In Q2 of 2011, the implications of the Patient Protection and Affordable Care Act (ACA) continued to sink in as the economy continued its slow and relatively jobless recovery. Believe it or not, the healthcare services industry was one of the best performing segments of the economy as Reuters reported that healthcare jobs lead the way with roughly 20,000 jobs/month created in Q2 and Fitch Ratings reported that healthcare providers look relatively stable as low interest rates have stimulated many to refinance debt in preparation for operations in the new era of enhanced efficiency and consolidation. Balancing federal and state budgets and implementing operational reforms such as the Employer Mandate and Accountable Care Organizations are the primary issues facing providers and influencing the mergers & acquisitions marketplace currently.

In Q1, the Obama administration published a budget proposal that was generally supportive of homecare providers who participate in the Medicare and Medicaid programs. In Q2, House Republicans led by Budget Committee Chairman Paul Ryan responded with a budget proposal of their own which would radically restructure both Medicare and Medicaid. The Ryan plan would eliminate Medicare as the guarantor of healthcare services for the elderly by replacing it with a voucher program to subsidize the purchase of private insurance by seniors over state regulated exchanges and it would replace Medicaid (and the federal requirements for participation) with block grants to give the states more flexibility in determining eligibility and services offered. Of course the Ryan budget was immediately criticized by advocates for the elderly such as the AARP and Leadership Council of Aging Organizations for denying the most vulnerable beneficiaries access to care. The CBO found that most elderly people would pay more for care and the Kaiser Family Foundation estimated that 44 million Medicaid beneficiaries would lose access to care under the Ryan budget. In a New York Times editorial, Peter Orszag pointed out that the policy shifts healthcare costs to consumers without reducing costs overall. Since the Ryan budget was proposed in the beginning of the quarter, the budget brinksmanship has only increased from the threat of a government shutdown to the current debate about the debt ceiling and the preservation of the full faith and credit of the United States.

Medicare

It seems rather quaint that last quarter we were so worried about rate cuts and other tweaks to the Medicare program when in Q2 Congressional Republicans would have us wonder if the Medicare program would even survive at all. Entitlement spending threatens to bankrupt the federal government and estimates regarding the date of Medicare insolvency have been recalculated to be five years sooner than previously predicted, so something must be done! Since homecare is the most efficient link in the continuum of care, it’s only logical that expanding homecare should be a significant part of the plan to reduce health care costs across the board. However, with proposals ranging from the introduction of co-pays and means-testing all the way to replacing Medicare with vouchers to subsidize private insurance, the question remains: What type of healthcare system will homecare be expanding within? Many different proposals to control health care costs are being debated, but the one that providers must react to right now is the Patient Protection and Affordable Care Act because it is the only proposal that currently has the force of law. As ever, the primary elements of the ACA that affect homecare providers in the M&A market are the 36 Month Rule, Rate Cuts, and Bundling of Services into Accountable Care Organizations.

The proposed rule published in the Federal Register describes ACOs as “a legal entity comprised of eligible participants to manage and coordinate care for Medicare fee for service beneficiaries.” The rule doesn’t specifically mention the role of home health in ACOs, but the expertise of home health providers in managing care suggests that home health agencies stand to become part of the foundation of the ACO model. The only problem is that the rule also states that ACO participants shall exert “proportionate control over the ACO’s decision making process” and home health providers are proportionately the smallest providers participating in ACOs. Thus, in order to take their rightful place at the core of the ACO model, home health providers will have to convince their larger primary and acute care counterparts that they offer a significant value proposition of reduced costs through increased efficiencies.

According to a study published by KPMG and EptseinBeckerGreen, roughly 30% of large providers surveyed are still unsure about assuming the risks in exchange for the rewards associated with participation in an ACO. Our experience is that the other 70% are quite sure of the financial benefits of being first and are aggressively preparing for the new world order that is approaching much faster than many people might have anticipated. We are aware of many ACOs in every region of the country that are being formed to take effect in 2012. Since most home health providers are far too small to establish their own ACO (AHA estimates start-up costs to be $10-$20 Million), home health providers must position themselves to be included as partners to avoid being left behind. In theory, this shouldn’t be too difficult because home health agencies are already informal partners with their referral sources and are already accustomed to delivering cost effective care management to achieve positive outcomes for patients. Under ACOs, this partnership is formalized and the home health agency is included in the risk/reward equation and is financially incentivized for concrete contributions such as reducing lengths-of-stay and re-hospitalizations. The impact on the M&A market is that leading home health agencies are very much in demand as large providers prepare to either establish or participate in emerging ACOs and successful agencies continue to command top premiums.

