Description

Update to QCP Write-Up

After spending substantial time on this write-up, today is a Reuters report that a consortium of Welltower Inc (HCN) and Promedica Health Systems Inc. are putting together a bid for QCP at a level around the current share price.  Obviously, this price is substantially below our SOTP analysis. Despite this significant new development, I figured that I would post my write-up anyway. At the current time, we do not know if this offer is unsolicited or negotiated by QCP management. Mark Ordan, QCP’s CEO, previously sold Sunrise Senior Living to HCN, so he does have a relationship with the reported buyer.  However, Ordan has also sparked a bidding war for Mills Corp, another company where he was previously CEO.

Our analysis is meant to represent the value that we believe can be created over the medium term with a lot of heavy lifting and some risk.  An offer for the whole company right now would transfer that risk to the buyers and cap much of the future upside. However, the fact that there may be a current offer on the table should create a floor for the stock. Therefore, this stock should present a nice risk/reward in case the bid is rejected or another company makes a higher bid. Therefore, there is still some value in understanding our QCP SOTP analysis.

Quality Care Properties (QCP) Long Write-Up

Quality Care Properties (QCP) is a healthcare services provider with significant real estate holdings and market-leading positions in the skilled nursing, senior housing, home care and hospice industries.  We believe that QCP’s shares are trading well below net asset value because the stock is currently a complicated special situation investment with no Wall Street coverage. However, in the coming weeks, QCP will own the assets previously controlled by HCR Manorcare (“HCRMC”) pursuant to a pre-packaged Chapter 11 bankruptcy.  As part of this ownership transition, the Company will hold its inaugural Investor Day which should reintroduce QCP to the investment community and dramatically simplify the story. Investors will also be introduced to QCP’s CEO Mark Ordan, who has a strong track record of unlocking hidden asset value in past turnarounds of public companies and is highly aligned with shareholders through his equity-based compensation package.

While HCRMC has had a checkered corporate history of late, it still owns some of the best assets in its key markets.  To date, these assets have been housed in a company with an inappropriate capital structure and a demotivated management team.  This situation will be quickly rectified when QCP takes over ownership in the coming weeks and refinances the company, eliminating the costly lease payments that have handcuffed it for the last several years.  With these past issues resolved, we believe Ordan will articulate an exciting vision for the future that should further unlock the value inherent in QCP shares.

While we purchased the shares at a lower price, we continue to see significant upside in QCP shares over the coming year.  We believe that the following catalysts will unlock further value inherent in the shares: 1) HCRMC should emerge from bankruptcy in the coming weeks; 2) shortly thereafter QCP will hold an inaugural Investor Day to highlight the attractiveness of the Company’s hidden gem assets, such as its Heartland Home Health Care and Hospice business and its Arden Courts senior housing business; 3) QCP should realize significant value in the sale of its underperforming assets, building credibility in its plan and dramatically improving its capital structure; and 4) QCP should begin to show progress in the turnaround of its poorly-managed skilled nursing business highlighting the value potential therein.

Over time, we believe that QCP will be able to lease most of its assets to third parties allowing it to unlock the significant value of its real estate portfolio.  As these catalysts occur, the shares should trade toward our estimated net asset value of between $34.26 and $45.90 per share, representing upside of between 73% and 132% from current levels.  If this value is not sufficiently reflected in the share price, we believe that Mark Ordan will ultimately sell the Company as a whole, a strategy that he has effectively pursued in his other turnarounds.

HCRMC’s Troubled History Has Prevented It From Maximizing Shareholder Value

HCR Manorcare was founded in 1982 as the healthcare investment arm of Owens-Illinois (OI).  After a series of acquisitions transformed OI’s division into a major skilled nursing provider, a publicly traded company called Health Care and Retirement Corporation (HCR) was formed in 1991 to purchase these assets.  HCR continued to grow through acquisitions including the transformational Manorcare deal in 1998 until it was ultimately acquired for $6.3 billion by The Carlyle Group (CG) in a 2007 leveraged buyout. While the timing of this acquisition was less than ideal, as it occurred right before the 2008 financial crisis, CG ultimately achieved a return on its investment by selling its real estate to HCP Inc (HCP), a publicly traded healthcare REIT.  In December of 2010, HCP agreed to a $6.1 billion sale-leaseback where it would buy the real estate underlying HCRMC’s skilled nursing and senior housing properties and lease them back to HCRMC pursuant to a master lease with annual escalators.

