Home Health: Downgrading Sector View; Cutting Estimates; See More Downside – Baird

Baird’s Health Care team is downgrading Home Health Sector to Underperform this morning saying they would not buy any home health stocks and expect the tape/news flow to get worse. Furthermore, 2012 estimates look to be 20%-30% too high, multiples stretched relative to the 2-3 year trading range and in general, the group looks vulnerable. Admittedly, sentiment is horrible, but we think it gets much worse before better, expect 2Q misses, lowered guidance, a very negative CMS proposal (will surprise many) and increasingly worry about the sector’s exposure as a doc-fix/debt ceiling pay-for.

– AFAM cut to Underperform, $21 target (prev. $32)

– LHCG cut to Underperform, $17 target (prev. 27)

– GTIV cut to Neutral, $23 target (prev. $35)

– AMED target is cut to $26 (prev $35)

The details:

This is not a negative “call” on known issues of the F2F reg, but rather: 1) issues stemming from documentation which will lead to higher bad debt reserves, 2) we see significant risks in the upcoming CMS proposal and 3) valuations look stretched, we do not believe M&A is coming and the group is very vulnerable as doc-fix/debt ceiling pay-for.

Street too complacent on 2012 CMS proposal. We are struck with the large number of investors who do not see the risks to the 2012 coding creep. Our DC lobby contacts struggle to see any scenario in which the -3.79% coding creep does not grow and/or potentially point to future reductions. CMS will absolutely consider 2009 “coding” in the 2012 rule. Both our outside consultant and the industry’s lobby believe CMS has identified ~3.3% of “increased coding” from 2008-2009. Thus, if CMS does not spread out cuts (’11 reg said they wouldn’t), we could easily see a ~7% case-mix adjustment. Our revised 2012 numbers assume a 5% rate cut, which we believe is not aggressive.

Based on our recent conversations with many private companies and industry contacts, we believe the industry on average is struggling to obtain proper documentation for approximately 10%-25% (in some cases much more depending on what month) of home health SOCs (starts-of-care; e.g., admissions). Ironically, the Street has obsessed about the “volume” impact from patients that potentially would not meet the 90 days prior to or 30 days after rule, but based on multiple conversations with our network of industry participants, we have uncovered a substantial problem in obtaining the “proper” documentation from patients that actually meet the 5 requirements of the reg. As a result, we understand some providers may book ~100 bps of additional bad debt expense to account for the uncertainties related to obtaining F2F documentation for these patients (i.e., the “collectability” of these revenues). We do not believe investors are aware of this issue and it could pressure 2Q and 2H11 results.

Lowering estimates, group looks vulnerable. Our 2012 EPS estimates are now 20%-30% below the Street. We firmly believe the CMS proposal surprises on the downside probably in mid-July, which is before earnings. We expect all providers to likely miss and lower not just for the F2F “volume” impact, but due to higher reserves as providers are struggling to get documentation for patients that meet the encounter requirement. Home health stocks likely oscillate near 10x earnings (we fear could be worse as HH is likely to be included in the doc-fix/debt ceiling), thus we worry about another 20%-30% sell-off in the coming months. With this research note, we are revising our sector suitability rating to Higher Risk.

Notablecalls: This is going to hurt. Looks like Baird has done some real digging and uncovered additional problems in the sector. Many of the names appear cheap on surface but if one adjusts for the new info from Baird, they suddenly don’t look that cheap anymore. It’s been a tainted sector for a while.

This is a fundamental call & although many of the names carry hefty short interest I expect 5-7% downside moves in LHCG & AFAM.

GTIV and AMED will also get hit but less so.

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