The Carlyle Group Wins The Bid To Acquire Manor Care

Carlyle Wins Manor Care Bid-
Its Size Will Only Be Topped By The Sale Of Holiday

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When Manor Care (NYSE: HCR) announced in April that it had hired JPMorgan to look at the company’s "strategic alternatives," the shares shot up in value by 11%, which came on top of a 19% increase in three months and an 18% gain in 2006. Even after acknowledging that the market for high-quality senior care stocks has been strong, especially among the private equity crowd, when Manor Care’s shares topped $65.00, reaching a high of $68.86 at the end of May based on the euphoric speculation that the winning bidder for HCR just had to pay a decent premium to the current price, we thought enough was enough.

Yes, Manor Care is a very good company, with many saying it’s the best in the skilled nursing business, with strong management, good markets, properties mostly built by the company, ownership of nearly 100% of those properties, strong margins, a very high quality mix of revenues (probably 66% for the SNFs and 73% when the other businesses are thrown in)…need we go on? We are sure this is what attracted The Carlyle Group, which has made much smaller bets in the assisted living business with huge returns, into the bidding for Manor Care. The good news, other than for shareholders, is that the bidding did not escalate into the $70.00 to $75.00 per share range that some investors had been predicting (perhaps wishful thinking). The bad news is that any way you look at it, Carlyle surely paid a full price at the top of the market for a company which, dare we say, has little room for improvement.

Carlyle has agreed to pay $67.00 per share for HCR, representing a 2.6% premium over the previous day’s close but a 20% premium to the price just prior to when the company made the strategic alternatives announcement. Shareholders, or should we say speculators, were furious, sending the shares down by $1.19 per share to $64.10 on volume of more than 9.5 million shares. In the three days following the announcement, trading volume totaled close to 21.5 million shares, or about 30% of the shares outstanding. Average daily volume over the past three months has been closer to 1.5 million shares. How do we spell disappointment for investors who bought shares between $64.00 and $69.00 per share? No premium to market and, unlike the case with Genesis HealthCare (NASDAQ: GHCI), little prospect of another bidder trumping Carlyle.

The total purchase price, inclusive of assumed debt, comes to about $6.3 billion and should remain the largest acquisition in the skilled nursing sector. While most of Manor Care’s business is skilled nursing, it also has a hospice and home health business (mostly hospice) with annual revenues approaching $550 million as well as 65 assisted living and Alzheimer’s facilities with 5,080 units. The company does not release much information about its assisted living business, but we do not believe it operates at the top end of its peer group. If we use a $150,000 per unit value for the ALFs and about $500 million for the hospice business, we are left with a little over $5.0 billion for the 38,353 skilled nursing beds, or about $130,000 per bed.

The average price per bed paid in the market for skilled nursing facilities has been between $40,000 and $50,000 the past three years, and while Manor Care’s skilled nursing facilities are certainly above the average, are they two and one-half times the average in value? Every year there are few sales above $100,000 per bed, and a few months ago we reported on a small portfolio in Texas that went for $130,000 per bed (24% EBITDA margin), but these are the exceptions to the rule.

There is always the portfolio premium aspect, but we wonder how many of HCR’s nursing facilities, if sold individually, would command a price above $100,000 per bed. We suspect the average would be closer to $90,000 per bed, which assumes an 11% cap rate, and to get to $130,000 per bed you would need an 8% cap rate across the board. Need we remind you that cap rates are already at historic lows, with interest rates just above their recent lows?

We have no idea what Carlyle’s exit strategy will be, and some people have assumed they will opportunistically sell off the hospice business and perhaps the assisted living facilities to pay off some debt. The problem is that we view this acquisition as a big Medicare bet, with the hospice business heavily funded by Medicare, and a significant portion of the skilled nursing profits coming from Medicare, which has essentially been subsidizing the Medicaid program for skilled nursing facilities for years. Ask anyone if they think Medicare reimbursement for SNFs in five years will be better than it is today, and you may find one adventurous soul out of a hundred who thinks it is possible.

The people at Carlyle are obviously smarter than we are, but so were the people at Apollo Real Estate Advisors, who in the late 1990s bought the merged entities of GranCare, Living Centers of America and Mariner Health. Although not in the forecast, the ultimate exit strategy on that one was Chapter 11. In addition to overrated properties, high leverage coupled with a change (decrease) in Medicare reimbursement were the main causes of that fiasco. That investment was made exactly 10 years ago, and at the last peak in the senior care market. Manor Care is obviously a much higher quality company, and while the outcome will be more positive than Apollo’s entrance in the field, we have yet to figure out an exit strategy for Carlyle to provide the private equity returns it needs. Our guess is that everything will have to go in their favor, and that will be difficult in a business with so much government reimbursement. Alternatively, the strategy could be for a long-term holding period and let the cash flow just continue to grow, with the value following. Now that would be a novel idea for the private equity market, and it could work.

From what we read, Carlyle is paying about 10.8x estimated 2008 EBITDAR, which is about 200 basis points higher than the multiple paid for Genesis HealthCare. As one market participant asked, is it worth paying three times the price that was paid for Genesis to get a little more than twice the cash flow? The numbers may be a bit rounded, but the point is that although a full price was also paid for Genesis (and more than they had originally expected), there seems to be more upside potential with Genesis than with Manor Care, but this also assumes a stable Medicare environment for at least the next two to four years.

It seems to us that HCR is operating at the top of its game, with operating margins that are 200 basis points higher than Genesis, occupancy that is close to its 10-year high and property locations that may be too good for the business it is in (the issue of highest and best use). If we had to buy one company in the skilled nursing business, it would be Manor Care. We would just want a good Medicare reimbursement insurance policy before paying $67.00 per share.

Irving Levin Associates, Inc., 268 1/2 Main Avenue, Norwalk, CT 06851
800-248-1668; 203-846-6800
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general@levinassociates.com

Since 1948, Irving Levin Associates, Inc. has been the leading source of information and investment research on mergers and acquisitions in the Behavioral Health Care, Biotech, e-Health, Home Health Care, Hospitals, Laboratories, MRI and Dialysis, Long Term Care, Managed Care, Medical Devices, Pharmaceuticals, Physician Medical Groups, Rehabilitation and other health care markets.

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Carlyle Wins Manor Care Bid- Its Size Will Only Be Topped By The Sale Of Holiday Email Editor

Carlyle Wins Manor Care Bid-
Its Size Will Only Be Topped By The Sale Of Holiday

Email Editor