Unfortunately for HCP, the reimbursement environment for skilled nursing facilities (“SNFs”) began to change in 2011.  As part of these changes, Medicare and private insurers began a push to reduce the average length of stay in SNFs to lower-cost settings more quickly.  Moreover, payers began to move away from traditional fee-for-services models, and instead began to tie reimbursements to patient outcomes. This change in reimbursements hit HCRMC particularly hard as it had an attractive “skilled-mix,” meaning that it received a higher than average percent of its revenues from Medicare and private insurance and a lower percentage from lower paying Medicaid patients.  HCRMC’s centralized business model, which relied on its national scale, made it less nimble and slower to adapt to these changes. This resulted in revenue decreasing while labor costs increased and rent expense continued to escalate per the terms of the HCP deal. Furthermore, HCRMC could not properly reposition its portfolio for the changed environment by selling poorly-positioned assets and reinvesting in new assets because HCP owned the underlying real estate and was unwilling to take losses on its investment.  In April 2015, the situation deteriorated further when the US DOJ sued HCRMC for pressuring its employees to “meet unrealistic financial goals,” causing them to administer “medically unreasonable and unnecessary services to Medicare and Tricare patients” and to keep Medicare “patients in its facilities even though they were medically ready to be discharged.” This case had a chilling impact on HCRMC’s employees, causing them to be overly cautious in their Medicare billing practices and added legal expenses that the company could ill afford.

While HCP (and later QCP) entered into agreements to lower HCRMC’s rent in exchange for asset sales and HCRMC contributing other assets to HCP’s security package, it soon became clear that the sale leaseback arrangement would no longer continue to work.  HCP was primarily an income-oriented REIT, owned by financial advisors and mutual funds for its safe and predictable yield, and its investors could not stomach the volatility that would be caused by a complex bankruptcy negotiation with HCRMC. Therefore, in November 2016, HCP spun its HCRMC assets into a REIT called Quality Care Properties, under the ticker QCP.  At the time of the spin, QCP had a book value of $33.97 per share, but the stock traded at an average price of $16.73 per share over the ensuing year.

When we began purchasing shares of QCP in September of 2017, it was clear to investors that HCRMC would declare bankruptcy or come to an out-of-court restructuring agreement with QCP.  Nevertheless, investors were discouraged by the slow pace of the negotiations and there was substantial uncertainty around what shape the restructuring would take. Meanwhile, the SNF business continued to perform poorly, reporting a disappointing quarter.  Thus, QCP appeared to be at risk of breaching its debt covenants. Even positive events, like the DOJ dropping its case against HCRMC, did not help increase the stock price and QCP’s shares remained generally weak. In fact, on February 28th of this year, just two days before HCRMC’s bankruptcy was announced, QCP’s shares closed at an all-time low of $12.39 per share.  However, as we gained confidence in our estimate of net asset value and the track record of CEO Mark Ordan, we added to our position opportunistically.  Finally, on March 2nd, HCRMC announced that it would file a pre-packaged Chapter 11 bankruptcy and transfer all assets to QCP, and the stock appreciated 31.2%.  As more information on HCRMC’s assets has emerged, the shares have continued to trade strongly. However, we continue to see upside of 73% to 132% from current levels as the shares approach our net asset value target.

