The SeniorCare Investor: Manor Care Suprises Market--

But Is A Sale Of The Company Really In The Cards?

It has been apparent that the skilled nursing industry has been in the crosshairs of the capital-abundant equity firms, hedge funds and any others with enough money to pull off a multi-billion-dollar transaction.

The focus really got a boost back in 2005, when Formation Capital and various partners, including its former friend Northbrook, tried to buy Beverly Enterprises but were ultimately outbid by a rival before Fillmore Capital Partners stepped into a negotiation where the seller did not want Formation to win. Now Fillmore knows how it feels to be "unwanted," with the management of Genesis HealthCare (NASDAQ:GHCI) publicly backing the Formation team in the current bidding imbroglio.

After Beverly, the next watershed deal was Formation’s sale of six skilled nursing facility portfolios to GE Healthcare Financial Services last summer for about $1.4 billion. Partly because GE was buying the real estate subject to existing leases, and partly because it was GE, this transaction seemed to arouse the interest of other equity investment players who had stayed away from "health care" real estate, and who also preferred the more modern assisted and independent living properties. At the same time, private equity firms were also jumping into the acute care hospital business, so the "fear of health care" myth was eroding quite quickly. And let’s not forget a little factor called yield.

When the "first" deal for Genesis was announced last January 16, most of the remaining skilled nursing stocks jumped on speculation of renewed interest in the sector and another company becoming a takeover candidate, including the shares of Manor Care (NYSE: HCR), which initially jumped by 7%. From January 17 until the time of HCR’s announcement in April 11 that it had hired JPMorgan as its exclusive financial advisor to review "strategic and related business alternatives to enhance shareholder value," the stock wandered its way up by another 10%, then jumped by 11% on the day of the announcement and has added another 5% since then. That is a longwinded way of saying that HCR’s shares have jumped by almost 40% this year, on top of an 18% gain in 2006. It is also a way of saying that the shares may now be fully valued, which could complicate things for the board. Or maybe not.

The "strategic alternatives" phrase is one that is overused and meant to imply the sale of a company. In the short term, the best way to enhance shareholder value is usually through a sale, especially in this market with private equity firms flush with cash and raising more. But three things bother us. First, this is so unlike Manor Care that it leads us to believe something else is going on. Second, with the full "takeover" premium already in the stock, shareholders that want to sell can do so now, and about 20% seemed to do so in the four days following the announcement. Any buyer would be hard pressed to offer even a 10% premium to today’s price, even in this market, even for these assets. But that seems to be what the board would have to be looking for in a price, because there would be little reason to sell at no premium.

Finally, we don’t believe CEO Paul Ormond is ready to retire at age 57, and neither is COO Steve Guillard, also 57, who came aboard less than two years ago with, we assume, aspirations to succeed, some day, Mr. Ormond as CEO of the premier skilled nursing company in the country.

Manor Care has always been known as a conservative company. All one has to do is look at its balance sheet (only $22,000 per bed/unit of debt), and the fact that it owns virtually all of its properties, having decided very early on that sale/leasebacks were not in its best financial interests. The only big acquisition of the past 10 years was the merger of the former Health Care & Retirement Corp. with the original Manor Care, but keeping the Manor Care name with the combined headquarters in Toledo, Ohio. Mostly with organic growth supplemented with an acquisition here and there, the company has also become the third largest hospice provider in the country, with the combined hospice and home health annual revenue run-rate topping $500 million.

The fact that Manor Care owns practically all of its real estate (98% of the facilities) would make it a likely candidate for those financial buyers that would have fun recapitalizing the real estate in the most economical manner possible. Using HUD, cumbersome as it is, would be one way with cheap, long-term and non-recourse debt. The owners of the former Mariner Health Care seem to think that is the way to go. Despite operating skilled nursing and assisted living facilities in 29 states, just seven of those states account for almost 75% of the beds and units owned by Manor Care, with Pennsylvania, Ohio, Florida and Illinois leading the way. But in nine of the 29 states HCR operates just one or two facilities, which seems to be a bit inefficient.

