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Two For The Price of Sun

September 6, 2010

the.knowledge.pile@gmail.com
Sun Healthcare Group Investment Thesis
 Leading Skilled-Nursing Services Provider
 Strong cash flow generator
 Recurring revenue streams
Ticker: SUNH  Recession resistant business
Stock Price:
$8.24  Embedded in the company are significant
real estate holdings
Recent Valuation  Company intends to unlock the value of
Multiples: real estate properties by spinning out
5.5x ‘11e EV/EBITDA* Operating Company
5.4x ’11FFO**
 Company has a hidden deferred tax asset
Capitalization: that should shield company from income
Enterprise tax for many years
Value: $1.1bn
Equity Market  Intrinsic value of company not currently
Value: $618mm reflected in the market

 Company worth significantly more on


*based on estimated sum-of-the-parts basis
EV/EBITDA for OpCo
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**implied FFO based
on OpCo
Company Description

Sun Healthcare Group is a leading provider of long-


term, sub-acute and specialty healthcare services
primarily to senior citizens in the U.S. via a network
of facilities in several states.

The company operates 182 skilled nursing facilities,


12 assisted and independent living facilities and 8
mental health hospitals with 22,000+ beds in 25
states.

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Operating Company: A diversified business model

SUNH operates in three business segments:

Inpatient Rehabilitation Medical


Services Therapy Staffing

•Daily nursing, Speech pathology, Licensed physical,


therapeutic physical therapy occupational and
rehabilitation, and occupational speech therapists,
social services, therapy nurses, pharmacists,
housekeeping, physicians, etc
nutrition and
administrative
services

~87% Revenues ~6% Revenues ~7% Revenues

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SUNH recently announced it will soon be split into two businesses

Operating REIT
Company

Skilled nursing, 87 properties


Rehabilitation, Medical  68 SNF
Staffing  10 mixed
(SNF/AL/IL)
 6 AL/IL
 2 Mental Health
9500+ beds

SUNH owns 45% of the facilities it operates, most of which will


comprise the REIT (“Sabra”). 5
Some terminology

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Terminology

 Medicaid: State and Federal healthcare program for low income


individuals or families
 Medicare: Federal healthcare program for elderly individuals
 Acuity: Refers to the level of complexity or intensity of patient care
 Concurrent Therapy: One therapist treating multiple patients at the same
time with the patients performing different activities
 Look-Back Period: Services received within 14 days prior to admission
used to gauge reimbursement levels
 RUG: Group which Medicare patient is classified into based on services
needed and functional status
 Skilled Mix: Refers to all non-Medicaid revenues patient days
 Quality Mix: Refers to all non-Medicaid revenues
 Census: Refers to the number of inpatients in a given facility
 Minimum staffing levels: Sets minimum level of nursing staff required at
facility

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A little about the industry

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Post-Acute Care Industry Overview

 $100bn/yr+ industry
 Provides services to patients typically after hospitalization but
before they return home
 Majority of revenues come from government programs,
Medicare and Medicaid
 Post-Acute care providers are organized based on offering
type and subsequently by level of reimbursement, which are
determined by acuity/intensity levels of patient care
 Largest sub-category by expenditure is the skilled nursing
facility (SNF) segment

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Post-Acute Care Industry Overview (cont’d)

 SUNH, a skilled nursing facility (SNF), falls at the mid-point of the acuity spectrum:

 Companies can improve profitability and margins by moving up the acuity


spectrum.
 SNFs typically have a greater presence in smaller, rural areas, affording
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them some buffer against less acute services (i.e., the only game in town).
Post-Acute Care Industry Overview (cont’d)
• SNFs typically provide two types of care:

Skilled Medical Rehabilitation, respiratory


Care therapy, medication

Custodial Care More limited services to those


who can no longer care for
themselves
• The industry is fairly fragmented. SUNH is the 6th largest SNF operator by bed count (and
second largest public one ) but only has ~1.5% market share. Though on a weighted average
based on beds-per-state, SUNH has a 6.2% market share.

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The transaction

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The Transaction
 On May 24th 2010, Sun Healthcare (“SUNH”) announced plans to split into
two publicly traded entities: an operating company and a REIT.
 The company will spin-out its operating unit (“New Sun”) on a one for one
basis and convert the remaining entity consisting of the company’s real
estate holdings into a REIT (“Sabra Health Care REIT”). Properties will be
leased back to Sun.
 In doing so, management feels it can unlock the value of the company’s
real estate portfolio and afford the operating company flexibility to
pursue growth strategies and focus on core competencies with less
financial debt.
 SUN recently raised ~$225mm through a stock offering in order to reduce
the company’s debt levels (proceeds used to paydown 9.125% senior sub
notes and outstanding term loans).
 Post spin-off, Rick Matros, current CEO of Sun, will become the CEO of
Sabra, while current COO of Sun Bill Mathies will become the CEO of New
Sun. All other management will remain unchanged.

