Encompass Health

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

Encompass Health is a provider of post-acute healthcare services in the United States, primarily operating inpatient rehabilitation hospitals and home health and hospice agencies.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Encompass Health’s business revolves around post-acute care, which includes inpatient rehabilitation, home health, and hospice services.

  • Inpatient Rehabilitation: This segment operates inpatient rehabilitation hospitals that provide intensive rehabilitation programs for patients recovering from conditions such as strokes, fractures, and spinal cord injuries. These hospitals aim to help patients regain their maximum level of functional independence, and stay profitable due to high demand, and long stays.
  • Home Health: This segment provides healthcare services, such as skilled nursing, therapy, and home health aides, to patients in their homes. This segment is very sensitive to legislation since insurance providers (Medicare / Medicaid) pay most of the costs of these services.
  • Hospice: Provides specialized care, including pain management and emotional support for terminally ill patients and their families. A recent CMS decision limited the amount that can be paid for services, resulting in lower profitability across the board for the industry.

While all of the segments of the business are in the same healthcare space, there is significant differences in their operations, reimbursements, and competitive landscape.

Industry Trends:

  • Aging Population: The primary driver of demand for EHCY’s services is the aging population in the US, which is expected to drive demand for post-acute care services for years to come.
  • Shift to Value-Based Care: Healthcare is moving toward value-based care models, which seek to reward providers for cost-effective patient outcomes instead of quantity of procedures.
  • Increased Acuity: Post-acute facilities are seeing patients that are sicker and need a higher level of care because patients are being discharged from hospitals sooner, requiring more complex and resource intensive care at the post acute facilities.
  • Labor Costs: Staffing in healthcare can be very challenging. There is a shortage of nurses and other personnel which can drive costs higher. Competition for talent is fierce.
  • Regulatory Landscape: Federal and state regulations, Medicare and Medicaid reimbursement policies, and other government actions all have large influence on the business and margins for companies in this space. Medicare and Medicaid are the primary payers in the space, therefore their policies are very important to watch.

Competitive Landscape:

  • Inpatient Rehabilitation: The market is moderately concentrated, with several large players and many smaller regional players, but the barriers to entry are quite high, due to the need for regulatory approvals and high upfront capital costs. These include building a full facility.
  • Home Health: This market is more fragmented, with many regional and local providers. The barriers to entry are much lower, making competition intense.
  • Hospice: This market is also quite fragmented, and the services provided are usually localized. There is also an element of religious and nonprofit organizations competing in this area which may have different motives than for profit companies.
  • Direct Competition: Encompass Health faces competition in each of these areas, from regional and national players. This can affect pricing power.

EHCY has seen rapid growth over the last few years, acquiring new locations and expanding into new markets. This has given an edge over some competitors.

  • Scale is very important: EHCY benefits from scale, which gives them a cost advantage. Operating and scaling a large multi facility organization helps streamline supply chains and administration to lower costs.
  • Strong Brand: Encompass Health is well known brand and is trusted by physicians and hospitals where patients are often referred from, also benefiting from economies of scale.
  • Integration: They use their own network in their various segments, allowing them to get more control over all aspects of a patients recovery.

Moat Rating: 2 / 5 EHCY possesses a narrow moat due to network effects and location advantage in some of its facilities. The difficulty in replicating its network, and the strong preference among hospitals for referrals to a known provider, provides some insulation from competition. The scale and brand are also a plus. This moat is fragile, however, because the company operates in a competitive healthcare environment subject to reimbursement risk. The margins can erode over time if competition or regulation intensifies. Also, the network effect and scale only provides a slight moat, since this isn’t a zero-sum game, a few different large players can and do operate in the same markets.

Risks to the Moat and Business Resilience:

  • Regulatory Changes: The primary risk to EHCY is changes in government reimbursement policies. This can severely affect profitability. This risk cannot be avoided, since that’s the biggest part of their revenue. They mitigate this by being diversified in segments, so if one part of the business is less profitable, it can be offset by other segments, but still this is a big risk.
  • Labor Costs: Increasing labor costs and worker shortages will always increase costs and decrease profit margins. The healthcare industry is very labor intensive, and automation in most parts of the business is simply not feasible. This risk can be mitigated by being a large player, with standardized operations that keep operational efficiency high.
  • Disruptive Technology: New technologies can make some treatments obsolete or new players can use technology to gain market share. One way the company can mitigate this is by being on the leading edge of technology and always being looking for ways to create new, needed products and services, and always being prepared to change how they do business if things change.
  • Competition: If competitors become more aggressive in pricing or develop a competing service, this could decrease prices and make it harder to get a higher level of business. EHCY attempts to mitigate this through its brand recognition and the referral partnerships they have with hospitals.
  • Economic Cyclicality: Healthcare is one of the more resistant areas of the economy. Patients need care no matter what is going on, but still, changes in general economic situations can cause issues with reimbursements, consumer demand, and other effects that can negatively affect performance.

