Hospice: An Hospitable Investment

Companies can become attractive value opportunities for a variety of reasons, such as a short-term drop in earnings or residence in an out-of-favor industry. In some instances, uncommon variables make a company difficult to value.

The latter is the case with Chemed Corp (NYSE: CHE).

Chemed operates two very disparate businesses. In addition to owning the iconic Roto-Rooter company, the largest provider of plumbing and drain cleaning services in North America, it also owns VITAS Innovative Hospice Care. VITAS is the largest provider in the US of palliative care services, otherwise known as hospice, with about 8 percent market share in the country, operating 51 programs in 18 states.

As America’s World War II generation passes away and the Baby Boom generation rapidly turns gray, hospice has become a growth industry. While industry data is fragmentary, in 2009 about 33.5 percent of Medicare beneficiaries who passed away died at home, according to a study published by lead author Joan Teno that appeared in the Journal of the American Medical Association earlier this year. Of those, 42 percent died in hospice care as compared to only about 20 percent in the year 2000.

Federal Medicare spending on hospice care has also grown at a compounded annual rate of 16 percent from 1999 to 2011, up from just $2.4 billion at the beginning of that period to $13.8 billion at the end. Over that same period, the number of hospice providers grew from 2,303 to 3,585.

Thanks to this rapid industry growth, VITAS now accounts for about three-quarters of Chemed’s $1.4 billion in revenues last year, with Roto-Rooter making up the remaining 25 percent. As VITAS has steadily accounted for more and more of Chemed’s sales, sales have averaged 6.3 percent growth over the past three years while new income has grown 6.7 percent and earnings per share are up 12.6 percent.

Despite that extremely attra! ctive growth and Chemed’s $1.3 billion market capitalization, the company receives surprisingly little analyst coverage, thanks to its uncommon business dichotomy.

As a result, it trades at a persistent discount to other health care companies, commanding a price-to-earnings (P/E)  ratio of just 16.6 times trailing 12-month earnings compared to an industry average 21.2. It also trades at just 2.9 times its book value (the industry average is 3.7) and a slight discount to trailing one-year sales.

Despite that discount, Chemed’s earnings are forecast to grow by 15 percent over the next five years, handily beating the S&P 500 forecast for 9.8 percent growth.

Much of that growth can be attributed to changing attitudes towards death.

A study conducted by the Pew Research Center five years ago found that about 81 percent of respondents said that religion is important to them, making the US a huge outlier in terms of developed nations. Countries with similar wealth on average saw only about half of respondents say that religion was important to them. And as measured by religious observance, America has been becoming increasingly devout over the past decade.

This increased religiosity has helped to soften attitudes towards death, making death at least a bit more palatable.

A growing number of Americans are also making end-of-life decisions earlier, creating advanced directives and living wills and making their care decisions known to family and medical providers early on. According to a poll conducted by the Associated Press in 2010, about a third of Americans reported having an advance directive in place and 70 percent said that they would prefer to die at home.

Those changing attitudes make it likely that Chemed and VITAS should be able to continue the division’s nearly 13 percent average annual growth in net income over the past decade, if not grow it organically. On top of that, given the extremely fragmented nature of the hospice in! dustry, t! here’s ample opportunity for acquisitions to drive additional growth.

Perhaps the best thing that could happen for investors, though, is a breakup of the two businesses. Despite the relatively strong growth in both the Roto-Rooter and VITAS divisions, the markets don’t give Chemed sufficient credit because of the divergent nature of the two divisions. A breakup would unlock huge value for shareholders, because each division could then be judged on its own merits.

Investors would be well compensated while they wait for the company’s value to be unlocked. Shares currently yield just 1.1 percent, but the dividend has been steadily growing for five years, rising from a total annual payout of $0.24 in 2008 to $0.68 cents last year and $0.76 this year. At a payout ratio of just under 15 percent, there’s ample room to maintain dividend increases along with earnings.

There is one significant caveat. Earlier this year, Medicare filed a lawsuit against Chemed, claiming that VITAS falsely billed the government for medical care. There has been no determination of liability yet so it’s impossible to know what the company’s financial exposure might be. However, the government is suing for treble damages, statutory penalties, legal costs and interest.

The government has been investigating hospices over the past few years, as a growing number of patients are opting for palliative end-of-life care rather than aggressive treatment. So far, 11 smaller hospices have paid $88 million to settle Medicare over-billing allegations.

The odds are that VITAS will pay to settle the allegations, following in the footsteps of most of its competitors in these situations. However, any settlement is likely to be at least a year off. Until then, the suit will hang over shares.

That said, any settlement won’t likely make a huge dent in earnings considering the small recoveries thus far. False billing claims are pretty tough to prove, particularly in the ca! se of hos! pice care.

For investors who can stand some volatility and afford to wait, Chemed is an attractive value play up to 80.