A Home-Health Industry Overview

The home-health industry in the U.S. has favorable growth prospects with support from demographic tailwinds, the aging population, and being a relatively cost-efficient site of care (much cheaper than a hospital or skilled nursing facility). Providers also benefit from limited fixed costs. However, the industry is highly fragmented with low barriers to entry, intense competition, little differentiation, and operates with a tight labor market, high employee turnover, and below-average profitability compared witho the other segments within the health care services industry. The top 10 companies account for about 20% to 25% of the industry market share.

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Rated and other leading home-care companies affected

We rate three home-care companies affected by this change: Gentiva Health Services (dba Kindred at Home; B/Stable/--), Pluto Acquisition I (dba AccentCare; B-/Positive/--), and BW Homecare Holdings (dba Elara Caring; CCC/Negative/--).

Additionally, we rate Encompass Health Corp. (BB-/Stable/--) which generates about 25% of its revenue from home health or hospice and represents a sizeable market share as the fourth-largest provider (or about 3.7% market share) of home-health services in the U.S. However, the company's primary business is inpatient rehabilitation facilities (75% of revenues). Other significant players include publicly traded (not rated) Amedisys and LHC Group.

We also rate pediatric home health provider, Aveanna Healthcare (CCC+/Negative/--), and post-acute care provider, CareCentrix Holdings (B/Negative/--). Although both companies have exposure to home health, we expect limited impact on ratings due to PDGM.

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Near-Term Impacts Of PDGM Will Be Profitability And Liquidity

We expect PDGM will likely increase operating costs (absent any reduction in staff), pressuring margins and short-term liquidity needs, as the new payment plan will reduce reimbursement periods to 30 days from 60 days, approximately doubling the number of claims needing to be processed. We expect providers could see some initial delays in collections following the transition given the significant nature of the changes, including the increase in claims, revisions to scheduling and documentation, and the increase in case-mix groupings absent robust process management and IT systems.

That said home-health providers have had more than a year of advance notice to adjust and prepare for these changes, and many providers use a third-party platform like Homecare Homebase (HCHB), which is a cloud-based automation software to help home-health providers with scheduling, routing, notes, billing, and payments. In addition, we expect minor working capital needs could be offset by the working capital benefit of the shorter 30-day service periods, which reduces the capital needs associated with funding wages in advance of reimbursement from Medicare.

CMS also plans to terminate Request for Anticipated Payments (RAPs), a prepayment in which home-health providers historically received between 50% and 60% of the anticipated episodic payment. In 2020, CMS reduced this payment to 20% and will ultimately eliminate RAPs by the end of 2021. This will increase working capital needs, making the industry less attractive, especially for smaller companies with limited access to capital, driving consolidation.

More consolidation is likely over the next two years

We suspect terminating RAPs may be part of CMS' effort to reduce the number of smaller providers, the level of fraudulent behavior (which is believed to be more common among small players), and the effort needed to audit/monitor for fraud. This is consistent with the effect of the moratoriums on new HHAs in various cities between 2013 and 2016, which limited the number of home-health providers.

Following the initial rollout of the old PPS reimbursement plan, the industry saw significant consolidation, with an estimated 25% of agencies either closing or absorbed by larger players. We expect PDGM will have a similar impact over the medium term, as weaker industry participants will likely face attrition. Additionally, with the phase out of RAP payments and increased need for technological resources, we see fewer small-scale new entrants into the industry. Economies of scale will provide meaningful cost advantages in the low-margin home-health industry, and we expect larger players to be opportunistic in increasing market share and making the industry more efficient.

PDGM: Another attempt to curtail fraud, waste, and misaligned incentives

Given the third-party payor dynamic within healthcare, where the payor is not the same as the beneficiary, fraud and abuse (false and unnecessary claims) is a significant problem, particularly for government payors. In the case of home care in the U.S., Medicare is the primary payor because these services are predominantly provided to the elderly. Although CMS faces a constant battle to minimize fraudulent claims across the health care system, given low barriers to entry and the asset-lite nature of the business model, home health is believed to be an area with above-average levels of fraud, particularly among smaller providers. With taxpayers on the hook, the Medicare program is under constant scrutiny to curtail fraud. In fact, CMS administrator Seema Verma recently unveiled her "five pillars" strategy to prevent fraudulent claims, identify new and emerging risks, ease provider burden, and utilize new technologies.

Historically, the culprits discovered in home health have primarily been small and local agencies collaborating with dishonest physicians or nurses. In the past, CMS issued long-standing moratoria to certain areas of the U.S., preventing new small HHAs from forming. Over the past 10 years, newly registered HHAs have come down significantly each year as a result of these efforts, with slightly more than 11,000 registered HHAs as of year-end 2019. The moratoria was implemented in 2013 extended 10 times, each for six months, with the 2014, 2016, and 2018 extensions including new geographic expansions. Ultimately the moratorium expired Jan. 30, 2019. We expect PDGM will likely have a similar effect reducing new entrants and shuttering small agencies that have less resources to handle the complexity and higher frequency of claim submissions.

