We continue to view Psychiatric Solutions (PSYS; recent price, $38) as one of the best positioned companies in the health-care facilities industry based on what we see as an underserved and fragmented market, limited new capacity coming on market in the near term, and a more favorable reimbursement position when compared to other health-care providers.
In addition, we believe that the company has a strong management team that has successfully demonstrated its ability to identify and integrate acquisitions. We also believe that the approximately $300 million in borrowing capacity on the company's balance sheet, plus strong cash-generating capability ($37 million in cash flow from operations generated in the 2007 second quarter), should provide Psychiatric Solutions with ample liquidity to pursue its acquisition strategy.
Our 12-month target price would result in price appreciation of more than 25% from current levels. All told, we view Psychiatric Solutions' fundamental position and valuation as compelling and our recommendation is 5 STARS (strong buy).
The Franklin (Tenn.)-based Psychiatric Solutions is a leading provider of inpatient behavioral health services encompassing both freestanding psychiatric facilities and residential treatment centers (RTCs). As of June 30, 2007, and following the acquisition of Horizon Health Corporation in June, 2007, Psychiatric Solutions owns or operates 90 facilities with approximately 10,000 patient beds. Its business is divided into two segments, acute care (53% of revenues) and residential treatment facilities (47%).
Acute-care facilities are used to house those patients who pose an imminent danger to themselves or others. These patients typically receive 24-hour observation and care with daily visits by psychiatrists, and have an average length of stay of 10 days, at which point they are moved to a less-intensive form of care.
Residential treatment facilities are used primarily for mentally ill children and adolescents who require a less-intensive degree of care in a nonhospital setting, and generally do not pose an immediate danger to themselves or others. Patients in residential treatment facilities generally receive care from a broader spectrum of providers who are seeking to address not only the medical and psychiatric, but also the social and academic needs of the patient. These patients have an average length of stay of 180 to 270 days.
Company and Industry Outlook
We believe the market for the company's services is large and relatively underpenetrated. According to the National Institute of Mental Health (NIMH), an estimated 58 million adults (aged 18 and older) suffer from a diagnosable mental disorder, of which an estimated 13 million are serious mental illnesses. In addition, approximately 12 million children (under 18) suffer from mental illness, according to the NIMH. Based on a 2003 study in the journal Psychiatric Services, we estimate the size of the inpatient behavioral health segment as a $20 billion market, and believe it is growing at a high-single-digit rate.
While demand for behavioral health services has remained solid, we view the market for inpatient behavioral health services as generally underserved due to both the dramatic decrease in capacity in the 1990s as well as the incidence of undiagnosed and untreated mental illness. For example, since peaking at 800 facilities in 1991, the number of inpatient facilities declined by 43% between 1991 and 2005, according to the latest available data from the American Hospital Assn.
Moreover, given the lack of adequate diagnoses of mental illness as well as the continued stigma that is attached to diseases such as depression and schizophrenia, we view the market as largely underserved. Indeed, the NIMH estimates that approximately one-third of all children with serious mental illness do not receive any mental health services at all (a figure which we believe can be conservatively extrapolated to the adult population).
Primed to Benefit from Bigger Market
Given the potential for passage of mental health parity legislation in the U.S., we think the size of the behavioral health market could increase dramatically, especially among the untreated and undiagnosed as they begin to seek more comprehensive treatment due to improved insurance coverage and as coverage limits are increased.
We believe that PSYS has an approximate 20% share of the inpatient psychiatric hospital market and is the largest pure-play public company in the inpatient psychiatric industry. (Universal Health Services' (UHS; $53) behavioral-care division is second with 83 facilities but is not a pure play, while PHC (PHC; $3), through its Pioneer Behavioral Health subsidiary, is a pure play, but has only four facilities.)
We also believe that PSYS enjoys a superior reimbursement position relative to the acute-care inpatient hospital providers, in that its bad debt exposure is approximately 2% of revenues, compared with around 11% for our universe of publicly traded hospital operators.
The company also benefits from a much more diverse and stable payor mix than the facilities industry as a whole, as well as higher per diem reimbursement from government payors. We estimate that Psychiatric Solutions' average per diem rate in its acute-care business is $350 per day, while the average rate in its residential treatment business is approximately $630 per day. This compares with a weighted average of $247 per day for Manor Care (HCR; $65), a nursing home company widely considered to have one of the most attractive payor mixes in the health-care facilities industry.
The company seeks to increase revenues organically by 7% to 9% per year by raising annual admissions about 3% to 5% (through the addition of beds to existing facilities, new programs, or increased marketing resources), and increasing pricing 3% to 5% per year. The company seeks to supplement organic growth by targeting at least six acquisitions per year (which are not included in management's financial guidance).
We forecast revenue growth of 46% in 2007, reflecting the acquisition of Horizon Health, and 17% in 2008. We expect the Horizon acquisition to add modestly to results in 2007 and be more significantly accretive in 2008. Our forecast assumes low-single-digit increases in patient days as well as low-single-digit revenue increases on a same-facility basis. We look for approximately $10 million in merger synergies due to the integration of Horizon (which added an additional 1,600 beds).
Our 12-month target price of $48 assumes that Psychiatric Solutions will trade at a price-to-earnings ratio of 24 times our 2008 EPS estimate of $2.00, a slight discount to the company's five-year average p-e of 25 times, given the potential integration risks we see from the acquisition of Horizon Health.
Our target price also equates to a p-e-to-growth ratio of 0.7 times, based on a projected EPS growth rate of 35% for 2008, a level we think is justified given our strong fundamental outlook for the company, balanced against its strategy to use acquisitions to supplement growth. (Most high-growth companies are valued at a PEG of 1.0 times, but we discount this due to acquisition risk.)
Overall, we have a favorable view of the company's corporate governance practices.
We view positively that more than 75% of the board of directors is composed of independent outsiders; that the board has a committee that reviews corporate governance issues and that it has met within the past year; that there are between six and eight directors serving on the board; and that there were no "related party transactions" between the company and the CEO or the company and any other officers or directors of the company.
We view negatively that the compensation committee of the board includes outsiders who are affiliated with the company; that the positions of chairman and CEO are combined; and that Psychiatric Solutions does not have corporate governance regulations and policies that have been publicly disclosed.
Risks to our recommendation and target price include potential cuts in Medicare, Medicaid, or other third-party reimbursements, and failure or delays in receiving the required statutory approvals for new facilities, such as certificate-of-need approvals. Difficulties or delays in integrating the operations of Horizon Health, and any changes to reimbursement rates in the state of Texas, where Psychiatric Solutions has a significant number of facilities, could also adversely affect results.