The SeniorCare Investor: Ancillary Services in Spotlight -

 

Sunrise, Sun Healthcare buying hospice businesses

During the 1990s, senior care companies increased their cash flow and organic growth by expanding into various ancillary services such as institutional pharmacy, rehab therapy and, to a much more modest degree, adult day care and home health care. Successful staffing has always been a problem, but changes in reimbursement, particularly Medicare payments, can cause a dramatic change in business plans, and profitability.

Take the case of the pre-bankruptcy Mariner Health, which had a robust therapy business worth perhaps $300 million to $400 million that basically disappeared a year after making a $90 million acquisition for a private therapy company.

Now, however, ancillary services are making a comeback, and hospice care seems to be the business de jour, at least for a few companies. But like the other ancillary businesses of the past 20 years, hospice care is heavily dependent on Medicare reimbursement, and while hospice care saves "the system" a lot of money compared with hospitalization, hospice expenditures have been the fastest growing part of the Medicare budget in recent years, and could be targeted in the future for rate cuts or changes in length of service. Despite this risk, for senior care companies today it represents a tremendous diversification strategy, as well as an important service to their customers.

In early August, Sunrise Senior Living (NYSE: SRZ) announced the acquisition of Trinity Hospice, Inc., the country’s eighth largest hospice care provider, for $68.0 million plus $3.0 million of transaction costs. Trinity is expected to have about $60.0 million of revenues in 2006, 94% of which consists of payments from Medicare. Based in Dallas, Texas, it operates 24 hospice programs in nine states, most of which are not states where Sunrise has a lot of assisted living operations. Trinity’s 24 locations have a combined average daily census of approximately 1,400 patients, or less than half the number of Sunrise residents who utilize hospice care each year. The difference is that currently, Sunrise residents go through almost 150 different hospice agencies around the country with little financial benefit to Sunrise, other than longer lengths of stay. That is about to change. Trinity is a portfolio company of KRG Capital Partners, a Denver, Colorado-based middle market private equity firm.

The purchase price is just over 1.1x 2006 revenues, $48,500 per average daily census and could be about 9x to 10x EBITDA depending upon the operating margin assumed for Trinity. Larger independent hospice providers, such as Odyssey Healthcare (NASDAQ: ODSY) can have a 12% EBITDA margin, but we have to assume that Trinity, which is one-sixth the size of Odyssey, may be slightly lower. But with hospice care nationally growing at well over 20% annually, Sunrise will get a boost with organic growth at Trinity plus bringing more of its hospice care in-house at its 420 communities. This acquisition, which can easily be funded with cash on hand and is expected to close late this quarter or early in the fourth quarter, should be the proverbial slam-dunk and we believe it is an extremely important strategic investment as Sunrise continues to spread its wings from being an assisted living provider to being a national health care provider in the senior care market. We can also see Sunrise becoming one of the top four hospice providers in the country within two years if they can bring more of the hospice care in-house.

Almost four weeks later, Sun Healthcare Group (NASDAQ: SUNH) announced that it agreed to purchase Preferred Hospice of Oklahoma, Inc., which operates two hospice programs in Oklahoma, as well as an agreement to buy out the management agreement for the management of five hospice programs that are owned by Sun subsidiaries in Oklahoma, Colorado and New Mexico. Financial terms of the two transactions were not disclosed, but these seven programs will be the base upon which Sun expects to grow its hospice business. At the same time, Sun announced the sale of its SunPlus Home Health Services, Inc. subsidiary to AccentCare Home Health, Inc. for $19.3 million. SunPlus provides skilled and non-skilled home health care as well as pharmacy services in California and Ohio. We believe that this is part of an on-going process of tweaking Sun’s business to prepare for bigger things to come.

