Odyssey: A Compelling Tale for Investors

S&P thinks this provider of hospice services is ready to post higher profits and fatter margins

We think that Odyssey Healthcare (ODSY: $13) will post earnings growth above its peers in the hospice-care industry. (Hospice services are designed to provide a wide range of care and services to terminally ill patients and their families.) In our view, management is taking the necessary steps to improve admissions trends and manage its exposure to the so-called Medicare cap—the fixed amount government insurance will pay per hospice-care beneficiary. We believe the company's new referral programs and additional service offerings will enhance revenue growth.

Given our view of Odyssey's potential for above-average earnings growth and expansion of its profit margins, we think the shares are attractively valued. We also think the company's balance sheet remains strong, with almost $2 per share in cash and short-term investments and no debt. The stock carries Standard & Poor's highest investment ranking, 5 STARS (strong buy).

Odyssey is one of the largest providers of hospice care in the U.S., in terms of both patient census and number of facilities. The company provides a full range of hospice services, including nursing care, medical social services, physician services, patient counseling, general inpatient care, and medical equipment and supplies.

The company's four levels of care, based on Medicare payment rules, are routine home care (97.4% of total days of care provided in 2005), continuous home care (0.8%), general inpatient care (1.6%), and respite inpatient care (0.2%).

Hospice Management

As of Sept. 30, 2006, the company provided care from 81 Medicare-certified hospice programs in 30 states. The average daily patient census was 8,329 for the first nine months of 2006, up 6.7% from the prior-year period; the same-facility average daily census increased 5.5% in the first nine months of 2006. The average length of stay for the nine months ended Sept. 30, 2006 was 85.4 days, compared to 82.4 days for the corresponding period of 2005. In 2005, 59.7% of Odyssey's patients resided in their own homes, while 40.3% resided in nursing homes and other long-term care facilities.

In an effort to manage the Medicare cap, the company actively manages its length of stay on a market-by-market basis. This is achieved by analyzing each hospice program's mix of patients and referral sources. The company is also implementing an integrated billing, clinical management, and electronic medical records information system. We expect the implementation to increase overall operating efficiencies, and it should be completed in 2008. Odyssey plans to expand its continuous care program, which accounted for 0.8% of total days of care in 2005 (up from 0.2% in 2004).

The most common patient diagnosis was cancer (31% of patients), while other diagnoses included end-stage heart disease (20%), dementia (19%), and debility (13%). Odyssey assigns each patient to an interdisciplinary team that assesses the clinical, psychosocial, and spiritual needs of the patient and his or her family. This team coordinates care and treatment and is responsible for clinical outcomes and cost of services.

Range of Services

Hospice services are designed to provide a wide range of care and services to terminally ill patients and their families. A patient is eligible for hospice care if two physicians determine that in their best medical judgment, the patient's life expectancy is six months or less, and the patient agrees to forego curative treatment for the patient's terminal diagnosis.

Hospice care became a covered benefit under Medicare in 1983. Medicare's hospice benefit covers a wide range of palliative services, including counseling for patients and their families. Medicare covers virtually all aspects of care, including medical equipment, supplies and drugs. Approximately 36% of the total hospice market is for-profit.

In 2005, Medicare provided 92.1% of Odyssey's revenue (92.5% in 2004), with the rest coming from Medicaid, private pay, and other sources.

Medicare payment rates are updated annually based on the hospital market basket index and are further adjusted by a wage index to reflect differences in geographical labor costs. In the government's fiscal year ended Sept. 30, 2005, the payment rate was increased by 3.7%, and an additional 3.7% increase has been implemented for fiscal 2006. In fiscal 2007, we forecast a rate increase similar to that of fiscal 2006.

Cap Considerations In an effort to control costs associated with hospice benefits, Medicare imposes an annual cap (a fixed dollar amount per beneficiary) on coverage, which is calculated on a per-location basis. The cap amount was set at $19,778 for fiscal 2005, and $20,585 for fiscal 2006. We forecast a low-single-digit increase for fiscal 2007. However, we note that individual locations that are operating above the cap are not necessarily unprofitable. In order to maximize profits, each location should operate as close to the cap as possible.

In 2006, we look for an EBITDA margin of 10.4% and operating EPS of 74 cents. In 2007, we see the EBITDA margin widening to 12.2% on a decline in direct hospice costs, partially offset by an increase in SG&A expenses, resulting in EPS of 86 cents. Going forward, we estimate a three-year compound earnings growth rate of about 20%.

As of Nov. 30, Odyssey had seven inpatient units under development, and we expect six of these to open in 2007. Capital expenditures totaled $8.1 million in 2005, up from $4.4 million in 2004. We forecast spending of $9.5 million in 2006 and $11 million in 2007. In November, 2006, the company announced a $10 million share buyback program, to be completed over a 12-month period.

Projected Values

We see revenue growth of 10% in 2007, on our projection of a low-single-digit increase in average daily census and admissions. Our forecast assumes a Medicare reimbursement increase in the low single digits in fiscal 2007 (for the government's fiscal year, which begins on Oct. 1). We see additional gains coming from new startups and acquisitions. In 2007, we think EBITDA margins will widen slightly on a reduction in direct hospice costs as a percentage of revenues, partially offset by higher SG&A expenses. We look for Odyssey to more effectively manage cap exposure in 2007.

The shares were recently trading at about 15 times our 2007 EPS estimate of 86 cents and 0.9 times our 2007 revenue forecast of $460 million. Relative to the company's peers in our health-care facilities coverage universe, the stock was priced in line with peers on a forward P-E basis and slightly below peers on a price-to-sales basis. In addition, the 2007 P-E is in line with the multiple for the S&P 500. However, given our view of Odyssey's potential for above-average earnings growth and margin expansion, we apply a forward P-E multiple of 22 times our 2007 EPS estimate, which produces our target price of $19.

Based on our discounted cash-flow analysis, we calculate the net present value of expected free cash flows through the year 2020 at about $19 per share.

Positive Policies

Overall, we view Odyssey's corporate governance policies favorably and believe the company compares well in this regard relative to peers. We view the following factors as positives: The board is controlled by a supermajority (greater than 75%) of independent outsiders; the nominating and compensation committees are comprised solely of independent outside directors; all directors with more than one year of service own stock; all stock-based incentive plans have been approved by shareholders; the audit committee is comprised solely of independent directors; and the company has not restated financial results for any period during the past 24 months. In addition, the company has not been the subject of any SEC enforcement regarding stock option backdating.

However, we view several governance issues negatively. These include: shareholders not having cumulative voting rights; the board is authorized to increase or decrease the size of the board without shareholder approval; the company has a poison pill in place, and the poison pill does not contain a qualified offer clause and has a trigger of less than 20%; and shareholders may not call special meetings.

Risks to our recommendation and target price include unexpected changes in third-party reimbursement rates, particularly Medicare, and federal budget deficits that could result in future cuts to Medicare payment rates. The company is subject to a cap in Medicare payments. If this cap is not effectively managed, results could be negatively impacted. Additional risks include a decrease in demand for hospice services and/or increased competition from other types of health-care facilities.

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