Chemed stock remains a buy from a long-term perspective (NYSE:CHE)

Investment update

After my last publication about Chemed Corporation (NYSE: CHE) The stock is unchanged and I reiterate my buy recommendation for the stock after the announcement of earnings in the second quarter of fiscal 2024.

The last publication entitled “Continues to increase value for shareholders with double-digit returns” argued for a switch to CHE based on a number of factors, all of which are still relevant today, namely:

CHE is a long-term compounder with a cycle of high returns on capital invested in its operations, a sizable portion of that being poured back into the asset base, and the process repeating. As a result, it attracts high valuation multiples to capital (currently ~6x, but historically up to ~8x), providing exceptional compounding ability with every dollar of discretionary cash management reinvests in the business. If it is valued at ~$6 per dollar (which is justified given the consistency of its ROICs), then any excess investment management should be given good marks immediately.

• One could argue that paying such a high multiple greatly reduces the return for the investor. very short term:
• Book capital = ~1.9 billion USD (as of Q2 FY 2024)
• Profit on book capital = 292 million USD = ~22% return
• We pay = 6 x book capital = 8.4 billion USD
• Investor return = $292 million / $8.4 billion = ~3.4%.
• Unfortunately the view must be long-term So that this first-class compounder can benefit from the effects of the performance of this equally first-class management.

To illustrate, a hypothetical example (I will explain my scenarios later):

• Pay 6x your book capital = $8.4 billion – assume a 25% ROIC
• Total cumulative NOPAT, 5 years = $1.22 billion ($407 million/year)
• Management reinvests ~33% NOPAT into the capital base = $403 million
• New capital base = USD 1.75 billion
• At 6x = 10.5 billion USD = 24.3% growth in goodwill.
• Compared to 50% reinvestment = $611.5 = $1.96 billion (vii) At 6x = $11.7 billion = 39% growth.

These same economic principles apply specifically to CHE, in my firm view, which I will briefly explain here. I have a long-term price target of $700/share for CHE (>5 years), but in the meantime, I see the next price target at $580-600/share, which I will go through here today.

Based on my assessment of the latest updates and recent developments, I continue to rate CHE as a buy, next price target $580/share, then $600.

Earnings breakdown for the second quarter of fiscal year 2024

CHE had approximately $596 million in revenue for the quarter, increasing revenue by approximately 760 basis points year-over-year on earnings of $5.47/share. Each of the company’s portfolio companies continues to grow and employee headcount increased this quarter, which may be a plus as it ranks 7th in the healthcare services industry with net income of approximately $20,000/employee (top 4 are (CI), (ASTH), (OPCH) and (PINC)). The trend of increasing revenue is now well established and I see further growth in operating income from here (see: Figure 1, Appendix 1). Management’s comments on the average daily count (“AVD”) on the conference call also caught my eye:

In Q2 2024, our average daily patient count was 21,036, an increase of 14.4%. VITAS has achieved quarterly ADC growth for the past seven quarters. In Q2 2024, the total number of VITAS admissions was 17,334, an increase of 11% compared to Q2 2023.

Management revised its guidance upward and now expects VITAS growth of 16.3% to 17.3% (before a Medicare cap), with AVD growth forecast at 13.3% to 14.4%. Roto-Rooter is expected to decline 4% to 5%. It expects adjusted EBITDA margin of ~19% and earnings at the high end of ~$23.80/share.

As for the highlights of the division, my findings were the following:

• VITAS reported 17,344 admissions in Q2, +11% YoY. ADC was +2,644, otherwise +14.4% YoY. VITAS generated revenue of $374 million (~+17% YoY). Growth was highlighted by a +14.4% increase in days of care, coupled with a +2.5% change in Medicare reimbursement. In particular, the acquisition of Covenant Health (see below) contributed ~$8.5 million to revenue.

• Average revenue per patient per day was $200.03 (153 basis points year-over-year). Reimbursement for routine home care averaged $176.73/day, while critical care averaged $1,071.65/day. Despite a slight decline in critical care days as a percentage of total days (-21 basis points year-over-year), total revenue per patient day is the number to look at, in my opinion.

• Meanwhile, the Roto-Rooter business faced challenges in the second quarter, resulting in revenue declines in both residential and commercial segments. Revenues declined 500 basis points year-over-year to $221.3 million, primarily reflected in residential (-160 basis points year-over-year) and commercial (-820 basis points year-over-year) revenues. Total call volume declined 6.1%, reflecting weaker demand in the market.

Impact of the acquisition of Covenant Health

• The acquisition of Health of the Alliance As mentioned, contributed approximately USD 8.5 million to quarterly sales, which corresponds to a profit of approximately USD +1.7 million.

• For fiscal year 2024, Covenant Health is expected to contribute approximately $30 million in revenue, with adjusted EBITDA of approximately $8.5 million and earnings of approximately $5-6 million.

In my view, the company’s quarter was tremendously strong, with continued growth in unit costs across both operating segments. CHE’s management is a good steward of capital and exhibits many shareholder-friendly policies aimed at treating investors like partners, not names on the share registry. It views the company’s cash + capital as shareholders’ cash + capital and has used it wisely over the years (I discussed this in detail in my last CHE analysis). I have updated my modeling accordingly (see: Appendix 1).

Figure 1.

Valuation potential remains

The company trades at a compressed valuation of ~6x EV/IC, but I’m happy to continue that as 1) it leaves room for expansion and 2) it would take tremendously poor business efforts to make it trade below that range. Even 6x is bearish in my view – this is a company that 1) generates >20% on total invested capital, 2) has a long reinvestment period to deploy capital (my numbers suggest an average of ~11% of NOPAT through FY28), and 3) where at least >2% of revenues result in economic profit (excess returns above our 12% minimum return).

Figure 2.

Figure 3.

Valuation Insights

• In my view, the company has the opportunity to reinvest about 11% of NOPAT per annum through FY2026, which gets us to about $603/share at 6.3x EV/IC + ~20% ROIC by FY2026. Any opportunity to return more funds to the company should be highly valued in this regard. On the other hand, we can lower the multiples to 6x EV/IC, and under these assumptions I still get about $580/share by FY2026. So the bar is not set high in my view.

Figure 4.

• My estimates are that if a wholly owned company could generate more freely available cash at a comparable level of risk (here, about 6% initial return of many investment grade companies) and a 12% discount, it would be worth about $585 per share. In my view, there is upside risk here as CHE’s ROICs are 1) cyclical, 2) currently at the bottom of the cycle, and 3) starting to move higher. Excess ROIC and economic gains are positive for valuation, with 25% ROIC by FY2026 getting me to a discounted present value of $600/share – but I’ll stay conservative to avoid introducing forecast errors.

Figure 5.

Risks of the investment thesis

The downside risks to this thesis include 1) ROICs

Investors must be fully aware of these risks.

In summary

CHE remains a buy in my opinion due to 1) the high-quality economics that generate strong returns for reinvestment, 2) the attractive entry multiples underpinned by this economic environment, and 3) valuations that support $580-600/share under various scenarios. The bottom line is that I reiterate the buy.

Appendix 1.