AAC Holdings – American Addiction Centers

 

Introduction

It’s no secret that addictions ranging from food to drugs are a blight on the human condition. The CEO of AAC, Michael Cartwright, aims to provide a national network of centers dedicated to helping people recover from their struggles and lead a more normal life. Today the company operates seven treatment centers with revenues of $116M.

Addictions and mental health are often poorly accommodated by existing health plans and the system in general. This creates a situation where many people don’t get treatment. AAC won’t solve all the problems, but they can help address the demand for what I’d describe as an option for those with money or very good private insurance coverage. Management calls it a “premium brand.”

Management aspires to do with addiction treatment what Acadia Healthcare (NASDAQ: ACHC) has done with psychiatric treatments. ACHC has done well – the shares have quadrupled over the past three years putting the market capitalization at $3B, just over 4x revenues. It should be noted that ACHC is best-in-class. Most companies in the space trade at substantially lower multiples, often below 1x revenue.

Investors should expect AAC to make acquisitions in addition to their existing plans to add new capacity with additional beds. Management expects to expand capacity by 66% by 2016. The revenue machine is fairly simple, driven by the number of beds and the utilization rate. Management notes the market opportunity is large given the $35B “behavioral healthcare space” and the millions of partially or untreated patients.

From a valuation standpoint, the management team will be focused on adjusted EBITDA margins as a measure of their success. They stand at 13% for the first half of 2014 with a long-term target of 20-25%. Our IV is based on operating income, which should be able to reach at least the mid-teens over time.

The known unknown here is what types of acquisitions will be done and how they will be factored in. The expansion plans will involve more capital, which may help them recruit additional banks and coverage for the company beyond the small team (Blair, RayJay and Avondale) they used on the IPO.

The Weird Part

As attractive as AAC is on the fundamentals, there are a few things that have made investors a little ambivalent. For one, the whole scheme has a feel not unlike the paid-for-college degree programs made famous by the “University of Phoenix”, owned by Apollo Education Group (NASDAQ:APOL). Many will no-doubt say that APOL has nothing at all in common with AAC; after all it’s education, not healthcare, and APOL fed on the government sponsored guaranteed student loan programs whereas AAC doesn’t rely on any government programs. There are still some parallels here.

Like Apollo, the plan at AAC is to win patients with marketing. You will see ads on TV, online, and anywhere that generates demand and promotes callers into their center where the focus is on “conversion” to client. The Mayo Clinic or Memorial Sloan Kettering are not running infomercials to get people into their treatment centers. We’re not saying that management at AAC will let things go awry like Apollo did and turn their sales teams into bullying liars, but mixing a marketing and sales focus with substance abuse programs seems a little squishy.

Investors may take note that during the ascendant phase of the Apollo Story, APOL stock had an impressive multi-year run from around $10 to close to $100 before their growth tactics got caught up in controversy and they were no longer able to basically print money off the back of the student loan programs. Even after ten years of declines, APOL still generates over $1B in revenue and carries a $2.8B market capitalization. Online education is still a good market.

Management appears quite passionate and committed to quality as the CEO stated at the end of their IPO roadshow:

“To me, it’s not just about making money. It’s about making sure we have a clinical product that we can be proud of. A clinical product that any one of our family members would [use for] treatment and come out and live a nice, healthy, productive life.”[1]

But this quote raises another question for investors at the same time – what is the model for investor returns? The company is intent on growing into a national operation that will entail a combination of adding to facilities, green field projects, and acquisitions. This all suggests a persistent need for capital – whether from operations, debt, or equity financing.

Competition

We take one small issue with the way the market opportunity has been presented – just because it’s “fragmented” doesn’t mean it’s begging for consolidation.  Most doctors, including mental health care professionals, tend to see patients and refer them to resources in a local geography, and most if not all urban and suburban areas have these types of facilities available within a reasonable driving distance.

AAC will be taking a unique approach to building a “national brand” by advertising directly to the consumer, but this is also likely to increase demand for local centers as well. After seeing a TV ad, the individual might prefer to go see their doctor for recommendations rather than calling an 800 number and enrolling in a course of treatment over the phone.

Although the model demands substantial capital to start up or acquire a new treatment center, the *incremental cost* for an existing facility to add substance abuse treatment programs is not nearly as high. These local centers also compete for the personnel that AAC needs to grow. Many of these professionals seek employment where they already work and live.

AAC will have advantages in terms of focus and quality of facilities, and may be able to achieve their stated goals of leading reputation and brand recognition if their quality of clinical programs and services distinguish themselves in the field. It’s too soon to know if they will be able to accomplish that.

Conclusion

AAC was an attractive IPO that remains fairly compelling even at a higher price point. There are quite a few moving parts in the financials because their growth strategy will involve acquisitions, but our initial valuation models point to near-term share prices around $30.

The key risks are execution (common in our IPO work) and multiple contraction if the promised growth and operating margin levels become doubtful. While leaders like Acadia Healthcare (ACHC) trade at 4x sales, the averages hover around 1x. AAC clearly wants to be an ACHC in their niche, but they still have much to prove.

 

[1] IPO Candy Transcript – October 2014