Description

Description: 

I believe The Pennant Group Inc. “Pennant” (Nasdaq: PNTG) a provider of home care and senior living facilities is a short after shares have more than doubled (+111%) in the past 5 weeks on no news. 

I believe the opportunity to short PNTG comes from a lack of understanding in investment community what Pennant really is due to: 

1. A lack of sell side coverage with only one analyst Frank Morgan of RBC covering PNTG with a “Sector Perform” Hold rating and $20 price target (42% downside from current price). 

2. Indiscriminate generalists have rushed to buy PNTG shares due to fact that it is a spin- off. Yes, I know this is the opposite of the dynamics described by our own JG in his seminal book You Can be a Stock Market Genius, but I do believe this is a real phenomenon in today’s market. 

As a result, Pennant is trading at a significant premium to home health and hospice peers on all metrics. 

I believe investors are ascribing Pennant’s home health and hospice business which is currently doing $19m per year in EBITDA a 49x EBITDA multiple which is roughly 25 turns higher EV/EBITDA than unlevered, higher margin and similar growth rate peers like Amedisys trading at 24x and LHCG trading at 21x). However, even more concerning than the extreme valuation gap I believe investors are overlooking significant negative factors about the Pennant story:  

1. Significantly inferior business mix versus home health peers AMED, LHCG, CHE with 40% of PNTG revenue coming from inherently asset heavy, oversupplied Senior Living segment where peers who own significant real estate like Brookdale (of which PNTG owns none) trade in the 10x EBITDA range and have suffered years of stock underperformance due to industry supply growth driven by the relentless search for yield in a 0-1% interest rate world 

2. Significant capital lease balance sheet leverage (PNTG is levered ~4.9x Debt+ Capital Leases/EBITDAR) versus covenant of ~5x that will limit the pace of acquisitions and growth and make it difficult for PNTG to grow into their way above peer valuation any time soon without significant equity share issuances. 

Background: 

Pennant is a provider of home health & hospice (60% of Revenue) and senior living facilities (40% of Revenue) recently spun off from Ensign Group (ENSG). Ensign has admittedly has a strong history of shareholder value creation through acquisitions of underperforming nursing facilities; however, I believe given Pennant’s current valuation it will be very difficult for PNTG to deliver above market equity returns at least in the intermediate term. To illustrate the gap between Ensign in its infancy versus Pennant today:  In January 2008 (before crash) ENSG had a $300m EV in relationship to $54m in EBITDA (5.5x); today PNTG has a $1B TEV in relationship to $25m in EBITDA (40x). 

Pennant is a combination of two distinct business units from within Ensign. Senior Living had been the orphan segment within Pennant gradually accumulated since the Ensign’s founding in 1999 and cordoned off as a separate business unit in 2010. The homecare segment was the brainchild of current Pennant CEO Danny Walker who was working as a lawyer within Ensign when he got the greenlight to incubate a potential new segment focused on home health and hospice. Despite Danny not running the senior living business within Ensign, it was lumped together with his homecare venture in order to create a company that on a consolidated basis was large enough to be public. 

Bottom line is Pennant’s two segments have significantly different business characteristics, asset requirements/leverage levels, operating environments and peer multiples. Given there is little synergy between the two businesses I think they should be valued separately using a sum of the parts (also the methodology that PNTG’s only analyst Frank Morgan of RBC uses). 

Recent Results: 

Hard to say the recent stock performance is due to exceptionally strong financial results. In Q3’19 Pennant’s only quarter as a public company consolidated Adjusted EBITDA (excludes 3.4m in 1x separation costs) was $6.495m versus $7.180m in prior year Q3’18. 

The company attributes this wage inflation in nursing as well as impact of recent lower margin acquisitions. 

Senior Living Segment: 

While the sky isn’t falling in this segment it suffers from several years of supply growth ahead of demand. This is likely due to operators who set up senior living facilities with the idea to monetize the real estate at very low cap rates given search for yield. 

CEO Danny Walker isn’t holding his breath for an improving market dynamic in senior living:  

So I'm probably not the best -- I'm not as -- we generally aren't as concerned about whether we're meeting an inflection point or how closely that's going to be. We're not holding our breath. -Q3’19 CC

Other operators in the space have had issues as well. Capital Senior Living (CSU) is a distressed equity after several years of revenue declines driven by industry wide overcapacity. Brookdale Senior Living has struggled with its share price down over 80% in the last 5 years. 

If Pennant executes as well as people seem to think they can then sure Senior Living can be an ok business. 

I only argue this business has significantly different characteristics from home health and hospice which are asset light, variable cost models with higher organic growth. 

Senior Living Segment Leases: 

The Pennant Group Balance sheet carries $241m in capital lease debt. 

Rent coverage may be good relative to distressed peers in the industry this is still a very levered asset with EBITDAR/Rent overage ratio of 1.48x based on Q3’19 financials. 

