The SeniorCare Investor: One In, One Out: The Bankruptcy Train Rolls On

Although it hardly came as a surprise, Assisted Living Concepts (AMEX: ALF) finally filed for Chapter 11 bankruptcy protection after prolonged negotiations with holders of the company’s two convertible subordinated debenture issues. While the filing was expected, the negotiations did not go as well as some investors were hoping, and over the last several months, several of these bondholders left the negotiating table and others gave up and ultimately liquidated their positions. Unlike the other senior care company bankruptcy filings, ALF’s filing was "pre-negotiated" with creditors, or at least some of them.

In ALF’s pre-negotiated plan, the only creditors that will be impacted are the convertible debenture holders, with no changes to the amounts or terms of other lenders’ or lessors’ interests. This is very different from other bankruptcy filings, and common stockholders will not be left completely empty handed.

The pre-negotiated deal has the support of management and owners of 47% of the aggregate amount of the two outstanding convertible issues, which currently totals $161.25 million. The obvious question is, What about the owners of the remaining 53%? In order to have the plan approved by the bankruptcy court, owners of at least 67% of the outstanding debentures will have to support the reorganization plan as filed. Since they were not involved in the final negotiations for the current proposed plan, it is not known where they stand. Our guess, however, is that enough will go along with it to get the plan approved because there are few, if any, other choices.

The plan calls for the exchange of both convertible debenture issues plus certain other unsecured debt of ALF for $40.25 million of seven-year secured notes with an interest rate of 10%. In addition, these debt holders will receive $15.25 million of ten-year secured notes (new junior secured notes) bearing interest at 8% per year, payable in additional junior notes for three years, and payable in cash at 12% for the remaining seven years. The convertible debenture holders will also receive 96% of the new common stock of the reorganized company. Existing common stockholders will receive 4% of the new common stock. The number of new common shares to be outstanding has not been revealed.

Assuming this plan is approved, the convertible debenture holders will receive about 34 cents on the dollar (based on par value and not what they may have paid for their investment), plus common stock of an indeterminate value. There are two ways to look at what ALF’s equity will be worth. One is the conservative view, which is to take the most recent quarterly results and recomputed net income and EBITDA using the new capital structure. When the paid-in-kind interest payments are added on to the principal amount of the new junior subordinated notes, and the 12% interest rate kicks in after three years, the annual interest expense savings is about $3.2 million. The savings might have been greater, but the 66% decline in principal amount of the convertibles is partially offset by the doubling of the average interest rate.

This conservative analysis assumes that ALF’s properties remain at the second quarter average occupancy rate of 84.2%, which presumably is unrealistic. But the average size of ALF’s existing 185 facilities is about 40 units, so they are all theoretically just six residents shy of 100% occupancy. With such small facilities, the traditional rules of "stabilized" occupancy fall short because the difference between stabilized or not could be just one or two residents, which can change overnight during flu season.

So if occupancy does not increase under this scenario, ALF continues to show a GAAP net loss, but net cash flow (after adding back depreciation) begins to approach breakeven. In theory, this would mean that the new common shares would still have little value, something that no one would look forward to.

Perhaps a more realistic scenario, especially by the end of 2002, is that occupancy rates will increase to a range between 90% and 95%, which is just an additional three residents per facility. Based on the company’s average monthly rate of $2,056, this would yield additional revenues of approximately $3.4 million per quarter. Assuming this represents 100% profit (even though more realistically it is probably closer to between 80% and 90%), the quarterly net cash flow after lease and the new interest payments increases to just over $2.4 million.

The annualized EBITDAR would grow to a range of $45 million to $50 million, and using an 8x multiple, we back into an enterprise value of close to $375 million. After deducting all of the debt and the leases capitalized at 12.5%, the equity component is worth between $85 million and $90 million. At this value, the convertible debenture holders are almost made whole, and it ends up tripling the value of the current common stockholders stake based on seven cents per share today.
The reality is that future occupancy levels, and profitability, will lie somewhere between the two scenarios described.

Quarterly net income will be very modest and cash flow will range between $2 million and $3 million, before capital expenditures. The more long-term issue is whether ALF’s business model, which relies on 20% to 30% of its residents to be funded by Medicaid in small facilities, will survive. Obviously, it is easier, and cheaper, to operate facilities with 60 to 80 units each than ALF’s traditional model with 35 to 40 units. Job roles are more fluid in the smaller facilities, and we know that ALF had quality of care problems at several sites, which we expect have been mostly corrected by now.

