The SeniorCare Investor: As Industry’s Prospects Improve, Equity Investors Cheer

When 2003 began, things did not look too encouraging for the skilled nursing facility industry. Kindred Healthcare (NASDAQ: KIND) had seen more than 50% of its market capitalization wiped out as a result of patient care liability issues, Centennial Healthcare had just filed for bankruptcy protection, the Medicare "cliff" had disappeared the previous October and, with the weakened economy and associated state budget shortfalls, everyone expected the worst from Medicaid reimbursement.

By July, sentiment clearly turned, partly the result of the Medicare "give-backs," but also because investors began to realize that the skilled nursing sector had been grossly undervalued in the first half of the year, despite the inherent difficulties. Now, with the unprecedented run-up in share prices (see below), the problem facing investors, and companies trying to raise new equity, is that the sector looks a tad rich, or at a minimum, fully valued, with Kindred and National Healthcare (AMEX: NHC), based on their adjusted P/E ratios, having the most potential for some additional price improvement.

The assisted living and retirement housing sector did not have the same degree of risk as the skilled nursing sector, not to mention fewer opportunities for public equity investors, but it performed almost as well as the publicly traded nursing home stocks. Once again, the upside potential now appears limited with the end-of-year price run-up, and not even the most bullish investors and analysts expected Sunrise Senior Living (NYSE: SRZ) to hit $40 per share in 2003, which it did on the last trading day. Legg Mason finally had to cut its recommendation from Buy to Hold when SRZ blew by its bullish price expectations in December; the lowered rating at the beginning of the New Year resulted in an immediate 5% price drop.
Last year, the senior care sector posted its best public market returns ever, and it is unlikely there will ever be a better year. All but one company posted a positive return (a record), the average return was 152% (a record) and the median return was 131% (also a record). The best year prior to 2003 was 1997, when 24 of 35 companies posted positive returns, with the average 58% and the median 43%.

That year CareMatrix ranked number two with a 119% return followed by Alterra Healthcare (known then as Alternative Living Services) with a 106% return. Both ended up in bankruptcy and are now gone from the public market scene, but the number one performer in 1997, Assisted Living Concepts (NASDAQ: ASLC), is still around and doubled in value in 2003. The worst year ever was 1999, when all senior care stocks declined, ranging from a 35% to a 99% drop.

So the overall winner in this year’s total return sweepstakes was Sun Healthcare (NASDAQ: SUHG), with a total return of 616%, largely the result of starting the year at just $1.39 per share before heading down to just $0.11 per share based on fears that it may have had to file for bankruptcy protection again. Those fears started to diminish during the summer, and as the company’s second restructuring began to take shape with additional poorly performing facilities divested, cash coming in from asset sales and an improved operating performance, the shares just started to take off beginning in July and investors never looked back. We are not sure that if asked last spring, even SUHG management would have ever guessed that the share price would close the year at $9.95.

Management should be given a lot of credit for taking the reins of a company that really had not been properly prepared to emerge from bankruptcy. Saddled with too many unprofitable facilities and leases that still did not make economic sense, they persevered in the midst of many naysayers (including this publication), and slowly got their house in order against many odds. Increasing cash balances, as well as cash flow, has been a primary goal of management, and at the end of 2003 they announced an agreement to sell Sun’s rehab business to AEGIS Therapies, a subsidiary of Beverly Enterprises (NYSE: BEV), for $34 million, which will further bolster SUHG’s balance sheet.

The top six performers in 2003 were nursing home stocks, five of which more than tripled in value. Although not making it into this group, Manor Care (NYSE: HCR), the largest senior care company (measured by market cap), turned in a not too shabby 86% return. In the assisted living/retirement housing segment, Assisted Living Concepts led the way with a 154% return, followed by Capital Senior Living (NYSE: CSU), up 131%. Although close to the bottom of the rankings, the two largest publicly traded assisted living companies, Sunrise and Emeritus Assisted Living (AMEX: ESC), posted solid returns of 56% and 52%, respectively.

With investors, option-holders and management jumping for joy with this kind of performance, the bad news is that the best is behind us. While investors are not oblivious to some of the major difficult issues confronting all senior care providers, they seem to be temporarily ignoring them, buoyed in part by the significant rise in the overall markets last year.

The key, as always, will be earnings and whether they can be increased enough to both justify current price levels as well as any potential price appreciation. An increase in interest rates, new reimbursement cuts or stiffer regulations are just some of the problems that could stop the rally in its tracks, if valuation alone does not do it. It is still unclear, however, whether this recent exuberance in public market valuations will result in a stronger (i.e., higher prices) acquisition market.