Over the past six months, Select Medical has been a great trade, beating the S&P 500 by 10.3%. Its stock price has climbed to $16.42, representing a healthy 15.1% increase. This run-up might have investors contemplating their next move.
Is there a buying opportunity in Select Medical, or does it present a risk to your portfolio? Get the full breakdown from our expert analysts, it’s free.
Why Is Select Medical Not Exciting?
We’re glad investors have benefited from the price increase, but we're sitting this one out for now. Here are three reasons we avoid SEM and a stock we'd rather own.
1. Demand Slips as Sales Volumes Slide
Revenue growth can be broken down into changes in price and volume (the number of units sold). While both are important, volume is the lifeblood of a successful Outpatient & Specialty Care company because there’s a ceiling to what customers will pay.
Select Medical’s admissions came in at 8,950 in the latest quarter, and they averaged 10.7% year-on-year declines over the last two years. This performance was underwhelming and implies there may be increasing competition or market saturation. It also suggests Select Medical might have to lower prices or invest in product improvements to grow, factors that can hinder near-term profitability. 
2. EPS Trending Down
Analyzing the long-term change in earnings per share (EPS) shows whether a company's incremental sales were profitable – for example, revenue could be inflated through excessive spending on advertising and promotions.
Sadly for Select Medical, its EPS declined by 9.3% annually over the last five years while its revenue was flat. This tells us the company struggled because its fixed cost base made it difficult to adjust to choppy demand.
3. High Debt Levels Increase Risk
As long-term investors, the risk we care about most is the permanent loss of capital, which can happen when a company goes bankrupt or raises money from a disadvantaged position. This is separate from short-term stock price volatility, something we are much less bothered by.
Select Medical’s $2.85 billion of debt exceeds the $26.52 million of cash on its balance sheet. Furthermore, its 6× net-debt-to-EBITDA ratio (based on its EBITDA of $493.2 million over the last 12 months) shows the company is overleveraged.
At this level of debt, incremental borrowing becomes increasingly expensive and credit agencies could downgrade the company’s rating if profitability falls. Select Medical could also be backed into a corner if the market turns unexpectedly – a situation we seek to avoid as investors in high-quality companies.
We hope Select Medical can improve its balance sheet and remain cautious until it increases its profitability or pays down its debt.
Final Judgment
Select Medical isn’t a terrible business, but it doesn’t pass our bar. With its shares beating the market recently, the stock trades at 13× forward P/E (or $16.42 per share). This valuation multiple is fair, but we don’t have much faith in the company. We're pretty confident there are more exciting stocks to buy at the moment. We’d recommend looking at one of Charlie Munger’s all-time favorite businesses.
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