Description

Extendicare – Ticker EXE:CN

Stock Price: 6.35

Short interest: 1.1mm shares (source Bloomberg)

Shares Outstanding: 87mm

Investment Type: Value without a catalyst

Risk / Reward: $5.50 / $10-14 (excluding 0.48 annual dividend)

Why do we have this opportunity to buy EXE, a discount bond?

Extendicare is a dislocated equity that has had its fulcrum event / catalyst of monetizing its US business, come…and now go. Unfortunately for common stock holders, the management team did a dis-service. The exited a business that has resolved various legal and business overhangs and sold the business for an unchallenging multiple of 8.5x. In addition, they sold the business in a tax disadvantaged way. Lastly, shareholders really have no recourse to block, object or attempt to stop the deal or seek appraisal as it is highly likely Formation Capital closes the deal in April 2015.

What are we left with now? At a high level we own a bond that pays a 7.5% yield, which is trading at 70 cents on the dollar, and has a forgiving balance sheet. In addition, EXE just announced a small tuck-in transaction for $80mm that should alleviate concerns regarding the dividend coverage.

Valuation:

Pro forma for the US exit, the stub Canadian business is trading at 9.5x EV / EBITDA, a 40-65% discount to peers depending on who choose to use. On a dividend yield basis (not my favorite metric), the new EXE trades at 25-30% discount. On a cap rate basis, EXE trades at 11%.

So how does a 70 cent bond with an entrenched management team trade to par? And if it can trade to “par,” is there an opportunity for a “make whole” payment? The answer is fairly straight forward. For starters, EXE has to improve sentiment. I believe this process began this morning with the announcement of a small tuck in transaction that is accretive FFO, and should allow investors to get comfortable that the dividend is secure for the foreseeable future. If management can re-invest some of the US disposal proceeds back into its Canadian operations and demonstrate future returns that alone should help the shares re-rate higher from the current unchallenging valuation levels.

The “Make Whole”: This business is small. It’s orphaned. The sell-side for the most part has given up on it, and doesn’t really have a strong relationship with management. We believe once EXE restores confidence in the dividend, that they can consistently meet quarterly numbers, and that the existing cash post the US disposal and close of the recent tuck in transaction will be used to for share repurchase, the shares will re-rate materially. In 9-18 months the business will be prepped for a competitive auction process. What’s the value of this make whole? It’s really difficult to say, but it could be 100-150% or higher from where the shares are currently trading.

Other ways to win:

Could an activist show up? Sure. Will they put pressure on the management team to re-lever the balance sheet more in line with peers? Sure. My suggestion to various activists who I have spoken with about this situation is don’t focus on the immediate gratification trade…Call the management team. Coach the management team. Help them introduce the right answers to the marketplace. These include: provide more metrics to the sell side; help us understand the reinvestment opportunity in the Canadian operations; run sensitivities on re-levering the balance sheet in order to shrink the float; articulate a concise plan at conferences. The financial engineering is easier to swallow for the management team, if an activist can really focus on the business.

Summary:

EXE is a bond trading at 70 cents on the dollar, paying 7.5% (monthly dividend) that can trade to par over time and there is a make whole in the event the company runs a competitive auction. The downside is undemanding, and there are various ways to make money.

Risks:

Biggest risk: have estimates stopped going down

Catalyst

Value without a catalyst

or

Activism

Sale of the company in 18 months