CEO Mark Ordan Has a Strong Track Record of Turnarounds

Given that HCP knew that QCP would be facing a difficult situation when it was spun-off, it appointed a seasoned turnaround specialist, Mark Ordan, as its CEO.  Mr. Ordan has enjoyed a storied career of turnarounds and sales of businesses, many of which faced even more difficult situations than QCP. His first successful venture was founding Fresh Fields Markets, an early player in the natural foods space.  In 1996, five years after its founding, he sold the business to Whole Foods Market (WFM) for $135 million in stock. After the Fresh Fields Markets sale, Mr. Ordan served on several boards of directors and was CEO of the grocery chain Balducci’s. Then, in 2006, he established his credentials as a turnaround specialist when he was appointed as CEO of Mills, a discount shopping and entertainment center real estate company.  Mills was reeling from a difficult accounting restatement and leverage issues. Nevertheless, within a year, Ordan stabilized the business and sold it to Simon Property Group (SPG) and Farallon Capital Management after a heated bidding war with Brookfield Asset Management (BAM).

After the Mills sale, Ordan would face an even more difficult challenge at Sunrise Senior Living (“Sunrise”).  Sunrise was a REIT that owned senior housing properties and had also faced a disruptive accounting investigation.  Mr. Ordan assumed the CEO role in July 2008, after the founder resigned. Soon after, the 2008 financial crisis hit, and Sunrise was on the brink of bankruptcy.  However, Ordan was able to work with Sunrise’s lenders to establish a plan of asset sales that would give the company breathing room for a turnaround. Ordan’s plan was ultimately successful and he was able to sell Sunrise to what is now Welltower (WELL) for $14.50 per share, an attractive price considering the stock troughed at a low of $0.27 shortly after he took over.  Most recently, SPG appointed Mr. Ordan as CEO of its spin-off of Washington Prime Group (WPG), which would own SPG’s strip centers and smaller malls. However, shortly after the spin-off, Mr. Ordan arranged a merger with Glimcher Realty Trust (GRT) and relinquished his CEO role to Michael Glimcher.

From these roles, Mr. Ordan gained valuable experience and contacts in the senior care space that should help in the turnaround of QCP.  Indeed, Mr. Ordan has already recruited a strong team to manage HCRMC after the conclusion of its bankruptcy. Guy Sansone, the Chairman of Alvarez & Marsal’s Healthcare Industry group will serve as HCRMC’s CEO, and Laura Linynsky, Sunrise’s former COO, will serve as its CFO.

We believe that Mark Ordan’s history of successful turnarounds and sales of businesses, coupled with his experience in the senior housing industry, should position him well to oversee the transformation of QCP.  Furthermore, we are encouraged that Mr. Ordan has accepted compensation that is heavily weighted toward options. As part of his compensation package, Mr. Ordan has received approximately 2.2 million options with a strike price of $15.73 per share and 311,446 shares of restricted stock.  Some of these options do not vest until the share price exceeds $31.46. On a fully vested basis, Mr. Ordan’s options and restricted stock increase in value by $2.5 million per every $1.00 increase in the share price. This compares to a base salary of $800,000 and a maximum annual salary and performance bonus of $2.8 million.  Moreover, within five years of initial employment Mr. Ordan will be required to own stock worth 6x his annual base salary. We believe that this compensation package insures that Mark Ordan will be significantly more incentivized to take shareholder friendly actions to improve the stock price rather than merely collect on his salary.

Investor Day to Highlight the Value of QCP’s Hidden Gem Assets

While investors have primarily focused on QCP’s SNF business and the challenges that it has been facing, we believe that they have overlooked the significant upside inherent in the Company’s two hidden gems.  In the coming months, when HCRMC emerges from bankruptcy and QCP takes control of its assets, QCP will hold an Investor Day to reintroduce the Company to the public markets and to outline its strategy going forward.  We believe that this Investor Day should serve as a catalyst for the shares as investors gain familiarity with some of QCP’s smaller but more valuable assets: Heartland Home Health Care and Hospice business (“4H business”) and Arden Courts.  The 4H business is a market leader in the hospice industry, one of the most-attractive markets in the healthcare services industry that is benefitting from the changes in reimbursements that have hurt SNFs. Arden Courts is a leading chain of memory and dementia care assisted living facilities.  Both of these businesses have the potential for superior growth and higher valuation multiples than the core SNF business.

