Thesis
KND is a
highly levered company with strong competitive positions in its markets and an
upcoming spin-off that will unlock considerable value for shareholders. The stock’s current valuation more than
compensates investors for the regulatory risk it faces while underestimating
the opportunity KND has to improve cash flow though improvements in its
operations. I estimate fair value for
the stock at $38-40 per share.
Description
KND
operates 4 businesses: long term acute
care hospitals (LTACH), skilled nursing facilities (SNF), contract rehab therapy
and institutional pharmacy. The business
is complex and has a long checkered history, so please refer to its filings for
a full business description. I will
outline the opportunity and identify the risks, but for the sake of brevity and
clarity, I will refrain from going into all the details.
Pharmacy
Spin-Off:
Before
the end of January, KND will be releasing SEC filing for its upcoming merger
and spin-off of its institutional pharmacy business. Here are the main points:
·
The
institutional pharmacy business distributes pre-packaged doses of drugs on a
patient-by-patient basis to healthcare facilities. Omnicare (OCR) is the market leader with +50%
market share and I would refer you to various comments from Larry Robbins of
Glenview Capital for the bull story of the industry.
·
KND
and AmerisourceBergen (ABC) will be merging their institutional pharmacy
businesses on a 50/50 basis. KND will
then spin-off shares in the merged entity on a tax-free basis.
·
Upon
completion of the merger but prior to the spin-off, the pharmacy business will
borrow $300 million in debt and pay a dividend to KND and ABC ($150 million to
each).
·
The
merged business is expected to have $1.9 billion in revenue and $130 million in
pro forma EBITDA (which included $30 million in synergies).
·
KND’s
pharmacy business has been growing at double digit organic growth rates and a
considerable opportunity for market share gains exists as customers have been
looking for an alternative OCR’s market dominance).
Assuming
the merged business trades at a 1-2 multiple point premium to OCR (given the
higher growth profile of the smaller company), then the pharmacy business could
account for nearly $16 of KND’s current $25 share price.
|
Pharmacy
Spin-off
|
|
|
Pro Forma
EBITDA
|
130
|
|
EV/EBITDA
|
12.0
|
|
Enterprise Value
|
1,560
|
|
Debt
|
300
|
|
Equity
Value
|
1,260
|
|
Equity
Value to KND shareholders
|
630
|
|
Equity
Value per share of KND
|
$
15.75
|
The
legacy KND business (valued at $370 million in equity value) will generate $4 billion
in revenue and operate the #1 LTACH, the #2 SNF and the #2 contract rehab
businesses in the country. The legacy
business will have over $150 million in cash and enormous operational leverage
to small improvements in the business.
The company will also have significant financial leverage with over $2.6
billion in capitalized leases.
LTACH Segment
- KND is the market leader in
the LTACH industry, operating about 25% of all the facilities in the US.
- Patients are referred to
LTACH’s from general acute care hospitals when they require longer stays
(25-35 days). The most common
conditions include respiratory failure and neuromuscular disorders.
- The industry is
concentrated, with KND’s main competitor Select Medical having about 22%
market share. About 75% of all
LTACH beds are operated by private, for-profit companies. Additionally, LTACH’s are concentrated
in the Mid-West and New England.
- About 70% of KND’s client
census is over the age of 65. KND’s
beds are highly concentrated in 4 states:
California (16%); Texas (15%); Florida
(10%); and Illinois
(10%). The payer mix is about 67%
Medicare, 6% Medicaid and 27% private insurance.
- About half of all LTACH’s
are located within general acute care hospitals (HIH) and half are free
standing facilities. About 80% of
KND’s facilities are free standing while 90% of Select’s are HIH.
- The LTACH industry is under
intense regulatory scrutiny due to its rapid growth, high pricing and
geographic concentration.
Key
Point: The LTACH industry is populated
with players that are gaming the system by accepting patients who would be
treated at lower cost in alternative settings.
However, the claim that KND and Select Medical are providing real
service to medically complex patients I supported by 2 key measures:
- KND and Select have acuity
indices of 1.1-1.2 (average is always normalized at 1.0) and account for
about 50% market share of the LTACH industry. Using basic algebra, this would imply
that the other half of the industry is treating patients of well below
average complexity, about 0.8-0.9.
- KND has steady been
increasing is customer mix towards private insurance, the most cost
conscious of all payors.
Conclusion: While the regulatory risk is high given the
financial leverage, moves to tighten regulations should benefit KND as lower
quality players exit the industry.
SNF Segment
- KND is the 2nd
largest nursing homer operator in the US behind Manor Care ($2.7bl
in revenue) and ahead of Genesis Healthcare ($1.5bl).
- KND operates 248 facilities
and about 31,000 beds. Occupancy
rates have improves slightly from 85.6% in 2003 to 86.9% in 2005.
- The payer mix is 67%
Medicare, 17% Medicaid and 18% private pay. Consequently, revenue metrics and
margins tend to run slightly below its competitors who have a higher
proportion of private pay.
- Six states account for 55%
of total capacity: Indiana (14%), Massachusetts
(11%), North Carolina (9%), Tennessee (8%), California
(7%) and Wisconsin
(6%).
- Revenues have grown in the
mid-single digits over the last 2 years despite a reduction in the number
of patient days and beds, driven by increasing reimbursement rates.
- KND’s strategy in this
segment is to continue to drive quality of care improvements, augment
service offering to include more Alzheimer’s and rehabilitation services
and increase the share of private insurance in the payer mix.
