Danger Zone Stocks: Acadia Healthcare Company Inc (ACHC) by Kyle Guske II

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

The high-low fallacy makes certain investments appear much more attractive on the surface. When one peers below the surface, the fundamentals of the business are often revealed to be in much worse shape. This week’s Danger Zone pick has a history of executing a traditional roll-up strategy to great success – if you only care about revenue growth. For those that care about profits, the increasing losses and declining ROIC earn Acadia Healthcare (ACHC: $55/share) a spot on July’s Most Dangerous Stocks list and the Danger Zone this week.

GAAP Growth Masks Cash Costs of Acquisitions

Acadia Healthcare’s economic earnings, the true cash flows of the business, have declined from -$13 million in 2012 to -$223 million over the trailing twelve months. These losses come despite GAAP net income growing from -$35 million in 2011 to $124 million over the last twelve months. See Figure 1. See the reconciliation of Acadia’s GAAP net income to economic earnings here.

Figure 1: Disconnect Between Revenue and Economic Earnings

Acadia Healthcare, ACHC, Danger Zone Stocks

Sources: New Constructs, LLC and company filings

The acquisition approach to growth accounts for the large discrepancy between the accounting earnings and economic earnings of ACHC. Since 2011, ACHC has undergone over 25 separate acquisitions, which have cost upwards of $5.3 billion. While these acquisitions are “accretive” to EPS, they are highly dilutive to cash flows and ACHC’s balance sheet. From 2011-2015, Acadia’s debt grew 66% compounded annually to $2.3 billion. Over the last twelve months, debt has ballooned to nearly $3.8 billion, or 77% of the current market cap.

Smart acquisitions improve ROIC. ACHC’s acquisitions have not been smart. Since earning a 9% return on invested capital (ROIC) in 2012, the company’s ROIC has declined to a bottom-quintile 5% over the last twelve months. Similarly, ACHC has burned through cumulative -$3.4 billion in free cash flow from 2011-2015, and over the last twelve months, FCF sits at -$2.8 billion. No matter which way you slice it, ACHC’s acquisitions have drastically deteriorated the economics of the business.

Misaligned Executive Incentives Mean More Value Destruction To Come

Apart from base salaries, executives at Acadia receive annual cash bonuses and long-term stock-based awards. The cash bonuses are paid out for meeting adjusted EBITDA and adjusted EPS goals. As seen in Figure 2, these two metrics paint a much rosier picture than the economics of the business and have significant costs of business removed. Additionally, stock-based awards are given based upon meeting adjusted EPS goals and also have a time based vesting requirement. At the end of the day, the metrics chosen to incent executives do very little to create true shareholder value. By removing costs such as compensation expense or acquisition costs, executives can grow the top line and adjusted metrics with little or no attention paid to the economics of their actions. The best way to create shareholder value, and align executives with the best interest of shareholders, is to tie performance bonuses to ROIC because there is a clear correlation between ROIC and shareholder value.

Misleading Adjusted EBITDA Rises While Profits Decline

While the decline in economic earnings is clear, investors following non-GAAP metrics would have a vastly different view of the firm. Companies routinely remove normal operating costs to create a more positive picture of business operations and ACHC is a poster child for the dangers of non-GAAP earnings. Here are expenses ACHC has removed when calculating its non-GAAP metrics, including adjusted EBITDA and adjusted EPS:

  1. Equity-based compensation expense
  2. Transaction expenses related to acquisition
  3. Sponsor management fees
  4. Debt extinguishment costs
  5. Loss/gain on foreign currency derivatives purchased in relation to acquisitions

These costs can be significant, particularly equity-based compensation expense and transaction expenses. In 2015, ACHC removed $20 million (18% of GAAP net income) in equity-based compensation expense and $36 million in transaction costs (32% of GAAP net income) to calculate its adjusted EBITDA. By removing these costs, along with the others, ACHC is able to report non-GAAP results that are much improved from economic earnings. Adjusted EBITDA grew from $215 million in 2014 to $405 million in 2015, 88% year-over year (YoY). GAAP net income grew “only” 36% YoY while economic earnings declined from -$52 million to -$153 million, or -194% YoY. This discrepancy, dating back to 2011, can be seen in Figure 2.

Figure 2: Misleading Non-GAAP Metrics

Acadia Healthcare, ACHC, Danger Zone Stocks

Sources: New Constructs, LLC and company filings

Lower Profitability Than Main Competitor: Acquisitions Not Adding Competitive Advantage

The behavioral healthcare industry is a specialized subset of the larger healthcare industry, and therefore has fewer true competitors. Acadia Healthcare competes primarily with Universal Health Services (UHS) and also hospitals and that may offer mental health services. By comparing ROIC, we can get a true measure across these specialized sectors to identify which firms are allocating their capital most efficiently. Per Figure 3, ACHC’s ROIC ranks below UHS and general hospital operators such as HCA Holdings (HCA).

When comparing margins its more apt to compare between UHS’s behavioral health segment alone, rather than hospitals in general where margins are impacted due to traditional hospital services. UHS’s behavioral health operating margin has topped 20% each year since 2011, and was 23% in 2015. Meanwhile, ACHC’s operating margin maxed out at 13% in 2014, and was 9% in 2015. Either way, ACHC has lower margins and ROIC than its direct competitor, which gives it less operational flexibility and pricing power.

Figure 3: ACHC’s Profitability Hardly Matches Competition

Acadia Healthcare, ACHC, Danger Zone Stocks

Sources: New Constructs, LLC and company filings 

Bull Hopes Rest On Roll-Up Continuing

The bull case with all roll-up strategies revolves around the company continually finding new acquisition targets, purchasing them, and growing revenue and non-GAAP metrics.

With this in mind, ACHC has executed this strategy to perfection. However, the bull case unravels with each acquisition, as the ability to “move the needle” shrinks. An acquisition when a firm generates $200 million in revenue is much more impactful than when the firm generates $2 billion in revenue. Without revenue growth, roll-up strategies lose momentum, and the underlying economics of business are revealed for what they truly are.

Additionally, the current bull case would imply that the past acquisitions have been a quality use of capital, which as shown above, is simply not true. The market ultimately rewards firms that generate the highest return for each dollar of capital invested. In the short-term. ACHC can report non-GAAP metrics that stoke investor interest, but long-term, the economics of the business are trending in the wrong direction.

The largest risk to the bear case is simply time. As we know, the market can stay irrational longer than investors can stay solvent. There is no specific timeframe for roll-up strategies to slow down and the market wake up to the growing economic losses. In the meantime, another risk is that a hospital or other

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