On the other end of the spectrum, the 36 Month Rule (which prohibits a newly formed or recently acquired agency from being sold for at least 36 months) continues to protect the smallest providers from having much competition when they sell. The 36 Month Rule has prevented sellers from “flipping” newly created provider numbers as well as keeping many legitimate but young agencies from coming on to the market. The flood of weak agencies heading for the exits before Bundling is implemented that was predicted by some has not materialized. Also, a recent HHS Departmental Appeals Board decision prohibits the relocation of acquired agencies and prohibits the temporary cessation of operations between owners, further limiting the options for buyers who “just want a provider number.” In all but the most overcrowded markets, it’s still pretty tough to find a clean little agency that is willing to sell for a steep discount. Since the value of the opportunity costs associated with starting from scratch has remained unchanged, the value of small agencies that are clinically sound but not financially successful has also remained unchanged.

Of greatest importance to home health providers who are considering an acquisition or divestiture is that all of the current winds of change are blowing in favor of larger providers. If the ACO experiment is successful, the net result will be far fewer providers providing care to the same large and growing base of patients. As fragmentation in the industry is supplanted by consolidation, the surviving providers will gain market share much more easily than in the past (which is why we warned against “too big to fail” last quarter) and become much larger than what is normal today. While this might be wonderful for the shareholders of the surviving providers, the value being created is at the expense of the multitudes of providers who become excluded from the system. Rate Cuts and non-ACA issues like Face-to-Face Encounters and PECOS only serve to enhance the advantages of large providers over small.

Meanwhile, program integrity continues to be an issue threatening to undermine the homecare industry’s claims that home health is a solution rather than a problem for government payers. CMS has stepped up its predictive modeling enforcement efforts by hiring Northrop Grumman to identify and analyze suspicious claims for the National Fraud Prevention Program. Many of the largest home health providers are still under investigation related to the Wall Street Journal article about therapy threshold manipulation, which is of great concern because it might suggest that “gaming the system” could be routine throughout the industry. Gentiva made news by settling a case accusing them of using improper marketing techniques under IPS for $12.5 Million, which, given that most providers gross far less than $12 Million, highlights the growing gap between large providers and small. As always, the market rewards providers who stay on the right side of the law and punishes those who push the limits on questionable practices.

Although the threat of Bundling services into ACOs might have scared many smaller providers into selling, we have not observed this to be true in the market. Many providers are still in the process of understanding ACOs and the impact they might have on the industry in general and their specific agencies in particular. Any successful agency that would warrant a premium valuation on the market today would also probably make a good ACO partner in the future. Since the upside to participating in an ACO is so great, many successful providers who might otherwise want to sell are strongly considering staying in the business to capitalize on the consolidation to be expected. This means that, even though the market is crowded by buyers preparing for Bundling, there are relatively few good agencies for them to buy!

We are consistently hearing from two types of buyers who have different approaches to the market. Large homecare providers (many who are private equity sponsored) are looking for relatively large acquisition candidates so they can compete effectively against facility-based providers. Facility-based providers are in the market to buy small provider-number deals so they can provide the full continuum of care without being beholden to the large homecare providers who are gaining market power through consolidation. The only problem is that sellers aren’t as motivated to sell as some buyers might like and there is a shortage of good listings on the market. Since larger sellers need to be incentivized to forgo the opportunities inherent in Bundling and smaller sellers are effectively protected from competition by the 36 Month rule, valuations have remained firm in spite of the fact that the ACA has initiated some potentially profound changes for Medicare providers.

Hospice

Although nowhere near as much as home health, the hospice industry has not been untouched by the ACA. CMS is still considering a complete overhaul of the payment methodology, but shifting to a “U-shaped” model in order to better complement the actual trajectory of typical episodes is a far cry from the radical restructuring home health providers are adjusting to. It’s possible that Bundling into ACOs could be extended to hospice, but providers have more immediate concerns right now. Just like their home health cousins, hospice providers are now receiving more OIG scrutiny and are also having to absorb costs associated with Face-to-Face requirements. However, unlike the home health benefit, CMS feels that hospice is an underutilized tool that can be expanded to create savings for the program while improving the quality of life for terminally ill patients. This portends significant growth for hospice providers.

Rules proposed by CMS in Q2 are actually relatively favorable for hospice providers. The small BNAF phase-out reduction is more than compensated for by an almost 3% market basket increase, netting a roughly 2.3% rate increase for hospice providers next year. Also, the Aggregate Cap calculation methodology may be liberalized to a Patient-by-Patient Proportional model that doesn’t punish providers when patients survive into the next Cap year.