Key
Point: KND currently leases the vast
majority of its SNF’s from Ventas, a health care REIT. Starting in April of 2007, KND will go
through a multi-year process of deciding which bundles of facilities it will
choose to continue to lease. Currently
the SNF segment operates near breakeven due to the age of the facilities and
the high level of rent payments.
Conclusion: KND has significant optionally value
here. Given the low margins and low
share count, small improvements in SNF profitability will have a significant
impact of profitability. KND’s current
facility base is amongst the indsutry’s oldest and the tight terms of the leases
(both on an operational and a corporate basis) provides the upside if KND were
able to step away from unprofitable facilities and/or renegotiate a loosening
the of the lease terms.
Rehabilitation Segment
- In 2004 KND reorganized its
rehab business into a separate operating segment. About 76% of revenues are generated from
KND facilities.
- The Rehab segment is the
second largest publicly-held rehab company behind Rehabcare ($454ml in
revenue).
- As a result of the high
level of captive revenue, EBITDAR margins are not comparable with other
companies in the industry.
- KND’s strategy for this
business is to recruit therapists and build the business organically. KND’s nursing homes provide it a
low-cost platform to take-on patients moving from in-patient rehab
centers.
Key
Point: Rehab is no-capital requirement
business that allows KND to generate incremental revenue from the patient base
in its own SNF’s as well as 3rd party SNF’s.
Conclusion: Even at low margins, the rehab business
enhances KND’s return on capital. As the
acuity in its SNF’s increase the rehab business could add upside. KND is looking at adding similar business
models, in hospice for instance.
Valuation
Given
the regulatory risk facing the LATCH business, I assume that most of the uncertainty
in the valuation surrounds getting a handle on how cheap the LATCH business
actually is. So I will start with
estimating the value of the SNF and Rehab business, arrive at the implied
valuation of the LTACH business and compare that to its comps.
Based on
the $16 estimate in equity value per KND share of the pharmacy business, I
arrive at $370 million equity value and $2.9 billion enterprise value estimates
for the legacy KND business.
|
Legacy
KND Share Price
|
$
9.25
|
|
Shares
Outstanding
|
40.0
|
|
Market
Capitalization
|
$
370.00
|
|
Cash
|
163
|
|
Debt
|
174
|
|
Capitalized
Leases (@ 8x's rent)
|
2,608
|
|
Enterprise Value
|
2,989
|
|
|
|
|
SNF Enterprise Valuation
|
|
|
Beds
|
30,679
|
|
EV per Bed
|
$
45,000
|
|
SNF Enterprise Value
|
1,381
|
|
|
|
|
Rehab
Enterprsie Valuation
|
|
|
EBITDAR
|
35
|
|
Multiple
|
8.0
|
|
Rehab Enterprise Value
|
280
|
|
|
|
|
Implied
LTACH EV
|
1,328
|
On a per
bed basis, publicly traded SNF trade at about $60,000 per bed and have been
valued at $70,000-$90,000 per bed in private market transaction. According to industry executives, replacement
value is $120,000-$150,000 per bed. KND
recently sold some money losing beds at $41,000 per bed. Conservatively valuing KND’s SNF business at
$45,000 per bed results in an EV of about $1.4 billion.
The
Rehab business is valued at 8x’s EBITDA based on the trading multiples of its
comps and the low capital requirements of the business.
Netting
out these 2 businesses results in an implied valuation of KND’s LTACH business
of about $1.3 billion. The following
table compares this valuation with information on Select Medical (a Welsh
Carson LBO) and Lifecare Holdings (a Carlyle LBO).
|
|
KND
|
Select
|
Lifecare
|
|
|
LTACH
|
Medical
|
Holdings
|
|
Enterprise Value
|
1,328
|
|
|
|
Net Debt
& Cap'd Leases (@ market)
|
|
2,115
|
459
|
|
|
|
|
|
|
Q3-2006
EBITDAR x 4
|
240
|
272
|
33
|
|
|
|
|
|
|
EV/EBITDAR
|
5.5
|
|
|
|
Net Debt
& Cap'd Lease to EBITDAR
|
|
7.8
|
13.8
|
|
|
|
|
|
|
Beds
|
6,359
|
|
894
|
|
EV (@
market) per bed
|
$
208,838
|
|
$ 513,870
|
For the
comparison, I take the market prices for the bonds of Select Medical (about 85%
of face) and Lifecare (about 60% of face) and apply the relevant discounts to
the capitalized lease obligations of each company as well (i.e., the net debt
& capitalized lease obligation for Select Medical equals (debt+(8 x’s rent
expense)) x 0.85). THIS ASSUMES THERE IS NO EQUITY VALUE ASSOCIATED WITH EITHER COMPANY.
Even
under these conservative assumptions, KND’s LTACH business appears attractively
valued at less than ½ Lifecare’s business on a per bed basis and more than
EBITDA multiple points below Select Medical.
Valuing
KND’s LTACH business at Select’s EBITDA multiple results in a KND legacy
valuation of $23 per share. This equates
to $39 price for KND shares today ($16 per share for the pharmacy spin-off +
$23 per share for the legacy business).
|
Legacy
KND Valuation
|
|
|
LTACH
|
1,872
|
|
SNF
|
1,381
|
|
Rehab
|
280
|
|
Total Enterprise Value
|
3,533
|
|
Cash
|
163
|
|
Debt
|
174
|
|
Capitalized
Leases (@ 8x's rent)
|
2,608
|
|
Equity
Value
|
914
|
|
Equity
Value per share
|
$
22.84
|
Potential share repurchase.