Encompass Health Corporation (ASX:New York Stock Exchange: EHC) and note that it exhibits many of the characteristics that will encourage further upside in the future investment climate.this is expensive A name with a high probability of successfully executing its growth strategy while maintaining a 10.2% annualized return on invested capital and ample liquidity. Profitability trends are a distinguishing feature, along with a defensible business model, and we value EHC as a buy at a valuation of $84.75 and seek a 64% return target up to that level.
Exhibit 1. EHC 6-month price action, Ichimoku cloud overlay. The price line and the lag line (blue) are each rising with cloud support, but the balanced volume indicates the long-term trend is in place. This price chart is probatively bullish .
Q2 Earnings Offer Insights on FY22 Exit Momentum
Earnings in the second quarter were strong but below consensus expectations from top to bottom. Total revenue he was $1.33 billion, a growth of about 310bps year-over-year. Of these, the Inpatient Rehabilitation Franchise (“IRF”) business contributed the largest 80% or $1.06 billion, with quarterly EBITDA of $196 million. As can be seen in Exhibit 2, income from each segment is seasonal, with growth trends normalizing to single digits in recent quarters.
Exhibit 2. Income mix by segment, trend back to normal range
Non-GAAP EBITDA posted $240 million, explaining that adjustments are needed to gauge the company’s liquidity profile. Exhibit 3 shows the reconciliation of net income to adjusted EBITDA. Upon investigation, we agree with most of the adjustments, except for the $8.8 million equity-based compensation and $3.2 million equity position fair market value changes. So he adjusted his EBITDA for EHC to $228.2 million.
Exhibit 3. Reconciliation of Net Income to Adjusted EBITDA – ~22% Difference Between Reported EBITDA and Adjusted EBITDA
This resulted in pretax operating income of $95 million, down from $181 million in the prior year and net income of $71 million. The year-over-year change was driven by higher operating costs and a 44% increase in interest expense in the SG&A line. As such, FCF translates to ~$177 million with a margin of 12.5%, up ~21% year-on-year.
Additionally, contract workers (including sign-on and shift bonuses) were ~$57 million in Q2, down ~$7 million quarter-over-quarter. ~62% and ~38% split between contract workers and sign-ons/bonuses respectively. Impressively, within the current labor market, EHC has actually increased the number of full-time equivalents of contracted work (“FTE”) from his maximum of 750 in March to 597 by June. % reduced.
The 130bps increase in revenue per ejection is commendable. However, this was offset by ongoing cost issues due to “staffing issues” according to earnings reporting. Nonetheless, some leverage came from each FTE’s second quarter agency rate, which reduced him from $240,500 to $222,000. The company’s agency fees peaked at $243,000 in February, so these are good trends and there was some uncertainty about the likelihood of this going back into the range again. Unfortunately, by June, overall agency fees were down more than 40% to about $209 million.
The company’s return on investment fell to 2.69%, above the quarterly average, as sales and operating income soared. Here we look at how much NOPAT EHC is generated from the previous year’s invested capital and determine this as return on investment (“ROIC”). As seen in Exhibit 4, his ROIC over four years normalized to 2.55% (10.2% annualized), well above the company’s annual WACC of 6.1%. This adds a very bullish edge to the investment discussion. These are steadfast, defensible and cash-rich investments on EHC’s books. Therefore, the company can continue to grow its cash at an average annual compounding rate of about 10%. This is an attractive trait in a positive environment.
Exhibit 4. ROIC trend reverts to the upside with NOPAT conversions
Guidance checked from top to bottom
Management said second-quarter earnings were in line with internal expectations, prompting the company to reaffirm its FY22 guidance. He raised the reserves allocated to bad debts from 200bps to a range of 200-220bps. Management also projects $280 million to $380 million in his FCF from the IRF segment. However, it’s worth noting that his year-to-date FCF in this segment has already put him at $290 million. This marks an increase in his CAPEX schedule for the second half of 2022, in line with seasonal trends.
Following the Enhabit spinoff, it released another series of accounts and forward-looking guidance in June. EHC revenue is now expected to be $4.225 billion to $4.3 billion, adjusted EBITDA of $820 million to $840 million and non-GAAP EPS of $277 million to $291 million. increase. It also announced a quarterly dividend of 0.15 cps, but with a forward yield of 0.3%, it can be ignored in our analysis.
Exhibit 5. EHC Quarterly Operating Income Trends
Same-store RN hires increased more than 135% year-over-year to 276, resulting in increased sign-on and shift bonuses throughout the quarter. As the company continues to hire more RNs, industry turnover continues to be high, and given the current state of the U.S. labor market, EHC expects both of these costs to continue to perform well over the remainder of FY22. expect to maintain.
As a result, the company appears to be shifting away from contract labor into this segment and expects agency rates to continue declining in unison with the previous quarter. However, the outlook remains uncertain as the Covid-19 situation is still unclear. In addition, agency fees are likely to remain high for longer due to ongoing staff shortages due to myriad other reasons (sick leave, retirement, etc.). EHC predicts.
Separately, CMS published the final IRF rules for FY23 in the last week of July. CMS has established an update of up to 4% to the IRF Basket Final Rule. Therefore, EHC will recognize him 4% in Medicare payments starting in October of this year when the new rules take effect.
The key point, however, is that a 400bps rise will not be enough to overcome surging operating costs and rising interest expense. It has $170 million of primary variable rate debt and approximately $398 million in Term Loan A facilities. Spreads for issued bonds are shown in Exhibit 6 below. The coupon is 4.6% to 5.75% and the term is 2023-2030. A sensitivity analysis of the company’s credit structure indicates that a 1% increase in commercial interest rates would increase EHC’s negative cash flow by approximately $3 million. The downside is the same.
Exhibit 6. EHC Credit Structure Observed Spreads on Issued Notes
This profile generates a total cash flow outflow/inflow of $3 million for each 1% increase or decrease in interest rates.
The stock trades at a discount to its peers at all multiples used in this analysis (stick multiples). Alas, it’s trading at a 13% discount to his 12.6x futures P/E over its peers in the GICS industry, suggesting the market is pricing in underperformance of the sector. This creates the optimal setup for the company to turn its bottom line upwards.
Figure 7. Multiples and Comps
That’s 12.6 times the company’s FY22 EPS estimate of $9.30, or $117 for the stock, which could be incredibly high if it survives at that rate. However, we are also aware that the company has a negative tangible book value, but it is trading at 2.6 times gross book value and 6.8 times cash flow, both at 50% and 60% discounts for the sector. However, EHC is trading at more than 15 times his estimated FCF for 2020, with the stock valued at just $52.50. Due to the large variability in distribution results, I am unsure of estimating the average valuation and use the median of all calculations to price his EHC at $84.75.
Additional data points:
- The stock has been winning bids since June, hitting a 52-week low in the process.
- At the same time, it is also being strengthened for the medical technology and healthcare provider sectors.
- To explain why this is likely an idiosyncratic factor, we see that the covariance structure of EHC to the benchmarks has remained level over this time period and then shifted downwards.
- Investors want to be rewarded for their inherent risk premium in FY22, and while the decline in equity beta in EHC is evidence of that, we presume by pushing the lows higher.
- This shows the technical momentum supporting the chart’s further rise.
EHC demonstrates quality attributes that investors are paying a premium for in FY22. The company has averaged his ROIC of 10.2% annually, boosting profitability and weakening the economic outlook. We have also proactively addressed the rapidly increasing costs associated with labor management. This keeps us bullish on the name with the latest sector rotation back in healthcare in the second half of 2022. EHC he rates as a buy with a target price of $84.75.