The SeniorCare Investor: Change Is In The Air: Marriott And Genesis Shift Gears

The senior care business continues to suffer from the hang-over caused by the excesses of the 1990s. Although just one more aspirin may be necessary to rid the sector of the pains from the past, some people are looking into the future and asking the hard questions. What is the expected growth rate for the business? Is the potential return worth the risk? Should I expand my focus into other, related businesses, or stay with the core that I know? Some of these questions are being answered today by Marriott International (NYSE: MAR) and Genesis Health Ventures (NASDAQ: GHVI).

Rumors had been circulating in the market for nearly a year that Marriott was thinking about selling its seniors housing business, known as Marriott Senior Living Services (MSLS). The potential for a sale was deemed to cast a negative pall on the seniors housing market because of the statement it would make to other investors: If the parent Marriott did not believe that the long-term prospects of the seniors housing business were good enough to provide it with solid, profitable growth, what’s in it for me? Fortunately, Marriott’s recent decision to spin out the seniors housing business was more complicated than that and somewhat unique to the company.

First of all, it must be remembered that MSLS represents less than 10% of the parent’s total business, so it is not as if there will be a major change at the parent. The seniors housing business, however, sometimes took a disproportionate share of management’s time, especially in the past few years as occupancy rates stalled and investors focused on how MSLS was doing in a deteriorating market and when a turnaround could be expected. Second, the hotel and hospitality business has suffered financially from the aftershock of September 11 and the weakened economy, and if the parent company has to concentrate its efforts on either hotels or seniors housing, the answer is obvious. Third, the reality is that seniors housing has increasingly become more health care oriented, a side of the business that is still somewhat alien to the parent’s management, who are much more comfortable in the hospitality arena. Finally, when an MSLS employee allegedly killed one of its residents earlier this year, senior management decided enough was enough, even though this could just as easily have happened at one of the hotels.

Marriott had three basic choices once the divestiture decision was made. It could sell MSLS in a market with low valuations, few qualified buyers and little debt available for acquisitions, especially for what is essentially a management company. A second option was to spin out the business in an IPO, but that market has been weak in general and would have no desire for a seniors housing company that is experiencing practically no growth. Finally, it could spin MSLS out to MAR’s shareholders, and let the value be determined by the market. That is where the decision stands now, and if all goes according to plan, MSLS will be traded on the NASDAQ in January 2003.

Although not a positive statement to the market about the state of seniors housing, the impact on the industry will end up being less negative than one might think. With most of the major nursing home chains having emerged from bankruptcy, there are enough comparable companies to derive some sort of market valuation, at least in the publicly traded arena, and that certainly impacts valuations in the private market. But the assisted and independent living markets are quite another story. There still is only one publicly traded company with a price above $4 per share (excluding Greenbriar, AMEX: GBR, which had to do a 1:25 reverse split to get into the single digits), and that remains Sunrise Assisted Living (NYSE: SRZ). But well over 50% of the valuation of Sunrise is derived from asset sales, so its use as a comparable PE ratio is significantly diminished.

With annual revenues of about $700 million and EBIT of at least $20 million, and 156 facilities housing more than 26,000 residents, MSLS will be one of the largest publicly traded seniors housing companies, and one that is solvent as well. From an investor perspective, this is something the industry needs, provided it does not flounder. Until the parent releases more detailed information on MSLS, it will be difficult to determine what kind of value can be placed on the company. Most of the facilities are not owned, however, so the market will get its first look at a true management company with substance, something that Sunrise may be interested in from a valuation perspective.

The impact of the spin-off on MSLS will be more mixed. On the one hand, it will give MSLS management the freedom to grow and there will be better management incentives to enhance the performance of the business (even though stock options have become a dirty word of late). On the negative side, MSLS will eventually be losing the "Marriott" name, a brand that is extremely significant in an industry that still has no recognizable name with consumers. In addition, being the subsidiary of a multi-billion dollar New York Stock Exchange company gives creditors, vendors and residents more financial comfort even if an explicit guarantee does not exist. An independent MSLS will obviously not have the same credit stature, but since we do not know what the new capital structure will look like, it is impossible to determine how future lenders will view the new entity.

The big questions that will be asked by future investors include how MSLS plans to grow and whether management envisions acquisitions, new management contracts, or both. And since Marriott itself will have no ownership interest, it will be interesting to see what the makeup of the new board will be. Since Marriott has been doing little with MSLS in the past few years, in the long-run the spin-off will be more positive than negative for the industry, as well as for the company. This assumes, of course, that the independent company will succeed. Regarding its future share price, since most Marriott shareholders will have little interest in holding the shares of the separate company, during the first month or two of trading there should be a consistent slide in the stock price as they sell off the new shares. This often results in a temporary drop of up to 50% in value (Hillhaven Corporation is a good example of that almost 10 years ago), at which time bargain hunters enter the market and drive the price back up. Whatever happens, it will be an interesting story to follow, and yet another example of how the senior care market is evolving and how perceptions of the business are changing.

A few months ago, when we reported on the departures of some of the founders of Genesis Health Ventures, we speculated that perhaps there was a difference of opinion between these founders and the new controlling shareholders of the company in terms of the future direction of Genesis. One common belief was that the board wanted to expand more into the ancillary services area, particularly its pharmacy business. At the end of July, the answer appeared in the announcement that Genesis had signed an agreement to purchase NCS Healthcare (OTCBB: NCSS), the country’s fourth largest institutional pharmacy company serving approximately 200,000 patients with annual revenues in excess of $650 million.

In a sign of the times (no pun intended), when The New York Times reported the transaction, it referred to Genesis as "an institutional pharmacy," with no reference to its sizable nursing home operations. We wonder if there is a message here. Genesis is offering about $340 million, made up of $308 million of assumed debt and the rest in Genesis stock, with an exchange ratio of 0.1 share of GHVI for each share of NCSS. That comes to about $1.60 for NCSS shareholders, or double the pre-announcement price of NCSS.

But hold on. The largest institutional pharmacy company in the country, Omnicare (NYSE: OCR), had also been trying to buy NCSS, but NCSS management refused to meet with them. OCR’s offer included the same assumption of the debt, but shareholders would receive $3.00 per share in cash, or twice as much as the Genesis stock offer. The two shareholders owning 65% of NCSS have already agreed to the transaction with Genesis, which makes no financial sense unless they are also shareholders of Genesis and believe that a GHVI/NCSS combination will result in a more than $1.50 per share increase in GHVI’s ultimate value, which it probably will. According to a Legg Mason report, GHVI management believes it will be able to increase NCSS’ EBITDA of $42 million by nearly $20 million annually.

Now that may have to be a $2.00 per share increase, because on August 1 Omnicare increased the cash portion of its bid to $3.50 per share, worth $83 million, and filed a lawsuit in Delaware Chancery Court to stop GHVI’s acquisition. If GHVI’s math is right, that additional $20 million alone is worth about $2.00 per share to GHVI’s share price by using just a 4x multiple, so they might have an argument. Unfortunately, it is a theoretical value and the 35% of NCSS shareholders may be more inclined to take the $3.50 in cash today. The decision, however, may now be up to the lawyers.