CMS Changes And Debt Will Curb Margins With Modest Recovery

Key Takeaways

• Heavy dependence on government reimbursement and tightening regulations presents ongoing risks to revenue growth and margin stability.
  
• High debt burden and labor cost pressures may restrict investment flexibility and threaten sustained earnings improvement.
  
• Regulatory pressures, reimbursement risk, industry shifts, and high debt burden threaten profitability, revenue growth, and financial flexibility amid intensifying competitive and structural challenges.

Catalysts

Through its subsidiaries, operates critical illness recovery hospitals, rehabilitation hospitals, and outpatient rehabilitation clinics in the United States.

• While Select Medical is well-positioned to benefit from an aging population and an increasing prevalence of chronic diseases-which is driving consistent demand for post-acute and specialty care services-the company's reliance on Medicare and Medicaid reimbursement exposes it to ongoing regulatory risk and potential changes to government payment models, which could weigh on future revenue and compress net margins if unfavorable policies persist or intensify.
  
• Although robust expansion of joint ventures and facility openings is expected to boost patient volume and broaden referral networks for the inpatient rehabilitation and outpatient divisions, the heavy investment required for geographic growth and capital expenditures adds to an already sizable debt load of nearly 1.9 billion dollars, limiting flexibility for future investments and raising interest expense, which may restrain earnings growth if financial leverage is not managed carefully.
  
• While operational scale and outpatient technology initiatives are improving margin performance and driving incremental EBITDA increases in the rehab segment, industry-wide pressures such as labor cost inflation and the potential for acute labor shortages in healthcare may abruptly increase operating expenses, eroding any efficiency gains and threatening the sustainability of margin improvement over the long term.
  
• Despite favorable demographic trends propelling patient demand, the ongoing shift toward outpatient and home-based care, coupled with tightening government reimbursement structures and heightened regulatory scrutiny-such as the LTAC 20% transmittal and high-cost outlier threshold adjustments-presents persistent headwinds that could reduce the utilization of Select Medical's critical illness recovery hospitals, pressuring both occupancy rates and revenue growth.
  
• While recent CMS rule changes offered slight relief in the form of modest reimbursement increases, the continual evolution of payer requirements and the growing proportion of Medicare Advantage and managed care patients, who are often associated with denial and preauthorization challenges, suggests the company could face ongoing disruptions to revenue recognition and working capital efficiency, limiting its ability to consistently grow earnings and cash flow.

Select Medical Holdings Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Select Medical Holdings compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Select Medical Holdings's revenue will grow by 5.1% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 1.5% today to 3.4% in 3 years time.
• The bearish analysts expect earnings to reach $207.2 million (and earnings per share of $1.66) by about August 2028, up from $81.1 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 9.2x on those 2028 earnings, down from 19.4x today. This future PE is lower than the current PE for the US Healthcare industry at 21.1x.
• Analysts expect the number of shares outstanding to decline by 4.64% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.3%, as per the Simply Wall St company report.

Select Medical Holdings Future Earnings Per Share Growth

Risks

• Continued regulatory pressure and policy changes from CMS, such as the rise in the high-cost outlier threshold and the implementation of the 20 percent transmittal rule, have significantly reduced reimbursement for high-acuity LTAC patients and driven EBITDA declines; this persistent regulatory risk could further compress margins and reduce net income over the long term.
  
• Heavy reliance on Medicare and Medicare Advantage for a large portion of patient revenue exposes Select Medical to adverse reimbursement changes and denials, as lower Medicare physician fee schedule rates already caused a multi-million dollar decrease in revenue last quarter, threatening sustainable revenue growth.
  
• The company's debt-heavy balance sheet, with $1.9 billion in debt and net leverage of 3.57 times EBITDA, increases interest expense and limits future financial flexibility; rising interest costs and the need for ongoing capital for acquisitions and expansions could erode net earnings if profitability does not keep pace.
  
• Increasing shift toward outpatient, at-home, and value-based care models across the industry may reduce demand for inpatient rehabilitation and long-term acute care hospitals, risking lower facility occupancy rates and stalling top-line growth in core business segments.
  
• Ongoing industry consolidation and growing bargaining power among payors, combined with competitive pressure from other efficient operators, could drive down reimbursement rates and tighten margins, limiting Select Medical's ability to grow revenues and protect earnings in the face of intensifying cost containment efforts.

Valuation

• The assumed bearish price target for Select Medical Holdings is $14.0, which represents the lowest price target estimate amongst analysts. This valuation is based on what can be assumed as the expectations of Select Medical Holdings's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $21.0, and the most bearish reporting a price target of just $14.0.
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $6.1 billion, earnings will come to $207.2 million, and it would be trading on a PE ratio of 9.2x, assuming you use a discount rate of 8.3%.
• Given the current share price of $12.71, the bearish analyst price target of $14.0 is 9.2% higher.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.