Home Health Mergers and Acquisitions Go Through the Roof

By Dexter W. Braff

For the first time in a long time, there is much to talk about - most of it good - in nearly all segments of home health care mergers and acquisitions markets: Medicare home health, hospice, Medicaid and State funded home health, and private insurance and private pay.

It's the result of a confluence of legislative and regulatory conditions, market dynamics, operating and consolidation strategies, Wall Street performance and a tide of broad-based optimism and momentum that has emerged over the past six to 12 months. The buzz in home health care mergers and acquisitions has become nearly palpable as buyers, seller, equity investors, lenders and others are energized to make deals.

In fact, the number of public and non-publicly announced home health transactions reached 57 in 2004, a 27% increase over the 45 deals recorded in 2003. Even better: with 30 transactions through the first half of 2005, deal volume is up 50% over the same period of 2004.

Wall Street gives Home Health the Nod
It appears that the view of home health from "the Street" is quite spectacular. Home health and hospice stock performance, according to our Braff Group Index, has surged 32.3% in the past year. (The BGI is an unweighted index that measures the stock performance of 38 companies in seven key health care service sectors including home health and hospice, hospitals, long-term care, specialty pharmacy and infusion therapy, home medical equipment, health care staffing, and e-healthcare. (All stocks were indexed to 100 on February 29th, 2000) And that tops off a full 24-month growth trend. Over the past two years, the TBG HHA/Hospice Index has risen an impressive 61%.

Moreover, at the end of July 2005, the HHA/Hospice Index closed at 501.66 - a record high not only for the sector, but a record high for every sector we track.

And in one particularly noteworthy event, LHC Group of Lafayette, LA, completed the first non-hospice initial public offering in nearly 10 years on June 14, 2005. As of August 2, the company's share price had risen 37% above its initial $14 offering price, giving it an enterprise value of 1.8 times revenue according to Capital IQ. That stunning metric puts LHC in the same league as a market leader Amedisys, which closed the same day at 2.17 times revenue.

From an M&A perspective, these figures are extremely important as they provide investors and lenders with critical market insight on performance, growth expectations, valuations, credit worthiness, and sector optimism; factors that determine interest in, and financing of, acquisitions. That should give sellers and extremely positive backdrop for their own M&A prospects.

Altogether, all of these factors mean M&A activity in the home health arena as a whole should heat up even further in the coming months. Based on the surge of activity in early 2005, we expect transaction volume to eclipse -- perhaps significantly -- the 57 deals recorded last year.

Medicare Home Health Delivers on the Promise
Ever since the prospective payment system was initiated in October 2000, with the opportunity to generate profits in a market that was (and still remains) extraordinarily fragmented, the speculation was that there would be a surge of merger and acquisition activity in the Medicare home health arena.

Well, with concerns regarding the viability of early financial returns under PPS, fear regarding cuts in reimbursement, pre-PPS valuation metrics that held pricing below what the sector's risk-profile would suggest, and a dearth of sellers (who were content to sit back and generate profits), the surge turned out to be more of a slow, but steady rise.

Over the past 6-12 months, however, the sector seems to have broken out with a series of high profile, sizeable transactions, including Amedisys' acquisition of Winyah Health Care Group and HouseCalls; Gentiva's acquisition of Heritage Home Care Services; and Healthfield's acquisition of Capital Health Management Group.

The market surge is expected to continue well into next year, for several reasons:

1. Wall Street bestows high valuations to Medicare focused firms such as Amedisys and LHC Group, turning the heads of private equity groups away from hospice and toward Medicare home health - a substantially larger market with even greater opportunities for consolidations.

1. The Medicare Modernization Act (MMA) calls for home health rate increases through 2006. Even under increased scrutiny from MedPac, with the MMA essentially politically declared off-limits until the prescription drug benefit is implemented, the near-term outlook for reimbursement is quite stable - an extremely attractive oddity in government reimbursed health care.

1. More attractive and sizeable sellers are testing the market, after having banked away four years of profits.

At the same time, buyers have replaced old valuation metrics with new benchmarks, principally earning before interest, taxes, depreciation and amortization (EBITDA), becoming more comfortable with the risk-return fundamentals of PPS. As a result, more high end - sizeable and profitable - transactions are closing.

We're finding larger agencies ($20 million or larger) are selling for anywhere between five to seven times EBITDA, and smaller agencies (less than $10 million) are bringing in four to five times EBITDA.

IMPORTANT: Valuation ranges reported in this article are intended to serve as basic guidelines for value. The actual price an agency may obtain in a competitive and strategically developed market can vary widely depending upon a host of factors such as the agency's state of compliance, market penetration and growth rate.

HHAs seek Compatible Private Duty Agencies
With an increasing number of Medicare-focused providers growing organically, or by acquisition, to a critical mass necessary to serve the populations they cover, we anticipate increased demand for private pay agencies as these firms pursue second stage development strategies.

Most of the acquisition activity today in the private pay arena involves large Medicare or Medicaid providers targeting private duty providers to diversify away from government reimbursement and/or to learn the unique operating strategies and fundamentals of the segment.