Operating margins at the facility level were 33.4% in the second quarter of this year, which should increase to a more respectable 38% as occupancy levels approach the 90% to 95% range. The company’s capital structure, however, will also be changing, as management has decided to purchase 16 properties in Texas that the company currently leases from an affiliate of the former Meditrust. The option for this purchase expires on October 31, 2001, and Heller Healthcare Finance has agreed to provide the financing at 500 basis points over the three-month LIBOR rate, which today would total 7.50% (not bad for a company in bankruptcy). Depending on the acquisition price, the debt service at that rate should be less than the lease payments, resulting in extra cash flow for the company when it emerges from bankruptcy, which is expected to occur in early 2002.

As an aside, LTC Properties (NYSE: LTC) currently owns approximately 7.1% of ALF’s outstanding common stock, which will decline to 0.28% of the new common shares. In addition, LTC owns approximately $30.5 million face value of the convertible debentures, which will decline to about $10.5 million of the new notes to be issued, but the REIT has already taken an $8.8 million write-off for the value of the debentures. LTC will also receive approximately 18% of the new common stock as part of its pro rata share of the distribution to debenture holders.

Earlier this year, ALF contacted LTC with a request to return nine assisted living facilities leased from LTC that had an investment value of $22.8 million with annual rent of $2.4 million. In addition to these nine, ALF leases another 28 facilities from LTC, and during the first quarter the entire 37 had an aggregate occupancy rate of 88% with just a 1.18x rent coverage before management fees. ALF has apparently proposed a rent reduction, which LTC management stated would be more than offset by the higher interest rate on the new notes.

As Assisted Living Concepts was seeking bankruptcy protection, Genesis Health Ventures (OTCBB:GHVEV) was emerging from bankruptcy. The Genesis and Multicare (now a wholly-owned subsidiary of GHVEV) senior secured creditors will receive $242.6 million of new senior notes, $42.6 million of new convertible preferred stock and 93% of the new common stock, or about 38.8 million shares. Unsecured creditors of both companies will receive about 7% of the new common stock as well as warrants to purchase an additional 11% of the new common stock (4.56 million shares) at $20.33 per share.

In addition to the allocations to creditors, there will be grants of 750,000 shares of the new common stock, worth about $15 million, that will be allocated among 43 management level employees. The exact amount allocated to each employee as well as the vesting period will be determined at a later date by the new board of directors. There will also be an employee option pool that will grant options to purchase another 2.7 million new shares based on performance at a price of $20.33 per share.

The $15 million value comes from the fact that initial trading in the new shares was between $20 and $23 per share. With 41.75 million shares outstanding, the new company now has a market capitalization of just over $900 million. Kindred Healthcare (NASDAQ: KIND) emerged from bankruptcy earlier this year with a market cap of just under $500 million and took almost four months to reach the $900 million level. It is doubtful that Genesis will see that price appreciation since it was probably valued off Kindred.

The company is definitely emerging in relatively strong financial shape, with $624 million of debt and a debt to capitalization ratio of 40%. Debt service coverage is projected to be a healthy 3.4x next year, with after tax income of $60.4 million, or $1.45 per share. A 15x PE ratio produces a price of $21.75, which is near the opening trading levels. The adjusted PE ratio (see stock table footnote 1 on page 3 for calculation) is 6.7x, which is very close to Kindred and Beverly Enterprises (NYSE: BEV), but still lagging behind Manor Care’s (NYSE: HCR) 9.7x.

Although financially sound, the company’s forecasts do not make one want to call his broker and buy the stock. Genesis is projecting revenues next year of $2.7 billion, with an EBITDAR margin of only 9.8%. That margin is projected to slowly decline to 9.3% over the following four years on annual revenue growth of 4.5% to 5.1%. About 50% of the revenues come from the nursing home business with EBITDARM margins of 16%, and 45% of the revenues are from the pharmacy operations with a 7.7% EBITDARM margin. Projections for a company coming out of bankruptcy are usually conservative, so we expect Genesis to perform better than this. What we cannot predict are management miscues such as those in the late 1990s, and although the management team is largely unchanged, we hope they have learned from their mistakes. On the positive side, another strong nursing home chain in the publicly traded arena is good for the industry, provides another valuation benchmark and increases the expectation that we may see a small IPO market by next year.

In other bankruptcy news, we keep on hearing that Integrated Health Services’ (OTCBB: IHSVQ) subsidiary, Ro-Tech Medical, will be divested and that the company may not emerge from bankruptcy. The "chief restructuring officer" does not appear to be doing much restructuring, and with former CFO Taylor Pickett moving on to be CEO of Omega Healthcare Investors (NYSE: OHI), he may be restructuring the financial office of IHSVQ. It is no secret that Mr. Pickett will not be moving to OHI’s Ann Arbor, Michigan headquarters, and that not many Ann Arbor employees will be moving to the Baltimore area. Our guess is that Mr. Pickett will be looking to hire some of his former staff who should have figured out by now they are going nowhere in their current jobs and might find trying to re-build OHI a better opportunity, and certainly more challenging, than disposing of Integrated’s assets. Besides, new OHI options could become quite valuable in a few years.