The SeniorCare Investor: Skilled Nursing At An Impasse?

 

Always Nervous About Medicare, SNFs Deal With Reform

At least once a decade, the skilled nursing sector seems to be under attack, although we are sure there are providers who think it is every year. Either for quality of care issues or reimbursement, politicians and their advisors are always trying to tinker with what has become a much more complex business, and always think that providers should be able to do a better job with less. Sometimes the political party in power "gets it," other times not. But there is always a sense that the industry is never well understood, that most people don’t want to understand it and perhaps even fewer people want to pay for it. The irony is that, as the low-cost producer on the health care food chain, skilled nursing facilities should be well-positioned in health care reform, where one of the goals is to lower costs and save money.

From an investment perspective, skilled nursing facilities have not been on quite the rollercoaster that assisted living has been on. Average cap rates have remained in a relatively tight 200-basis point range of 12.5% to 14.5% for most of the past 15 or 20 years, and even though per-bed values have gyrated, that had more to do with the quality of what was sold as opposed to changes in expected investment returns. And when looking at the share prices of the publicly traded companies, they neither deteriorated to the extent that assisted living companies did earlier this year, nor have they seen the solid gains this summer. In short, they have been somewhat resilient and steady.

The concern today, of course, is reimbursement. For the more sophisticated operators and public companies, the name of the game has been Medicare, because reimbursement and returns are higher and, quite frankly, it is a much more interesting business than long-term custodial nursing care. One of the reasons why skilled nursing facility occupancy has been declining is because of the higher turnover of patients who are in for two weeks to two months for a variety of types of rehab and short-term problems. That type of constant turnover results in many days of empty beds, much like a hospital, and while it is profitable for the facility, it should lower overall health care costs as well. That is why we are often perplexed when the Medicare Payment Advisory Commission (MedPAC) always wants to lower Medicare reimbursement for skilled nursing facilities, not caring that the Medicare revenues subsidize the losing proposition called Medicaid. This may be about to change.

As the Senate Finance Committee diddles with the Baucus Bill for health care reform, one of the many amendments that was actually passed in September was one that will require MedPAC to consider Medicaid reimbursement levels and profits (or lack thereof) when making its recommendations on Medicare payment rates. This has never been done before, and all we can say is, it’s about time. What this means, at least in theory, is that MedPAC would no longer be able to look at the Medicare profits of the skilled nursing industry without also taking into account the losses on Medicaid. By taking both into consideration, there will be much less likelihood of what became an almost automatic recommendation to Congress to cut Medicare rates for SNFs year in and year out. If it is in the final bill that is passed—if any bill is passed—it would be somewhat historic for the industry, at least on paper. This is also important because there are those in Congress who would like to make the MedPAC recommendations (or its successor entity) more than just recommendations to Congress, changing them into reimbursement law. This, of course, would provide political cover to our wonderful Washington wimps.

For the current fiscal year which began October 1, there is a 2.2% market basket (inflation) rate increase, which is reduced by a 3.3% "forecasting error" reduction, for a net decrease of 1.1% in average Medicare reimbursement rates to SNFs. While not welcome, the industry will be able to live with this, and not all rates will be increased or decreased the same. Some RUG categories will fare better than others, and skilled nursing providers always seem to be able to play the reimbursement game. The fear is that with increasing pressure on Medicare in general, reimbursement rates for skilled nursing will be on the table with everything else, without looking at the big picture. RUGS-IV is the next problem the industry will have to deal with, but next year.

In the case of Sun Healthcare (NYSE: SUNH), the world is definitely not coming to an end. Taking into account the 1.1% average Medicare reduction for the current fiscal year, Sun did reduce its full-year 2009 earnings per-share estimates by about eight cents per share, but it will still be profitable and some equity analysts are maintaining their Buy recommendations despite the lower forecast. The company’s EBITDAR margin will decrease by only 30 to 40 basis points for the full 2009 year compared with earlier forecasts. For 2010, when the full brunt of the reimbursement cut will be felt, Sun is already planning on some infrastructure cuts to help mitigate any lost revenue. While we are sure management would prefer not to do this, they are being disciplined in a difficult environment, and investors were probably not worried anyway.

Earnings estimates have been reduced slightly for Skilled Healthcare Group (NYSE: SKH) as well, with minimal growth from 2009 to 2010. The company is cutting back on the development of its Express Recovery Units for the rest of 2009, even though they expect to pick up the pace by 2010. This will result in some of the slower growth in earnings on top of the Medicare cuts. But the company is still expected to make somewhere near $1.00 per share in 2010, and that’s GAAP earnings, not cash flow from facility operations.

For the 60% to 70% of the skilled nursing census that is paid by Medicaid, there really is no light at the end of the tunnel. The federal government does not want to fix it because it doesn’t know how to and because it really is a state-administered program that happens to get more than half its funding from Washington. The states don’t know how to fix it and are now in a position where they have little ability to do anything because most of them don’t see a way out of their current budget deficits. Consequently, the absolutely absurd "provider tax" continues unabated, because the feds are willing to go along with the game and it is the only way the states can fund their Medicaid commitments.

The industry today, however, is much healthier than it was at the end of the 1990s from a balance sheet perspective, and unlike in the delivery of care in hospitals, there really are no more efficiencies that can be squeezed out. High acuity will continue to be the path the industry will go down, and it should because that is where they can wring some efficiencies out of the broader health care system, and hopefully get properly paid for it at the same time. Average per-bed prices will be down this year, but not because large increases in cap rates. In fact, by the end of the year there may not be much of an increase at all even though the small decrease we saw in the first half of the year will be reversed. Two of the recent deals disclosed below appear to be where the market is today and probably next year as well.