Select medical stock: add to position for additional upside capture (NYSE: SEM)

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Andresr

Summary of investments

The purchase thesis on Select Medical Holdings Corporation (New York stock market :NYSE: SEM) remains well intact after its Q2 FY22 figures. I’ve covered the stock extensively before [here]and noted several tailwinds related to its earnings and investment trends over the years to date.

With these trends continuing into the second quarter of FY22, the company appears well positioned to continue to deliver earnings growth and generate a sufficient return on its invested capital going forward. We continue to add to the SEM position to these ranges [in small parcels to better manage sizing]looking for an initial yield target of up to $31 on a buy recommendation.

Earnings trends continue in latest numbers

SEM posted a strong set of quarterly numbers for the three months ending June 30, 2022. Revenue of $1.58 million (“mm”) was up about 130 basis points on the year, although ‘they were linked to a 775 basis point increase in the cost of services to around $1.4 mm. Total costs for the year jumped about 720 basis points, however, this included a non-cash amortization charge of $51 million for the quarter [+10bps YoY].

Digging a little deeper into the operating parameters shows pleasing results in my estimation. Agency rates decreased 22% sequentially from the first quarter of FY22 to the second quarter of FY22, reducing the average agency rate (“AAR”) by $111 /h for the quarter [from $143/hr]. In June and July, the AAR had dropped to $95/hr and $90/hr respectively. While usage also compressed 37.5% in the last quarter to 24.1% in June, the agency’s overall spend was down about 37% year-on-year to $56.4 million. dollars from the first to second quarter period, and had fallen to $12.8 million in June.

A key factor in the debate about investing in SEM remains its sensitivity to key rates and what it does to hedge that duration risk. I discussed this at length in our previous SEM analysis and noted that the company’s interest expense had declined since fiscal 2019. Interest expense, however, increased during the quarter and totaled $41.1 million versus $33.9 million in the previous three months. Regarding his coverage activities on this subject, I made the following comments previously, supported by Exhibit 1:

“Interest charges on its term debt are also expected to decrease over the next few periods. This is due to SEM’s collar on a floating rate, which is pegged to 1-month LIBOR/SOFRA. Interest caps the floating rate exposure on a notional $2 billion term liability at 1%.When the 1% cap is exceeded on term debt, the counterparty to the contract is liable for payment.

SEM has this hedge in place until September FY24, and the position is now sitting at around $70 million in the money. Indeed, we see SEM’s sensitivity to rates decrease significantly as a result of this move. Interest expense has been declining since 2019 while cash interest payments are following suit. As central banks embark on the tightening cycle, this adds weight to our ‘quality’ thesis for SEM’s balance sheet, despite its leverage.”

Providing an update on the company’s accountability structure, CEO Martin Jackson was pretty transparent on the second quarter earnings call:

“At the end of the quarter, we had $3.8 billion in debt and $94.7 million in cash on the balance sheet. Our debt balance at the end of the quarter included $2.1 billion in term loans, $350 million in revolving loans, $1.2 billion in 6.25% senior notes and $88.4 million in other miscellaneous debt We ended the quarter with net leverage for our 5.44 times senior secured credit agreement.”

This point is a key factor in the evolution of the debate [$3.8 Billion is no small obligation] and may impact FY22-24 pre-tax and post-tax earnings by estimate.

Table 1. SEM Interest Rate Sensitivity: Q4 FY14-Q1 FY22, Semi-Annual. Interest expense has since risen to $41 million in the second quarter from $33 million in the first quarter.

  • This remains essential to the company’s ability to invest capital, generate a return on its investments and translate it into profits.
  • Debt outstanding is now $3.8 billion, made up of a mix of term loans, revolvers, and includes $1.2 billion in senior notes paying 6.25% YTM.
  • Net leverage on secured credit at ~5.4x.

