We would like to express our thanks to Bleecker, that came out with a short article on AAC. We decided to conduct our own research on areas not covered by Bleecker. While we appreciate Bleeckers work, we are not affiliated with them and do not express an opinion on, or endorse, the research of any third party.
Thank you also to my partners Richard Trojan and Giordana Grego, whose help has been invaluable.
Quintessential Capital Management has recently opened a short position on the stock of American Addiction Centers (NYSE:AAC). Despite the inherent growth potential of the industry it operates in, we believe that this issuer, which recently went public, is a ticking bomb waiting to explode given its apparent reliance on unsustainable business practices such as predatory marketing, ineffective therapies, and unethical and exploitative treatment of patients. Most importantly, at least a third of AACs revenue (and all of its profit) is now in jeopardy as it relies on questionable urine-testing practices, which are being challenged by insurance providers and by the government. Despite these issues, the company is trading at what we believe are inflated multiples and in our view looks grossly overvalued.
About American Addiction Centers
AAC Holdings, Inc. provides substance abuse treatment services for individuals with drug and alcohol addiction in the United States. It operates seven residential substance abuse treatment facilities and one outpatient facility in Texas, California, Florida, and Nevada. The company also operates an obesity treatment center in Tennessee. Total current capacity of AAC is around 700 beds, plus another 300 under development. The company raised $75m in an IPO last year, with William Blair and Avondale as underwriters.
AACs history, however, starts in 2004 with a company called A Better Tomorrow Today founded by Mr. Jerrod Menz, the current president of AAC. That company, which subsequently changed its name to Forterus, was listed in 2008 through a reverse merger with an OTC shell, but quickly stopped filing its financials and became a non-reporting entity. Later on, it ran into trouble following the death of four patients and the subsequent license-revocation on one of its facilities. The company eventually merged with Performance Revolution, founded by current AAC CEO Michael Cartwright, and following a streak of acquisitions, it became AAC.
AACs management says it has ambitious goals, aiming to build a nationally recognized brand in the addiction-treatment industry, which is currently very fragmented. The idea is to grow aggressively, both organically and through acquisitions, and establish a strong brand nationwide. Growth has been impressive so far, although from a relatively small base, because of the significant capital provided by the initial IPO and subsequent secondary offerings (some are still in the pipeline). The high stock valuation has facilitated the expansion process by providing more dollars per unit of equity. This is, in large part, due to the enthusiastic reporting of certain analysts covering the stocks.
Current state of the addiction recovery industry
A recently released documentary featured in Forbes Magazine titled The Business of Recovery and produced by Greg Horvath, is exploring the current state of the addiction-recovery industry. According to Mr. Horvath:
Over 90% of addiction recovery centers (including AAC) are based on the 12-step program popularized by Alcoholics Anonymous.
- Scientifically rigorous studies conducted on the 12-step program show extremely low success rates, frequently in the 5-10% range or lower, as observed by addiction expert amp; author Lance Dodes, MD – Harvard Medical School Graduate.
- The size of the addiction recovery industry today has grown to about $35b while the mortality rate has tripled during the last 20 years, possibly pointing to the ineffectiveness of existing therapies.
- Addiction recovery centers are relatively lightly regulated and staff often has minimal certification. Horvath questions the integrity of the current system of accreditation.
- Families across the US are facing financial ruin in order to finance drug treatment programs for their loved ones.
The documentary reports an increasing awareness of this issue and an expectation that the government will intervene in the future with some form of crackdown and regulation. According to the documentary, Obamacare has exacerbated the problem by increasing the available pool of patients and by requiring insurance companies to cover addiction treatment costs. The resulting increase in industry turnover has attracted new players to the industry, including, according to Horvath, many incompetent, ineffective or fraudulent ones.
