The Health Care M&A Monthly: Skilled Nursing Performs
Solid Q:1 Results, But With Reimbursement Hangover
Way back in the 1990s, when the skilled nursing industry went through a kind of rebirth with the coining of the term "subacute care," investors hopped on the bandwagon, pumping in far too much debt and equity capital as the large national chains went on a buying binge that included everything from other large national chains to large therapy companies to institutional pharmacy companies. Things came to an abrupt halt after some changes in Medicare reimbursement upset the apple cart, even though those changes were well-known in advance. And while the industry often liked to blame its subsequent financial woes on the Medicare change, which resulted in bankruptcy filings for many of them, the reality was that many of them overpaid for too many of their acquisitions in their pursuit of earnings growth, as fictitious as that may have been.
In addition, excessive leverage as a result of these pricey acquisitions was probably not sustainable even if Medicare had not changed, at least for some of the companies, and it was the leverage that actually did many of them in. Without the high level of fixed charges, many of the companies could have adapted to the new reimbursement environment. Instead, these large companies collapsed under the weight of their debt and lease payments, combined with the end of their acquisition sprees, which had provided them and their investors with the illusion of earnings growth. The black eye they received tarnished the sector for a few years, and just like the assisted living sector (for its own reasons), it took several years to make a comeback, and come back it did. It should be noted that the fallout that began by the end of the 1990s had a disproportionate impact on the larger companies than it did on the small operators or even the regional companies that did not take on such high leverage and did not overpay for companies with no hard assets (real estate).
After bottoming out in 2003, the average price paid per skilled nursing bed surged in the next four years to a record $55,200 per bed in 2007, or about 75% higher than the 2003 average of $31,600 per bed, which was the lowest price since 1993. This sharp increase in a relatively short timeframe doesn’t include the effective per-bed prices paid in the take-private acquisitions of both Genesis Healthcare and Manor Care, which would have been from $75,000 to $100,000 per bed. Partly because of these transactions (some would say mostly because of them), the stock prices of the few remaining publicly traded skilled nursing companies performed quite well in 2006 through mid-2007. Since then, however, the picture has been far from rosy.
When the crisis in the credit markets began to materialize in August of 2007, the certainty of The Carlyle Group’s purchase of Manor Care came into doubt because of the massive amount of debt that was required to close the deal. The sale did close in late December of that year despite the attempt by the SEIU to derail it, and all we have heard is that Manor Care’s financial performance has been as good, or better, than expected. And with LIBOR-based debt, Carlyle has fared pretty well from a cost of capital perspective, adding an extra little kicker to its total return. How Manor Care will be priced in a future sale or IPO is anyone’s guess right now, but we have to believe that it will be many years before the future multiple will get up to what it was in 2007, and probably will never get there. That may not matter to Carlyle if the cash flow growth continues. The other large national chains that remain publicly traded may not be performing as well as Manor Care, but they certainly are not performing badly either. You would never know it looking at the share prices, however.
When the seniors housing stocks started their long tumble into despair in 2007, the common opinion held that the combination of the tightening credit markets, the deteriorating housing market and a worsening economic environment would have a more negative impact on the much-touted "private-pay" market than it would have on skilled nursing. Skilled nursing stocks declined, but by nowhere near the plunge suffered by seniors housing companies. In this year’s early spring rally, however, skilled nursing stocks have not performed nearly as well as the seniors housing stocks, despite the fact that financially, the publicly traded skilled nursing companies happen to be performing better than their lower acuity relatives, at least for now. So what’s going on?
First of all, other than Sunrise Senior Living (NYSE: SRZ), which has problems unique to its particular circumstances, the complete sell-off of the seniors housing stocks through early March of this year was the result of perceived weakness in a sector that turned out to be much more resilient than investors expected. A 300-basis-point drop in occupancy over a 12-month period hardly warrants a 60% to 80% plunge in stock price. True, there were also concerns about liquidity and refinancing debt, but for most of the companies this was definitely an exaggerated concern. Unfortunately, investors just didn’t listen to management when they tried to convince shareholders that debt maturities were not as big a problem as people thought and that they were in discussions with mostly receptive creditors (with the exception of Sunrise, whose creditors are none too pleased) when they needed to be. In one case, Capital Senior Living (NYSE: CSU), they had already refinanced all their debt so this just was not a credible concern. It should be stated, however, that the credit market concerns, combined with the housing market, obviously impacted growth potential through new development, and this did eventually cause CSU to suspend its development activity. But whether it was dumb luck or incredible foresight to be that prepared for the worst capital markets in 50 years, CSU entered the credit crisis with almost zero near-term refinancing exposure, and didn’t get any credit from investors for the fact (pun intended).