The peers in this segment are Brookdale (owns a chunk of real estate) and I would argue you could say the parent company Ensign is a peer of sorts as they are a facility based provider (albeit one with a clinical bent and a government payor revenue stream). Ensign also owns a significant amount of real estate. 

Historically the returns in the post-acute facility-based space have been a lot higher for the lessor than the operator (see Vencor which spun out Kindred Healthcare and Ventas with the latter massively outperforming the former). 

As far as valuation is concerned, I believe something in line with Brookdale (10x EBITDA) and Ensign (11x EBITDA) is reasonable for this segment.  

Home Health and Hospice Segment: 

Unlike senior living, home health and hospice is an area that is very much in favor given the secular growth and shift in patients from higher cost post-acute settings into this home. While this segment is clearly what drives most of the value at Pennant, it is not without its own concerns. 

The first point I would make is health care reimbursement and valuations are cyclical. This is counterintuitive given these businesses are almost completely detached (at least on the revenue side) from the overall business cycle. 

However, the home health and hospice sector has just gone through a massive 5 year upcycle in terms of valuations and margins after bottoming post the early implementation of “Rebasing” a series of cuts that took place 2014-2018. I believe this will happen again at some point. Recently the industry is rejoicing in their victory at having the punitive aspect of Patient Driven Groupings Model (PDGM) pushed out another year. 

That said, many veteran industry observers believe its only a matter of time until another cut comes. 

Recently MedPAC published a presentation pushing for a 7% rate cut in 2021. 

From MedPAC: 

Historically, home health Medicare margins averaged better than 16% from 2001 to 2017, according to MedPAC.

“Medicare has overpaid for home health since the [Prospective Payment System] was established. The fact that home health can be a high-value service does not justify these excessive overpayments,” one official argued. “These overpayments do not benefit the beneficiary or the taxpayer.”

In 2018, the average home health fee-for-service Medicare margin checked in at 18%. MedPAC estimates that margins for 2020 will hover around 21%.

“This is a result of several payment and cost changes,” the official said.

While Peer company Amedysis now trades for over 20x forward 2020 EBITDA and nearly 2.5x Revenues it was as recently as June 2014 that AMED had a $335m market cap and was trading for .3x Revenues. Things are good now. Maybe they stay good a long time. All I am saying is historically we are closer to the peak in terms of home health and hospice margins and multiples than we are the trough. 

The 4% cut people feared with PDGM has been averted for now but in my opinion, it is a matter of when, not if, there will be another cut in this industry.  

Valuation: 

Given PNTG has limited historical financials I will use a combination of the Q3’19 run rate for each segment as well as PNTG 2020 guidance. I chose to allocate unallocated costs to each segment in the ratio of each segments revenue to total company revenue. 

Sure you could value each segment and ignore the corporate costs, but if that is the case you would have to use an M&A multiple for each segment as opposed to a platform multiple. Given acquirers typically pay single digit multiples of EBITDA for these assets and Pennant’s only chance of being worth what it is trading for is as a platform company that acquires other companies, I believe including unallocated costs in our valuation is a must. 

First I start by valuing Pennant groups Senior Living Segment. 

Facts: 

• This segment produced $1.865m in Adjusted EBITDA in Q3’19

• Annualizing this aEBITDA gets us a run rate of $7.5m 

• This segment carries $241m in capital leases with an EBITDAR/Rent Coverage of <1.5x 

Peers I will use for comparability are Brookdale (BKD) and Ensign (ENSG) both facility-based providers. As I mentioned earlier both of these comparables own a number of their facilities real estate whereas Pennant group owns none of their real estate. 

Brookdale has a $4.6B TEV excluding capital leases and generates around $430m in annual EBITDA or ~10x EBITDA

Ensign has a $2.6B TEV excluding capital lease debt and generates $240m of EBITDA or ~11x 

Select Medical another facility based provider has a $7.1B TEV and generates around $700m in EBITDA, also trading around ~10x. 

Sensing a pattern here? Don’t see a good reason why Pennants facility based Senior Living segment is worth more than plus or minus 10.5x EBITDA. 

Using the segment’s $7.5m run rate and a 10.5x multiple we get an equity value for this segment of ~$80m or $2.85/share. 

To be a bit more conservative lets use PNTG consensus EBITDA for 2020 of $28m and apply 30% (ratio of senior living segment EBITDA to consolidated EBITDA in Q3’19) to come to an EBITDA estimate of $8.4m for 2020. Using the same 10.5x EBITDA we get an equity value of $88m or $3.15 per share. 

Now we can do some basic math. 

1. Pennant group has 28m shares outstanding and their share price is $34.78 for a $974m market cap. 

2. In Pennant’s Q3’19 Press Release they state that their net debt excluding leases to adjusted EBITDA ratio was .95x which implies net debt of $25m which would give us a TEV of $999m. 

3. For simplicity Pennant is a $1 Billion TEV company excluding their capital lease liabilities. 

If we assume the Senior Living segment is worth $88m as we outlined above, that implies investors are paying slightly above $911m for the home health and hospice segment of Pennant. 

