Description
Marniner Health Care Inc. (“MHCA”) is an Atlanta, GA based nursing home, assisted living and long-term acute care (“LTAC”) operator. The company filed for bankruptcy in 2000 following a period of unsustainable growth through acquisitions in the late 1990’s and a significant change in Medicare reimbursements that left the company unable to service its debt. MHCA emerged from bankruptcy in a slimmed down form in March 2002. I am recommending MHCA as a buy.
Investment Thesis:
MHCA’s most recent financial results understate its ability to generate cash flow, EBITDA and earnings, as its performance currently includes several nursing homes that have been or will be disposed of, do not include recent Medicare reimbursement increases and favorable tort reform changes. As a post-bankruptcy, pink sheet company undergoing a significant transformation and not followed by Wall Street, the value of MHCA does not reflect all relevant information.
Supporting Details:
1. The company is purposely maintaining a low profile and understating its potential given that its management surrendered all options on June 13th for new options that will be issued December 15th. Old options were priced at $20 per share, well above the $5 share price in June. In fact, while the company was taking calls from investors as late as September 5th (when I spoke to the Treasurer), it is now not returning calls from or speaking to investors. The top 4 managers held approximately 600,000 options prior to their surrender in June and will receive a substantial portion of their compensation in options. Note that MHCA announced the divestiture of the 20 facilities after its third quarter was completed so that improved results will not appear in their 3rd quarter SEC filing, only in the 4th quarter after options have been re-priced.
2. The facilities that the company divested in FL leave it with a much stronger core business. Margins have shown improvement following the divestiture and there is reason to believe that management is understating the true costs of these facilities. In its last Q the company disclosed that it was losing approximately $4k per bed vs. a comparable company, Kindred Healthcare, who reported operating losses of up to $26k per on its FL facilities. The losses are largely due to high malpractice insurance costs in that state. Note that management has significant discretion in allocating these costs and might be understating its losses simply to keep the share price down (of course, this raises the issue of honesty of management, but based their track record – see below – I feel this risk is somewhat mitigated). Note that facilities are sold to private firms that, using a different legal structure, are able to vastly reduce insurance costs and operate facilities profitably. Several of these types of firms are emerging.
3. Two significant Medicare reimbursement changes will boost results. In July the Centers for Medicare and Medicare (“CMS”) introduced 2 increases in payments for skilled nursing facilities totaling 6.26% effective October 1st. Given that Medicare accounts for 34% of the MHCA’s revenue this increase is significant and does not increase costs. CMS also is allowing firms that operate LTAC’s to switch to a prospective payment system (“PPS”) from a cost-based reimbursement system. This change benefits low cost operators of LTACs. The Treasurer of MHCA indicated to me that all of its LTAC facilities will be switching to PPS this year. Based on the experience of Select Medical Inc. which boosted LTAC revenue by approximately 15% when it switched to PPS with no commensurate increase in costs, I am assuming the benefit to MHCA will be comparable. Kindred Healthcare experienced an even greater benefit from the switch to LTAC PPS.
4. Texas passed legislation in September capping damages awards. MHCA has 30% of its beds in TX. One insurance company in the state indicated that it will immediate cut premiums by 12% to reflect the reduction of expected litigation awards. In MHCA’s latest 10Q it reported that 41.7% of its malpractice expense related to TX. This legislative change is likely to significantly reduce an operating cost that accounts for 2.5% of MHCA’s revenue.
5. Unlike many of its competitors who lease facilities, MHCA owns its facilities making unprofitable asset divestitures easier and keeping debt on the balance sheet, rather than reporting potentially misleading debt loads. In addition, proceeds from asset sales are being used to pay down debt, thereby also reducing interest costs. Projected interest coverage is 2-3x EBIT with debt at 3-4x EBITDA. Admittedly high, but manageable, and will get better as cash is used to pay down debt. MHCA’s debt-to-capital ratio at about 58% is still below one of its public competitors, Beverly, which trades at a premium to MHCA.
6. With $50M in cash, available credit of over $50M and a current ratio of 1.2 the company will be able to operate without disruption in the near term.
7. With $575M in available Net Operating Losses for tax carryforwards, the company will not pay cash taxes for the foreseeable future, further freeing cash for debt pay-down.
8. Directors and officers as a group hold 17.1% of the shares outstanding. 6 of the 7 directors are non-managers of the company and 5 directors represent various stage private equity firms that hold 48% of the company. The management team consists of several industry veterans. Most notably, the new CFO that joined in February of 2003 left his position as CFO of Watson Pharmaceuticals, a $4.7B mkt cap company to join MHCA. Other board members include the former Vice Chairman of Albertson’s (he is chair of MHCA), the former Vice Chairman of Health Management Associates (HMA), and the former CFO of the Wakenhut Corporation. I think this is a fairly impressive group of individuals for a post-bankruptcy small market cap company.
9. With only 20M fully diluted shares outstanding, the company has tremendous potential for earnings leverage as costs are taken out of its operations and favorable reimbursement changes kick in.
Share Appreciation Potential:
On a projected normalized earnings basis, the shares currently trade at about 10x earnings and 6x EV/EBITDA vs. an industry average of approximately 17x and 10x, respectively. Of the company’s comparables the one with the lowest trading multiples is Beverly. Applying similar multiples to “normalized” earnings of MHCA would suggest a value of over $30 per share on an EV/EBITA basis and $22 per share on a PE basis, using a 40% tax rate. Of course all taxes are non-cash so on a pre-tax PE basis the shares would be worth $35 per share. Other metrics include P-S at 0.15x (vs. a group avg of 0.56x) and P-B, at approximately 1.0x (vs. a group average of 3.0x).
Conclusion:
With the shares currently at approximately $14, the risk/reward clearly lies to the upside. Note that these valuations do not include any potential boost from additional property divestitures which are very likely, nor does it reflect ongoing operational improvements that management is undertaking now, following some the stabilization of the business and larger asset sales.
Catalyst
Potential catalysts include press releases announcing the divestiture of additional unprofitable facilities and the company's 4th quarter earnings release in February. On this earnings release the company will have incentive to realistically outline its prospects going forward given that its managements' options exercise prices will have been reset.