Critique of AAC
Our research includes interviews with industry experts, former employees, former patients and medical practitioners. With few exceptions, the feedback we received on AAC has been negative. We list some of the main issues reported:
Aggressive marketing: AAC apparently markets its services through extensive use of call centers. Patients reach the company through a variety of venues and are persuaded to check into AAC facilities by skilled phone or online operators. Call center personnel typically does not have any form of medical credentials, but is trained and compensated aggressively to maximize the number of patients enrolled, with particular attention to their purchasing power and insurance coverage. Clinical considerations seem to be of little importance. [Source: interviews with former AAC employees]
Questionable advertising: Several former patients have found AAC to over-promise, but under-deliver. Call center operators frequently promise facilities, individual psychiatric care, daily activities, medical care, etc. that are often either unavailable or not available under the terms promised. Once the patient finds out, he/she typically is unable to leave the facility on reasonable terms. [source 1,2,3]
Maximizing profit at the expense of clinical efficacy: The length of stay and type of facilities prescribed by the call center, are typically only a function of insurance reimbursement and revenue maximization, rather than of clinical considerations. Clinically redundant treatments will be pushed if covered by insurance, while appropriate ones will be often denied if not covered.[source: interview with former employees]
Inappropriate environment: Several former patients have complained about the presence of drugs and inappropriate sexual behavior within the facilities. Many have questioned the effectiveness of patients monitoring.[source]
Ineffective treatment: High rates of relapse have been reported following AAC treatments. Just as in other addiction centers, AACs daily schedule includes the 12-step program, yoga, horse therapy and other activities that have no known scientifically proven value.[source]
Work environment: Former employees questioned by QCM have reported questionable work practices at AAC, including shouting, cursing and psychological pressure. One report mentioned a worker being fired for no other reason than to create a climate of fear. Some performance targets are apparently set at unrealistically high levels and often based purely on monetary criteria, with disregard for clinical outcomes. [source: interview with former employees]
Unethical behavior: several employees complained that AAC treats patients like merchandise rather than individuals. Call center operators apparently have used the expression closing a deal whenever a sick patient agrees to check in to the facilities. In some cases employees encourage patients to extend their stay at AAC, sometimes by refusing to return personal belongings or by pressuring the patients family.[source: former patient] In other cases, presumably if the facility is at full occupancy, patients are instead encouraged to remain in the facility only for the first week or so (typically the most profitable period due to detoxification) and are then pressured to leave by an employee giving them a hard time. In most cases, the prescribed length of stay and type of facilities were assigned solely based on financial rather than clinical considerations. [source: interview with former employees]
Is there a real rationale for nationwide growth?
In our opinion, AAC is led by management that may have experience in the industry, but that has no prior experience in running a large, publicly traded corporation. Foundations, the addiction center formerly managed by Mr. Cartwright, was apparently successful because of its relatively small size and high level of individual attention, making it a popular choice among celebrities, for example. However, many of the people we spoke to are skeptical about replicating the success of a small center in a large, mass-market facility.
In addition to this, we are skeptical of AACs rationale for nationwide growth. First, there are few firm- wide economies of scale beyond corporate overheads (most costs are personnel-related and do not decrease with scale). Second, patients in the field are generated either through referrals or through web searches: in neither case does size confer a strong advantage. Third, while in some industries, people equate size with quality, in healthcare, this is not necessarily so; on the contrary, smaller facilities often have a reputation for excellence, while larger ones may feel mass market. Finally, given the negative feedback we picked up from people who came in touch with the company, we doubt that management is prioritizing the development of a strong brand promise.
Bleecker Street Research has provided an analysis of AACs urine-testing practices. [source] Because it has been estimated that as much as 30% of AAC revenue originates from urine drug testing [estimated by Avondale], it is important to understand AACs testing practices.
Bleecker Street believes that AAC urine-testing practices are problematic on four fronts: first, testing is too frequent. Second, expensive confirmatory tests are used when redundant. Third, current testing practices may be illegal and subject to future litigation. Fourth, current testing practices are at odds with insurance reimbursement trends and, therefore, unsustainable. The bulk of our research during the past few months has focused on confirming or disproving these claims.