The company’s shares have been trading around $65 per share in late April, and we haven’t found anyone, on the record or not, to state they believe they are worth any more than that. Stifel Nicolaus did a "sum-of-the-parts" break-up analysis of Manor Care after the first quarter earnings were released, and came up with a theoretical value of $65.80 per share. In the analysis, they assumed a 1.5x coverage ratio on the SNF/ALF 2007 projected EBITDAM (before management fees) to derive a potential rent payment for a REIT of $414.8 million, and then applied a 7.5% cap rate to that rental stream. The coverage ratio was high, but equates to slightly higher than 1.1x after management fees are deducted. And the cap rate, while low, was based on the rental income, not operations income. If management fees had been deducted, the cap rate on the rental stream would have been closer to 8.5% to 9.0%, resulting in a similar end-result. The final estimate was a value of $5.4 billion for the real estate.

The hospice/home health business was valued at 9.0x 2007 estimated EBITDA, or about $560 million, and the therapy business was valued at 7.0x estimated 2007 EBITDA, or $39.8 million. One of the problems with a break-up scenario is that we do not know how intertwined the hospice, home health and therapy businesses are with the facility-based business. We assume there is significant cross-involvement, which we believe would diminish some of the break-up value. Consequently, we do not see any real upside to a $65.00 per share value, unless someone thinks they can run the company better than current management, which is doubtful.

So it is a good assumption that a strategic buyer is out of the question at these levels, leaving the well-capitalized financial buyers to dissect this specimen. If Fillmore Capital loses its bid for Genesis Healthcare, they may look at HCR, but we think it would be too large a transaction for them to take on. After all, half their equity for Genesis would come from a recapitalization of the former Beverly Enterprises. But as the larger private equity firms raise $10 billion to $20 billion in new individual funds, they need to put the capital to work, and we hear that JPMorgan is floating the idea of providing up to $4.5 billion of total debt to recap the real estate, plus a working capital loan to the operating company.

The deal may depend on the assumptions potential buyers have on Manor Care’s growth prospects. Looking at the recent sale of Holiday Retirement Corporation’s North American assets, the price paid was not based on current cash flow, but on the cash flow growth potential of 15 to 18 new properties per year, not to mention the incremental value in five years of those 75 to 90 additional retirement communities. With certificate of need laws you can’t build that many skilled nursing facilities each year, but you could expand the assisted living business, and hospice has been growing at a good clip at HCR. But there would be a greater leap of faith for growth in HCR compared with Holiday, so buyers will be more cautious. So what is really going on? Even though we hear that JPMorgan is already out shopping the company, with initial indications of interest due the first week of May, we believe most of the potential buyers are going to be tire-kickers at this stage and have no intention of paying much more than $65 per share.

Despite what is happening with Genesis, the EBITDA multiple for HCR is already 150 basis points higher than for Genesis, which while merited, may not have much room to move higher even with the current market environment. And at some point, someone (please) is going to say enough is enough and will put a lid on the valuations. Obviously, anyone who already owns assets doesn’t want this to happen, but if the market becomes overvalued, if it isn’t already, we could encounter some sort of meltdown like in the late 1990s. It would be different, but there could be some pain, especially for the recent buyers, lenders and investors.

Other possibilities include a major recapitalization, either with debt or sale/leaseback transactions, with the intent to distribute a major dividend to shareholders or to significantly expand the company’s stock-buyback program. The latter makes little sense, especially since the company has already repurchased 16% of its shares in the past two years.

A billion-dollar dividend could be feasible, especially with the current low tax rate on dividends, but that could change given the party change in Congress. Even that seems a little weird for a company that has historically been so conservative. And selling the real estate would definitely be out of character for the company, since the company has always been very real estate-oriented. Keep in mind that 18 months ago, senior management approached the board about taking the company private, a move that seemed to go nowhere. Perhaps that is in the works again, but with a more conservative approach to test the waters first, and then to see if a management proposal would yield the highest price. It was never revealed who management was teaming up with back in 2005, or if they even had a firm commitment. But a large private equity provider would be smart to at least have the conversation with management.

The company could add $2.5 billion to $3.5 billion of additional debt, but we don’t see that happening just to distribute a peace dividend to shareholders. And breaking up Manor Care would not be good for the industry, nor would a combination with another large operator, as "too big" has already been proven to be bad for business, at least in the skilled nursing business (are you listening Ron?). We have heard that the board could have a decision by mid-May, but what that will be is anyone’s guess at this point. However, we just don’t see a sale of the company happening just yet.