We don’t know if Sun’s management is eyeing Manor Care’s (NYSE: HCR) hospice business as a model for a skilled nursing provider, but it should. Manor Care combines its hospice and home health care businesses for financial reporting purposes, but we believe hospice is the dominant business, especially since the company is now the third largest hospice provider in the country and may soon be the second largest. On a combined basis, hospice and home health care at HCR produce annualized revenues in excess of $450 million, and with operating margins of 15% to 16%, that contributes operating profits of almost $75 million per year. And with annual growth of between 15% and 20%, it will be an increasingly important component of Manor Care’s business and growth strategy, especially since the much larger skilled nursing business is growing at a much slower pace. It will take a long time for Sun’s hospice business to catch up to Manor Care, but the strategy certainly appears to be heading in the right direction. The former Beverly Enterprises, before it was sold earlier this year, also had a hospice and home health care business with an annual revenue run rate of about $115.0 million, but we do not know how well it performed and what has happened since the company was taken private.

A company that is moving in a different direction, but for strategic and financial reasons as well, is Kindred Healthcare (NYSE: KND). While management has been preoccupied with ongoing rent re-set negotiations with its primary landlord, Ventas (NYSE: VTR), it was able to work out an interesting transaction with AmerisourceBergen Corporation (NYSE: ABC) to combine their respective institutional pharmacy businesses, PharMerica Long-Term Care and Kindred Pharmacy Services (KPS), into a new publicly traded company. The combined company will have annual revenues of $1.9 billion, EBIT of approximately $75.0 million, preliminary synergy cost savings of about $30.0 million and a customer base of 330,000 licensed beds in 41 states. Despite this apparent significance in size, it will still be a distant second to industry leader Omnicare (NYSE: OCR) with $6.6 billion of revenues, EBIT of $692.0 million and 1.4 million beds served. But because of this size discrepancy, merging the two businesses certainly makes financial and strategic sense.

In a relatively complicated transaction, both PharMerica and KPS will be spun out to their respective ABC and KND shareholders, followed immediately by a stock-for-stock merger of the two pharmacy companies, with ABC and KND shareholders each owning 50% of the combined new company. Just prior to the spin-off, PharMerica and KPS will each borrow $150.0 million and distribute, in a tax-free transaction, the proceeds to their respective parents, with the total of $300.0 million of new debt remaining on the newly formed company’s balance sheet. While this may not seem equitable to ABC’s shareholders, because PharMerica is about twice the size of KPS in terms of revenues and customer beds, annualized EBIT at KPS is about $39.0 million compared with $36.0 million at PharMerica. Obviously, the 50/50 arrangement is based on the earnings capability, which is how it will be valued as a new public company.

Now, why is Kindred choosing this point in time to spin out its successful pharmacy business, through a merger with a larger competitor, to shareholders in a newly formed public company? The cynics would say it has something to do with the Ventas rent re-set negotiations, because we hear that one of the lines of attack by Ventas is that Kindred’s nursing facilities are not as profitable as they should be because they are "overcharged" for various ancillary services by other Kindred subsidiaries, such as KPS. While Kindred’s pharmacy margins are double those of its new partner, they are 40% lower than industry leader Omnicare. And is a 6.1% EBIT margin at KPS really that unusual, or above market? Since Omnicare dominates the market, perhaps its 10% margin should be the standard, and one reason for the merger of KPS and PharMerica may be in order to gain some economies of scale to drive the margin higher.

Removing the pharmacy charges from the rent re-set equation may have had something to do with the spin-off, but it was certainly not the driving factor. For Kindred, whose stock price has been held down awaiting the rent re-set results, it was partly a simple matter of the sum of the parts being worth more than the whole, so Kindred shareholders will see, in theory, a small jump in the value of their holdings when the distribution is finalized. Plus, it just makes plain economic sense for the two smaller companies to merge from a cost-saving perspective (up to $30 million) and a competitive basis. And let’s not forget the $150.0 million of cash that Kindred will receive from its soon-to-be former subsidiary. This can be used to pay down debt or for acquisitions, but it just may be used in some negotiated settlement with Ventas that includes an upfront cash payment, something we have mentioned before. Whatever the reasons, the spin-off seems to be a good move for Kindred, and more importantly, for Kindred’s shareholders.