The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- Magic Formula Investing (MFI) has dug up two companies in the home healthcare sector that now sell well below recent valuation levels:
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.
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 its $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 12 months, Gentiva is covering its $87 million in interest expense only about 1.9 times over -- far below the minimum of five 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 cannot 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
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.