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Note: SEM Q2 FY22, cash interest and interest expense not shown. Data taken from previous HB Insights analysis on SEM from June FY22. (Data: HB Insights – SEM [June 2022]; SEM SEC filings)

In addition, and as shown in Exhibit 2, quarterly free cash flow (“FCF”) trends have been notable on company earnings since at least the 2018 fiscal year date. Exhibit 2 is a loaded graph, synthesizing a wide range of data into a single image. The key features to note, however, are the company’s narrowing FCF yield [blue line]which now corresponds to the levels of the 2016 financial year.

However, while the realized yield of TTM FCF has tightened, the absolute conversion of FCF has been a key part of the SEM investment debate. FCF is the lifeblood of any business and therefore I am pleased with the company’s level of free cash conversion from operating profit as shown below. It made $125 million in FCF in the second quarter. Meanwhile, CFFO’s ratio to net profit remains at a healthy level of around 2.6x, indicating that there is a high degree of cash supporting the company’s valuation. [from an earnings perspective].

Exhibit 2. FCF quarterly trends were notable for SEM

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Note: All figures in millions of dollars or [%], calculated using GAAP earnings without reconciliations. Free cash flow calculated as [NOPAT – investments] with free cash flow net of dividends as [(NOPAT – Investments) – dividends]. Free cash flow yield calculated based on enterprise value. Operating cash flow to net income calculated as follows [CFFO/NI] on a quarterly basis. (Data: HB Insights; SEM SEC Filings)

At first glance, this seems alarming, observing the drop in FCF yield of SEM at such a steep gradient. However, I would also point out that a falling FCF [and/or FCF total] is a desirable characteristic, if the company’s return on investment (“ROIC”) is high or increasing, comfortably exceeding the cost of capital, and if it has access to sufficient capital.

As shown in Table 3, SEM’s FCF yield and ROIC met at a crossover in the fourth quarter of FY21, with the latter continuing to climb and reach highs of around 10% against a yield. FCF of approximately 2.5%. [both on TTM figures]. While the ROIC compressed at Q2 FY22, it still exceeds the WACC hurdle by about 1 lap. As such, the company generates a sufficient return on its invested capital as a result of FCF’s massive reinvestment in the business. Note that the trends started converging in the second quarter, and I believe this could be a tailwind for earnings going forward as SEM begins to recognize earned revenue on its ROIC.

Exhibit 3. ROIC continues to hover above realized FCF yield and WACC hurdle and easily offset FCF crunch

  • The decline in FCF/FCF yield along with the increase in ROIC that exceeds the cost of capital is an attractive feature.
  • The crossover point came in FY20 for SEM as the ROIC shrunk following a large FCF reinvestment.
  • Trends are converging again as the company begins to realize FCF spillovers from ROIC revenue.

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Note: All figures in [%]. Return on invested capital calculated as [NOPAT / Invested capital] based on the TTM. For more on the relationships described above with ROIC, FCF and revenue, see: Mauboussin & Callahan (2022): Good Losses, Bad Losses; All losses are not equal; Conscientious observer: Counterpoint Global Insights, Morgan Stanley Investment Management (data: HB Insights, SEM SEC documents)

Evaluation and conclusion

Concurrent with my previous analysis, the stocks are trading at a respective average discount of around 60% to their peers on the multiples used in this analysis, as shown in Appendix 4. I have made no changes to my previous price target of $26-$31 based on the company’s latest results.

SEM comes in at 8.7x P/E and is priced at 2.95x book value, each representing compelling value in my estimation. Coupled with the above ROIC and FCF trends, the discount seems unwarranted and this is supported by a ROE TTM of 37% which is more than 135% above the peer group. At 8.73x EPS of $2.98, SEM is valued at $26, suggesting the stock is fair and reasonably priced.

Table 4. Analysis of multiples and comparisons

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Image: HB Insights; Data: HB Insights, Refinitiv data feeds

SEM remains a buy following its latest set of numbers. Earnings trends indicate that the company still has a significant amount of forward upside capture and is priced reasonably in my assessment. I continue to recommend SEM as a buy on an initial price target of $26-$31 outlined in my previous analysis.

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