The SeniorCare Investor: Timing Is Everything, And For Beverly, The Time Is Right

While everyone was focusing on the heated acquisition market for assisted and independent living communities, the skilled nursing sector was taking a back seat. Yes, there was the billion-dollar deal for Mariner Health Care last year, which provided a lot of excitement and speculation to what had become a fairly staid market and industry since the 1990s. But that deal appeared to be an exception, and by the end of the summer someone greased the wheels of the buyers in the other senior care markets, prices soared as cap rates dropped, and all of a sudden the seniors housing sector was hot again, after languishing in the freezer for several years. And, we have to admit, it is fun again, for participants and spectators alike.

So just as everyone was getting over the buzz created by Sunrise Senior Living’s (NYSE: SRZ) $500 million deal to buy the assets of The Fountains (more on that later), and the juicy deal for six assisted living facilities in Pennsylvania (later for that, too), on the night of January 24th we all learned that an investment group had been in preliminary discussions with Beverly Enterprises (NYSE: BEV), the former 1,000-facility gorilla of the skilled nursing industry, regarding its interest in buying the company in a transaction valued at over $2.0 billion. Within a few days, BEV’s shares were up 33%, going above the preliminary price of $11.50 per share that was initially mentioned, and other nursing facility stocks jumped as well.

Although everyone was surprised by the news, it should not have been unexpected. Beverly has long been the subject of takeover and break-up rumors, especially when its share price drops precipitously low, which it has been prone to do on many occasions. In the late 1980s, Beverly traded below $4.00 per share as rumors heated up about a potential bankruptcy filing. During the go-go 1990s, the shares mostly stayed out of single-digit territory, but by 2000 they dropped to $2.31 per share before jumping back up to over $12.00, only to freefall to $1.60 per share in 2002 and then rise to a high of $9.41 last year. The only pattern here is inconsistency, but many investors made a lot of money riding the stock up and buying back near the bottom on each of the cycles. To its credit, however, Beverly was one of only three major publicly traded chains that did not file for bankruptcy protection during the time of troubles from which we have recently emerged.

Every time the shares plunged, the number crunchers went to work to see what the "break-up" value was, trying to figure out what a reasonable per-bed valuation assumption was, which states should be sold off and how to finance the theoretical acquisition. But each time the analysis was for naught, until now.

Beverly has had a bad rap in the investment community for nearly two decades. After becoming a behemoth with three times the number of facilities of its closest competitor, and realizing that size was just not enough, the management that took BEV to more than 1,000 facilities started the process of downsizing the company. When new management arrived four years ago, it didn’t take long for them to figure out that the pruning was not over, and asset sales continued, and with some reasonable success. At last count, Beverly was down to 369 facilities, all but 18 of which are skilled nursing facilities.Ten years ago, BEV’s market cap was $1.2 billion when it had 725 facilities (with a lot more debt than today as well), and now it is just above that level as a result of the acquisition talks.

So what do Arnie Whitman, Formation Capital and the equity backers see in Beverly and what will eventually happen? First of all, this is a serious bid, since the group has already purchased more than 8 million shares on the open market, now worth more than $100 million, and the investors have stated they will put up to $375 million of equity into the deal, an amount not to be trivialized. And the major equity investors, including Appaloosa Management LP, Franklin Mutual Advisors LLC and Northbrook NBV LLC are not to be trifled with either.

The deal itself can be looked at from many angles, but let’s make it relatively simple. The initial $11.50 per share price yields an equity valuation of about $1.25 billion, and when the debt ($570 million) and leases capitalized at 12% ($258 million) are added, the total deal value comes to $2.07 billion, which would make it the second largest transaction in the senior care market ever, after the $2.9 billion acquisition of Manor Care in 1998 by the former Health Care & Retirement Corp., now known as Manor Care (NYSE: HCR). A $13.00 per share price takes it to just over $2.2 billion. Frankly, these are big numbers, even for Arnie.

Beverly’s annualized third quarter EBITDA is about $185 million, before any adjustments, so at the lower per share price, the transaction would be just over 11x EBITDA and $51,800 per bed. No one really believes that Beverly’s beds are worth $50,000 per bed today, so some portion of the value obviously comes from Beverly’s hospice and therapy divisions, which are growing and produce significantly better margins than the nursing facilities. The Formation Capital group has estimated the ancillary businesses may be worth $4.00 per share, or more than $400 million, which is about 1.6x estimated 2005 revenues and 6x EBITDA.