The latter is particularly important for Medicare providers as they prepare for the prospect that, given legislation contained in the MMA designed to shift dollars from Medicare fee for service to Medicare managed care, an increasing number of beneficiaries may join these plans and receive services with reimbursement akin to private pay.

And buyers are willing to pay more to protect themselves than they have in the past. The largest private pay agencies ($5 million +) are going for four to five times EBITDA, and even smaller agencies are selling for multiples of 3.5 to 4.5 times EBITDA.

Private duty, however, isn't proving ripe for large scale consolidation or rollups (as we are seeing in Medicare home health) because private duty companies have not proven very scalable.

Private pay (including private insurance) home health is typically consumer driven, service and relationship intensive, and demands substantial oversight and owner involvement. That means it is fundamentally difficult for a private pay provider to grow organically into a large entity of $10 to $20 million or more in revenues. In fact, the median size of a private duty agency in 2004 was $1.5M, according to a survey conducted by Success in Home Care's sibling publication, Private Duty Insider.

As a result, the segment is less than ideal for consolidation solely within the sector because (a) the nature of the business as described above makes it difficult to flourish under non-owner management, which (b) makes it difficult to scale, and (c) because a buyer needs to acquire and integrate an inordinately large number of providers to get to revenues of $50 to $100 million or more - the sweet spot for aggregation and divestiture strategies.

Hospice Momentum Slows
After several years of being the "golden child" of home care mergers and acquisitions, hospice appears to have reached its peak.

Several factors over the recent past have contributed to this inevitable slow-down. First, in February of 2004, the Rand Corporation released a report regarding the financial impact of hospice and concluded that while "cancer patients who chose hospice care were about 1% less expensive for Medicare", overall "expenses were 4% higher.among patients who used hospice services compared with similar patients who received traditional medical care".

While the services provided under hospice are nearly universally lauded, the added benefit of reduced cost - an economic factor that could go a long way to sustain reimbursement long into the future - may not be there.

Second, with the Office of the Actuary of CMS reporting that hospice expenditures have doubled from $3.5 billion in 2001 to an estimated $7.0 billion in 2005, and MedPac reporting that the number of for-profit hospices have grown 25% from 2001 to 2003 (compared to 1% and 3% for government and not-for-profit hospices, respectively) the benefit is under increased scrutiny from MedPac.

Third, amidst increased regulatory oversight and difficulties with hospice cost caps, the hospice providers in our TBG Home Health and Hospice Index fell 50% in 2004, shaking the confidence of the capital markets. Although less than a year ago CMS indicated that a review of hospice reimbursement was a low priority at that time, the combined weight of all the above, among other factors, took a toll on what heretofore was a veritable frenzy of hospice M&A activity.

Even with these threats, buyers are still buying, though as the market has matured, pricing has leveled off. Buyers are focusing more on return on investment valuation based upon multiples of EBITDA vs. capacity-building valuation based upon multiples of census.

Furthermore, while much of the M&A activity over the past two years has been driven by larger buyers, particularly private equity groups, who sought to establish base infrastructures, we anticipate an increase in "add-on" transactions in the months ahead...that is, purchases of smaller providers that can be efficiently and profitably layered onto these platforms as the hospice market continues to mature.

Medicaid and State-funded Home Health in Flux
The past year has been a series of ups and downs for Medicaid reimbursed home health care.

On April 28th, Congress approved a budget resolution cutting Medicaid spending $10 billion over 5 years beginning in 2007. While certainly unwelcome news, these cuts amount to less than one half of one percent of the more than $2 trillion in Medicaid spending projected by the Office of the Actuary in the National Health Expenditures report released earlier this year.

At the same time, self-directed care initiatives continue to gain momentum, initiatives that could reduce, or eliminate the role of agencies in providing certain Medicaid services.

On a more favorable note, however, "the State revenue picture for most states improved dramatically in fiscal 2005, a situation that is expected to continue in fiscal 2006 as projections indicate revenues up an additional 5.2 percent", according to a July 7th press release from the National Governors Association (NGA).

And while the NGA reported that "despite extensive cost containment, expenditures for Medicaid.continue to outpace revenue growth", many remain convinced that part of the solution to curbing Medicaid spending is to move from institutional care to community based services, notably home care.

On balance then, we suspect that home care's role as a solution to curb Medicaid spending far outweighs the threats of budget cuts and consumer directed care.

Accordingly, our sense is that the M&A market for Medicaid -- and State-funded home health is no longer in free-fall and has begun to stabilize. Moreover, we have recently noted an emerging acquisition strategy in which buyers (a) are targeting large Medicaid providers to gain an operating infrastructure with management skilled in recruiting and working under tight margins, (b) upon which they can subsequently layer on Medicare and private duty services, and (c) at pricing below the premiums currently being offered to like-sized Medicare providers.

That is driving healthy deals for larger State-funded HHAs ($30 million or more) at four to six times EBITDA. Agencies that are smaller than $10 million, on the other hand, are still seeing values of two to three times EBITDA in this market.