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Under PDGM, documentation of patient diagnosis and more frequent assessments are required to support reimbursement and should reduce some unnecessary claims. We expect the transition to a 30-day payment period and the gradual elimination of RAP payments by 2021 will disproportionately pressure smaller providers that have limited liquidity and technological resources to adapt, driving consolidation. We expect many small providers to shut down or be acquired by larger providers. Some forecast as many as 30% of home-health providers to close over the next year or two due to the RAP elimination. This provides an opportunity for market share expansion, and increasing economies of scale, for the larger more capable players.

The Effect On Ratings

We believe the current scale, therapy mix, and referral sourcing (scored as positive, neutral, or negative to the rating) are the most relevant factors in evaluating the potential impact on individual companies from the transition to PDGM, relative to their performance in 2019. Moreover, HHA's with stronger liquidity and access to capital will be better able to take advantage of market share opportunities.

We believe providers with substantial scale are more likely to have sufficient resources to implement technological advancements and take advantage of growth opportunities. In contrast, we expect smaller agencies to be more likely to fail under the administrative and working capitals needs of PDGM.

The reimbursement impact from PDGM will vary based on case mix, as some categories will be reimbursed more favorably than in the past (for example, wound care) while other categories will experience lower reimbursement. Under PDGM, the first 30-day payment period is considered "early" and is reimbursed more favorably than the subsequent 30-day periods. Reimbursement is increasing for patients sourced from an institutional setting, with the assumption that the need for care and benefits of care (such as avoiding readmission) are greater. Although patients sourced from community-based settings require a lower cost of care, potentially preserving margins, we expect this to have some negative impact on providers who focus on attracting patients with less-acute medical needs (such as those from the community rather than those recently discharged), who likely need fewer services over the standard 60-day episode of care.

Additionally, we expect agencies that promoted high utilization of therapy (speech, occupational, or physical therapy) sessions (which increased reimbursement) or that otherwise had a higher therapy mix profile, to face a disproportionate negative impact to reimbursement rates. This is because therapy utilization is no longer a key variable driving the level of reimbursement under PDGM. CMS expects agencies to shift their focus and marketing to seek patients with more attractive reimbursement levels and to record the most lucrative diagnosis as the primary diagnosis (for patients with multiple co-morbidities), and has accounted for this with the overarching behavioral adjustment.

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Of the home-care providers we rate, we see Gentiva Health as having higher risk to their current rating, than the other peers, given their exposure to a negative impact from the therapy mix and substantial sourcing from the community, only partially offset by its significant scale, diverse service offerings and strong profitability. We see AccentCare as best positioned to benefit, given their favorable therapy mix and large portion of referrals sourced from the institutional setting, partially offset by its smaller scale.

When The Dust Settles

Though some private-equity-backed companies have prepared for the workflow changes, the relatively high levels of debt leverage and constrained cash flows (after interest expense) could limit business development opportunities (absent an infusion of new equity). In contrast, publicly owned companies with lower debt and robust cash flow generation, such as Encompass Health, Amedisys, and LHC Group, will likely be better equipped for opportunistic acquisitions. However, early signs have indicated attrition of some smaller providers due to the pressures of PDGM, resulting in a transfer of patients to other regional providers. We expect this could preserve some liquidity while increasing market share in certain geographies where larger providers have a significant presence.

We expect skilled nursing facility (SNFs) and long-term acute care hospital (LTACHs) companies could enter the home-health market, for the right opportunity, as that would give them the ability to better manage their discharged patients through the continuum of care (more control to avoid readmissions), and enable them to establish a relationship with potential future customers. The new payment scheme is designed to reduce total costs in the health care system with a higher reimbursement for referrals sourced from the more acute and expensive setting such as SNFs and LTACHs (to reduce readmissions), compared with community based referrals (which are thought to sometimes be less necessary or unnecessary). However, the University of Pennsylvania's March 2019 study based on data between 2010 and 2016 found that although patients discharged from a hospital to home-health care provides immediate savings, the rate of readmissions was higher compared with patients discharged to SNFs.

We also expect companies, such as Phoenix Guarantor Inc. (B/Stable/--), with significant capital could be more opportunistic and enter the home-health industry during the tumult of PDGM. Phoenix has significant scale, strong cash flow expectations for 2020, and limited initial impact from PDGM given their smaller home-health business. We see the potential for it to pursue an opportunity to enter a disrupted industry, adding to their broad continuum of care services.

We expect significant disruption in the industry including closures of smaller agencies, consolidation driven by the largest providers, and potential payment model revisions from CMS, should the industry unexpectedly become unstable. Given the significance of PDGM, there is significant uncertainty how providers will weather the operational transition to PDGM through the initial quarters of 2020. In our view, providers with scale, significant cash flows, an attractive mix of patients (referral from institutions, not high utilization of therapy session) and good access to capital will be well positioned to take advantage of potential opportunities to expand their geographic footprints and market share. We are watching financial performance closely including the impact on working capital, for these issuers over coming quarters.

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