to reopen. Retail commercial customers who contribute to 30%-40% of commercial revenues (10%-12% of total Roto-Rooter revenues) were hit the hardest. Roto-Rooter retained all of their employees and ended up gaining market share, especially with the 24/7 call center.
Positives and negatives of having two disparate business segments
Like we mentioned at the beginning, there is little strategic reason for Chemed to own both VITAS and Roto-Rooter. They both happen to be good businesses, especially relative to their sector, but a tax-free spin of Roto-Rooter is easily achievable if management wanted to take that route.
The small benefit from having these two business segments is that the overall fundamentals of the business are less volatile. If there are changes in hospice reimbursement, the increase or decrease in hospice fundamentals are muted by the steady growth in Roto-Rooter. The company also operates with an under-levered balance sheet in case there are big changes to either of the businesses.
The drawback is that while the management team at Chemed wants to operate a healthcare company and be recognized as one, Chemed is an underfollowed company due to the complexity of having to analyze two businesses. There are currently three sell-side analysts covering the company and they don’t attend all of the company’s earnings calls. In 2Q and 3Q of FY17, there were no analyst questions on the earnings call.
Chemed has the option to either (1) spin off Roto-Rooter to become a pure play in hospice care or (2) fully invest in Roto-Rooter and expand into new regions and aggressively pursue repurchasing of franchisees by increasing the multiple on future deals.
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