1. Testing frequency
AAC claimed in its quarterly conference call; to test its patients on average 4-9 times per month (1-2 times/week). First, we believe that the range is too wide and the company should be more precise in its disclosure. We crosschecked this claim with various sources:
– Phone surveys to AAC call centers: tests are conducted 1-2 times/week.
– Chat surveys with AAC online chat: tests are conducted 2-3 times/week.
– Former employee interviews conducted by QCM: tests are systematically conducted 2 times per week.
Based on the above, we believe that AAC tests on average twice per week and this is consistent with the companys upper end of the claimed range. There is also a rationale: because urine tests can detect drugs up to three or four days back, two tests per week, if administered consistently, can generally guarantee that any abusing patient will be detected.
Is this too frequent? While there are no rules written in stone, there are three ways to answer this question: we can check what AAC competitors are doing, we can check industry best practice literature and we can check insurance reimbursement guidelines.
– A significant sample of competitors approached by Bleecker declared that they test only 2 times/month, typically upon admission and discharge.
– The American Society of Addiction Medicine ASAM, by the standards of which AAC claims to abide, does not mention a testing frequency for residential programs, but does report what is reasonable and customary in outpatient programs and in PHPs (programs meant to monitor physicians). In both cases, the maximum frequency mentioned is one test per week:
It is not unreasonable to consider weekly random testing as appropriate in these [outpatient] settings, both to verify abstinence of the individual and to maintain the integrity of the sober residence for the group. [page 52] [hellip;]
In general, most PHPs [Physician Healthcare Programs] set the frequency of random testing at once a week early in their monitoring. The frequency of testing is reduced to twice a month and then once a month after long-term sobriety is achieved. [Drug Testing: A White Paper of the American Society of Addiction Medicine page 55]
We systematically sampled several insurance reimbursement guidelines. The overwhelming majority of them supports a maximum testing frequency of 1 time/month. Many do not reimburse tests for residential setting at all.
– A senior executive in the industry also gave us his point of view:
Industry standards are not what they [AAC] are doing. If its a residential program, it is reasonably secure. The fact that patients are using is an admission of treatment failure. [hellip;] For viable inpatient programs there really is no need to test more than necessary at admission and maybe an occasional test for suspicion or admission of drug use. That would be very typical. If drugs are pervasive [in the facility] there is something fundamentally wrong with the program. [Senior industry executive interview – June 26th]
Bottom line opinion: in light of what we believe is competitors practice, industry guidelines and reimbursement policies, for testing frequency of twice a week appears in our opinion to be above the norm, especially for inpatient facilities, where clients should not have access to substances.
2. Type of tests
There are two types of drug tests. Point-of-care (POC) tests can be performed directly at a facility and are typically inexpensive. They can detect the presence of substances, but have limited precision and cannot detect the level of drug concentration present in the urine source. Confirmatory (or quantitative) tests instead are performed with advanced lab tools, are more accurate and expensive (over $1000) and can detect precise quantities of substances used.
Based on our research, POC urine test samples at Leading Edge (a company acquired by AAC in 2012) were sent systematically to a lab for confirmatory tests. As it turned out, the lab offered complimentary POC tests if the corresponding urine samples were sent also for confirmatory testing. In this way, the lab made extraordinary profits from a high volume of expensive quantitative tests and Leading Edge enjoyed higher precision tests and free POC.
Bleecker Street believes that AACs management may have learned from Leading Edge about this profitable practice upon acquiring the company, and subsequently, decided to apply it on a company-wide basis. In the 3rd quarter of 2013, AAC opened its own testing lab in Tennessee, and if the theory is correct, AAC would now be using its lab to perform large number of redundant confirmatory tests from samples coming from most of its facilities as well as from other treatment centers. Is this theory correct? QCM has investigated these claims.
