The SeniorCare Investor: The Asset Redeployment Saga Continues

After the nursing home industry hit bottom two years ago and the assisted living sector was reaching it, investors, lenders and operators all thought that 2002 would finally be the year when a great number of senior care assets would be redeployed. Lenders would finally accept lower valuations for their troubled assets, stronger companies would be back in the acquisition market and equity players would be sniffing around for deals. For most of the year, however, activity has been relatively light. But now, it looks as if the fourth quarter is making up for the previous lackluster months of 2002, and the pace will only increase into 2003. Recent news from Beverly Enterprises (NYSE: BEV) will set the stage for the next year.

A little over 10 years ago, Beverly Enterprises operated more than 1,000 nursing facilities with 100,000 beds. This followed a time when management would literally show up at state nursing home conferences, checkbook in hand, and see if anyone was willing to sell. Size was what mattered, and in the 1980s Beverly was the only publicly traded nursing home chain that mattered. The problem is that management, and most everyone else, was wrong. After many divestitures over the ensuing 10 years, the company pared down to fewer than 500 nursing facilities with just over 50,000 beds. Even as the sales were being completed, many of us still said that was not enough. But finally BEV’s new management has agreed to do something about it.

In the company’s Halloween third quarter earnings announcement, management disclosed that it expects to divest a "significant portion" of its nursing home capacity over the next two years. In the earnings conference call, management would not elaborate on the meaning of "significant," but for starters the facilities being initially considered are those that are projected to continue to account for more than 50% of BEV’s estimated 2002 patient care liability costs. The number one liability problem, Florida, was sold off last year, so Mississippi, with about 2,600 beds in 21 facilities, can be assumed to be high on the priority list (Texas was divested several years ago).

With the tort lawyers moving on to California, and with BEV’s recent patient care problems there, that state would seem to be another good candidate. The problem is that California represents more than 12% of BEV’s beds, and it is the largest and second-largest concentration of the company’s outpatient therapy and home health/hospice care businesses, respectively, in the country. In other words, given the number of homes, it would be a difficult sell, and leaving behind 25% of the company’s outpatient therapy, home health and hospice business that would remain in California without the core nursing home assets probably does not make sense (more on this later).

Back when Beverly operated more than 1,000 facilities, we always said the company would be better off split into three or four regional companies of 200 to 300 facilities each. While perhaps better than the status quo, it still was not the best solution because shareholders would have been left with several mediocre companies instead of one. And with senior management in short supply, there was no guarantee that operating results would not deteriorate further. While BEV’s current CEO, Bill Floyd, may not be overly popular within the company and had little (if any) prior health care experience, it appears that he is taking the necessary steps to re-fashion a laggard company before it is too late. Shareholders should be in for a welcome surprise, but they will have to be patient.

Selling off a significant portion of its nursing facility assets will not be an easy task in this market, and management is smart to estimate that it will take two years (at least). Mr. Floyd has indicated that an investment bank will be retained to assist with asset dispositions. They would be wise, however, to look at the model offered by Alterra Healthcare (AMEX: ALI), which hired Cohen & Steers to coordinate the sale of more than 100 assisted living facilities, but ended up engaging several regional brokers that specialize in seniors housing to find the smaller buyers that will be necessary for Beverly to accomplish its goal.

Beverly’s nursing home operations are currently in 28 states, but two-thirds of the beds are in just one-third of the states. The largest concentrations are in California (12%), Pennsylvania (9%), Arkansas (8%) and Indiana (7.5%), but 11 states have more than 2,000 beds each. Another 10 states have fewer than 1,000 beds each, and unless they make sense from a regional perspective for the future Beverly, these may represent opportunistic divestitures regardless of their liability environment. One rumor circulating is that Beverly may try to reposition itself to be east of the Mississippi River, which represents about 50% of its beds (minus Mississippi itself), but would exclude Arkansas, where the company headquarters is located. The solution may not be this simple, but it makes little sense for the company to be operating from all four corners of the country.

Mr. Floyd has the right mindset for what should be important. He stated that he is concerned with neither size nor revenues, but with return on invested capital. Well, if that is not a novel concept! All sarcasm aside, as investors in senior care stocks know, this fundamental concept of corporate finance was missing in action for the past five years, if not longer, and if Mr. Floyd can stick with that objective, real change may actually be forthcoming at the company. The funds from the divestitures will be used to pay down debt, which is just $18,000 per owned bed and $12,000 per operated bed, and to reinvest in the facilities that are kept. There are no current plans to buy back the company’s common stock with the asset sale proceeds.

The long-term goal is to be not a "nursing home" company, but an elder services company. To that end, Alzheimer’s care, home health and hospice care are expected to grow significantly. BEV’s hospice care, currently with just $30 to $40 million of revenues, is expected to grow into a $100 million business, and by year-end the company will have added a total of 100 Alzheimer’s programs at its facilities. In two years, liability costs will be lower, margins higher and the stock price will not be $2.00 per share. Having been a mediocre company, at best, for many years, Beverly may finally have the opportunity to shed its past demons (and reputation) and move up the quality scale. Now, if they could only move their headquarters out of Arkansas…