Description

Sun Healthcare Group (SUNH) provides long term, sub acute and specialty healthcare services. Approximately 72% of its forecast ’04 revenues of $850M will come from its in-patient services division called Sun Bridge Healthcare, comprised of about 100 long term care facilities with 10,500 beds. The rest of the revenue comes from ancillary businesses in home health care, rehabilitation services, and medical staffing services.

Like much of the nursing home industry, this company went into bankruptcy as a result of changes to reimbursement rates in the late 90’s. Or, one might say, that was the pin that pricked the balloon of overbuilding and overinvestment. The company emerged in 2002 with too much debt, large unfunded self-insurance liabilities, and uneconomic leases in some facilities. It appeared headed for a second bankruptcy and liquidation. Instead, the new CEO, Richard Matros (formerly of Regency Health) played hardball on the leases, ceasing payment on about 60% of the nursing homes, and essentially restructured the company during 2003. The company renegotiated rents, divested facilities, and improved the balance sheet with $56m of new equity raised in Q1 ’04.

This restructuring has created a value opportunity which continues to be masked by complicated earnings reports, the uncertainties surrounding its self-insurance liabilities, and the failure, so far, to grow through acquisition or merger, management’s announced strategy. In its recent Q3 release, a little more clarity has emerged, but the stock has traded weakly since it fell sharply last May (after rising as high as $14.30) upon the issuance of Q1 earnings. Although it is getting late in the cycle of investment opportunity for this sector, and although SUNH, unlike ASLC and MHCA, is not real estate rich, valuations of other operators suggest it is plausible that the stock could double or better if the company can acquire or merge itself into larger scale, something like $1-1.25 billion in revenue. Using an EBITDA benchmark of 3-5% of revenue, not unreasonable for the industry, and using a mid-point calculation produces $45m in EBITDA sheltered by $1.1 billion in NOL carryforwards. Diluted share count today is 15.35 million. Adding in all outstanding warrants and options will bring the total closer to 18 million.

Significantly, the company was able to issue 4.4 million shares at $12.70 last February, when it was operating under a “going concern” qualification, subsequently lifted. In addition 2 million warrants were issued, exercisable between $12 & $16. This fund raising venture, however disappointing so far to institutional buyers who presumably did their due diligence, has greatly strengthened SUNH’s balance sheet and provides a kind of confirming marker of potential future share value. One of the company’s lessors, Omega Healthcare, also converted notes to 760,000 shares of common stock at an implied value of $ 9.60/sh. The company restructured outstanding mortgages of more than $20m, as well.

In its Q3 release and conference call, Sun Healthcare increased its 2004 guidance to $18-20M EBITDA and $58-62M EBITDAR. Revenue forecast remains at $840-850M because of the company’s sale of its clinical lab and radiology operations (for $3.3M cash and notes) which contributed an $11.5M net loss on a similar amount of revenue for the first 9 months. Medicare and Medicaid rates have increased on a better than 90% occupancy rate in SUNH’s nursing homes (the most recent Medicare increase was 2.8% in October), and this will improve NOI going forward. Unrestricted cash grew to $29M (nearly $2/sh). The company has just over $30M of availability on its credit line. Debt grew to $108M from $79M at 6/30, but this was more than accounted for by consolidation on the balance sheet of nine New Hampshire facilities with their associated mortgages.

Home healthcare, rehabilitation, and medical staffing businesses, which will account for well over $200M in revenue did not provide particularly strong revenue comp’s, but the CEO seems confident that management changes, acquisitions, and the BioPath sale will provide a stronger story going forward. Sundance, the rehab division, should recover from the disruptions of a failed acquisition agreement with Beverley Enterprises last winter.

Getting a handle on $184M (at 9/30) of accrued self insurance obligations is tough. The company recalculates these reserves twice a year, with the next actuarial exercise due at year-end. Significantly, those reserves are down from $197M at 12/31/03, and the CEO describes them as “trending positively.” They are undiscounted. Company filings refer to the gradual elimination of some of these liabilities as they age beyond the statute of limitations. Suffice it to say that with all the uncertainties involved, SUNH has little incentive to reduce these reserves prematurely, and one can hope they prove overly conservative. The current shareholders net worth deficit of $100M reflects this major balance sheet liability.

Overall, the company was close to breakeven on the 9 months of 2004, a substantial and accelerating improvement over the year ago numbers. The CEO agrees there is upside left on a same store basis but that the company needs acquisitions/merger for meaningful growth. He has left no doubt in recent conference calls that this is the plan and that SUNH is actively considering combinations. Would it be too cynical to suggest that senior management has an incentive to walk slowly, rather than run for the exit until the next tranche of their options price on 12/3/04? The earlier tranche priced shortly after the stock was cut nearly in half following the Q1 earnings release. The fact that options are being repriced from an original $27/sh. gives some sense of the false hopes surrounding emergence from bankruptcy in 2002. In addition, there have been numerous insider share purchases in the $5-8 range during periods of price weakness.

Catalyst

-Continuing EBITDA improvement
-Reduction in self-insurance reserves
-acquisition/merger to scale above $1 billion revenue