Bleecker Street has interviewed a former employee who claims that every POC test sample is automatically sent to a lab for confirmatory testing. QCM has conducted its own independent research and confirmed this claim with another, high-level source. Lets examine the evidence provided by a trustworthy former employee of AAC:
Yes it was everyones understanding, as told to us by the billing companies we used and the labs we used, that to bill for the qualitative portion of the test (POC) you must send it to the lab for high complexity/quantitative testing/confirmation. Alere/AVEE/Millennium etc. all said that to us. So, to bill for the POC test we were told we had to send it off for confirmation. All of us who drug tested our clients regularly were very happy to do this by the way because prior to being able to send off our samples for confirmatory and high complexity, quantitative testing, labs charged us for high complexity testing. [former employee declaration, June 22nd 2015].
The above declaration confirms the testing practices at Leading Edge.
Yes. I mean that every treatment center in the United States that does quantitative/qualitative testing, including all of AACs facilities, currently test twice per week and send those tests off for quantitative testing. It is the standard in the industry. When we test a patient twice per week there is no way that a patient has any window to be able to relapse (drink alcohol/use drugs). So twice per week was and is the standard across all of AACs facilities. [former employee declaration, June 23rd 2015].
And this appears to confirm that Leading Edges testing practices are now extended across all of AAC facilities. Of course, while at Leading Edge it was Avee/Millennium (the lab testing firm) that was making the bulk of the gains, now AAC can reap all the profits from confirmatory tests since they use their own testing lab at Brentwood, TN.
Another potential way to confirm AAC testing practices is to crunch the numbers using AAC reported figures and Avondale estimates [source: Avondale analyst report]:
From the simple calculation above, we can see that AAC must be charging between $600 and $1,345 per test. Those figures are consistent with frequent confirmatory tests (POC tests should cost less than $100).
The evidence suggests that AAC systematically uses confirmatory tests twice per week.
3. Are AAC current testing practices legal? Does existing industry best practice support them?
We believe AAC is performing confirmatory quantitative urine drug tests on a systematic basis twice per patient per week. Similar practices have already being challenged in court.
From AAC annual report:
Horizon Blue Cross Blue Shield of New Jersey v. Avee Laboratories et al.
On September 4, 2013, Horizon Blue Cross Blue Shield of New Jersey (Horizon) filed an amended complaint in the Superior Court of New Jersey against several defendants, including Leading Edge Recovery Center, LLC, one of our subsidiaries. Leading Edge Recovery Center, LLC formerly operated a drug and alcohol treatment facility in New Jersey. Horizon alleges the defendants submitted and caused others to submit unnecessary drug tests in violation of New Jersey law and is seeking recovery for monetary and treble damages.
This lawsuit refers to the testing practices at Leading Edge and discussed earlier in this report. AAC acquired Leading Edge. Moreover, Millennium (the lab used by Leading Edge for testing) is reportedly about to settle for $250m with Medicare for precisely the allegations: expensive, unnecessary confirmatory tests. [source]
Finally, to confirm that current testing practices are not condoned even by the industry standards AAC claims to adhere to, here is an excerpt from the ASAM guidelines:
Definitive testing. Definitive (also: confirmatory or identification testing) testing, which involves chromatography and mass spectrometry, incurs additional expense and thus should be done for specific indications. In general, a previously agreed upon protocol should be in place such that definitive testing is performed based upon rational clinical indicators. [hellip;]
Definitive testing following negative immunoassay results: in clinical practice there is no compelling rationale for subjecting all negative IA results to definitive testing.Although mass spectrometry-based testing offers state-of-the-art sensitivity, thus turning some analytical false-negative IA results into true- positive definitive results, the clinical value of this additional information must be balanced by the costs associated with its acquisition. [source: ASAM, page 55]
4. Insurance reimbursement
The high cost, low efficacy and dubious testing practices of many addiction centers during the last few years have not gone unnoticed by insurance providers. We spoke to a few players, representing a substantial portion of AACs third-party revenue, and asked them their opinion about the current situation. In fact, we kept wondering why insurance companies would continue to finance questionable testing practices and expensive, largely ineffective treatments.