4H Business Should Drive Strong Growth and Significant Valuation Upside

HCRMC’s Heartland Home Health Care and Hospice business is a best-in-class market leader in an exciting and high growth industry.  Since this business was never owned by HCP or QCP prior to HCRMC’s bankruptcy, investors may be underestimating its strength and the value it can provide.  We believe that QCP’s inaugural Investor Day will shine a bright light on this asset. Furthermore, in a healthcare services environment that is starved for growth, this business is an attractive target for strategic acquirers who have been willing to pay high multiples for similar assets.

Home health care and hospice businesses have been a prime beneficiary of several powerful secular trends that should provide strong growth tailwinds for the foreseeable future.  As the American population continues to age, Medicare enrollment is projected to grow rapidly over the next 25 years, with participants projected to increase from 47 million in 2010 to 81 million in 2030.  This growing population of seniors is expected to provide strong demographic tailwinds for home health and hospice providers. Moreover, older adults have grown increasingly comfortable with the standards of care provided by home health and hospice providers.  The share of Medicare fee-for-service beneficiaries who have used home health services has grown from 7% in 2002 to 9% in 2015. Similarly, the share of Medicare participants who passed away in a hospice facility has grown from 23% in 2000 to 49% in 2015. Thus, increased Medicare enrollments and growing acceptance have driven strong growth rates for home care and hospice providers.  From 2002 to 2015, home health episodes have grown by 61%, from 4.1 million to 6.6 million. Meanwhile, hospice growth rates from 2000 to 2015 have been even more impressive with beneficiaries growing by 180%, from 0.5 million to 1.4 million, and Medicare payments to hospice providers growing by 448%, from $2.9 billion to $15.9 billion. Given these dynamics, home health and hospice providers are seen as a solution to rising healthcare costs as they can deliver high quality care at a much lower cost than hospitals and SNFs.  Consequently, these businesses are among the most prized assets in the healthcare services industry.

While secular trends favor all players in the home health and hospice business, we believe that Heartland Home Health Care and Hospice is well-positioned to grow at an above-market rate.  Many of HCRMC’s businesses have underperformed their peers as they faced the dual distractions of a DOJ investigation and financial distress, but the 4H business has continued to thrive. Since this business was not encumbered by the QCP master lease, the Carlyle Group had hoped that it could maintain ownership of this valuable asset even if it lost control of the other businesses.  Consequently, HCRMC funneled any capital it could into this business investing $380 million over the past five years. Moreover, Mike Reed, one of HCRMC’s strongest and most seasoned leaders, has overseen the 4H business as a VP/General Manager since 2008. Finally, based on our industry channel checks, we believe that this business is significantly more weighted to hospice than homecare, and thus deserves a materially higher valuation than investors currently perceive.

HCRMC’s investments in Heartland Home Health and Hospice have paid off as the business has generated strong results over the last several years.  In 2016, despite a negative change in Medicare reimbursements, the 4H business grew revenue by 2.9% and EBITDA by 7.1%. Without this headwind in 2017, revenue growth accelerated to 7.7% and EBITDA to 14.0%.  This growth compares favorably to public peer Chemed (CHE), which grew revenue by 0.7% and 2.2%, and EBITDA by -4.8% and 8.2% in 2016 and 2017, respectively. More importantly, the outlook for the 4H business appears to be very strong.  In HCRMC’s bankruptcy filing, management provided projections for the 4H business which included revenues and income from the outpatient rehabilitation business and other related businesses that are expected to be included in the group going forward.  For 2019 and 2020, these projections call for revenue and EBITDA growth CAGRs of 4.7% and 10.5%, respectively. Typically, projections in bankruptcy documents err on the side of conservatism, so we expect growth to exceed these projections. Nevertheless, these projections indicate growth that should exceed that of CHE’s Vitas segment.

