Article by AlphaTreeGroup  @toddalphatree

Cubs win and a nice price to wake up to on Thursday…

AAC Holdings Inc (AAC)

As I try to emphasize in my online investing course, it always, always pay to do your due diligence.

David Einhorn’s work on Allied Capital is a great example (check out that story here), as well as Bill Ackman’s work on MBIA (you can check that story out here as well).

[drizzle]Occasionally, I like to buy put options on companies I’m bearish on, but prefer not to short. American Addiction Centers was one of those names, and that ended up working quite well.

A few months ago, I read a fantastic write-up on AAC,  the second largest operator of substance abuse centers,  that was posted on the Value Investors Club. The thesis was simple:

AAC is overbilling for their drug testing, there are massive reimbursement cuts going around, and the company’s profits are about to drop drastically.

Yet, on the surface, the company’s story looked much differently.

At one point, AAC was the hot healthcare growth story, with an on-fire roll-up strategy and new de-novo’s location (aka new locations) opening up all time. Surprisingly, it looked like the company was making money as well.

The story was perfect: high growth and profits! Yet for the diligent investor that looked beyond the surface, it was ugly, ugly, ugly.

In a past life, I covered some small healthcare companies, including rehab centers like AAC (mainly CRH, AAC’s biggest competitor) and small toxicology labs. I learned two things during that time:

It didn’t surprise me at all when the short thesis’ main argument was that the company was making all of it’s money on drug testing, and losing money on the rehab business.

In 2015, the company had about $57mm in drug testing based revenue (they really make you dig for that which is sketchy already). The margins on drug testing are VERY high, which is why abuse tends to be very, very high as well. It costs very little to test for extra things in a drug test, which is why some greedy physicians will bill for unnecessary tests to stuff their pockets a little more. For example, drug testing senior citizens for angel dust.

The author of the VIC article estimated that AAC’s drug testing margins were greater than 90%, which essentially would mean the rehab business is EBITDA negative.

Because of this abuse, major insurances made large changes to their reimbursement policies, which would lead to massive decreases in drug testing payments to company’s that abuse it like AAC.

Sure enough, AAC’s average daily residential revenue started dropping.

AAC Holdings Inc (AAC)

From Q3:

“Our average daily residential revenue declined 21.1% to $768 for the third quarter of 2016 from $973 for same period in 2015.The decline in the average daily residential revenue was significantly impacted by a greater percentage of client related revenues being derived from in-network beds during third quarter of 2016 as compared to the same period in the prior year combined with a decrease in point-of-care drug testing and diagnostic laboratory services as a percentage of client related revenue.

I think now it’s pretty clear to the market that AACs whole business model was a facade:

AAC Holdings Inc (AAC)

AAC Holdings

Moral of the story? Always do more due diligence than you think you need to.

Never blindly trust management, or sell side analysts who have little incentive to actually be right.

Do your own work.

 

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