Jenks Healthcare Business Report September 2002

In the September 2002 issue:

HealthSouth: Three Strikes And You’re Out?

In the equity markets, HealthSouth has had a troubled past. In three of the past five years, the company’s stock price has plunged for a variety of reasons, with the most recent problem occurring in the past month. Will the current plummet be the last straw with investors, or is the market missing a real opportunity at these low values? See page 1

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Public Equity Market

Despite several companies pulling their IPOs during the summer lull, in mid-August a new health care REIT completed its IPO, and several other companies are lined up for secondary offerings. See page 6

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Venture Capital Market

Although not a record, the 22 venture capital financings during the past month is another strong showing for health care companies. The total volume was just over $300 million, or an average close to $14.5 million per deal. See page 9

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Acquisition Market

Unlike other industry sectors, the health care M&A market is on track to post a slight gain this year over 2001. The medical device sector, claiming more than 25% of the deals in the past month, continues its strong showing. See page 9

Jenks Healthcare Business Report

HealthSouth: Three Strikes And You’re Out?

Small fortunes have been made by playing the peaks
and valleys of stock price movements, and in the market environment of the past several years, health care has seen its share of opportunities. Whether in the pharmaceutical, biotechnology, long-term care or home health sector, volatility has been extreme, sometimes because of changes in the market, other times as a result of management missteps or just not paying attention. HealthSouth (NYSE: HRC), the largest rehab provider and operator of ambulatory surgery centers in the country, provides a good example of all three.

In three of the past five years (1998, 1999 and 2002), HRC shares have plunged by at least two-thirds in value from the price at the beginning of each of those years. In the two earlier periods, HRC’s shares then jumped by 131% and 284%, respectively, a year after hitting those lows. As of the last closing price of $4.85 per share, HRC’s shares are down 68% in 2002. The dilemma facing investors now, at least for those who have not already dumped their shares in disgust, is whether lightning will strike for a third time and send the company’s shares soaring once again. Or, to take a pessimist’s view, is it three strikes and you’re sent up the river?

The current share price fiasco has resulted in the numerous expected lawsuits, but some of them may have more validity than the usual legal outcries when stock prices plunge. In particular, holders of the $1 billion of bonds that were sold last May could have a legitimate claim that management did not disclose enough information that was material to the credit rating of the company. This would include the minor detail that the ambulatory surgery business might be spun out of the company, something that was not announced until late August but surely discussed internally for several months beforehand.

Some investors believe they have been duped because HealthSouth’s chairman and former CEO, Richard Scrushy, cashed in options for about 5.3 million shares of stock last May 14 when the company’s share price was $14, or almost three times higher than it is today. The fact that his options were set to expire the next day apparently did not satisfy their concerns. What is more troubling, from a timing perspective, was Mr. Scrushy’s sale (or transfer) on July 31 of 2.5 million shares to HRC at just over $10 per share to pay off a $25 million loan from the company. The share price plunged less than a month later.

On July 1, the Centers for Medicare and Medicaid (CMS) issued a directive to Medicare Part B carriers requiring that outpatient therapy services provided to two or more patients in a single time period should be paid for under the group therapy payment code, regardless of whether such patients were engaged in the same activity. During July and August, management sought clarification from CMS in a series of meetings, but they had to know that the impact would not be neutral. Rather, it was just a matter of how bad, and how much it would send HRC’s share price down. It is naïve to think that management, in July, did not expect the company’s cash flow to suffer from this new "interpretation," which is why shareholders believe the timing of the July 31 stock sale back to the company was not overly ethical.

The issue of Medicare reimbursement has often been murky, and a brief summary of the particulars for HealthSouth is as follows: An average physical therapy patient receiving "individual" treatment on an outpatient basis may have up to three or four different procedures in one visit, with the charge for each procedure between $25 and $30. The group rate is just under $20 per visit, per person. Consequently, a Medicare patient being billed individually could yield between $75 and $100 per visit to the therapy center, whether the service was being provided in a group or solo.

Going to the group rate for Medicare obviously means a significant drop in revenues, and until some changes can be put in place, it looks as if there is a dollar-for-dollar top-line and bottom-line drop in income. Apparently, HCR’s competition has already been complying with the "change" in policy. It seems unusual that the number one rehab company in the country would not know what is going on regarding something as important as outpatient Medicare reimbursement. Was it arrogance, a case of the proverbial head in the sand, or don’t ask, don’t tell (shareholders)?

HRC currently has about $240 million of Medicare outpatient therapy provided in its inpatient facilities, and another $90 million at its outpatient facilities. By estimating that there will be up to a $175 million shortfall in annual EBITDA from this change, management is really saying that close to 50% of its outpatient Medicare revenues may disappear. What the non-Medicare payers will do is still a matter of speculation.

What may be more troubling, according to Kemp Doliver of SG Cowen, is the company’s extensive use of students and other unlicensed "extenders," which may be what the government is investigating under the False Claims Act. Other providers have already stopped using students (and billing for them), but it is unclear what the financial impact of this may be on HRC.

