Description

We are short NHC, a business that faces multiple secular challenges with an imminent earnings cliff.  The company has no sell-side coverage and valuation is supported by what we believe is an unsustainable dividend, resulting in a shareholder base that is not really paying attention to the rapidly deteriorating fundamentals of the business and long-term challenges.

National HealthCare Corp (NHC - $840mm market cap, $660mm EV) operates skilled nursing facilities (as well as assisted living and independent living facilities) primarily in Tennessee, South Carolina, and Missouri (as well as other parts of the Southeastern US). 

To sum if up on one sentence.....the major insurers have spent billions of dollars (UNH/LHC for $5.4bn; Humana/Kindred for $8bn; CVS/Signify for $8bn) and are explicit about their desire to shift volumes towards home health at the expense of SNF):

"And we know effective home-based medical care, can reduce hospital admissions, ER visits and time spent in skilled nursing facilities by 15% to 25%." - United Healthcare

"For example, we believe that a substantial share of acute care services that today are provided in higher cost settings like skilled nursing facilities can be shifted to the home. We believe the skilled nursing facility at home opportunity in particular will be significant with a potential $700 million of Humana SNF spend that could feasibly be shifted to the home." - Humana 

"So when we think about specific population, exactly the populations you're talking about, people transitioning out of the hospital who are frail, keeping them out of the hospitals, keeping them out of skilled nursing facilities by using more virtual services and physical services in the home are a core population. " - CVS / Aetna

Key Point 1: Secularly Challenged Business

The vast majority (~80% of revenue) of the business is skilled nursing facilities.  Payer mix (by revenue) is ~35% Medicaid, 25% Medicare, 20% private pay, and 15% managed care.  Medicare pays ~2x as much as Medicaid, so the mix appears to be more Medicaid focused by volume (~50%).  When patients are discharged from a hospital but require further monitoring, they receive "post-acute care" at a skilled nursing home.  Patients receive ~60-90 minutes of therapy per day across a 3-4 week stay. 

Importantly, there is a significant shift away from skilled nursing facilities towards home healthcare.  Home health is materially cheaper with similar patient outcomes. 

While this shift has been gradual, we believe two recent phenomena are accelerating this headwind.  Hospitals are typically slow to shift habits in choosing where to send patients when they discharge them.  The pandemic drove elevated consideration for home health over SNF's as hospitals feared sending patients to crowded nursing homes.  We believe this essentially "opened the floodgates" for a shift that should have been happening on an economic basis already.  

Further, the growth of Medicare Advantage also further increases the financial incentives to drive patients to the most cost-effective care setting.  Medicare patients are also disproportionately profitable for SNF's, so that is a further challenge for the company.  I'd also highlight UNH's recent acquisition of LHC, Humana's acquisition of Kindred at Home, and CVS acquisition of Signify Health as significant validation of this secular shift. 

Data from MedPac also validates this thesis:

Key Point 2: End of pandemic stimulus will drive significant decline in earnings

While NHC's pandemic stimulus appears to be an immaterial drop in the bucket (~$50-60mm in each of FY'20 and FY'21) vs an ~$1bn revenue base,  these are 100% margin revenues vs a HSD-LDD margin core business.  Thus, as these high-margin stimulus revenues melt away, the true earnings pressure of challenged top line due to volume pressure combined with nursing labor pressure show a massive profitability hit. 

 However, the "stimulus revenue" disclosed in the company's income statement also understates the amount of stimulus received.  In addition to the plainly broken out line items from the Provider Relief Fund ("PRF"), there's another ~$20mm from supplemental Medicaid payments buried in "net patient revenue."  This stimulus begins unwinding in March of 2023. 

The inpatient service business typically made a fairly stagnant ~$60mm of annual operating income prior to COVID.  Compared to pre-COVID, revenues have fully normalized, but now is running at ~$10mm of operating profit.  Once you remove the remaining ~$30mm of stimulus revenue (both the clearly disclosed $11mm as well as the hidden $20mm from Medicaid), we believe the business is now structurally unprofitable.  Labor costs simply are not reversing enough to offset these headwinds - skilled nursing facilities are some of the least desirable places for nurses to work and that shortage is structural.  Even if you assume 2.4mm patient days in 2022 re-normalize towards 2.7mm in 2019 at healthy incremental margins and day rates (which we think us unlikely given the aforementioned challenges), the business is unlikely to generate significant FCF when considering the ~$25mm of annual capex necessary.  

End Game: What's it worth?

NHC takes pride in its long history of a steady growing dividend.  However, as the core business has become structurally challenged, management will likely either have to cut the dividend or lever up the balance sheet to maintain it as it burns through its cash position. 

We'd also note that Bloomberg overstates the amount of cash on the balance sheet (at $302mm) - ~half of that is restricted for workers comp and professional liability claims.  The usable cash balance of ~$150mm is now down to where management historically held it prior to the pandemic.  With a FCF-burning core business, we suspect they will reduce the dividend rather than burn the cash balance dramatically lower.  Further, given the challenges in the core business, we suspect it would be difficult to lever up in the current financing environment. 

We believe a sustainable dividend level is likely 50% lower than the current $33mm annual dividend, implying ~$1.30 per share.  With a declining dividend, a 5% dividend yield implies $35 (plus giving them credit for cash on b/s), for ~35% downside.  This would imply ~7x EBITDA, which feels reasonable for a secularly challenged, no-growth business that requires some capital re-investment. 

Risks

Further government stimulus - seems unlikely

"Re-opening" tailwinds as patients shift back towards SNF and away from home healthcare - seems unlikely

Cost relief on nursing front

Lever up balance sheet, burn cash, monetize assets to maintain dividends - this is the most likely scenario, but probably ultimately further increases the downside

M&A takeout

Catalyst

Catalysts

We are already seeing earnings decline as stimulus fades

Further earnings headwinds

Dividend cut