Description

Kindred Healthcare (formerly Vencor) operates 314 nursing homes and 56 long-term acute care hospitals. It also has an institutional pharmacy business and a rehab therapy business. The stock has declined precipitously on concerns regarding Medicare reimbursement for nursing homes. I believe that these concerns are unfounded and that the stock has 90%+ upside from current levels. (currently trading at 3.7x EBITDA)

Vencor filed for bankruptcy in September 1999 and emerged as Kindred on April 20, 2002. The stock started trading in the mid-$30s and rose to as high as $68 before declining to current levels. The company priced a secondary offering of 3.5mm shares (2mm primary; 1.5mm selling holders) at $46/share.

Shares outstanding:

primary 15.6mm
warrants ($30 strike) 2.0mm
warrants ($33 strike) 5.0mm
options ($32 strike) 0.6mm
secondary offering 2.0mm
total 25.3mm

Net debt:

cash and equivalents $154mm
free “restricted cash” $40mm
offering proceeds $90mm
warrants/options $244mm
debt $302mm
net cash $225mm

Enterprise value:

Price $37.93
Shares 25.3mm
Mkt cap $956mm
EV $731mm

KIND should do $200mm of EBITDA in 2002. At the current price, it is therefore trading at an EBITDA multiple of 3.7x!!!!! EPS should be about $3.70-3.80, so the current P/E multiple is about 10x. In the stock were to trade at a modest EBITDA multiple of 8x, it would be at $72/share!

Furthermore, there is significant upside potential from recent legislation passed in Florida limiting patient liability suits against nursing homes. KIND has been accruing $60mm/year for such liabilities, but it has only been paying out $10mm/year in damages. The new legislation may allow it to reduce accruals dramatically. Just as an illustration, if patient liability accruals were to decline from $60mm/year to $30mm/year (still well above actual payouts even before recent legislation), EPS would increase by 80-90 cents!

I’d point to three contributors to the recent decline in the stock:

1) concerns about Medicare reimbursement for nursing homes
2) November secondary offering increased supply of shares
3) Ventas distributed 350k shares of KIND to its shareholders on Jan 7

Factors #2 and #3 are self-explanatory and transitory in nature. The primary factor in the price decline is #1.

In 1997, Congress passed the Balanced Budget Act of 1997. This legislation ordered that Medicare reimbursement for nursing homes transition from a cost-plus system to a per diem system. It also set these per diems at a level which reduced total funds going to nursing homes. The result was that all publicly traded nursing home companies with the exception of HCR and BEV fell into bankruptcy. In order to correct the situation, Congress passed the BBRA in Oct 1999 and BIPA in Nov 2000. These two pieces of legislation reversed some of the cuts enacted in the original legislation. As reimbursement improved, the industry stabilized – HCR and BEV saw their stocks go up in 2000/1 and GHVE and KIND emerged from bankruptcy in 2001.

The current issue is the following: Some of the relief legislated in 1999 and 2000 was enacted for a limited amount of time, due to budgetary constraints – much like many elements of Bush’s recent tax cut are scheduled to automatically “expire” after a number years. For nursing homes, this expiration date is October 2002. In order for the recent relief to continue, Congress must pass legislation by the end of this year. Last week, an advisory organization called MedPac recommended that Congress not continue some of this relief. Immediately thereafter, nursing home stocks sold off precipitously.

To put things in perspective, the nursing home business accounts for 57% of KIND’s revenues and Medicare accounts for 31% of KIND’s nursing home business. So the revenues in question represent 18% of KIND’s total revenues.

I believe that Congress will pass the legislation necessary to maintain current reimbursement levels:
1) a very significant portion of the industry in still in bankruptcy
2) Congress never intended relief to be “temporary”
3) some of the major players involved in passing BBRA and BIPA seem to be on board
4) this is an election year
5) MedPac’s recommendation (which precipitated the recent sell-off) is not binding; in fact, MedPac also opposed the relief bills enacted in both 1999 and 2000, so it’s influence is questionable at best

In the worst case scenario, ie. MedPac’s recommendations are adopted, 2003 EPS would fall to $2.60. So the stock is trading at 14.5x worst case 2003 EPS, lending some comfort that downside is limited. Furthermore, a significant portion of this potential reduction in EPS could be offset by reduced patient liability accruals in Florida.

Catalyst

Return of investor rationality.
Movement on the legislation front, which should start to become apparent during the summer, at the latest.