On July 11, 10 days after the CMS directive, HRC issued a statement confirming its 2002 earnings projections, but met with CMS a week later and subsequently stated that they were confused after the meeting. Obviously, Mr. Scrushy was not so confused that he couldn’t sell 2.5 million shares back to the company at $10 per share at the end of the month. Given the changes that were about to take place, the timing of the earnings confirmation was questionable, to say the least.

When the company finally revealed in late August that annual EBITDA may drop by $175 million because of the change in reimbursement, the announcement came along with the news that the ambulatory surgery center business would be spun off to shareholders as a separate company. In addition, it was announced that Mr. Scrushy would step down as CEO of HealthSouth, but would become chairman of the new entity, to be called Surgical Care Affiliates.

HRC lost almost one-half its value on the news, which was hardly proportional to the 15% decline in cash flow with the reimbursement change. One of the biggest problems, and the one that resulted in the investment community losing faith in the company, was the inability to provide earnings guidance for the rest of the year and 2003 and the unwillingness to elaborate. At its current price, HRC’s market cap has dropped to just $1.8 billion from $5.6 billion last May. The general feeling is that if management was not on top of something as important as how they are going to get paid by Medicare, no one is minding the rehab store and it is not worth waiting until someone can figure out what is going on.

At first blush, we were in agreement with that sentiment, but the numbers tell a different story. It must be remembered that HealthSouth is the largest outpatient rehab provider in the country—two times larger than the nearest competitor—and is the largest inpatient rehab hospital company in the country with no national competitor. It is also the largest operator of ambulatory surgery centers in the country and again, the next largest competitor is less than one-half its size. The point is that HRC is the leader in several different markets, a claim that few health care companies can make.

When trying to understand the underlying value of the company, the first step is to look at the surgery center business, which has annualized revenues of $1.05 billion and an EBITDA margin of between 30% and 35%. HRC’s two publicly traded surgery center competitors, Amsurg (NASDAQ: AMSG) and United Surgical Partners (NASDAQ: USPI), trade between 7x and 8x EBITDA, but both are faster growing (mostly because they are so much smaller), and USPI has a much smaller relative minority interest than the other two. Applying similar numbers to HRC’s division yields a value of at least $2.0 billion, or close to what the market is valuing all of HealthSouth.

In other words, when buying HealthSouth today at $4.50 to $5.00 per share, the investor basically is getting the entire rehab and diagnostic imaging businesses (with the debt) for free. After removing the surgery center business (and the minority interest that is part of it), as well as deducting the $175 million in EBITDA that HRC may lose in its outpatient therapy business, the remaining businesses theoretically will produce about $800 million in EBITDA this year, barring any other financial calamities. The majority of this is derived from the inpatient rehab hospital business, so applying a 6x multiple (which some would consider to be conservative) yields a $4.8 billion value, from which the $3.0 billion of net debt can be deducted. That produces a per share value of $4.50 on top of what the surgery center business is worth. Even if the multiples on all the business lines are lowered, a value below $5.00 per share for the entire company just does not make sense.

If another shoe drops on the rehab business, and it may since management remains a bit fuzzy as to what is happening with reimbursement, at current levels the downside is protected by the value of the surgery center business. This is a case where the sum of the parts is definitely worth more than the whole. Now, there is also the possibility, as some analysts think, that the $175 million reduction in EBITDA is overly conservative. If this is true, then a combined price range above $10 per share is very realistic. If we have déjà vu all over again, it will take six to 18 months for a recovery in HRC’s stock price to take place. But since the surgery center business will be spun off to shareholders, presumably in the next six months, the timing should be faster.

Although investors hope to get some clarity with a scheduled September 19 conference call, one motive for spinning out the successful ambulatory surgery center business could be to insulate it from any potential liability from the government investigations. As a separate company, any further announcements or penalties related to Medicare reimbursement would not impact Surgical Care Affiliates’ market value.

Some risks, however, remain. Felice Shiroma, a bond analyst at Gimme Credit, an independent corporate bond research firm, issued a report recently discussing HealthSouth’s new loan agreement with a maximum debt/EBITDA ratio of 3.5x as one of its covenants. With the lost Medicare reimbursement and the surgery center EBITDA being pulled out, that’s going to be very tight unless some of the debt goes with the surgery business. And speaking of debt, it is going to be more expensive to refinance any portion of the existing $3.5 billion of debt with the current problems, and HRC’s access to the capital markets in general is in jeopardy, at least in the short term. In addition, it is unclear what impact, if any, the new Medicare reimbursement for outpatient therapy will have on HRC’s inpatient Medicare business, and whether other payers will tighten the screws on group therapy payments.

One thing is clear, however, and that is that investors are not happy with Mr. Scrushy. He claims he has strong management teams in place at the surgery center business and the rest of the company, allowing him to relinquish the CEO position at both. Once the spin-off is complete, it may be an opportune time for Mr. Scrushy to pick up his guitar and take his band on a long concert tour, avoiding, of course, the financial centers of the country. And if he needs a sax-ophone player, we hear Bill Clinton may not be doing his talk show after all.

Read the past headlines.