Due to the strong trends in the home health care and hospice business, merger and acquisition activity has been active and multiples have been high.  In fact, in December 2017, Kindred Healthcare (KND) announced a sale of the company, and its hospice and homecare business was carved out of the sale to reflect the higher multiple inherent in that business.  Also, two of the largest providers, Almost Family and LHC Group (LHCG), just completed a merger in early April 2018. According to S&P Capital IQ data, hospice and home health care businesses have sold for an average EV/EBITDA multiple of 16.2x in 2017 and 14.5x in 2016, a 2.8x premium to healthcare services industry-wide average multiples.  Similarly, public comparable companies have enjoyed attractive valuations. We have used a peer group of Amedisys (AMED), Addus HomeCare (ADUS), CHE and LHCG, which trade at an average multiple of 14.1x this year’s EBITDA. To value the 4H business, we have used a peer multiple on 2018 projected EBITDA and looked at it as a standalone business and a takeout candidate with G&A synergies.  Based on these metrics, we arrive at a value of $1,608 million to $1,907 million, or $17.93 to $20.37 per QCP share.

Arden Courts’ Operations Inflecting

HCRMC’s Arden Courts memory and dementia care business has established a strong market position in an attractive industry that is on the verge of a significant inflection point in supply/demand balance.  However, this business is not currently well understood by the investment community because it has previously been buried in the long-term care segment with the much larger SNF business. In fact, the 2017 QCP 10-K is the first public filing which has broken out the EBITDA contribution of the senior housing business in this segment.  The broader senior housing industry is generally broken down into three major categories: independent living, assisted living and memory care. Since the independent living and assisted living are much larger than the memory care segment, public companies devote most of their commentary to these areas. However, 51 of the 58 core HCRMC senior housing units are in the memory care business.

The memory care segment differs significantly from other segments as the care requirements are greater and the average monthly rent for these residents is around $6,400 versus $4,800 for assisted living, and $3,200 for independent living.  Finally, our industry contacts indicate that this business has never been a significant focus for HCRMC. With Mark Ordan’s experience in operating and selling senior housing businesses during his tenure at Sunrise Senior Living, we believe that this business has the potential to add substantial value to QCP through either a turnaround or sale.

After several years of overbuilding, the memory care segment of the senior housing industry appears poised for a strong rebound.  Until recently, the strong demographic trends in the senior housing space and weak demand in other real estate sectors, led developers who had traditionally focused on other real estate assets to enter the space.  This resulted in overbuilding of senior housing which was concentrated in the assisted living and memory care segments. Consequently, occupancy in the overall memory care space has decreased from a high of around 89% in 2012 to a low of 84% in late 2017 according to the CBRE Seniors Housing Outlook report.  However, as occupancy has dropped, financing has dried up for these developers. Units under construction peaked in early 2016 and have been falling ever since which should result in less new supply in 2018 and beyond. In Q3 2017, memory care saw a strong sequential increase in occupancy which industry participants expect to continue.  According to a 2018 survey of industry executives from Senior Housing News, 67% of respondents expect memory care occupancy to increase over the next 12 months versus only 12% who see a decrease, reflecting a much more bullish outlook for this segment than independent or assisted living.

While the memory care industry should broadly benefit from improved supply/demand dynamics, Arden Courts has a much greater opportunity under the stewardship of Mark Ordan and his team from Sunrise Senior Living.  Currently, the senior housing units that will be retained by QCP have an occupancy rate of 80%, which is much lower than the memory care industry average of 85%. Moreover, occupancy levels at this segment dropped by 400 basis points over the last year, while the industry occupancy has remained broadly stable.  Based on our channel checks, we believe that this weak occupancy is the result of poor focus on the business and distractions caused by the financial distress at HCRMC. Indeed, the skilled nursing facilities at HCRMC should be able to refer memory care patients who leave skilled nursing to Arden Courts homes, resulting in better than average occupancy.  Since memory care facilities have a high level of fixed costs due to the stringent care requirements, the incremental revenue associated with increased occupancy should flow through at a high incremental margin.

Even with the low occupancy levels, we believe that this business is running at EBITDA margins of 34-35% before general and administrative expense allocations.  However, industry sources indicate that margins have been as high as 40% in the past. If Arden Courts can increase occupancy to industry average levels and achieve normal industry rate increases, we believe that this could drive segment EBITDA growth of as much as 24% at this division.  This could increase further if the overall industry occupancy trends improve toward historical levels.

