The SeniorCare Investor: Skilled Healthcare Debuts

IPO Priced, And The Ensign Group Files For Its IPO

Timing is everything, and right now is a good time to own a skilled nursing facility or, better yet, a portfolio of nursing facilities. All one has to do is look at what happened with the auction of Genesis HealthCare (NASDAQ: GHCI) over the past two months (more on that later), the current auction of Manor Care (NYSE: HCR) and the record average price per bed paid last year for skilled nursing facility sales. The skilled nursing sector is running on all cylinders right now, and the investment community has taken notice.

Onex Partners is one firm that noticed the improved environment. Last October, less than a year after closing on the purchase of Skilled Healthcare Group, Onex Partners filed with the SEC to take the company public. After a six-month registration process with the SEC, Skilled Healthcare Group (NYSE: SKH) finally priced its IPO on May 15. The anticipated range was $14.00 to $16.00 per share, and the shares debuted in the high end of the range at $15.50 per share. Initially, Onex planned to sell just over 8.3 million of its shares plus the same number of new shares, but demand was high enough for the selling shareholders to sell an extra 2.5 million shares for a total offering size of nearly 19.2 million shares. In the two weeks after pricing, the shares have reached $16.57 per share and dropped to $15.22, but essentially have stayed very close to the offering price. Based on 36.9 million shares outstanding, the company’s market cap is close to $575 million. The lead managers for the IPO were Credit Suisse, UBS Investment Bank and Banc of America Securities.

Life was not always so good for Skilled Healthcare. Back in 2001, when it was known as Fountain View, Inc., the company was forced into Chapter 11 bankruptcy to protect itself from a lawsuit that threatened the company’s financial viability. There was no problem with creditors, so the equity owners kept their full ownership when the company emerged from bankruptcy protection in 2003. And, just as importantly, the company did not suffer during or after the bankruptcy period, turning a profit (excluding reorganization expenses) in every year since 2001. Current annualized revenues and EBITDAR are about $600 million and $108 million, respectively. As an historical footnote, in 1998 the company purchased then publicly traded Summit Care.

So what makes Skilled Healthcare an enticing investment for its new shareholders, and possibly an attractive takeover candidate for another investor in the months ahead? We can simplify it with one acronym: "MOM," which stands for margin, ownership and Medicare. The company’s pro forma EBITDAR margin for the first quarter ended March 31, 2007, was near the top for the industry at 18.1%. This compares with an approximate 13.6% EBITDAR margin for Manor Care, which is held down by its large hospice and home health care business, and 9.1% for Genesis HealthCare.

Only National HealthCare Corp. (AMEX: NHC) comes in higher among the publicly traded skilled nursing companies. This is not a fluke for SKH, as its EBITDAR margin has ranged from 15.5% to 18.2% over the past three years. This will decline a bit as it begins to incur the expenses associated with being a publicly traded company, estimated by Jefferies & Company to be about 40 to 50 basis points, but the company’s margin will remain among the best.

For the second component of "MOM," the "O" stands for ownership, and Skilled Healthcare owns 75% of the 77 facilities it operates. Of that total, however, 13 are assisted living facilities, which helps to boost the margin, but Manor Care has roughly the same proportion of assisted living facilities in its portfolio. During the 1990s skilled nursing IPO boom, real estate ownership was considered to be a negative in many cases because of the depreciation hit to earnings and the attempt by some of these companies to portray themselves as "health care" providers and not real estate owners. But now, investors and analysts have finally been able to move away from GAAP earnings and on to cash flow earnings, which is swinging the pendulum back to ownership of the real estate.

The real benefit, at least from an investor’s perspective, is the financial flexibility that comes with real estate ownership and the ability to recapitalize those assets when doing a major corporate acquisition. This has been a driving force in both the Genesis HealthCare and Manor Care auctions. With no hard assets, the options available to the investor wanting to take a company private diminish. This theory, however, may be tested before 2007 is over with Sunrise Senior Living (NYSE: SRZ), but that’s a very different story (growth by development). Finally, we all know that Medicare (rounding out "MOM") is what is driving the current financial strength of the skilled nursing business, and just over 38% of Skilled Healthcare’s revenues are from Medicare, compared with 31% at Manor Care (excluding the hospice business), and the overall revenue quality mix for both companies is close to 70%. Skilled Healthcare has improved its quality mix of revenues from 61.4% in 2004 to 70.5% today, which is quite a significant improvement, especially when considering the starting point was relatively high. In the first quarter of this year, SKH’s average per diem Medicare revenue at its nursing facilities was $481, the highest we have ever seen in the SNF sector, and it is 3.8x its average Medicaid rate and 3.2x its average private pay rate. This has helped to push the company’s average EBITDAR per bed to about $12,000, which is almost double what the average has been for skilled nursing facilities sold over the past three years. The point is, these appear to be high-quality assets earning above-average returns in what is otherwise considered to be a relatively low-margin business.