In addition to the impact of the credit crisis, skilled nursing companies face a whole set of other "economic" issues that, while different from those affecting seniors housing, have the potential to produce a similar devastating effect. Fortunately, at least for now, they have been spared and may continue to be so if the economy starts to stabilize by the end of the year. The problem, however, is that they can get hit by both Medicare and Medicaid, and the former already subsidizes the latter, so there is little room to maneuver.
As we previously stated, most of the skilled nursing companies turned in a reasonably good first quarter performance. Both EBITDAR margins and the absolute level of EBITDAR increased year-over-year at five of the six companies. Advocat (NASDAQ: AVCA) was the only one to deteriorate a bit after making some adjustments for liability insurance, but its occupancy rate increased by 80 basis points from a year ago. Occupancy has become less of an issue for skilled nursing companies because as the acuity levels (Medicare census) have increased, turnover has also increased. Having a Medicaid patient in a bed for three years obviously helps occupancy, but from a cash flow basis having that same bed filled for 270 days of the year with an assortment of Medicare rehab patients is much more preferable, and profitable. This is very different from the seniors housing side of the business, where an occupied unit is an occupied unit and pretty much delivers the same return (unless you take Medicaid-waiver residents). Other than Advocat, the other companies have occupancy rates between 80% and 90%, and this has not changed much in the past 18 months.
During the first few weeks of May, earnings results came out and despite headlines such as "Strongest first quarter to date" (Sun Healthcare, NASDAQ: SUNH), and "Results beat estimates again" (Kindred Healthcare, NYSE: KND), not much swayed investors to push prices up. In the case of Kindred, the earnings beat was not the usual penny or two of earnings "management" that has become all too regular in corporate America; it was $0.57 per share compared with the consensus estimate of $0.44 per share and well above management’s own guidance range of $0.40 to $0.50 per share. In more normal times, these results would have sent the shares flying and provided longer-term momentum. Sun Healthcare’s share price is within 20 cents per share of where it was when the first quarter earnings were released, while Kindred’s price is down about 4%, even though it briefly jumped by 30% a few days after the release. Remember, these results are coming at a time when the majority of companies and industries are reporting earnings declines, losses or bankruptcy filings. In other words, the numbers being posted would have been decent in more normal times, but are remarkable in this economic environment. Still, the companies get no respect.
Perhaps the best year-over-year improvement came from The Ensign Group (NASDAQ: ENSG), with a 22.4% increase in EBITDAR and a 100-basis-point increase in EBITDAR margin to 16.2%. All of this with the second lowest occupancy rate of the six companies of just 79.8% in the first quarter. Obviously, if they can fill some of the beds and get to the occupancy mid-point of the sector (85%), the impact on margins and cash flow will be significant. The highest operating margin belongs to Skilled Healthcare Group (NYSE: SKH), which increased by 25 basis points from the year-ago quarter to 18.2%. True, the company’s margin is helped by a small assisted living component (1,204 units), but investors are not giving it any credit for maintaining its margins and increasing EBITDAR by 6.3% compared with the year-ago quarter. There are some reasons for this, and while these reasons have been around for a few decades, they are weighing more heavily now than ever before.
One of the reasons why Wall Street fell in love with assisted living in the 1990s was that it was basically 100% private pay in brand new, purpose-built properties that felt more like a hotel than the dreaded "home" that none of our parents want to move into. The skilled nursing facility industry has tried to change that image with physical plant upgrades where possible, but that is difficult to do when 70% of your census, on average, is funded by a stingy Medicaid system that in many states doesn’t cover all the costs of operations, let alone physical plant upgrades. To counter that, as we all know, the sector went "subacute" in the 1990s and despite the reimbursement disruption in the late 1990s, it has been a successful, and necessary, transition.