•Stockholders’ rights plan: No single shareholder can acquire more than 10% of the company
without making a fair bid for the entire business so that no single investor can derail the
company’s plans of electing REIT status.
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The Transaction is not without precedence

 There was a similar transaction in 1998 when Vencor was split


into an operating company and a REIT. The remaining
companies today are Ventas (REIT) and Kindred Healthcare
(OpCo).

 When the Carlyle Group took HCR ManorCare private in 2007


for $5bn+, many analysts cited the company’s hidden real
estate value as a key driver for the acquisition.

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Transaction Timeline

5/24: 8/17: Oct: Q4 10: 1/11:


Transaction $225mm ~$325mm Business Elect REIT
share debt Separation Status
Announced
offering refinancing
completed

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The two businesses

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SUN Healthcare (“OpCo”)
 Recession resistant business
 Experienced management team
 Strong market position
 Consistently high occupancy rates (~90%)
 Predictable, stable and recurring revenue streams
 Reliable payer base-US Government as largest “customer”
 Good long term prospects (favorable demographics)
 High barriers to entry (certificate of needs limitations in 17/25
markets)
Leading provider of skilled-nursing services.
High-quality business operating in favorable demographic/secular environment as
the populations ages and there is more accessibility to health care coverage.
Once uncertainty surrounding reimbursement rates settles, company should see
expansion of valuation multiples.
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Sabra Health Care REIT
Positive Factors Negative Factors
 High quality tenant  Single tenant
 Experienced management team  Single property type
 Strong growth opportunities that  Small market cap/limited initial
large players may shun (small size, appeal to real estate investors
easy to push the dial)  Non-investment grade
 Geographically diverse portfolio  Limited operating history/track
 Sale potential record
 Sector expansion/diversification over
time (ALFs, ILFs, hospitals, MOBs)
 Attractive dividend

Sabra’s only pure comp is Omni Healthcare, a long-term care facility REIT.
Given Sabra’s single tenant/property type, balanced with its high quality tenant and
strong growth potential, Sabra should trade at a discount to OHI’s valuation
multiples (~12x fwd FFO, ~8% cap rate), though this gap should close over time.

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Lease Terms

 Master lease on all facilities


 10-15 year term, with 5 year renewal options (at existing
rates)
 Lesser of CPI or 2.5% escalators
 1.6x lease coverage

Management maintains that the transaction will not restrict its operating
flexibility or ability to conduct renovations or capital improvements.

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Deferred Tax Asset
SUNH also has potentially valuable DTA’s that will shield income taxes far
into the future.

 $227mm in net operating loss carry-forwards


that can be applied to future earnings (as of
6/30/2010)
 Utilization amounts subject to IRS Section 382
Limitations

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High Quality Management Team

 Extensive experience
 Rick Matros has been the CEO of three Healthcare
companies
 Handled turnaround/bankruptcy emergence operations
 Operated in many different market and operating
environments
 Conservative mindset
 World class operators
 Entrepreneurial spirit
 Shareholder oriented

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A secular tailwind

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Favorable Demographics and Industry Structure
The number of certified care facilities continues to decline, presenting a favorable
supply/demand imbalance.

Trends in certified nursing facilities, beds and residents

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Favorable Demographics and Industry Structure (cont’d)
While elderly population growth…

US Seniors Population Trends (70+ years old)

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Favorable Demographics and Industry Structure (cont’d)
…is likely to continue to outstrip new facility supply

Senior housing construction starts in Top 31 Metros (units)

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So what is the company worth?

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OpCo Valuation

2011E 2011E
EBITDAR 250 250
Current Rent 75 75
Incremental Rent 70.9 70.9
EBITDA 104.1 104.1
Multiple 5.5 6
Enterprise Value 572.55 624.6
Less Debt 198.00 198.00
Equity Value 374.55 426.60
Shares Outstanding 75.00 75.00
Equity Value 4.99 5.69

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Sabra REIT Valuation
PropCo
Pro-Forma Rent Payments 70,200
Value
G&A 2,400 FFO Multiple Per Share
D&A 23,681 9x 5.5
10x 6.1
Interest 22,190
Total Costs 48,271 Dividend Yield*
9x 10.00%
10x 9.00%
EBT 21,929
Taxes - *Assumes 90% FFO payout
Net Income 21,929

