Encompass Health

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

Encompass Health provides inpatient rehabilitation services, operating a network of rehabilitation hospitals and employing medical professionals.

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 (EHC) operates in the healthcare industry, specifically providing inpatient rehabilitation services through a network of hospitals and home health & hospice agencies.

Let’s start by evaluating Encompass Health’s moat, or its sustainable competitive advantages.

Moat Analysis: 2/5

  • Brand and Reputation: EHC has a well-established brand in the rehabilitation sector. EHC has long-standing presence in rehabilitation, which helps them gain patient trust. However, they don’t have a differentiated brand that brings them a clear advantage over their peers. Other players may be similarly perceived as providing quality care, limiting pricing power and stickiness of clients.
  • Switching Costs: While EHC does have an impact on a patient’s life, choosing a rehabilitation center is not very sticky and there are limited switching costs, making the “stickiness” moat weak. As healthcare is usually paid by insurance companies, the insurance provider and plan benefits influence the patient’s choices, thus limiting the patient choice. So, EHC has a limited moat based on customer stickiness.
  • Economies of Scale: EHC benefits from some scale advantages due to its nationwide presence. It has a relatively large number of facilities, and has established relationships with healthcare providers. Yet these economies are not particularly unique, and other larger players may be better positioned in the market to take advantage of scale, thereby making EHC’s moat narrow on scale.
  • Proprietary Technology or Processes: EHC does not have any proprietary technology or processes that create a meaningful competitive advantage. While it may implement specific protocols to streamline efficiency, such measures are easily copied by the competition, providing a limited moat on a company level.

The healthcare industry has many companies providing similar services, thus the industry is quite competitive, creating an oligopoly situation with only a few companies being highly profitable.

Overall, EHC possesses a narrow economic moat. It has some advantages due to its brand, the switching costs involved for customers, and its scale, but these are not enough to generate high and sustainable returns over a long period. Also, its peer firms are in an oligopolistic sector and are not easily beaten by any single company, as such a large industry player, EHC will find it difficult to sustain a moat. This is therefore rated as 2/5.

Risks to the Moat and Business Resilience: The factors that may erode EHC’s competitive advantage are:

  • Regulatory Changes: Healthcare is a heavily regulated industry, and any changes in healthcare policy, reimbursement models, or licensing regulations could significantly affect EHC’s operations, profitability, and the sustainability of their moat.
  • Competition: The company operates in a highly competitive environment, with new entrants and established players challenging its market share. In particular, smaller niche players can disrupt certain areas. Also, changes in consumer preference can cause a change in business.
  • Technological Disruption: Healthcare delivery is not immune to new technologies that might affect or reduce demand of their services. For instance, advances in rehabilitation methods, new pharmaceuticals, or remote healthcare services can all displace some of their offerings and reduce their competitive advantage.
  • Recessions: economic downturns and slowdowns in the general market. The company may see a decrease in patients admitted for elective rehabilitation procedures, as well as a decline in health insurance coverage due to unemployment, thereby reducing the company’s revenues.

However, EHC has some positive traits, which include:

  • Essential Service: EHC provides necessary rehabilitation services, which are hard to replace completely. As long as there are accidents and medical conditions requiring rehabilitation, this is an important business segment.
  • Diversified Locations: EHC operates in several states and urban areas in the U.S. While this diversification doesn’t ensure that every market does well, it provides some geographic resilience to the company overall.
  • Established Relationships: EHC has established relationships with healthcare providers, insurance companies, and physicians, which, while creating some barriers to entry, also give a degree of sustainability to their operations.

Business Overview Encompass Health Corporation, headquartered in Birmingham, AL, is a large provider of post-acute healthcare services in the U.S. It operates through two segments: Inpatient Rehabilitation and Home Health & Hospice. Their inpatient rehab segment operates hospitals for rehabilitation services and the home health segment provides care in a home setting.

