CRC Health Corp: On a Rollup

Armed with a Stanford PhD in decision theory, Karlin came to addiction treatment from the world of high-tech, where he founded a company now called NAVTEQ. A $375 million NYSE listed enterprise, NAVTEQ provides the navigational technology that is commonplace in automobiles today, as well as in Internet searches at sites like MapQuest. Certainly, when Karlin joined the business he knew little about addiction, its treatment or anything else about substance abuse: “I was told there was a chemical dependency treatment facility for sale nearby, so I asked what kind of chemicals it was that they manufactured.”

In the Beginning

CRC Health Group started with the 1995 purchase of The Camp, a 40 bed facility in Northern California. Since then, Karlin has spent between $200 and $400 million acquiring over 85 facilities, including thriving first class names like Sierra Tucson and Life Healing Center of Santa Fe, and less lustrous regional outfits in need of some sprucing up, like White Deer Run of Pennsylvania and Starlite Recovery Center of San Antonio, Texas.

Behind the CRC acquisition strategy lie many of the classic business consolidation rationales, but the strategy also has unique features based on Karlin’s bedrock belief that treatment service delivery is fundamentally a local business and that long-term survival for treatment centers is dependent on providing very high quality care.
“We do not go into an acquisition with the objective of cutting costs as our primary goal,” says Karlin. But throughout U.S. business history, from JP Morgan and the creation of the massive trusts over 100 years ago to Wayne Huizenga and Blockbuster Video in the 1980s, business consolidations have been mostly about cutting costs through economies of scale combined with standardization of commodity or service delivery. That’s why many in the addiction treatment business have been fearful that CRC would wind up buying a lot of treatment centers while drastically cutting costs, in the end delivering a kind of standardized “McTreatment” nationwide.

Surveying the Landscape

Certainly, when Karlin surveyed the treatment landscape he saw many of the elements that make for a successful consolidation, or what Wall Street calls a “roll up.” He saw economy of scale possibilities in a highly fragmented business populated with well over 10,000 treatment centers, many of which were run very inefficiently in a $12 billion industry that was highly resistant to change. Having started CRC in 1995, Karlin also saw a business that had hit the managed care wall hard, a collision that caused revenues at most institutions to plummet. Lower revenues meant lower asset values, potentially creating ample opportunities for Karlin to buy treatment centers counter cyclically on the cheap.

However, Karlin never saw much possibility in standardizing treatment service delivery, which was a common and very key element of most of the ill-fated treatment center roll ups of the late 1980s, including Parkside, CompCare and others. “McTreatment” in other words, has never been part of the CRC consolidation equation.

What has emerged at CRC, to a large extent as a result of Karlin’s bedrock belief in running most of his treatment businesses as locally oriented and managed operations, is a strategy that can be described as: think local, act national. CRC does indeed add value to the equation in many ways, but not through standardization of the product or the creation of a national brand, although the emergence of CRC as a brand – a kind of umbrella organization that is synonymous with quality treatment – may certainly occur.

When CRC buys a property it keeps the storefront intact, and in almost all cases existing management as well. “At our most elemental, what we are about is improving the treatment process and laying the foundation for growth, that’s where we add most of our value,” says Karlin.

CRC attempts to add value to its transactions at many levels, one of the most important being its ability to generate new revenue streams at acquired institutions. One very key way CRC does this is by taking over the management of relationships with insurance payors.

“A big part of our consolidation strategy is based on my belief that CRC can substantially increase the revenue base,” said Karlin. “Managing relationships with insurance carriers is one of our top core competencies, and in some cases can substantially boost revenues at our acquisitions.” One the main responses of the treatment industry to managed care has been that many centers stopped taking insurance or limited their acceptance extensively. Tapping into CRC’s extensive payor relationships can be a way for acquired institutions to quickly boost the number of “covered lives” in their area, thereby expanding revenue generating opportunities.

“We have over 700 reimbursement contracts with insurance companies, which is by far the highest of any addiction treatment provider in the country and is a considerable competitive advantage for us,” said Karlin. “The provider with the next highest number of payor relationships has less than 100.”

Also, one of CRC’s goals is to grow by tapping into the huge “treatment gap” the 15 million or so individuals who need treatment every year but for some reason do not seek it or get it. CRC hopes to make some inroads into the treatment gap by improving relationships with insurance carriers and managed care companies, persuading them that expanding coverages lowers overall health care costs and makes good economic sense.

Another way CRC adds value by increasing the revenue stream is through referral and marketing investments that pay off in higher census counts at acquired institutions. Last year, CRC built a big new national call center that substantially supports the local business development functions at all CRC facilities, and CRC is among the most active treatment providers in marketing over the Internet.

