The SeniorCare Investor: Harborside Sails Into Sun(set) -

 

A $625 Million Deal A Long Time In The Making

After several months of potential bidders taking a look at the assets and operations of Harborside Healthcare Corporation, and with investment banker UBS Investment Bank narrowing the field down to the final four or five, everyone’s favorite to be the winning bidder seemed to be Sun Healthcare Group (NASDAQ: SUNH), including some of the other bidders. In September, Sun CEO Rick Matros was heard to quip, "I might as well be wearing a ‘Buy Harborside’ t-shirt!"

So in one of the biggest non-surprises of the year, Sun came out on top in a field that towards the end of the game had also included a handful of financial buyers. But in this case, the strategic importance of the deal, combined with Sun’s capacity to assimilate Harborside’s facilities at little additional overhead cost, made Sun a buyer on a mission, and shareholders were thrilled. A little known fact is that the two companies had serious discussions a few years ago, but with their roles reversed, so there is some familiarity between the two.

Harborside commenced operations in 1988 and initially was under the control of The Berkshire Companies and the Krupp family. During the 1990s the company completed more than 10 acquisitions in seven states, paying between $38,000 per bed and $87,000 per bed for most of its acquisitions. During the IPO bonanza in the 1990s, Harborside went public in mid-June of 1996, selling 3.6 million shares at $11.75 per share. Just two years later, Investcorp International paid $291 million for a 91% interest in the company, when Harborside had 47 facilities with about 5,700 beds, which came to an adjusted 9.5x 1997 EBITDAR.

The timing was horrible, as over the next two years the skilled nursing industry suffered its worse financial depression ever. In those two years, six of the major publicly traded skilled nursing chains filed for bankruptcy protection as a result of changes to Medicare reimbursement and excessive leverage, losing almost $9.0 billion in shareholder value from their peak prices. While Investcorp may have intended a three- to five-year investment horizon, it turned into eight years, but it was well worth the wait as the skilled nursing market is currently in its best financial condition since 1998.

Financial details. Sun is paying approximately $625 million for Harborside, made up of $350 million in cash and $275 million of assumed debt, plus assuming leases on 26 facilities. In eight years, Harborside has expanded to 76 facilities and just under 9,100 beds, with most of that growth coming in the past 15 months with two acquisitions in Kentucky of 20 facilities and one in Connecticut with three. For the 12 months ended June 30, 2006, Harborside had revenues of $544 million, but that would have increased to $635 million after giving full credit for the recent acquisitions. The current revenue run-rate is closer to $660 million (inclusive of all pending acquisitions), or triple the revenues when Investcorp bought the company in 1998. More importantly, EBITDAR has grown from $33.7 million in 1997 to an estimated pro forma of about $90 million.

There are a lot of numbers floating around, confused in part by Harborside’s recent acquisitions and various assumptions regarding the synergies with Sun and the associated reduction in costs. The best we can tell is that after approximately $20 million in annual rent, recent operating improvements and adjusting for the $12 million to $15 million in expected synergies, Harborside will have an adjusted EBITDA of between $80 million and $85 million, which puts the transaction multiple (at least for Sun) at between 7.5x and 8.0x EBITDA.

Admittedly, this is for the expected annualized performance after Sun takes over, which won’t be until the end of the first quarter 2007 at the earliest. And, these EBITDA assumptions do not take into consideration the capital expenditure requirements, which we have heard were cause for concern for at least some of the buyers, especially the financial buyers who did not have the strategic synergies that Sun would have. In measuring their expected rate of return, they just did not want to have to worry about above-average capex costs to continue Harborside’s expansion in the high-end Medicare business. The capex, or "replacement reserve," rule of thumb is $300 per bed, but we all know that this number is woefully inadequate, especially for skilled nursing facilities that are usually 20 to 30 years old. So, doubling that, which is still probably low, would decrease EBITDA by at least $5 million. But the multiple remains attractive in this market, and a pro forma cap rate over 12% for an acquisition of this size, in this frothy market, is appealing even to us. Unfortunately, we do not know Sun’s opinion on the capex issue, but Sun does have that $12 million to $15 million synergistic cushion, which others did not have.

Capacity to grow. Several years ago, Sun had claimed that it could double its size without adding much overhead, and this is a major reason why the Harborside acquisition was worth more to Sun than to other buyers. The deal is estimated to be accretive by $0.05 to $0.07 per share based on a full year’s performance, and what’s not to like about that? Investors were obviously impressed, taking Sun’s shares up by almost 18% to a 30-month high of $14.00 per share before settling down a little. The bottom line is that from a financial perspective this is a good transaction for Sun, and investors must have recognized that. It didn’t hurt that several analysts covering the stock liked it as well and raised their price targets.

There is even more good news. Harborside’s Medicare mix and overall occupancy are 400 basis points higher than Sun’s, and after exercising various purchase options, Harborside will own 53 of its 76 facilities, compared with just 30 out of 155 at Sun, and Sun’s management has a goal of increasing its ownership percentage. However, some of the Harborside facilities may be sold and leased back in order to finance the acquisition. As an aside, Sun’s overall occupancy declined after it closed the Peak Medical acquisition last year, but it should be rising with this deal. And, Harborside’s operating margin is higher than Sun’s, helping with the earnings accretion.

On the negative side, 46 of Harborside’s 76 facilities are in six states that will be new to Sun’s portfolio, including Kentucky (20 facilities), Connecticut (10) and Florida (9). But the acquisition does significantly increase Sun’s penetration in states such as Ohio, Massachusetts and New Hampshire. When the deal is completed, nearly 50% of Sun’s facilities will be in six states, and 66% in 10 states. But from a geographic point of view, it will look like two distinct companies. One will consist of 79 facilities (34% of the total) in nine states from California to the Rockies, while the other will consist of 142 facilities (61% of the total) in 15 states east of the Mississippi. The remaining 5%, or 12 properties, are in Oklahoma. As we all know, size matters, but we hope Sun management is not spreading itself too thin from an operations perspective, not to mention 25 different Medicaid reimbursement systems to deal with.

The other cause for concern is the price per bed that Sun is paying for Harborside. While acknowledging that the cash flow multiple and the level of earnings accretion are the more important acquisition criteria, we do believe in checks and balances. After capitalizing the leases, the acquisition comes to about $90,000 per bed, which is obviously at the high end of the market, but not too far from recent transactions, such as the sale last summer of Tandem Health Care and the six Formation Capital skilled nursing portfolios. This relatively high price is also increasing Sun’s relative leverage, which was high before the Harborside transaction. But we believe that the quality of Harborside’s facilities, plus the margin enhancement and earnings kick, outweigh any negatives associated with the price per bed and increased leverage. And the happiest investors of all may be the former owners of Peak Medical, who took Sun common shares in their transaction, shares that are now worth twice as much as when they closed the deal at the end of 2005.