While the senior housing space has experienced tepid trends of late, real estate private equity interest in the space is strong.  There have been several large private equity funds raised recently with a mandate specifically focused on senior housing. KKR and Kayne Anderson Real Estate Advisors have both recently closed senior housing funds with capital under management approaching $2 billion in assets, and other smaller funds have also been launched.  These funds are primarily focused on the real estate value of senior housing assets, as many senior housing operators sell the real estate underlying their properties and enter into a long-term lease or management agreement with an unrelated operator. Since QCP owns all of the real estate underlying its senior housing properties, it should present an attractive target for these investors either now or once the operations improve.

Based on CBRE’s Winter 2018 Seniors Housing & Care Investor Survey, core Class A memory care real estate assets have sold at an attractive 6.7% capitalization rate.  In order to derive our valuation of Arden Courts, we have assumed that QCP leases its Arden Courts assets at an EBITDA-to-rent coverage ratio of 1.2x, which is the current industry standard.  Then we have assumed that QCP can sell the assets at the average capitalization rate suggested by CBRE. For our upside case, we have looked at the value of the business if it can improve its operations under Mark Ordan’s leadership.

In all, we value the Arden Courts business at $896 to $1,136 million, or $9.57 to $12.14 per share.  We believe that this value is sufficiently conservative given the Arden Courts business will likely be sold in a sale leaseback transaction since it is a cohesive business and not a collection of assets.  In this scenario, QCP would likely retain the operating income of the business after lease payments. At the 10.0x EV/EBITDA multiple at which distressed peer Brookdale Senior Living (BKD) trades, this could add an additional $120 to $152 million, or $1.28 to $1.62 per share, of value. However, in order to remain conservative, we have not ascribed any value to this part of the business.

SNF Turnaround Opportunity Should Drive Strong Upside

While the 4H and senior housing business offer the opportunity for long-term growth, the SNF business turnaround will be driven by restructuring the operations and managing the portfolio through opportunistic asset sales or lease transactions.  Over time, strong demographic trends should benefit the skilled nursing space, but the current reimbursement environment could limit the upside opportunity. Medicare and health insurance providers continue to work to push patients from high-cost settings like skilled nursing to lower cost settings like home care, hospice and outpatient rehabilitation.  That said, the reimbursement environment does appear to have stabilized and there has been little to no new supply of SNFs. Therefore, we believe that strong operators that can adapt to the current environment will continue to generate solid performance.

Non-Core Asset Sales Opportunity

One of the most significant changes for the SNF business under QCP ownership is that Mark Ordan and his team will take an active approach to portfolio management in the troubled SNF business.  Under the QCP master lease, HCRMC’s management had limited flexibility for sales of underperforming assets. On the contrary, QCP will be aggressive in disposing of these assets, which have significant value and have previously served as a distraction.

QCP has already evaluated the SNF portfolio and designated a large piece of the portfolio as non-core.  Non-core assets represent 71 of the 231 skilled nursing facilities and 3 of its 61 senior housing units.  QCP will begin marketing these assets for sale immediately and should execute on transactions in the near future.  These assets in aggregate generated -$3 million of EBITDA but should still retain significant asset value based on their real estate and permits.  

Despite the industry struggles, the transaction market for SNFs and senior housing units has remained liquid.  Moreover, from late 2015 until early 2017, HCRMC sold 50 underperforming facilities with larger EBITDA losses than the current portfolio.  Therefore, to derive our estimate for the proceeds from the non-core facilities, we have used the historical sale price per bed values that HCRMC received for non-core assets, and then compared them to industry data provided by National Investment Center - Senior Housing and Care (“NIC”).  To be conservative, we have assumed that these assets will sell for values that are substantially below industry averages. Finally, QCP will own a medical office building and a small surgical hospital that generated $6 million in EBITDA in 2017. Since these assets are unrelated to the rest of the portfolio, we believe that QCP will look to monetize them.  Currently, medical office and surgical hospital REITs like Healthcare Trust of America (HTA) and Physicians Realty Trust (DOC) trade at implied capitalization rates of approximately 6.0%, but higher quality medical office assets are reportedly trading at 4.5-5.0% capitalization rates. We have valued these assets at a conservative 10.0% capitalization rate, which is a substantial discount to peer valuations.

