The SeniorCare Investor: IPO Filed For Skilled Health

If Successful, It Will Be the Second IPO In Eight Years

There has been much talk about the senior care IPO market opening up, but so far only one company, Brookdale Senior Living (NYSE: BKD), has been able to successfully complete its initial public offering. Prior to Brookdale, the last senior care industry IPO was a 2.8 million share offering by Grand Court Lifestyles in March of 1998, and it took less than two years for that company to disappear into the dustbin of history and shareholders to get burned. Perhaps that explains why we have seen such limited action, but the reality is that most companies don’t want to be publicly traded anymore, they aren’t big enough to attract interest or, with the acquisition market so strong, their private market valuations have come to equal or exceed the potential public company value.

Tandem Health Care went down the IPO path last year, while simultaneously negotiating the sale of the company to a variety of investment groups, and ended up with a sale, which may have been easier and, more importantly, allowed the primary shareholder to get out once the deal was completed, as opposed to waiting for a secondary offering after a successful IPO to provide it with liquidity and something beyond merely a paper return. And it probably got a better value as well.

But the investor interest in Brookdale was so strong, pushing the shares up higher than even its controlling shareholder, Fortress Investment Group, ever thought possible in such a short period of time, that someone had to take notice that demand was reasonably strong, to say the least. Just a few weeks after Brookdale priced its IPO, Onex Corp. (TSX: OCX), an industrial conglomerate based in Canada, closed on its purchase of Skilled Healthcare Group for approximately $645 million through its Onex Partners private equity fund, which committed about $225 million of capital towards the transaction. While the timing of the two events was purely coincidental, Onex had to take note of the strong reception of Brookdale. And then in the following 12 months, the skilled nursing market took off, for both public equities and the private transaction market. As they say, timing is everything, and in the case of Skilled Healthcare Group, which is officially going public as SHG Holding Solutions, Inc. (SHG), the good timing is getting even better, with the Dow hitting an all-time high in October.

SHG, which operates skilled nursing facilities in five western states and a physical therapy company, filed for bankruptcy protection in October 2001 when it was known as Fountain View. The bankruptcy filing was primarily the result of a professional liability judgment against the company that essentially tied its financial hands during the appeal process. SHG emerged from bankruptcy less than two years later, with creditors getting paid in full and all equity holders maintaining their stakes in the company (compare that with the public company bankruptcies). The controlling shareholder was Heritage Partners, which invested in the company in 1997, and then the seven-year itch came, albeit a year late.

Not wanting to invest more money to fund SHG’s growth, it was time to cash out. Onex was no stranger to the U.S. health care market, having bought a controlling interest in Magellan Health Services (NASDAQ: MGLN) in 2003 for $285 million and a 30% interest in Res-Care (NASDAQ: RSCR) in 2004 for about $83.4 million. But the SHG acquisition appears to be its largest, and its first major foray into the senior care market in the U.S.

Having an impact? With just 10 months between when Onex closed on its acquisition of SHG and the IPO filing, there certainly wasn’t enough time to have much of an impact, whether Onex wanted to or not. SHG currently owns or leases 60 skilled nursing facilities and 12 assisted living facilities, which is just four facilities more than at the end of last year. The company purchased a long-term leasehold interest in Las Vegas, Nevada for $2.7 million last June, as well as two skilled nursing facilities and one residential care facility in Missouri (a new state) for $31.0 million in March.

These acquisitions added a total of 543 beds, bringing the total to 8,249 beds, with 45% in California and 38% in Texas. The remaining facilities are in Kansas, Nevada and, now, Missouri. In addition, SHG has a therapy company, Hallmark Rehabilitation, that services its own facilities plus an additional 93 third-party contracts. Annual revenues from these contracts are $55.0 million, plus another $1.8 million from a recently started hospice business.

There are a couple of unusual—and positive—aspects of SHG that should make for a successful public offering. First, it owns about 72% of its facilities, a rate that is only surpassed by Manor Care (NYSE: HCR) among the publicly traded skilled nursing companies. Even though many companies have opted out of real estate ownership, and the associated depreciation charge to earnings, investors do realize that ownership can provide financial flexibility. Second, the revenue quality mix has increased from 58.8% in 2003 to 68.4% in the first six months of 2006, with a little more than half of that coming from Medicare and the remainder from managed care and private pay sources. It is believed that in California SHG has about the highest Medicare/managed care combined census among the major chains. Overall occupancy was about 87% in 2005 and has increased to just below 90% this year. The occupancy is held down a bit by the high turnover of higher acuity patients, which is the business that most skilled nursing providers want to be in right now.

Revenues in 2005 were $462.8 million, a 25% increase over the previous year, and revenues for the first six months of 2006 were $256.4 million, a 16% increase over the same period in 2005, and are on track to top $510.0 million for the full year. Adjusted EBITDA has grown by 22% from $35.2 million in the first half of last year to $42.9 million for the six months ended June 30, 2006. The 16.7% EBITDA margin is quite respectable and compares favorably with 12.8% in Manor Care’s most recent quarter. The one real negative, other than the high concentration in two states, is that SHG is relatively small, and we value the current equity at about $400 million to $450 million, based on an adjusted PE ratio of 10x to 11x using annualized six-month numbers. A 100% return on its investment in one year is not too bad for Onex, although it will be a paper return for now since it does not plan to sell any shares with the IPO. With the new shares to be issued and the associated pay down of debt, the market cap may be in excess of $600 million.

The underwriting group, led by Credit Suisse, UBS Investment Bank and Banc of America Securities, would like to get the IPO priced before the end of the year, but it is now in the hands of the lawyers at the SEC. They are applying to list the shares with the New York Stock Exchange under the symbol "SKH," and we estimate that they will try to sell between 10 million and 15 million shares.

Waiting in the wings. A few months ago we reported that little Adcare Health Systems was waiting to go public, and it is still waiting. With its latest SEC filing in October the number of units may be just 800,000 with an expected price of $8.50 per unit. Meanwhile, the spin-off of Assisted Living Concepts (ALC) to shareholders of Extendicare (NYSE: EXE/A) was expected to be completed on November 1. In "when-issued" trading, the shares have traded between $8.25 and $8.65 per share. ALC was expected to release third quarter earnings in mid-November, but Extendicare just announced that it is delaying the proposed reorganization of the company and spin-off because of the Canadian Finance Minister’s announcement of the "Tax Fairness Plan for Canadians" late on October 31, and the board has to consider any consequences of this Plan on the reorganization. The attractiveness of converting to a REIT has been significantly compromised, so Extendicare’s conversion plan may be terminated. Perhaps there will be more news soon, but we don’t know whether ALC will still announce third quarter earnings separately.