The SeniorCare Investor: Sun Healthcare To Split In Two–

Taking Advantage Of Relative Market Valuations
 Skilled nursing companies have always had a difficult time explaining themselves to investors.  Are they health care companies, or are they large real estate entities with an important health care business component?  Is the real estate actually valuable, or is it so dependent on the license, certificate of need and operating capabilities of the provider that real estate takes a back seat or, perhaps, is put in the trunk?  Can great operations overcome lousy “real estate,” or can great real estate command a premium despite less than satisfactory operations and cash flow?  Investors can be a fickle bunch, and they obviously go hot and cold based on emotion, opinions of larger macroeconomic trends and, of course, whatever is hot or not in the current market.
 We assume that the management and board of Sun Healthcare Group (NASDAQ: SUNH) had been thinking all of these things as the company’s share price rose by just 4% in 2009 and had been flat to a little down in the first several months of 2010.  Health care reform and its impact on Medicare reimbursement may have had just a little to do with it as well.  Meanwhile, health care REITs had a median total return of almost 30% in 2009.  The interesting aspect of it all is that with real estate in general having been under such pressure for the past two years, value still can be created by splitting out the remaining owned real estate from a health care company and creating a new real estate investment trust from that real estate that will simply collect rent from the operating company.  This is because investors place a higher value, or multiple, on the REIT cash flow and shares than on the underlying operating company, especially when it comes to skilled nursing facilities.  This is the basic Opco/Propco strategic decision that others are looking at as well, and in the case of Sun, the strategy should benefit shareholders.
 So, what’s going to happen?  There are several steps that Sun will have to take to effect this transition into two separate companies.  The first will be to raise equity through a common stock offering, which is expected to net approximately $160 million.  These proceeds will be used to pay off some relatively expensive debt (9.125% interest rate), which will also help to deleverage Sun before its rent payments increase.  Jon Santemma and his team at Jefferies & Company will be leading the equity offering, which is expected to occur in about six to eight weeks, and will also act as the co-advisor on the spin-off along with MTS Securities, LLC, which will be the lead adviser to Sun. 
 Once the equity raise is completed, the capital structures of the two companies will be pretty much set.  The operations of the current Sun Healthcare will be spun off into a new company which will retain the Sun Healthcare name.  Its revenues, operating expenses and EBITDAR will be basically identical to the existing Sun, with the main difference coming “below the line,” in terms of lower interest and depreciation expense, but much higher rent payments.  The net result of the realigned capital structure will be a much smaller EBITDA, but just a slightly smaller net income.  The 93 real estate properties that Sun currently owns will remain in the original company, which will eventually change its name to Sabra Health Care REIT and will be publicly traded (proposed ticker symbol is “SBRA”).  These 93 properties, which include 82 skilled nursing facilities, nine assisted living facilities and two mental health facilities, will be leased to Sun, joining the 112 properties that Sun already leases from various landlords.  Depending on what the ultimate lease rates are, this restructuring will almost double Sun’s annual lease payments to just over $150 million.  The current shareholders of Sun will receive one share of Sabra and one share of the new Sun for each share of the old Sun, and each company will then have just over 60 million shares outstanding.
 Sabra’s portfolio will include 9,934 beds in 21 states, but only 9,586 beds are actually available for occupancy.  The occupancy rate during the first quarter of this year was 89.4%, down from 89.9% in 2009 and a little over 91% in the previous two years.  For the skilled nursing industry, these are above average occupancy rates.  There is a significant concentration in four states, with Kentucky and New Hampshire each having 15 facilities and Connecticut with 10 and Ohio with eight.  Five states have just one facility each, but that is more of a concern for the operator than the landlord, and Sun may have additional operations in those states.  Sun’s “Rehab Recovery Suites” are in 27 of Sabra’s 82 skilled nursing facilities, and 10 of these SNFs have “Solana” Alzheimer’s units.  In addition, Sabra will start off with about $373 million of long-term debt.  
 There are obviously several decisions that will have to be made, such as whether all 93 properties will be in one Master Lease, or in a few leases, and what the exact dividend rate will be (most likely it will have an initial yield of about 7%, and perhaps a little higher).  But from the initial filings with the SEC, it looks like the annual rent that Sabra will collect will start off at $71.9 million, and its funds from operations (FFO) will be close to $46.5 million, or about $0.76 per share.  The lease coverage ratio at the new Sun (with the increased lease payments) will be just over 1.6x.  Most everyone seems to think that Omega Healthcare Investors (NYSE: OHI) is the closest comparable among the health care REITs because of its almost exclusive concentration in skilled nursing facilities, and OHI trades at about 10.5x FFO.  Using that multiple would put Sabra’s initial value at about $8.00 per share, but after discounting for the small size of the REIT and a discount for having a 100% concentration with one tenant, the initial value would theoretically be less than that to start off, perhaps near $7.00 per share.  The hope, of course, is that this is just the beginning. 