Based our analysis, we believe that QCP could realize sale proceeds of between $635 million and $762 million, or $6.78 to $8.14 per share for non-core SNF, senior housing, medical office and surgical hospital assets that were marginally profitable in aggregate.  Strong execution on the sale of non-core assets should build investor confidence in QCP’s ability to derive value from the SNF business and the assets as a whole. Finally, these proceeds will allow QCP to pay off between 32% and 39% of our estimate of post-bankruptcy net debt, substantially shoring up the capital structure.  

SNF Business Performance Opportunity

Prior to its bankruptcy, we believe that HCRMC had been pursuing a flawed strategy for its SNF assets and that new management should be able to at least stabilize the business and potentially grow it over time.  Based on Mark Ordan’s comments in his few public communications since he assumed the CEO role of QCP, it is clear that he believes that a decentralized regional model works best in this industry and that HCRMC has proven that national scale does not add value.  Regionally managed SNFs can do a much better job of maintaining strong relationships with local hospitals and health insurance payers. This allows regional operators to gain new patient referrals and better understand the services and therapies that can improve outcomes for residents at attractive reimbursement rates for providers.  Therefore, in the current environment of high patient turnover and outcome-based reimbursements, local market knowledge appears essential for SNFs to succeed.

This model has worked well for Ensign Group (ENSG), which has continued to produce strong results as many of its skilled nursing peers have faltered.  Moreover, one strong benefit of the regional strategy is that QCP can lease its valuable real estate assets to other operators, like ENSG, who have already achieved success in their local markets.  If QCP can carve up its portfolio into regions and execute leases with strong coverage ratios to best-in-class operators, the Company’s net asset value will benefit substantially.

We believe that HCRMC’s facilities should be attractive to potential lessors as the performance has not been as bad on the surface.  In Q3 2011, HCRMC’s SNF portfolio that was leased to QCP did $652 million in last-twelve-months EBITDAR and boasted occupancy of 88.4%.  In 2012, with the change in Medicare reimbursements, EBITDAR fell to $452 million and then rebounded to $508 million in 2013. After this, EBITDAR declined steadily at a CAGR of 11% per year for the next three years until 2017 when it abruptly declined 23%.  This precipitous decline has spooked investors because it is hard to underwrite the value of an asset with its profitability in free fall. .

Despite these weak headline results, we see some positive trends under the surface that lead us to believe that the 2017 results were unusually depressed and a turnaround is possible.  First, occupancy declines have moderated recently. After losing an average of 1.1% of occupancy per year from 2011 until 2016, skilled nursing occupancy only declined 0.4% from 82.6% to 82.2% in 2017.  Second, in the core HCRMC SNF portfolio, overall occupancy is well above the industry average at 84.4% versus a national average of 82.2%, according to NIC data. Third, QCP’s mix of revenue from Medicaid is much lower than the average SNF facility according to NIC and even compares favorably to best-in-class companies like ENSG.  This is positive because Medicaid patients typically pay the lowest rate. As of its last report on this metric, HCRMC received 38% of revenue from Medicaid, compared to an industry average of 49%, and 42% for ENSG. Finally, HCRMC’s reported EBITDA is likely understated relative to its potential under QCP’s management and public company reporting standards.  One clear example of this understatement is that ENSG excludes legal costs from its reported results and HCRMC does not. If these costs were included, it would have resulted in a 7% reduction in ENSG’s EBITDA.

Finally, our channel checks indicate that the dual distractions of the DOJ investigation and the financial insolvency created a very risk-averse environment at HCRMC.  HCRMC employees and managers were worried that they could face legal liability for performing therapies that the DOJ could deem medically unnecessary. Moreover, HCRMC was a centralized organization and managers at the head office were distracted by the financial issues of the company and disaffected because their HCRMC equity would soon be worthless.  Additionally, HCRMC became a target for lawsuits due to the DOJ investigation, causing costly ongoing legal expenses that were completely unrelated to the investigation. Now, with the DOJ investigation dismissed and QCP’s management team firmly in control, we believe there is an opportunity for the SNF business to stabilize and potentially even rebound.

