Are Home Health Stocks Too Cheap?

This article is part of our Rising Star Portfolios series.

The Un Portfolio is always looking for down-trodden stocks in out-of-favor industries. But the key is understanding risks to determine if prices reflect fear or valid concerns. The major players in the home health industry are trading at less than 10 times earnings on average -- is now a time to buy?

Your health-care investments need rehabilitation
Over the past year, the health-care sector has remained flat while the S&P 500 rocketed up nearly 20%. One part of the health-care industry especially in need of critical care is home health: providers of care to homebound patients. The dominant four firms, Amedisys (Nasdaq: AMED), Gentiva Health Services (Nasdaq: GTIV), LHC Group (Nasdaq: LHCG), and Almost Family (Nasdaq: AFAM) have all seen their share prices decline over the last 12 months.

Taking the axe to home health
Medicare spending on home health care in 2009 was $54 billion, with $18 billion going to home health agencies like the big four. Even though the Centers for Medicare and Medicaid Services expect the cost of providing such services to keep rising by more than 2 percent each year, the agency is sick of home health agencies making so much money. Accordingly, the Department of Health and Human Services slashed the 2011 base Medicare reimbursement rate that these companies rely on by 5.2%. More reductions are expected in future years.

With declining reimbursement revenue and increasing costs, perhaps a price-to-earnings ratio of 10 is justified. Because a decline in reimbursement revenue has no associated decline in costs, it has a disproportionate impact on profitability. Here is an extremely simplistic view that shows operating margins declining dramatically (on average, by -34%) had 2010 reimbursement rates been at 2011 levels.

Source: Capital IQ, a division of Standard & Poor's. Pro Forma revenue assumes a 5.2% decline across the board. Operating margin assumes all operating costs remain the same. Dollar figures in millions.

The sick get sicker
The example above is a bit of a dramatization: Not all revenue comes from Medicare reimbursement (though most does), and not all revenue is paid at the base rate for home health services -- but it remains eye-opening. With the financial picture in flux, it's even more disconcerting that the industry is under scrutiny from the Senate Finance Committee and the Securities and Exchange Commission for some of its billing practices. Even though the companies have denied wrongdoing, these extracurricular activities and uncertain outcomes have weighed on the shares.

It's not all bad
With all of these risks, shares of the big four are appropriately cheap. But the fact remains that home health services remain a key part of the solution to America's growing health-care problem. Patients prefer home health to hospital stays, and the care is much cheaper. A typical 60-day home health treatment costs Medicare $2,200. The same time spent in a skilled nursing facility would cost $29,000, and in a hospital, it would cost $276,000.

These cost advantages have led to massive industry growth. Today, there are more than 10,000 agencies. And as hospitals discharge patients more quickly, home health agencies have picked up the slack, treating 2.9 million patients. The number of patients using home health services has been growing at 4% per year, with the number of treatments increasing even faster.

The threat of lower reimbursement revenues and increased scrutiny has prompted many smaller players to sell their agencies. The industry is now clearly in a state of consolidation, and the leaders are the big four. All told, the big four have grown impressively over the past five years, and acquisitions should fuel further growth.

The bottom line
The home health industry is vital to the American health-care system. Even at lower profitability levels, demographic and industry consolidation trends indicate that the big will only get bigger at the expense of smaller players. At the right price, I'd be willing to invest some of the Un Portfolio's capital in the industry for the long term. Next week I'll dive deeper into what price I'd need to see. Head over to the Un Portfolio's discussion board to share your thoughts on the home health industry.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money free stock picks. See all of our Rising Star analysts (and their portfolios).