The SeniorCare Investor: The Value Disconnect–

Investment Opportunities Abound In Senior Care Market
 
When the Centers for Medicare and Medicaid Services (CMS) made its July 29 announcement about the average 11.1% cut in Medicare reimbursement for skilled nursing facilities, the shock was apparent.  This was not expected, as the industry thought it had worked out an agreement with CMS for a three-year phase in of an 8% cut, with the annual cuts approximating 3%, 3% and 2%.  Apparently, the White House overruled CMS as it was hunting for cuts during the debt ceiling negotiations in July.  The result was a stock sell-off of a magnitude that we rarely see, with an unusual impact on the mostly private-pay seniors housing sector. 
The following Monday, share prices plunged, with the larger skilled nursing companies dropping between 30% and 57% before a very slight recovery late in the day.  The impact on the seniors housing stocks was delayed by a week, with August 9 representing the low point for most of them, with declines of 23% to 39% from the August 1 close.  The low point, that is, until October 4.  And that date represents the low point for the skilled nursing sector as well.  Even after the August 1 plunge for the skilled nursing sector, several of these stocks plunged by another 30% to 43% to new lows on October 4.  And a few of the seniors housing stocks fell by 15% to 30% from their initial August 9 floor. 
All we can say is, enough is enough, and other than the economy turning into a depression or a few of the top five banks going under, we believe that October 4 will represent a market bottom for both skilled nursing and seniors housing stocks, even if the overall market declines (as a disclaimer, we do not own or purchase shares in this sector).  At some point, the valuation disconnect has to become apparent to more investors.  We all know that institutional investors drive the market, and many of them abandoned the skilled nursing sector after the Medicare cuts, and the rest just continued to sell.  It is just not worth their while to understand how these companies work, not to mention the pressure from both Medicaid and Medicare and the looming 2% across-the-board Medicare cut if the congressional super committee doesn’t come to an agreement later this year (odds are low).  The stock market capitalization of the entire SNF sector is only $1.65 billion, with just three companies making up 83% of that, so the sector is just too small to attract interest and the liquidity in individual stocks is not significant enough.  Not too mention that many funds and institutions don’t like owning stocks with prices below $10.00 per share.  That leaves the retail investor, who usually knows little and buys in limited quantities.  But given values today, and assuming a longer term view of the market, we have not seen a buying opportunity like this in quite some time.  And then you have to look at what is happening to values and acquisition activity at the property level, and the apparent disconnect becomes exaggerated.
Readers may remember in our October 2010 issue we wrote about skewed valuations, with Kindred Healthcare (NYSE: KND) as the primary example.  At the time, when its stock was trading at $13.00 per share, we pointed out that the value of its 39 owned and unencumbered properties (17 LTACs and 22 SNFs with an EBITDA of $97 million) was more than the entire market cap of the company, even after deducting KND’s unsecured debt from the calculation.  So the market, those sophisticated institutional investors, were giving the 267 leased properties no value (actually negative value).  And this was before the positive impact of RUGs-IV even began, which has now gone away plus some. 
After more than doubling in value to $28.99 per share over the next few quarters, Kindred has now hit a new low of $7.67 per share.  We don’t know how those 39 properties will be performing after the Medicare cuts that just went into effect, but our strong guess is that they are still worth more than the current market cap of Kindred ($450 million), and this is after the RehabCare Corporation acquisition.  This just does not make sense even though the reasons for the price collapse are understandable…Want to read more? Click here for a free trial to The SeniorCare Investor and download the current issue today