The problem, however, is that as revenues and profits become increasingly dependant on Medicare, those profits can fluctuate at the whim of the prevailing political winds. Even though the professionals at the Centers for Medicare and Medicaid Services (CMS) know that Medicare rates have been kept slightly inflated to subsidize the unprofitable Medicaid rates, legislators don’t like to see companies making money off of Medicare, especially congressmen such as Pete Stark. The skilled nursing industry has almost always gotten a pass in the last several years, but with federal deficits soaring and the Medicare "trust fund" reaching the point of insolvency sooner and sooner, even CMS is proposing a bit of a pullback in rates. We have to believe that this, combined with the flowing red ink at the state level, has public equity investors spooked despite the recent solid quarterly results.
The bottom line is that the current proposal (and let’s keep in mind it is still just that, a proposal) from CMS is for a net 1.2% decrease in the average Medicare rate for skilled nursing facilities for the next annual period. This is composed of a 2.1% increase in the market basket (inflationary) component, combined with a 3.3% decrease as a result of a recalibration of the rates for the various resource utilization groups (RUGs) which is adjusting for the over-utilization of some services. For the 2010 fiscal year, the total impact on the industry is estimated to be just under $400 million, which may not sound like a lot for a large industry, but with overall after-tax margins already low, it will definitely have an impact if enacted. Now, some of the RUG categories will have a smaller decrease, such as the higher acuity rehab categories that some of the publicly traded companies focus on, so the financial impact will end up being less pronounced on these providers than it may otherwise appear. In addition, a RUGs refinement has been proposed for 2011 that is expected to be budget neutral but will add 13 new RUG categories to the existing 53. We won’t know until next year what the rates on those may be.
With escalating pressure on the government reimbursement front, which covers more than 75% of the industry’s revenues, the skilled nursing business may be forced back into more of a cost-management business and not a revenue-management one, which it has been for the past 10 years or so. While not necessarily a bad thing, with the constant pressure on increasing the quality of care, there really is not much room to maneuver from a cost perspective. Perhaps going down the acuity scale may alleviate some of the pressures from and reliance on government reimbursement programs. This would include all private-pay high acuity Alzheimer’s care and assisted living. Would a skilled nursing company like to have the operations of a Silverado Senior Living with its $170 to $300 per day rates for its various Alzheimer’s programs, and these are programs with proven results? Absolutely. Or what about the model with high-end assisted living combined with a high-Medicare census skilled nursing component on one campus in the style of Trilogy Health Services? Yes again. Not everyone can do this, of course, but it certainly helps to mitigate some of the irrational fluctuations in reimbursement programs that force investors to be so demanding.
If these reimbursement cuts are passed, at least the industry will have had five months to prepare for them either by working their RUG mix or keeping a lid on costs, and probably both. How much longer these companies can keep putting up very respectable quarterly numbers is anyone’s guess, but they have coped with far larger problems before. And with industry giant Manor Care apparently outperforming its private equity owners’ expectations, there is obviously room for improvement by the other operators despite the reimbursement struggles ahead. But…what keeps some investors away from the skilled nursing sector is the government’s continual urge to tinker, which results in instability, or at least the perception of instability.
A case in point is the recent bill put forward by senator Jay Rockefeller (D-W.Va.) that would empower the Medicare Payment Advisory Commission (MedPAC) to do more than just advise Congress, and instead give MedPAC the power to set Medicare rates, and not just for skilled nursing facilities. This would, of course, be disastrous for the sector because year in and year out MedPAC recommends cutting the Medicare rate for skilled nursing facilities, and Congress and CMS usually ignore the recommendation. Giving more power to MedPAC would certainly mean lower Medicare rates, which would then put pressure on a Medicaid system that can’t afford to pay any more than it does without much higher taxes or cuts in other services. The end result would be a decline in cash flow for the industry. Investors like stability and predictability, not uncertainty, so with a daily dose of varying opinions and recommendations, they are often forced to look elsewhere. This may spell opportunity for some investors who have the stomach for these risks, and the first quarter results should have proved to these investors that the skilled nursing sector is healthier than they are giving it credit for, and deserves the common description as being "recession-resistant," at least for now.