Skilled Healthcare has made a push for the higher-acuity patients, and while they are currently the most profitable, the downside is that the turnover is higher than with less medically complex patients. This has the unintended consequence of keeping occupancy lower than what would normally be expected, and in the case of SKH, occupancy in this year’s first quarter averaged about 86% (Manor Care was 89%). But for now, Medicare is the name of the game, and we expect management to continue its efforts in this higher-acuity market.

In addition to its focus on Medicare, Skilled Healthcare’s operations are concentrated in three states—California, Texas and Kansas—which comprise 88% of its properties. Most of their facilities are in urban and suburban markets, which is good, and when you throw in the other two states—Missouri and Nevada—you end up with two very broad regions. In addition, SKH has a rehabilitation therapy company that provides services to 61 of its facilities plus 116 unaffiliated facilities, and a small hospice company that began operations in 2004 and now has annualized revenues of about $6.4 million.

The company is led by industry veteran Boyd Hendrickson, who held several senior level positions at Beverly Enterprises from 1988 to 2000, including president and COO. Prior to that, he was a co-founder and president of Care Enterprises, a skilled nursing company that was based in California. As a public company, SKH appears to be fairly valued with an adjusted P/E multiple of 10.2x, which is within the range of its peer companies. But if the acquisition market remains as hot as it is, with private equity companies trying to buy up skilled nursing chains, any dip in SKH’s price will get the number-
crunchers into high gear to see how they can make a deal work.

The Ensign Group. Also taking advantage of renewed investor interest in the skilled nursing facility industry is The Ensign Group, which was formed in 1999 and now operates 60 facilities (all but six are SNFs) with 7,342 beds, 88% of which are in three states: California, Arizona and Texas. It is unusually coincidental that both Skilled Healthcare and Ensign Group have 88% of their facilities in three states, that both companies also have 31 facilities in California, and Texas is one of the big three for both as well. The California connection may explain why Ensign also has a high average Medicare per diem ($442 in 2006), but this is where the similarities begin to diminish.

In May, Ensign filed to go public with D.A. Davidson & Co. and Stifel Nicolaus as the lead managers, and has applied for a listing on the NASDAQ Market under the symbol "ENSG." The size of the offering and the estimated price range have yet to be disclosed. Ensign has grown significantly since 1999, when it had just five facilities and 710 beds. In 2006, the company had revenues and EBITDAR of $358.6 million and $59.5 million, respectively, resulting in a very attractive margin of 16.6%. The percentage of revenues from Medicare is nearly 33%, or just above Manor Care, and its revenue quality mix is nearly 58%. Profits have been growing steadily, with net income in 2003 of $11.1 million, jumping to $18.4 million in 2005 and $22.5 million last year (this is GAAP net income).

On the negative side, occupancy levels have been relatively low, even for the skilled nursing industry, averaging between 81.1% and 82.0% over the past three years. In addition, the company only owns 37% of its facilities, and while it has options to purchase 12 of the leased facilities, we do not know how attractive the option prices are. Ensign has also had its share of quality problems and some aggressive attacks by unions in California, but it is possible that most of these problems are a thing of the past.

Despite being medium-sized, Ensign has set up its corporate operating structure so that there are half a dozen regional "companies" within the company, each with a CEO responsible for staffing, growth and acquisitions. The company believes that this more localized format will help it grow and put more responsibility at the local, operating level. We agree, and years ago said the same thing would have helped at the former Beverly Enterprises when it had 1,000 facilities. Ensign Group’s founder and chairman, Roy Christensen, was a founder and former chairman of Beverly and was also a founder and chairman of the former GranCare, which was subsequently merged into Mariner Health. It looks as if he has learned from the Beverly experience, although we don’t believe he has the same kind of growth expectations for Ensign. Son Chris Christensen is Ensign’s president and CEO, while another son is the executive director at one of the facilities (with a nice salary of $287,000 per year). The Christensen family controls just under 50% of the stock, with something called Ensign Group Investments controlling another 16.7%. The rest of the stock is owned by individuals and other family trusts. With the IPO of Skilled Healthcare appearing to be stuck around its IPO price, for Ensign to get some market traction the underwriters will have to price it a bit more cheaply. The float, however, will be relatively small, but with Genesis HealthCare soon to be leaving the public domain, as may Manor Care, it is nice to see the reserves stepping forward.