Psychiatric Solutions' Healthy Outlook

S&P likes the fundamentals and "strong" management team of the behavioral health-services outfit, giving the stock its highest rating

by Jeffrey Englander, CFA From Standard & Poor's Equity Research

We continue to view Psychiatric Solutions (PSYS; recent price, $38) as one of the best positioned companies in the health-care facilities industry based on what we see as an underserved and fragmented market, limited new capacity coming on market in the near term, and a more favorable reimbursement position when compared to other health-care providers.

In addition, we believe that the company has a strong management team that has successfully demonstrated its ability to identify and integrate acquisitions. We also believe that the approximately $300 million in borrowing capacity on the company's balance sheet, plus strong cash-generating capability ($37 million in cash flow from operations generated in the 2007 second quarter), should provide Psychiatric Solutions with ample liquidity to pursue its acquisition strategy.

Our 12-month target price would result in price appreciation of more than 25% from current levels. All told, we view Psychiatric Solutions' fundamental position and valuation as compelling and our recommendation is 5 STARS (strong buy).

Company Profile

The Franklin (Tenn.)-based Psychiatric Solutions is a leading provider of inpatient behavioral health services encompassing both freestanding psychiatric facilities and residential treatment centers (RTCs). As of June 30, 2007, and following the acquisition of Horizon Health Corporation in June, 2007, Psychiatric Solutions owns or operates 90 facilities with approximately 10,000 patient beds. Its business is divided into two segments, acute care (53% of revenues) and residential treatment facilities (47%).

Acute-care facilities are used to house those patients who pose an imminent danger to themselves or others. These patients typically receive 24-hour observation and care with daily visits by psychiatrists, and have an average length of stay of 10 days, at which point they are moved to a less-intensive form of care.

Residential treatment facilities are used primarily for mentally ill children and adolescents who require a less-intensive degree of care in a nonhospital setting, and generally do not pose an immediate danger to themselves or others. Patients in residential treatment facilities generally receive care from a broader spectrum of providers who are seeking to address not only the medical and psychiatric, but also the social and academic needs of the patient. These patients have an average length of stay of 180 to 270 days.

Company and Industry Outlook

We believe the market for the company's services is large and relatively underpenetrated. According to the National Institute of Mental Health (NIMH), an estimated 58 million adults (aged 18 and older) suffer from a diagnosable mental disorder, of which an estimated 13 million are serious mental illnesses. In addition, approximately 12 million children (under 18) suffer from mental illness, according to the NIMH. Based on a 2003 study in the journal Psychiatric Services, we estimate the size of the inpatient behavioral health segment as a $20 billion market, and believe it is growing at a high-single-digit rate.

While demand for behavioral health services has remained solid, we view the market for inpatient behavioral health services as generally underserved due to both the dramatic decrease in capacity in the 1990s as well as the incidence of undiagnosed and untreated mental illness. For example, since peaking at 800 facilities in 1991, the number of inpatient facilities declined by 43% between 1991 and 2005, according to the latest available data from the American Hospital Assn.

Moreover, given the lack of adequate diagnoses of mental illness as well as the continued stigma that is attached to diseases such as depression and schizophrenia, we view the market as largely underserved. Indeed, the NIMH estimates that approximately one-third of all children with serious mental illness do not receive any mental health services at all (a figure which we believe can be conservatively extrapolated to the adult population).