Business Description:

EHCY is the nation’s largest provider of post-acute healthcare services. They are an owner and operator of a network of 160 inpatient rehabilitation hospitals and 252 home health & hospice agencies across 37 states, making them a very big player.

  • Revenues: The primary source of revenue is the health insurance reimbursements they receive. Other parts include private payment from patients.
  • The segments break down as follows:
  • Inpatient Revenue is 56%
  • Home Health 32%
  • Hospice 12%
  • Margins: Margins can be variable due to changing market conditions and government rules. Net margin was 2.4% in the previous year.
  • Trends: As already mentioned, the population is aging, and this will be a tailwind for years to come. Also, there is a trend of patients needing more complex post-acute care as they get discharged from hospitals sooner, but still require intensive therapy.
  • Competitive Landscape: This is moderately competitive in most segments, with a few very big players, and several smaller ones. Barriers to entry are not impossible, but require substantial investment and navigating complicated regulations.

Financials Deep Dive:

It is important to note that Encompass Health is structured in three main segments: Inpatient, Home Health, and Hospice. They also have Corporate overhead costs and other items that are generally not part of operating performance.

  • Income Statement:
    • Revenues: Total revenues in 2023 were $5,177 million, with a steady increase each year due to acquisitions and growth.
    • Net Income: Has fluctuated, but ended up at $127 million in 2023, due to a variety of special charges and nonrecurring items that affected all 3 segments.
    • Operating Profit: $350 million for 2023. This is still not ideal, because this was $600+ million from 2018 to 2020. This indicates a serious decline in operating profitability that needs to be addressed.
  • Balance Sheet:
    • The company has total assets of $10.3 billion with Intangible Assets representing a large part at about 41%. Property, plant, and equipment is $4 billion, while cash sits at $100 million.
    • Total liabilities are $6.8 billion, and include long term debt of $3.3 billion, indicating a highly leveraged balance sheet.
    • Shareholder equity is $3.4 billion.
    • Goodwill is not separately classified, but listed in their Intangible asset figures, therefore calculating ROIC accurately is difficult, since they have acquired so many companies over the years.
  • Cash Flow:
    • Cash flow from operations was over $800 million in 2023, although that was helped by large adjustments. This is slightly concerning.
    • There was also about $140 million in investing cash flow, from acquisitions, new properties, and other such things.
    • On the other hand they had around $700 million in financing cash flow due to the high levels of debt.

Looking at the financials as a whole, the most important thing to focus on is the profitability of the company. While they are still profitable, the profitability as a percentage of revenue has decreased. The next step is to carefully analyze their projections of the future and compare with current numbers. It seems that the company’s strategy of acquisitions may have led to higher revenues, but there is also significant cost growth, which needs to be addressed to better profitability. The large amount of goodwill should also be looked at with care.

Understandability Rating: 2 / 5

Understanding EHCY’s business model and its complexities can take a while, and understanding their operations needs some financial knowledge. There is several factors that must be taken into account, before someone can fully understand the business, including operations, financials, regulation, and also competition. All this makes it more complicated than other businesses. However, some areas (like margins, growth, revenue) are easy to analyze if the data is easily understandable. Therefore, EHCY is given a 2/5 rating for understandability, leaning slightly towards the difficult end.

Balance Sheet Health: 3 / 5

EHCY’s balance sheet is moderately healthy. While they have solid asset figures, the high level of debt, high amount of intangibles, and low level of cash is a concern, and must be watched carefully. This is why a rating of 3/5 is given in this category. One of the things to consider is that they are a service provider and don’t have a huge need for tangible assets like other companies, and they generate consistent cash flows, but the amount of debt and intangibles is a risk.

Recent News, Controversies, and Management Commentary

  • 2023 Performance: EHCY reported full year 2023 results in February of 2024, showing a lower profitability, despite higher revenues. The company indicated that they have high occupancy rates and continue to face staffing problems, especially with nurses. They also said they will focus on cutting costs going forward.
  • Guidance for 2024: The management has predicted continued growth in revenues and earnings in 2024 and beyond, driven by the aging population, growing demand for their services and their increased capacity. However, they have also indicated uncertainty surrounding the future as well, due to the economic landscape, and government regulation.
  • Acquisition Strategy: During the latest earnings calls, the management has emphasized a continued acquisition strategy, where they acquire regional players to bolster profitability, get new talent, and integrate their practices into their existing network.
  • Capital Allocation: The management has also noted that they intend to use any excess capital for further expansion of operations and possibly to reduce debt.
  • Reimbursement Risk: The company has said the recent reduction in CMS reimbursements has affected profitability, and they have to continue to address costs in order to offset that, and to remain competitive.
  • Operating Expenses: The company also stated they are always looking to improve operational efficiency and cut costs, to combat inflation and other challenges they face in the marketplace.

Management has been aware of several issues that could affect them going forward, and has made steps to counter them. However, these issues are still a large concern and need to be watched.