FFO 45,610
Pro-Forma Shares 75,000
FFO Per Share 0.61

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Combined Valuation
Value Per Share EBITDA Multiple
(OpCo)
5 5.5 6 6.5
FFO Multiple 8 9.17 9.86 10.55 11.25
(PropCo) 9 9.77 10.47 11.16 11.86
10 10.38 11.08 11.77 12.46
11 10.99 11.68 12.38 13.07
12 11.60 12.29 12.99 13.68

Potential Upside EBITDA Multiple


(OpCo)
5 5.5 6 6.5
FFO Multiple

8 11.23% 19.65% 28.07% 36.49%


(PropCo)

9 18.61% 27.03% 35.45% 43.87%


10 25.99% 34.41% 42.83% 51.25%
11 33.37% 41.79% 50.21% 58.63%
12 40.75% 49.17% 57.59% 66.01%

Information asymmetry: valuation gap between intrinsic and trading value


likely exists as the situation is too complex for most retail investors and the
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company too small to interest most institutional investors.
Risk factors

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Risks and Mitigates
Some downside risk remain, though the company is actively addressing them

 Much already priced in with


Uncertain and challenging depressed multiple
reimbursement environment  Geographically diverse portfolio
~75-80% of revenues are from limiting the impact of any one state’s
government sources as States face economic health
budgetary issues  Diversified business model

Medicare RUG IV revisions coming Oct


1, 2010; impact uncertain (see next  Company is confident it can cope;
slides) history supports this view
Moving towards shorter stay,
more complex higher acuity and
higher reimbursement patient
High debt levels from historical
acquisitions, capitalized rent  Equity raise has reduced financial
leverage considerably
Unsettled capital markets

Reduced demand due to economy  Exogenous risk


(delaying surgeries, avoid co-pays) 31
 Cannot be delayed indefinitely
RUGs IV (Resource Utilization Group Version 4)

 Medicare currently classifies patients into 1 of 54 categories.


13 new categories to be added. The upper-nine RUGs are the
highest paying.
 New RUGs classification system scheduled to be implemented
on Oct 1, 2010.
 Categories are based on minutes of therapy required, need
for special services and an index base on the ability to
perform four activities of daily living (eating, toileting, bed
mobility and transferring).
 An opportunity for growth?
 Transition to higher paying patient types
 Could take several quarters to play out
 Top nine RUGs were intended to be ~20% of Medicare patient
days, actual number close to 26% as SNF’s targeted patients
requiring higher intensity, acuity and complexity.
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RUGs IV: Strategy and historical perspective

 SUNH successfully navigated RUG III changes, increasing its upper-nine


RUG utilization over time.

 It will likely take several quarters for SUNH to able to refocus on more
medically complex patients, but history shows management is capable of
doing so.
 The company does not believe it will be negatively impacted over time
and the OpCo/PropCo transaction should be seen as a vote of confidence.33
RUGs IV Changes

 Eliminates concurrent therapy and Look-Back Period


 Centers for Medicare & Medicaid Services (CMS) would
prefer to see concurrent therapy used as more of a
supplement.
 CMS is proposing time is allocated between all patients,
not as individual time.
 Analysts estimate this should only impact 4% of patients.
Real impact is additional costs associate with incremental
therapists.
 Look-Back Period: Five services were used as a proxy for
acuity/complexity. Patients who met these requirements
qualified for upper-9 payment rates. Patients will only
qualify if they receive these services AFTER admission,
whereas before it was within the past 14 days. There will
also be some additional rehabilitation requirements.

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The start of a trend?

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Potential follow-on opportunities
If the transaction is successful, other companies could follow suit.

 SUNH’s transaction creates comparable for other long-term care providers who
wish to monetize their real estate portfolios. This offers a pool of similar
opportunities and the potential to “wait out” the SUNH transaction and pursue
similar, future ones.
 Potential candidates include:
 Skilled Healthcare (SKH, 74% owned real estate)
 Ensign Group (ENSG, 63% owned real estate)
 Brookdale Senior Living (BKD, vast majority owned real estate)
 Privately held ManorCare and Golden Living already have an OpCo/PropCo
structure and may look to explore IPOs and use them to support acquisitions or
alternatively, may conduct reverse mergers.

 Risk: new accounting rules calling for operating leases to be capitalized may
present an obstacle.

A potentially repeatable investment theme.

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Conclusion

 High quality business with recurring revenue streams,


secular tailwinds and a great management team
 Trading at a significant discount to fair value on a sum-
of-the parts basis
 Spin-off opportunity presents catalyst to realize value
 Shares do not currently reflect upside potential of OpCo/PropCo
structure and transaction should unlock value
 Potential pipeline of other similar, attractive opportunities

Upside potential: 27-43% + value of DTA

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Appendix

SUNH’s revenue breakdown by payer type:

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Appendix
SUNH’s per day patient rates by payer:

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