Advocat Receives Offer - But The Board Does Not Seem Interested

Over the past two years, we have chronicled the resurrection of Advocat (OTCBB: AVCA) from a company that stood at the precipice of bankruptcy with a share price that had plunged to below $0.20 per share and profits nowhere to be seen, to one of the best stock performers in the skilled nursing sector and a share price that has tripled in value this year. In a comeback similar to that of American Retirement Corporation (ARC)—although they are vastly different companies— Advocat’s management has shed unprofitable assets, moved out of its low-end assisted living business and returned to profitability. And like ARC, is has attracted acquisition interest in a market searching for deals. The outcome, however, may not be the same.

Two investors have accumulated nearly 5% of the outstanding common shares of Advocat. One of them, Oakdale Capital Partners I, LP, purchased its 119,600 shares prior to this summer, while the other, Bristol Investment Fund, Ltd., purchased 99,290 of its 159,361 shares between July 17 and August 17 at prices ranging from $13.59 per share to $14.82 per share. Advocat closed on August 31 at $16.70 per share. Bristol is a privately held fund that invests primarily in publicly traded growth companies, while Oakdale is also a privately held fund that invests in undervalued publicly traded securities. We do not know if they have worked together on other transactions.

This past July 18, Bristol and Oakdale jointly offered to purchase Advocat for $16.80 per share, which, because it represented no real premium to the existing share price and because management probably had little reason to sell, the board verbally rejected. Undaunted, and also because they had a $4.0 million investment in the company, the investors met with management on August 15 to get an update on financial and operational progress at Advocat, where they learned that within six months of renovating a skilled nursing facility, management had increased occupancy from 57% to 75%, with 50% of the increase coming from Medicare patients. Two nursing facilities have completed renovations, and two more are underway. Obviously, they liked what they heard and believe there are more opportunities for internal growth to increase cash flow and value.

In a follow-up letter to Advocat’s CEO dated August 18, the investment group reiterated their interest in the purchase of the company, and stated that the company was trading at 6.5x earnings and 7.5x free cash flow, which they considered to be a bargain, or at least undervalued given the potential they saw. The "earnings" multiple is based on a negative (or net benefit) $3.9 million professional liability expense in the second quarter, which basically reflects actuarial adjustments to past charges and costs and consequently inflates GAAP earnings. But, a $5.0 million non-cash, stock-based compensation expense sort of evens things out on a cash flow basis. Therefore, the second quarter annualized funds from operations (cash flow) comes to about $18.8 million on revenues of $215.6 million, or a cash flow margin of 8.7%. When lease payments and net interest expense are added in, the EBITDAR margin increases to just over 17%, which isn’t too bad and will move even higher as the Medicare census rises after the facility renovations. So far, so good.

Advocat operates 43 nursing facilities with 4,505 beds, but almost all of them are leased. For the past 10 years, a common rule of thumb for acquiring skilled nursing facilities was a 7.5x multiple of cash flow, or a cap rate between 13% and 14%. Obviously, higher quality facilities in good states would command a higher multiple, and portfolios would also be sold at a higher multiple (the "portfolio effect"). But these multiples were for the real estate and the business, not just the leasehold interest. At the current offer of $16.80 per share, the total price would be about $128.0 million based on the current shares outstanding and the $30.6 million of recently refinanced debt. That represents about a 5.9x multiple of annualized EBITDA, which seems a little rich for us when there is very little hard real estate involved. We don’t know the terms, if any, of purchase options on the leases, and if they are attractive there is obviously some additional value associated with them. But the $128.0 million value also comes to just over $28,000 per bed, which is considered high for mostly leased beds.

Management has obviously done a tremendous job in turning around the company, and should be recognized for that accomplishment. However, unless there are some extremely rosy projections based on organic growth, it would appear that the company is fully valued, even in today’s high-value market. It was interesting in the investors’ August 18 letter that they cautioned management about making any "premature acquisitions you may be considering in light of the tremendous upside opportunity available in reinvesting in your own Company." The translation is that they don’t want management to use its "undervalued" stock as currency for acquisitions, believing it would be better to wait when the price, and multiple, is higher. That makes sense, in theory, but the wait could be a long one. And what these investors don’t want is to have their holdings diluted.

Advocat’s casual response to the offer probably reflects an attitude that they either don’t take it too seriously, or simply couldn’t justify a no-premium offer to shareholders, or both. What is most likely going on is that, with an investment basis close to 20% below the current share price, these two investors want to put Advocat in play and see if there are any willing takers so they can make a tidy 20% to 30% return before the end of the year. It does remind us of the situation with Capital Senior Living (NYSE: CSU) and Mercury Real Estate Advisors which owns over 9% of CSU and wants the board to hold an auction to sell the company to a larger operator who can realize economies of scale (which is the only way they can get out of such a large position in a relatively thinly traded stock). While we don’t see this happening with either company, this market has gotten so ahead of itself, with so much capital chasing too few deals, that anything is possible. The question is, is it probable?