While the public equity markets have generally soured on the skilled nursing space, there is substantial capital pursuing acquisitions in the private markets.  In the public markets, most SNF and senior housing assets are held in REITs that have a risk-averse, yield-oriented investor base. As the industry has faced tough times, many of these REITs have been left with distressed operating partners.  Rather than pursue a workout scenario to maximize value, many of these REITs have preferred to dispose of their troubled SNF assets,

creating an active transaction market for SNF portfolios.  Cantor Fitzgerald recently published a piece on the SNF merger and acquisition transactions of the 14 largest publicly traded healthcare REITs.  From Q1 2015 to Q3 2017, they found 510 transactions that occurred worth approximately $6.8 billion. These transactions traded in a range of 7.6% to 9.5% capitalization rates with an average of 8.4%.  On a price per bed basis, the larger portfolios averaged $124,000 per bed. Since many REIT and private equity investors in the space have very large existing portfolios, they favor larger portfolio acquisitions, as small transactions do little to move the needle.  Therefore, if QCP is able to create large regional portfolios of assets that are leased to strong operators and have appropriate coverage ratios, these assets should have significant value in the current environment.

Despite our cautious optimism on the SNF business, we have taken a conservative approach to valuing this business.  We have assumed no improvement in EBITDA from current levels and looked at a scenario where QCP leases its real estate to other operators at a 1.4x EBITDAR-to-rent coverage ratio that has historically been viewed as the industry standard.  We have also included QCP’s other SNF leases as part of this portfolio. We have then valued the assets at the 7.6% to 9.5% capitalization rate range derived from the Cantor Fitzgerald analysis. This yields a value for the entire SNF business of $2.0 to $2.5 billion, or $21.06 to $26.33 per share.  We believe this valuation is sufficiently conservative because the mid-point implies a value per bed of $89,521, which is below the $92,075 average value of the last four quarters according to NIC, and 18% below the value that Cantor Fitzgerald derived from its analysis of public company transactions.

Valuation and Conclusion

In summary, we believe that QCP represents a compelling opportunity to invest in a portfolio of valuable, but under-managed, real estate assets at a sharp discount to their net asset value, managed by a CEO who has a strong track record of extracting maximum value from very similar restructurings in the past.  While QCP is currently poorly understood by the investment community, we believe that HCRMC’s emergence from bankruptcy in the coming weeks and QCP’s subsequent Investor Day will shine a bright light on the Company’s valuable hidden assets like its 4H and Arden Courts businesses, as well as strategies to turnaround and maximize the value of its struggling SNF business.  Subsequently, the proceeds from the sale of non-core assets, which contribute minimally to the Company’s EBITDA, should be used to pay down debt and to provide an opportunity to refinance QCP’s restrictive credit facility. With improved flexibility, we believe Mark Ordan and his strong management team will be able to pursue aggressive measures to turnaround and rationalize underperforming businesses that could not be properly executed by HCRMC under its prior management or operating structure.

As QCP executes on its plan, we believe the shares will approach our estimated net asset value of $34.26 to $45.90, providing upside of between 73% and 131% to current shareholders.  Moreover, we believe that we have used conservative assumptions in valuing QCP. Given the tremendous headwinds that HCRMC has faced over the past several years, we may be understating the potential turnaround opportunity in its businesses.  Moreover, with a significant amount of capital chasing portfolios of healthcare real estate assets that will benefit from the country’s aging demographics, the multiples and capitalization rates we are using for asset values may ultimately prove conservative.  Nevertheless, we believe that Mark Ordan and QCP’s strong and highly incentivized management team will work tirelessly to extract the best value in as short a time as possible.

Catalyst

HCR Manor Care emerges from bankruptcy in coming weeks

QCP holds investor day in coming months

Investors become more familiar with "hidden gem" assets

Non-core asset sales pay down debt and highlight real estate value

Turnaround of skilled nursing business

Sale of businesses or the whole company