We will not opine on the merits of this valuation, but it is not outside the realm of possibility in this market, given certain assumptions. So if these ancillary businesses are removed from the valuation, the price does come down to almost $42,000 per bed, which was the average price paid in the market from 1996 through 1999. Prices have been a lot lower since then, but readers may be in for a surprise when we come out with our 2004 statistics next month, and based on preliminary numbers, we expect a significant jump in average prices from the dismal results in 2003.

But no one believes a deal will go through at $11.50 per share, especially since the market has already taken the shares above $12.00. Anything above $13.00 per share, however, begins to get dicey, especially for any new financial buyers with little experience navigating the vagaries of reimbursement and liability insurance. And the key, or at least one of them, will be the assumptions made on liability insurance accruals. Legg Mason has assumed a $45 million annual savings for someone like the Formation Capital group, which adds $350 million to $450 million in value depending on what multiple you want to use. But there is something else that only a few buyers will see, or be able to accomplish.

For the past decade, especially when Beverly was twice its current size, we have argued that it made more sense to break the company up into at least two or three smaller operating units in order to get operations, and margins, under better control. Beverly has relatively low margins in the industry, 50% lower than Manor Care’s, and since we all know that health care is local, a more localized approach to Beverly’s operations should help improve margins. The same goes with occupancy. And the combination of occupancy increases with margin expansion can have significant financial ramifications, as Formation Capital knows all too well.

Three years ago, an affiliate of Formation Capital purchased 49 skilled nursing and four assisted living facilities in Florida from Beverly for $165 million. Formation hired newly formed Seacrest Health Care Management, located in Florida, to operate the facilities while Formation acted as landlord. In just three years, the occupancy for the portfolio has jumped from 84% to 92.5%, and revenues have grown from $285 million to just over $400 million. Margins have increased and deficiencies have declined in the process, and the return on investment has been, well, unbelievable and not public. But our guess is that the profitability was disclosed to the investors backing Formation’s current bid, and it may have had a little to do with their interest in participating in the deal.

Now, we are aware that Florida is a somewhat unique situation, given the liability environment, the desire of most chains to get out of the state (sometimes at any price) and the fact that other than liability, Florida has always been one of the better operating environments in the country. Beverly still has a large presence in some difficult states, such as California, Minnesota and Indiana, but we still believe that a more local management structure will help to improve operations. So any analysis as to what the Beverly portfolio is worth has to include some assumptions about occupancy and margin improvements beyond any cuts in liability costs. Unfortunately, no one knows what the Formation Capital group is assuming, and for all we know, that is just the gravy (or the cushion) on top of what their minimum expectations are. But if history is any indicator of what will happen, they will separate the real estate ownership from the operations, and let local management teams, with an economic incentive, of course, take over.

This saga will play out over several months, and the games have already begun. Formation Capital’s first formal letter arrived on Thursday, December 23, but Beverly was closed for a four-day holiday weekend, so management apparently didn’t see it until Monday the 27th. Then during January, in its second letter Beverly said they would respond on February 4th, knowing that the next day was a deadline to get on the agenda for the upcoming annual meeting, effectively blocking the investor group from making their case to shareholders. These are common maneuvers in the rough and tumble M&A business, but it will all come down to what makes sense for shareholders, who right now are pretty happy with the stock valuation, and will most likely back a sale to the highest bidder.

Beverly CEO Bill Floyd was new to the industry when he took over four years ago, and he was in for a rude awakening. Industry problems, which had nothing to do with Mr. Floyd’s management abilities, took Beverly’s stock down to $1.60 per share in 2002. With additional asset sales, improving operations, growth in the hospice and therapy businesses and just a little help from Medicare reimbursement increases, Beverly was in its best shape in years at the time the offer was made. With a 30% increase in value, which may go higher, the Beverly rollercoaster can jump the tracks at its current high point. It will be sad, for those of us with a degree of industry nostalgia, to see one of the pioneers disappear, but Beverly’s time has come, and shareholders should take the best deal on the table.