The responses were enlightening. Insurance companies initially failed to react to the mushrooming of new, out-of-network addiction centers and to escalating fees. They would receive billings from addiction centers and from testing labs for urine tests often on a separate basis, so it was hard for them to cross-check the two and to understand if abuse was taking place. In recent times, however, the insurance industry is reacting and taking steps to rectify the situation. We heard of at least two important changes taking place:
1. So-called out-of-network providers (ie addiction centers that are not affiliated with any specific insurance company, like AAC) will no longer be reimbursed without limit. Reimbursement will be capped at the rate agreed upon with most in-network providers.
2. Urine tests will no longer be reimbursed on a separate basis; their cost will be bundled with the daily treatment charges (as is the case with in-network providers).
Because AAC has average daily revenue per patient of $920 and in-network providers usually charge $340/450, we believe this expected insurance company policy change to have material effect on AACs bottom line. These changes are being implemented gradually and they should be reflected in the companys statements during the coming quarters.
Our out-of-network benefits say: hey well pay 50%, but we are not going to pay you any more than we pay an in- network provider and the those [in network]rates include those lab costs, so we are flat out denying them once we discover them. Now, a year ago where we paying some? Yes, but we are doing a lot better job catching them now. Across the country all the plans are a lot more diligent in finding these.
Senior industry executive interview – June 26th
In other instances, insurance companies are limiting the frequency and type of tests they are reimbursing for urine-testing. For example, below is a reimbursement policy from Optum (United Behavioral Health), which AAC claims is among its main third-party payers [source AAC 10Q]. Please note how the policy strictly excludes any reimbursements for quantitative tests following a negative POC test.
Optum does not reimburse quantitative services when there is no underlying qualitative test or when the qualitative results are negative. [source]
This policy was revised in April 2015 so, presumably, any financial repercussions should be felt in the near future. We checked several other recent reimbursement policies and found this one to be representative. We believe AACs practices are at odds with current insurance reimbursement policies. [source].
Pricing for confirmatory tests, whatever their frequency, is also likely to drop significantly. According to the Wall Street Journal, prices for confirmatory tests might be capped at a rate between $175 and $350 per test. That implies a drop from current rates ranging from 40% to 90%.
What is AAC saying?
We spoke to AAC investor relations department recently. The company denies using the same testing practices prevalent at Leading Edge. They insist that testing decisions are taken on the basis of clinical needs and that confirmatory tests are not used systematically. But the evidence we found is in conflict with this statement.
A significant proportion of AAC revenue is not paid upfront, but must be collected from insurance companies and from patients after the treatment.
Apparently, AAC in 2012 dismissed its third-party billing collection agency and hired a brand new company owned by the wives of the AAC CEO and Chairman. Shortly before its IPO, the company changed the way it calculated its provision for doubtful accounts in a way that is materially accretive to its bottom line, arguably leading to a higher stock price. AAC subsequently acquired the collections company, paying a hefty goodwill for what appears to have been a related party transaction. [source]
Questioned by QCM, the company claims to have changed the accounting practice because it genuinely believes the new estimation criteria to be more accurate. That may be. However, we believe that the recent trends in insurance reimbursement might jeopardize the collectability of a significant portion of claims, leading to increased provisions and losses.
Normally we would expect a company with legitimate legal, regulatory and reimbursement concerns to trade at modest or, at least, reasonable multiples (despite its admittedly high growth rate). In this case, instead, AAC appears to us overvalued based on every metric we considered:
- P/E ratio: AAC trades at a trailing P/E of 103(!) and a forward (2015) P/E of 70.
- P/B ratio is 9.5.
- Price to sales: 7.13.
- EV/EBITDA LTM is 47.
- With $1b market cap and approximately 1,000 beds (including beds under development) AAC trades at a valuation of$1m/bed.