With the challenges facing Medicare Certified Home Health providers, many are looking to diversify into kindred disciplines to hedge against the risks associated with the coming changes. Hospice is a natural complement to home health and many home health providers are actively seeking hospice acquisitions. Most noteworthy in Q2 was Amedisys’s acquisition of Beacon Hospice in New England. The $125 Million price tag for $80 Million in annual revenue seems like quite a premium above the roughly 80% of revenue that Gentiva paid for Odyssey last year.

Home health agencies are not the only providers attracted to the hospice segment. We are hearing from hospitals, nursing homes, and assisted living providers who want access to the hospice market. Given the relatively small number of hospice providers compared to the relatively large number of prospective buyers, hospice opportunities continue to be relatively scarce and expensive.

Medicaid

Q2 brought some discouraging news for Medicaid homecare providers. Although it was not adopted, the Ryan budget proposed replacing the current entitlement with block grants that would limit the amount of funding for Medicaid beneficiaries and give the states more authority to reduce coverage and cap the number of enrollees. Also, the CLASS Act provisions of the ACA have been under fire and support from the Department of Health and Human Services seems to be waning. If that isn’t enough, many states continue to cut rates in response to weak tax revenue and some governors have threatened to pull out of the program altogether. In spite of proposals for extreme restructuring, expanding chronic care through the Medicaid program is still one of the best strategies for reducing costs of acute care throughout the system. CMS has initiated a pilot program in 15 states to coordinate care for the dual eligible (Medicare and Medicaid) beneficiaries who account for a disproportionate amount of spending.

The bottom line is that state tax revenues must increase in order for Medicaid providers to earn bill rates high enough to continue providing care. Most states have been cutting rates to the bone, further compressing some of the leanest margins in the homecare industry. Lean margins require economies of scale, so larger Medicaid providers are in the market for acquisitions to spread their costs over more and more revenue. As always, larger acquisition candidates attract more qualified buyers and command higher premiums than smaller, owner-operated agencies.

Private Duty

Although economic conditions hardly favor private pay services, we’re seeing some thawing in the market as activity is starting to pick up for private duty homecare providers. Many providers of assistance with the activities of daily living lost business during the recession, but some changed their approach by identifying new referral sources and new delivery models and were rewarded with positive growth trends in spite of the anemic recovery. We are seeing buyers in the segment start to come out of hibernation to resume acquisition strategies to stimulate growth. Although more cautious then they were before the recession, buyers are looking for quality private pay agencies that utilize W-2 caregivers. …and in a segment dominated by mom & pop shops, differentiation by size and professional management certainly yields the highest premium valuations.

Conclusions

The news from the beginning of Q3 indicates that pressures for efficiency and consolidation will continue to build as the country slowly digests its economic problems. After far too much political posturing, the debt ceiling was raised in time to avert a default, but not in time to prevent a historic credit rating downgrade. While the compromise did result in an additional 5% or so cut to Medicare home health rates, this was fairly modest compared to cuts affecting other Medicare providers and is further evidence of the relative desirability of home health in comparison to other segments of the healthcare services industry.

After seeming rather nonchalant for months, the financial markets finally reacted to the debt crises in the US and Europe and stock prices have been hammered. Healthcare service stocks, including home health providers, have been caught in the carnage in spite of the fact that most have fairly good prospects for surviving and thriving in the environment to come. This is why it’s always important to recognize that financial markets do not equal the economy and market capitalization does not equal enterprise value: This is especially true in the home health industry where the few publicly traded companies are not necessarily representative of the thousands of private agencies that comprise most of the market. Valuations are informed by long term market fundamentals, not short term fluctuations in the stock market. …and although healthcare service providers certainly have their fair share of challenges, market fundamentals continue to be very strong and the M&A market continues to be very active.

The healthcare services industry is at a crossroads. Economic realities require that providers of all types must do more with less. Efficiency and consolidation will be dominant themes in the healthcare industry for the foreseeable future. The good news is that, unlike with most other industries, healthcare is a necessity and the population of people in need is at the beginning of its largest growth trend in history. Absorbing that growth without bankrupting the country is a challenge for policymakers that presents significant risks and opportunities for healthcare providers of all types and sizes.

If you’d like to discuss how all of this affects you, feel free to contact us any time. We are always happy to discuss market conditions, valuations, and the process we undertake to effect a successful transaction.