 Regarding management, Sun’s current CEO, Rick Matros, will become CEO of Sabra, while Bill Mathies, the president of Sun’s primary operating subsidiary, Sunbridge Healthcare Corporation, will become CEO of the new Sun.  The rest of the current Sun senior management team will stay with the operating company, so there will be very little difference, with the exception of the departure of Mr. Matros.  While we understand that Mr. Mathies is very experienced, and we are sure he knows how to run a skilled nursing company, he has not run a publicly traded company, which requires additional talents and is not always what someone likes to do (shareholders can be an annoyance, and you have to watch what you say).  Mr. Matros is one of the most experienced industry CEOs that we know of, and he knows the industry, Wall Street and the corridors of Congress like the back of his hand, so he will be missed at the new Sun.  While we don’t know why he chose the REIT, we assume he had the option to choose either and we have to believe he will have more fun at Sabra.  And while he has always run an operating company (actually, several), he has never been at the helm of a REIT.  Our guess is that it will be a new challenge for him, and the growth opportunities at Sabra will be greater than at the new Sun.  Did we mention it will be a little more fun?
 As we stated, there will be a valuation penalty for being small, with one tenant and a concentration in skilled nursing, so Sabra will most likely try to diversify as quickly as possible.  This will include skilled nursing facilities operated by other tenants and, more importantly, private pay seniors housing assets, medical office buildings and perhaps an LTAC or rehab hospital or two.  Sabra will also consider additional investments with the new Sun, but the intent of splitting the company apart was not to create an acquisition vehicle for the operating company, even though the cost of capital for Sabra will be lower than for the new Sun.  The intent was to create value by shifting the owned assets to a REIT, with its higher valuation multiple, which would then be able to grow at a faster pace than the operating company, and provide shareholders with a steady dividend stream as well as growth potential from the addition of different property types.  While we agree with this in theory, and we believe that current Sun shareholders will benefit, there are a few issues.
 First of all, if Sabra’s initial valuation comes in at the $7.00 to $8.00 per share range, when combined with the theoretical value of the new Sun at $2.00 to $3.00 per share (from what we hear from analysts), that’s a $9.00 to $11.00 estimated range in value, which is not much higher than Sun’s recent trading range of $7.80 to $10.34 in the past 52 weeks.  So while there could be a 10% to 20% uptick from pre-announcement value, it is not earth-shattering.  Second, not all shareholders will want to stay in both companies, and if they don’t, they may lose much of the upside, which currently is expected to come from Sabra’s shares (perhaps another reason why Mr. Matros is running the REIT).  Third, if the operating company does trade at that low price per share, the board is likely to think about a reverse stock split, perhaps one-for-three, to get the share price up to more acceptable levels for institutional investors.  This usually helps, but it will also decrease the float of the shares, which never helps the valuation.  Fourth, the existing health care REITs don’t seem to be seeing a lot of opportunities in the market, or at least opportunities that are priced to their liking with stable tenants.  And the competition for medical office buildings, which has been where much of the growth has been of late, will only get more intense.  Consequently, Mr. Matros will have his hands full in trying to grow Sabra.  Now, he is on the board of privately held AVIV REIT, which has already made a few attempts at going public, so we can see some discussions going on there, which would also give him an in-place back-office platform (isn’t it always fun to speculate and start rumors?). 
 Despite some of these reservations, we like the transaction and think it will unlock a little bit of value in the near term, but a lot more value going forward, especially with Sabra’s shares.  We also think it is a great opportunity for Mr. Matros, who we suspect has had his fill with running operating companies and wants to join the ranks of George, Debbie, Taylor and a few others. After all, he is in his mid-fifties and probably wants to have a little investing fun using his health care industry expertise and years of experience.  One concern is that the new Sun, with no owned assets, will have less financial flexibility in an industry downturn, especially with the uncertainty surrounding Medicare reimbursement.  We assume The Carlyle Group will be watching this closely since they have been looking at ways to unlock some value with its HCR Manor Care investment and, more particularly, to create some liquidity for Carlyle and an investment exit.  Sun’s entire process will take the next six months to complete, and Sabra can’t switch its status to a REIT until the end of the year anyway.  So while we expect the spin-off to proceed, a lot can happen between now and December 31.