Using Q3’19 run rate EBITDA this segment is generating $18.4m in EBITDA for an implied 50x EV/run rate EBITDA 

Using 2020 consensus and assuming 70% of consolidated EBITDA is attributable to the Senior Living segment that implies $19.6m of EBITDA or a EV/EBITDA of 47x. 

That is just too high of a multiple for a company that sends out skilled nurses to peoples homes and has massive customer concentration with the US government (CMS).  

I would value the home health segment in line with peers in the 20-25x range. 

Using 22x 2020 estimated EBITDA of $19.6m we get a value of $430m for the segment which I believe is generous. Add in the $90m of value we are ascribing to the senior living segment and that gets us an EV of $520 and a market cap of $495m and a stock price of $17.67 per share or roughly 50% below the current share price. Even after losing half of its equity value, PNTG would still trade at 20x consolidated 2019 aEBITDA and 18x 2020 consensus EBITDA. 

I was going to lift a passage from Frank Morgan's latest report where he lays out his valuation. Then it came time to submit and I got scared of potentially using someones work without permission. Safe to say he uses a $20 price target and that INCLUDES an EBITDA number nearly 35% higher than current levels which he gets to by baking in future acquisitions. Check it out on your own.

Frank is taking a slightly different approach to valuation, but he is at least in the same ballpark. 

Acquisitions: 

Pennant is currently 4.85x lease adjusted leverage and 1x net debt levered. They have a 2x leverage covenant (and some negative covenants around 5x lease adjusted leverage). 

So how much EBITDA can they acquire? 

There is little information available about purchase price or revenue multiples in Pennant’s S1 so I will assume they are acquiring at a fully synergized 6x EBITDA multiple although in hospice it could be higher than that given how high M&A multiples are in that sector. 

If we assume they are willing to go up to 2x net levered that would give them room to acquire about $6m of ebitda for $35m which would give them net debt of $60m versus adjusted ebitda in the low $30s on a proforma basis. 

PNTG stock would still trade at ~30x EBITDA still well above peers. 

Perhaps they can accelerate their acquisition pace through equity issuances. 

While this is possible and a potential risk to the short I think its unlikely for two reasons: 

1. Limited number of targets within Pennant’s geographic clusters become available in any year

2. Pennant’s growth is limited by their ability to develop enough management capacity to take on more acquisition

Given these limiting factors, even if Pennant does an equity raise (which they should in my opinion given their very expensive currency) I think they will struggle to significantly increase the pace of their acquisitions. 

Conclusion: 

While Pennant is an OK company, investors are overlooking Pennant’s mix and shadow leverage and as a result mis-valuing PNTG equity. I believe as time goes by investors will better understand Pennant’s business mix. This could happen as other sell side analysts cover the stock.  It will also become more apparent with time that it will be difficult to grow EBITDA at a fast enough pace to justify a valuation of around 50x home health EBITDA. In a best case scenario I believe it will take several years of flawless execution for Pennant to conceivably grow into its multiple and be valued with the same ballpark as peers. In this time its likely at some point there will be an execution stumble or a reimbursement or regulatory monkey wrench that will revalue Pennant’s shares significantly lower. 

Exhibit: PNTG Credit Facility: 

Section 7.1. Indebtedness and Preferred Equity. The Borrower will not, and will not permit any of its Subsidiaries to, create, incur, assume or suffer to exist any Indebtedness, except:

(c) Indebtedness of the Borrower or any of its Subsidiaries incurred to finance the acquisition, construction or improvement of any fixed or capital assets, including Capital Lease Obligations (it being understood that the completion of the construction or development of additional beds at existing facilities or new facilities shall constitute the acquisition of property), and any Indebtedness assumed in connection with the acquisition of any such assets or secured by a Lien on any such assets (provided that such Indebtedness is incurred prior to or within 90 days after such acquisition or the completion of such construction or improvements), and extensions, renewals, refinancings or replacements of any such Indebtedness that do not increase the outstanding principal amount thereof (immediately prior to giving effect to such extension, renewal, refinancing or replacement, other than in an amount not to exceed unpaid interest and fees and expenses incurred in connection therewith) or shorten the maturity or the weighted average life thereof; provided that the aggregate principal amount of such Indebtedness at any time outstanding does not exceed the greater of $5,000,000 and, if the Lease- Adjusted Leverage Ratio (calculated on a pro forma basis giving effect to the incurrence of such Indebtedness) is less than or equal to 5.00:1.00 at the time of incurrence thereof, 25.0% of Consolidated EBITDA for the most recently ended Test Period; provided, further, that the aggregate principal amount of Capital Lease Obligations that are permitted under subsection (j) of this Section shall not be included in calculating the aggregate principal amount of Indebtedness for purposes of the limitation set forth in this subsection;

Disclaimer: 

This write up contains certain opinions of the author as of the date written. Before investing do your own work. The author or his employer may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaim any liability for investment losses that you may incur under any circumstances.

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