EHC - Encompass Health: Incremental Returns On Capital Key Confirm Buy

Summary

• Repurposing excess capital to additional beds at existing facilities, the highest return on capital for future growth.
• Encompass Health's solid Q4 numbers with incremental ROIC higher than historical ROIC, evidencing new-store profitability on top of legacy stores.
• Solid FCF conversion with clear optics on reinvestment for growth in FY23'.
• Reaffirm buy, revising target to $99 target.

Investment Summary

Since our last publication on Encompass Health Corporation ( EHC ) the stock has caught a reasonable bid and confirmed the buy thesis. As a reminder, the buy rating primarily stems from EHC's focus on adding new beds/expansions on existing hospitals, as this is the highest return on usage of excess capital for future growth, and, " that capital intensity is flattening, providing good headroom for NOPAT to grow ". The investment hypothesis being, that the incremental ROIC gains on new-stores [by adding new beds to existing stores, combined with de novo store openings] creates a lengthy tail of asset returns to compound the growth strategy [stores being hospitals]. Here we made a practical assessment of the incremental returns on capital, and observations from the Q4 FY22' analysis add more colour to the company's growth outlook looking ahead.

Exhibit 1. EHC price evolution, 2022-date

Q4 return on capital analysis

As mentioned, we're constructive on EHC's reshuffling of capital into growth opportunities and segments that offer the highest rates of return. We observed good headway from EHC this quarter on this front, especially at the pace of new openings. It opened 9 de novo facilities across FY22' - a company record. Referring to the growth strategy, it added 87 beds using a prefabrication strategy to execute the plan with minimal construction costs and 25% reduction in time to finish. Management expected a 15% annualized cost savings from this. Net-net, de novo facilities attributed an additional $4mm in the quarter. Subsequently, the incremental ROIC since FY20' [using a rolling TTM basis] ratcheted to >40% and supported the firm's buyback and dividend payouts, these findings confirmed by CEO Mark Tarr on the call : " [t]he strength and consistency of our free cashflow generation, allowed us to fund these investments and shareholder distributions, primarily with internally-generated funds".

It's also worth noting length of stay ("LOS") pulled to 12.5 for the quarter. Each 0.5 move in the LOS adjusts EBITDA by $8-$10mm, so we look forward to these numbers in FY23'. Labour costs have been an issue to margins [discussed later] so it's good to see projections for employees per occupied bed ("EPOB") guided flat at 3.4, back in-range with pre-pandemic levels. Related to EHC's capital budgeting strategies, the plan is for 8 new hospitals in FY23', coupled with 80-100 new beds to existing facilities. Looking closer, it sees 149 beds opening in March, with a 50 bed hospital opened by April. This will likely tie up the bulk of annual CapEx and OpEx by estimate, creating a potential tailwind for the latter half of the year. Further, along with its legacy facilities, EHC continues adding bed in its de novo's as well. It increased the average number of initial beds to 46 from long-term averages of 42-44 and looks to adding 49 beds through to FY25'. Judging from FY22' maintenance CapEx of $238mm, we'd expect some upside on this spend this year. Our buy rating is built on the hypothesis that new store openings are adding profitability on-top of legacy stores, i.e., that incremental ROIC>historical ROIC's. Note, EHC's incremental ROIC from Q2 FY20'-Q4 FY22' [rolling TTM basis] is 40%, confirming the thesis [Exhibit 2]. For the firm's growth initiatives described above, this bodes in well in our opinion.

Exhibit 2.

Looking deeper at the quarterly numbers, the subsequent findings are of utmost relevance to investors:

1. Quarterly top-line sales increased 910bps YoY to $1.14Bn on adj. EBITDA of $232mm, a 16% YoY gain . Growth was underscored by Q4 volumes and more favourable payor mix - same-store Medicare Advantage discharges were 410bps higher versus FY20, a 41% incremental gain since FY19'.
2. Extending from point 1), discharge rates were up 730bps YoY circumventing to a 220bps YoY growth in revenue per discharge to $20,840 [gross]. Same-store discharges were up 4.2%, underlined by 960bps YoY expansion in inpatient revenues.
3. Looking at the OpEx related to labour, agency rates again shifted higher with full-time equivalents ("FTE") rates up ~300bps to $211,000 . " Reducing contract labor expense remains a key focus" per management, especially with a >100% increase in recruiting/relocation costs to $7.8mm, pushing full-year costs in this line to $24.5mm from $12.7mm in FY21'. Further, inflationary headwinds were observed throughout quarterly OpEx, with 16% surges in food costs/patient day and utilities costs/patient day respectfully. Noteworthy, the latter was down 11% sequentially from Q3 as expected due to seasonality. Alas, we expect EHC to absorb higher utilities/patient day costs across the bulk of FY23'.
4. Outpatient visits LOS to 12.5 from 12.8 YoY, and levelled at 33,138 and crept down across the year, continuing the trend from FY21'.
5. Moving to inpatient analysis, occupancy was flat YoY at 71.7% on a wider number of 10,356 licensed beds [9,924 in Q4 FY21']. Number of occupied beds also higher at 7,425 vs. 7,096 the year prior. Further, net inpatient revenue came to $1.11Bn from $1.01Bn.
6. Down to bottom-line growth, it pulled revenues down to adj. earnings of $0.88 per share, ahead of consensus and ~930bps behind Q4 FY21'.
7. FY22' FCF growth of ~$10mm to $340mm after the maintenance CapEx and reinvestment to future growth. EHC's planned reinvestment of excess capital is observed in Exhibit 5.

Exhibit 3.

Exhibit 4.

Exhibit 5.

Valuation and conclusion

EHC is attracting a premium to 5-year historical averages at 24x trailing earnings [18x non-GAAP earnings]. Yet, it trades at a discount to sector peers. Given the profitability momentum described earlier we opine that EHC will continue driving value for equity holders looking ahead. Supporting valuation upside is the firm's growth strategy that generates incremental profitability on top of legacy stores, its same-store growth, and revised posture on adding new beds to existing facilities to improve per-patient metrics. Moreover, it is sustainably compounding capital and adding growth via the return on incremental investments, leaving plenty of residual cash flows as distributions to shareholders [ dividend analysis found here ]. Presuming it can maintain these numbers, we see the stock trading fairly at 37x trailing earnings, deriving a long-term price target of $99.

Exhibit 6.

Net-net, there's sufficient evidence to suggest EHC will continue creating shareholder value down the line. It's growth strategy of adding additional beds to existing structures along with build outs of de novo facilities creates a lengthy tail of high rates of return distributed across its new and legacy hospitals. This is key to driving upside in its per-patient metrics, by estimation. We see labour costs normalizing across FY23' and add this the company's profitability momentum. Reaffirm buy at $99 price target.

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