HealthSouth's Troubled Past Is Today's Buying Opportunity

HealthSouth is the leader in inpatient rehabilitation, with a clear path for organic facility growth, ongoing lease de-leveraging, and favorable tailwinds from an aging population. The company trades at 8x trailing EBITDA, despite delivering consistent 5% top-line growth and 25% EBITDA margins. After including $4 / share in DTA value, HealthSouth has ~40% upside.

Company Description
HealthSouth is the largest owner-operator of inpatient rehabilitation hospitals (IRFs) in the United States, with 9% of facilities and 21% of total discharged patients. The company offers a nondiscretionary service to a very specific demographic. The average patient is 72 years old, eligible for Medicare, has just spent a few days at an acute care hospital after suffering a debilitating episode (e.g. seizure, stroke, or hip fracture).

Brief History
Things weren't always so rosy at HealthSouth. HealthSouth's founder and CEO / Chairman between 1984 and 2004, Richard Scrushy, was convicted of bribery, conspiracy, mail fraud, and falsifying corporate earnings in 2006. HealthSouth paid $325M to the US Government to settle allegations of fraudulent Medicare use, and Scrushy was ordered to pay $2.87Bn in damages to HealthSouth's shareholders, but collection efforts are still ongoing. The silver lining: as a result of losses incurred in the aftermath of Scrushy's leadership, HealthSouth incurred a DTA balance of $493M, and nearly all of this is expected to be realized over time.

The current CEO, Jay Grinney, took the helm in 2004, and has done an excellent job turning around company despite the numerous regulatory headwinds (more details below). Between 2007 and 2013, while industry-level patient volumes declined, HealthSouth's inpatient discharge volume grew an annualized rate of 4.4% (with same-store comps accounting for 2.5%), total revenues grew at an annualized 5%, and adjusted EBITDA at 9.6%.

Industry Dynamics
The U.S. inpatient rehabilitation industry is highly-fragmented, and most rehabilitation care exists as smaller units located within hospitals or nursing homes. HealthSouth is the largest standalone IRF operator with 103 facilities (its next largest competitor has 15 facilities). The company's focus on rehabilitation care and elderly patient base bring some unique pros and cons…

The Bad:
With 80% of payments coming from Medicare, HealthSouth is subject to regulatory audits and government cost-cutting initiatives. Another headwind is sequestration, which has reduced Medicare payments by ~2% / year as of 2013, but this is not expected to be permanent. As an IRF, HealthSouth is also subject to "the 60% rule", which effectively mandates that at least 60% of HLS' patients must fit at least one of the CMS' selected medical conditions.

The Good:
Inpatient rehabilitation faces long-term tailwinds from an aging Baby Boomer population, growing life expectancies, and general desire by seniors to live independently. The Medicare-eligible population is expected to grow at 3% for the foreseeable future. Regulatory requirements for CON (certificate-of-need) approval in ~50% of the states where HLS operates effectively deters potential entrants. And even within existing operators, regulatory burdens have forced out smaller and less efficient operators, helping the remaining operators to gain share over the last few years.

Valuation:
I get a fair value of $46, which includes $42 of value from continuing ops and $4 from DTAs.

DCF:
Management's forecasted adjusted EBITDA growth over the next three years is 4-8%. This seems conservative in the context of HLS' 9.6% historical EBITDA growth (management has a tendency to sandbag). Adjusted EBITDA growth (as defined by HLS management) is good a proxy for FCF growth, and maintenance capex is expected to stay flat at $80-85M / year.

For my 10-year DCF, I assume that management is able to grow FCFs at the low end of its guided range, at 5% over the next 3 years, then 4% for years 4-10, and 3% into perpetuity (based on the long-term growth rate of the Medicare-eligible population). This gives us a base value per share of $42 at a 12% discount rate. HLS currently has a DTA balance that is worth $4.9 / share, and ~$4 after time discounting. Adding $4 value brings us to a fair value of $46, about 40% above the current trading price.

Potential Catalysts
*End to sequestration
*Effects of ACA policies become better understood, removing perceived uncertainty
*Acquisition by larger acute care operator
*Continuing share repurchases
*Opportunity to expand into related healthcare verticals

Risks
*Further Medicare cuts
*IRF operators frequently deal with lawsuits and regulatory audits