But adding value has not come just from growing revenues, there are also economies of scale. “Staff training and information technology have so far been two main ways we have added value in a traditional economy of scale type way,” says Karlin. CRC has signed a multi-million dollar deal with Qualifacts Systems Inc., a leading supplier of information technology to the treatment industry, to build a state-of-theart IT system that will substantially improve the efficiency of CRC staff, giving them more time to focus on the client and improve quality of care, according to Karlin.

And CRC is also making investments to position itself for leadership over the long term, with visionary efforts like eGetGoing, an Internet-based treatment platform that delivers outpatient care at half the cost of traditional face-to-face treatment.

And while eGetGoing has not yet developed into a thriving business to justify the millions of dollars invested, Karlin is confident that the business will pay off. “It is my belief that 70 percent of all medical services will be delivered over the Internet within the next 20 years,” said Karlin. “eGetGoing will take its place within that framework.”

Karlin does indeed seem to have added significant value to his acquisitions at CRC over the past 10 years, but all this adding value won’t amount to much for his investors if it doesn’t add up to what investors usually care most about, which is more money. But on that score too, Karlin’s unique strategy also seems to be paying off handsomely. “At the time we invested, CRC was roughly at $10 million in EBITDA (cash flow) and $40 million in revenues,” said Doug Lehrman, managing director at North Castle Partners, which acquired CRC in August 2002. “In 2004, revenues were $173 million and EBITDA was $45.6 million.”

Another key measure of how well CRC has been managed is the level of so-called “same store growth” – the rate of revenue growth at facilities owned or opened more than one year – which was a very fast paced 15% in 2004.

Karlin went to North Castle, which specializes in making investments in businesses that focus on healthy living and aging trends, primarily because he needed capital to support his acquisition strategy. But CRC, which had five or six term sheets at the time, decided on North Castle in large measure because the private equity firm’s focus on healthy living investment seemed a good fit with CRC. “North Castle has a set of values that are consistent with my own,” says Karlin. For its part, North Castle had already been looking at the addiction treatment business for possible investment.

The Supplier Chain

Industry IT Vendors Are Also Feeling the Urge to Merge

And Qualifacts certainly isn’t the only addiction industry IT vendor that’s on the buy side. In late June, Netsmart Technologies (Nasdaq: NTST), the parent of industry vendor Creative Socio- Medics (CSM), announced it had purchased the assets of Addiction Management Systems, a pioneer in developing automated computerized methadone dispensing. And guess who is among the combined company’s largest clients? None other than CRC Health Group, which has been the most aggresive entity in rolling up the nation’s fragmented methadone clinic industry. CSM will now serve more than 300 methadone clinics.

“When North Castle first looked at this industry, we looked at another possible business investment that we ultimately didn’t feel comfortable making, so we passed,” Lehrman said. But from that experience, North Castle learned a lot about the treatment business and saw considerable potential ultimately for making an investment. “We were attracted by the tremendous growth of this highly fragmented business and the importance of addressing an issue that was a huge cost to society,” said Lehrman, adding that the industry’s high profit margins and substantial free cash flows were also highly attractive. These last two things, combined with low capital expenditures, give treatment businesses an excellent ability to “quickly pay down debt,” Lehrman said.

And while Karlin describes the debt leverage at CRC as “modest” – he refused to divulge CRC’s exact gearing ratio – it is likely that debt is the principal means by which CRC and North Castle are funding their acquisition spree. In the late spring, just before the Sierra Tucson deal closed, CRC floated a sizeable $230 million senior debt offering in a private transaction with a group of institutional investors. All this debt finance could perhaps have some influence on what form North Castle’s exit from its CRC investment ultimately takes. Leverage, however modest, increases the risk profile of any investment, which could make North Castle more likely to quickly realize on its investment in a sale of the company to a third party, or perhaps a recapitalization. But Karlin says that for the moment all options remain on the table. “A sale of the company, a recapitalization or an IPO are all avenues we are looking at,” said Karlin. “No decision has yet been made.”

More growth, though, is definitely planned. “We are still very modest in size compared to the overall size of the industry,” Karlin points out. “The groundwork has already been laid for CRC to become a $500 million to $1 billion organization.” But over the past ten years, Karlin and CRC have had the green acquisition pastures of the treatment business pretty much all to themselves. With record dollars continuing to pour into the coffers of private equity houses like North Castle, and a growing dearth of places to put that money to work, can it be long before some other moneyed player enters the treatment center acquisition game, giving Karlin and North Castle a run for their money?

Industry analysts certainly expect it is inevitable that consolidation will continue to be a part of the treatment industry scene for some time to come. “This is a phenomenon that is likely to be with us at least for the next ten years,” said Chestnut Health Systems Research Consultant Bill White, who is also among the treatment industry’s leading historians. And White believes it is likely that a national treatment provider competitor to CRC will emerge that delivers the kind of highly standardized treatment services that are anathema to Karlin’s vision and CRC’s business model. “If you can put together a highly packaged form of treatment that delivers very low cost and great outcomes, combined with evidence-based practices, the payors will ultimately reward you.”