- CRC (a large competitor of AAC) was recently acquired by Acadia for $1.3b. That implies a valuation of $203k per bed, an EV/EBITDA of 10.2 and a price to sales of 2.6. Although the two companies are not identical, according to each of those metrics, AAC is valued 3/5 times more expensively than CRC.25
- The company has a 6.8% net margin and total operating income of $15.5m. Now, at least 30% of revenue or $30m derives from lab testing. Lab testing is a high margin activity (say 60%) so lab-originating income should be about $24m. Because AACs current operating income is about $15.5m, it follows that even a small reduction in lab revenue would have a dramatic negative effect on the companys bottom line. If the reduction were large enough, AAC would be running at a loss.
The obvious question would be how could this company reach such high valuations and we believe the answer is that analysts have been optimistic in portraying AAC and its future growth trajectory. Price targets are set aggressively and we believe analysts take whatever AAC management says at face value with what appears to be little propensity to perform independent due diligence and to challenge managements assumptions. Of course, it should be noted that William Blair and Avondale, the investment houses enthusiastically covering the stock, were underwriters in the Companys recent IPO and, to our understanding, in upcoming secondary offerings.
Because AAC is still growing rapidly, a successful short needs significant upcoming events to bring AAC valuation back to reality. We believe catalysts are not in short supply:
- Margin and/or revenue compression due to reimbursement pressures.
We believe insurance companies are capping daily rates, cutting billed days and ceasing to reimburse urine tests on a separate basis. We believe this trend will materially affect AAC income in the coming quarters.
AAC is currently a defendant in a lawsuit involving allegations of fraudulent urine testing. We believe an adverse conclusion of the lawsuit may have serious repercussions for AAC and lead to further litigation.
3. Federal crackdowns
The FBI is investigating the entire industry, especially in the Florida area (a major AAC area of operations). We believe increasing government scrutiny with accompanying media exposure may have a strong impact on AAC stock price.
4. Slowdown in growth rate
We do not see how the current growth rate can be sustained for much longer. We believe each new acquisition increases organizational complexity in a business that we believe is hard to manage on a large scale. Integration risks increase with each acquisition and we believe there are no significant synergies or economies of scale.
If the accounts of former employees and patients are to be trusted, deficiencies in clinical care and patients oversight may eventually lead to further deaths or accidents. In turn, this may lead to further litigation, revocation of licenses and negative press.
6. Insider selling
Insiders currently own about 64% of AAC shares. The lock-up period following IPO is now over and insiders have expressed their intention to begin unloading shares within the next 12 months [source: William Blair report]. We believe that considering the currently high stock price, the existing risks and their sizeable equity stake, a significant insider sale could have an impact on stock price.
AAC is a company trading at over 100 times earnings with what we believe is a questionable long-term growth model, with legal and regulatory threats. Virtually all of the profit originates from lab testing revenue, an activity undergoing powerful reimbursement challenges. Despite its acquisition pace and apparent efforts to compensate for reimbursement pressure with changes in revenue mix, we believe that AACs top and bottom line may soon undergo a potential collapse, with its share price to follow suit.
Selection of Supporting Documents
Florida Recovery Residences urine testing guidelines:
– Health New England reimbursement guidelines:
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– Tufts Health Plan guidelines: notices how routine confirmatory tests and tests for inpatient facilities are explicitly excluded:
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– Pemera Blue Cross testing guidelines:
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This publication represents the current opinions of Quintessential Capital Management (QCM) concerning American Addiction Centers (AAC). Funds and accounts managed by QCM currently have short positions in AAC. Although QCM does not expect to announce in the future any changes in either its opinion concerning or economic interest in AAC, both are subject to change. This article is for informational purposes only and does not constitute investment advice or a recommendation to purchase or sell any particular security or to pursue any particular investment or trading strategy. QCM cannot guarantee that any projection or opinion expressed in this publication will be realized. QCMs opinions are based on the sources cited in this article, but QCM cannot and does not provide any representations or warranties with respect to the accuracy of those materials.