2004 certainly will be remembered as one of the most dynamic periods in Chemed's 33-year history. In the last twelve months, we raised over $435 million in capital, took our 37% ownership of VITAS to 100%, finalized the reengineering of Roto-Rooter's operational infrastructure and entered into an agreement to divest our Service America operation. The end result of these changes was to deliver exceptional revenue, earnings and cash flow growth in 2004. The outlook for Chemed in terms of future opportunity and financial performance has never looked better.
- Chemed 2004 Annual Report
Although founded in 1970, Cincinnati-based Chemed (CHE) did not see the "modern" itself until 2004 when the company reorganized, resulting in two wholly-owned subsidiaries: VITAS Healthcare (provider of end-of-life hospice care), and Roto-Rooter (provider of plumbing, drain cleaning, and water cleanup services). Although we do not believe in any correlation between these two businesses, their commonality is apparent - being boring. And this trait is particularly an attraction to value/quality investors like us at Urbem.
Fast forward to today, both businesses own the lion share in their respective categories. A leading position in a slowly-growing (or even no-growth) industry often leads to high returns in our view, as smaller players are being squeezed out of the market, which is not so attractive to new entrants at the same time.
As of 2018, VITAS accounts for roughly two-thirds of Chemed's total sales, and Roto-Rooter the remaining one-third. Per the chart below, Chemed steadily improved its return on invested capital since 2004. For the past decade, the reading has never dropped below 15%. At the same time, The return on invested capital at Amedisys (AMED) and Encompass Health (EHC) have both been volatile. The consistency of the superior return on invested capital is a good indicator of the enduring competitive advantage. Concerning Roto-Rooter, we have difficulties in finding its competitors among public companies.
Through over 110 company-owned and over 400 franchisee territories, Roto-Rooter is providing plumbing services to approximately 90% of the US population and 40% of the Canadian population. Residential and commercial plumbing accounts for roughly 33% of the subsidiary's 2018 sales. Additionally, Roto-Rooter maintains an estimated 15% of the drain cleaning market. Residential and commercial drain cleaning represents 30% of the subsidiary's 2018 sales.
The business has extensive coverage in the US market (all but a dozen states or so), implying little room for geographic expansion. Still, the company can continue to acquire franchisee territories. The management has paid particular attention to quality and purchase prices, setting up its disciplines to screen and avoid overpaying. But we notice that the management appears to have just loosened the valuation standard from "4-5x EBITDA" in the second quarter of 2019 to "6-8x Proforma Adjusted EBITDA" in the third quarter. Any residual cash flow may be used to fuel growth at VITAS.
VITAS operates a comprehensive range of hospice in 14 states and the District of Columbia, owning around 7% of the US market share. The $18 billion hospice industry, filled with "Mom & Pop" not-for-profits, is much more fragmented than the plumbing and drain cleaning.
As the largest hospice provider in the US, VITAS has the scale advantage, when it comes to investing in technology, easiness of accessing capital, operational efficiency, and accessibility of care. The adjusted net margin at VITAS stood at 11.7% in 2018 and has been above 8% every year for the past decade, compared to the average operating margin of 4% to 8% in industry and approximately 50% of hospices with negative margins. Large hospice groups like VITAS should compete favorably as they can afford to lose money on some units while making up the losses through others.
Unlike Roto-Rooter, there are many "white spaces" on the map for VITAS to expand its footprint. The company plans to continue its organic growth while looking for acquisitions. Moreover, the aging population has been creating a strong tailwind for the hospice industry. According to the Washington Post, about half of Americans who died today employed a hospice service at some stage.
As we have seen, the acquisition is playing a pivotal role in Chemed's growth strategy. Therefore, investors may want to watch out for the inherent risk of overpaying. So far, we have seen improving asset turnover for the past few years. But the amount of goodwill on the balance sheet has jumped significantly this year, which could be a warning sign.
Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market; we do not own any stock mentioned in the article.
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