In 2022, the Inpatient Rehabilitation segment accounted for 81.6% of revenues while the Home Health and Hospice segment accounted for 18.4% of revenues. The key to their financial operations is therefore the inpatient care. The Home Health division may have lower margins.

  • Revenues: The company primarily generates revenues through patient care fees that are mostly from Medicare, commercial payers (like insurance), and Medicaid. As Medicare continues to be a large part of its revenue, changes in Medicare reimbursements can have an important effect on revenue.
  • Growth: The company’s recent expansion has been primarily focused on new hospital and facilities locations. In Q3 of 2024, it reported continued strength in demand for rehabilitation and home health services. The company aims to develop these by following a three-pronged strategy of growing volume at existing hospitals, adding new hospitals, and expanding home health services.

In 2022, the company opened 9 new hospitals, 22 new rehabilitation units in other hospitals and 3 de novo home health locations. This shows their focus on growing their company.

  • Margins: As per Q3 of 2024, EBITDA margins for all lines of business are around 20%. A good portion of this revenue came from a 3.7% growth in volumes in inpatient service, coupled with 5.3% growth in revenue per discharge. Home health and hospice saw some pressures with an overall 3.5% drop in revenue, and a 2% margin decline.
  • Competition: The healthcare industry is competitive, but EHC competes with several different types of companies, from other hospital chains to specialist clinics and even independent providers. Therefore, despite its moat, it’s constantly in a battle for patients. The company is primarily focused on cost control and operational efficiencies.
  • Differentiation: EHC’s main differentiator lies in its large national network of hospitals, coupled with a focus on rehabilitation care. As the company’s brand and reputation are recognized, and the company is an established presence, EHC becomes a favored choice for referrals. Also, EHC does claim to employ some of the best professionals in their fields.

Financials

  • Revenues: EHC’s revenues increased 7.9% year-over-year in the third quarter of 2024 with their operations segment recording 10.6% growth. This is mainly due to increase in case volumes and a rate increase. The Home Health and Hospice division however, declined by 0.7% for the same period.
  • Earnings: Net income attributable to EHC was $112.5 million in Q3 of 2024, a big increase compared to 88 million last year in the same quarter. Diluted earnings per share (EPS) for the period was $1.14 compared to $0.86 in the same period from last year.
  • Cash flow: EHC shows a positive operating cash flow, at $96.3 million, but the company is investing heavily in its business; capital expenditures were $159.7 million. As a result, the net cash used in investing activities totaled a negative $420 million. So, while the company is generating cash from its operations, it is being reinvested into expansion of the business to sustain its growth.
  • Balance Sheet: The company has a fair balance sheet, but it does have some issues. The company’s cash position is fine at around $600 million and a current ratio of about 1.2. The debt level, however, is substantial, as such a highly leveraged business, having $3.2B in long-term debt. As a percentage of their capital structure, their long-term debt-to-equity is around 110%.

EHC recently raised $400 million in Senior Secured Notes due 2031. The high amount of debt has caused credit rating agencies to rate their debt lower.

  • Recent Controversies/Problems: In Q3 of 2024, a labor shortage in the healthcare industry has led to wage increases and higher labor costs. The company’s revenues have been significantly affected by regulatory issues for Medicare and Medicaid. Also, the company’s acquisition of Enhabit Home Health & Hospice has not given the expected returns. EHC’s leadership has stated that it is addressing the current headwinds and is on track to continue to grow in the future.

Understandability: 3/5 EHC’s business is straightforward to understand on a surface level. However, many of its key operations and sources of revenues come from a complex interaction of healthcare insurance, government regulations, and reimbursement practices. It is difficult for the layperson to fully understand the complexity of their financial statements. This makes it harder to understand the company. Hence it gets a rating of 3/5 on understandability.

Balance Sheet Health: 3/5 The balance sheet shows some positives, like high cash flows and sufficient assets to cover liabilities. However, the company has very high levels of debt. While the debt is for long-term projects, as is typical of most healthcare companies, the company’s debt level still represents a meaningful level of financial risk. Thus, their balance sheet health is rated a 3/5.