The curtain is about to go up on the IPO market's busiest week in nearly two years, with 8 deals expected to raise a combined $3.5 billion. With higher quality companies continuing to lead the recovery in the market for new issues, we decided to highlight two upcoming deals, Shanda Games (GAME) and Select Medical (SEM), as our dual featured IPOs of the week. Both companies are familiar to investors as Select Medical was publicly traded for four years before being LBO'd in 2005, and Shanda Games is a carve-out of NASDAQ-listed and China-based Shanda Interactive's (SNDA) online games business. That, however, is the extent of the overlap between these two IPOs, which we believe provide unique opportunities to investors at different ends of the equity spectrum.
In an effort to focus more on developing its interactive entertainment platform and boost its war chest for acquisitions, Shanda Interactive is spinning off its highly profitable and market leading online games business, which accounts for 94% of Shanda Interactive's total revenue. "Shanda Games" is China's largest developer/operator of massively multiplayer online role playing games (MMORPGs) and has been a pioneer in several areas of the Chinese online gaming market, which reached $2.7 billion in 2008 and is expected to grow at a 17% CAGR through 2013. The company plans to offer 63 million shares, including 50 million from the parent, at a price range of $10.50 to $12.50. Goldman Sachs (GS) and JP Morgan (JPM) are acting as the joint bookrunners on the deal, which is expected to price on Thursday, September 24 and open for trading the following day on the NASDAQ.
Through both internal development and in-licensed content, Shanda Games has built a large portfolio of games with 31 titles in operation, which is nearly triple the size of its closest competitor. This has allowed the company to attract a vast community of over 9.7 million active paying accounts, contributing to impressive growth and substantial free cash flow. Further, future growth drivers appear to be in place with 24 titles in its announced pipeline and the recent launch of a potential "blockbuster" game in April 2009.
Shanda's two most popular titles, Mir II and Woool, account for 76% of sales and are in the mature stage of their life cycle. To that end, sustainability of growth is dependent on the reception of new titles and no game launched in the last three years has been able to reach 10% of annual revenue. Additionally, there have been several initiatives implemented by the PRC to restrict content, reduce the amount of time users can spend playing online games and put caps on the total amount of virtual currency issued by operators and developers.
Discount to Peers + Hot Sector= Strong Debut
US-listed Chinese online game companies have been red hot year-to-date with the average stock returning 95%. Key peer and Sohu.com carve-out Changyou (CYOU) is up more than 139% since its IPO in April. Although the governance picture leaves much to be desired with the parent receiving the majority of proceeds, retaining 97% voting control and continuing to pocket service fees from Shanda Games, the stock is coming to market at a discount to key peers on a P/E basis, which should help drive strong interest in the deal given its market leading position and attractive growth prospects.
Select Medical is not new to the public realm. The company originally went public in April 2001 only to be taken private four years late by its original private equity backers and management team at a cost of $2.3 billion. From its initial IPO to its "going private" transaction, the stock handily outperformed its peers and the overall market, delivering a 279% aggregate return on a split-adjusted basis. While industry dynamics and the regulatory environment are different this time around, Select Medical's seasoned management team - which has worked together for more than a decade - hopes to pick up where it left off in making money for IPO investors.
Unlike several recent P/E-backed deals, none of Select Medical's insiders is selling on the deal; rather, all of the expected $373mm in net proceeds is earmarked to repay its large debt burden. The offering, which consists of 33.3 million shares at a price range of $11 to $13, is slated to price Thursday, September 24 and begin trading the following day on the NYSE under the symbol SEM. Goldman Sachs, Morgan Stanley (MS), BofA Merrill Lynch (BAC) and JP Morgan are the lead underwriters.
Select Medical is one of the nation's leading providers of specialty acute care hospitals and physical rehab centers. With 92 long-term acute care hospitals and inpatient rehab centers, Select Medical ranks #2 behind the 99 facilities operated by HealthSouth (NYSE: HLS). For outpatient rehab, Select Medical is the #1 player with 948 facilities. Select Medical's specialty hospitals, which account for 70% of its revenue and almost 80% of operating earnings, provide services to patients with serious medical conditions such as respiratory failure, neuromuscular and cardiac disorders and various sever trauma that require long-term care. Its outpatient rehab business, which more than doubled in size in 2007 thanks to its acquisition of HealthSouth's outpatient rehab division, provides physical, occupational and speech rehabilitation services. In 2008, the company generated nearly $2.2 billion in sales, $270 million in EBITDA and $51 million in free cash flow.
A Proven Operator with Opportunities for Earnings Leverage
One of the key investment points behind Select Medical is its strong operational track record and cash flow potential. The company prides itself as being one of the industry's most well-run operators, and the numbers tend to support that claim. The company has a proven track record of growth and profitability, which it attributes to the use of a centralized operating platform that enables it to scale the business while keeping overhead in check and without sacrificing quality of care.
With Medicare rates showing signs of stabilization and given the opportunities to drive margin expansion both within both of its core segments, management aims to drive EBITDA growth of 8% to 10% per year over the next several years. While organic top-line growth will be lower given minimal expected growth in Medicare, the company sees opportunities to add incremental revenue and cash flow by forming partnerships with large healthcare centers or university hospitals for its inpatient rehab facilities and via potential acquisitions.
The Big "R"
The big risk here is regulation, with healthcare costs and reimbursement rates under significant attack by the current administration. Although Select Medical's payor mix is more favorable than most pure-play specialty hospital operators, its overall exposure to Medicare is still significant at 47% of 1H09 revenue. A moratorium on rate reductions extends through the end of 2010 (and was recently extended until the end of 2012), but federal regulations are constantly changing and nothing is ever set in stone.
As an example, the last major reimbursement change caused margins in Select Medical's specialty hospital segment to contract from 22.5% in 2005 to 15.7% in 2007. The company will also remain leveraged post-IPO with more than $1.3 billion in total debt, but the leverage appears manageable given the cash flow generation of the business (over $114 million in free cash flow over the last 12 months).
Strong Story but Valuation Could Limit Initial Upside
Select Medical comes to market with the wind at its back in terms of sector momentum, with many hospital stocks more than doubling or tripling from the market lows. Alleviation of capital concerns and less onerous changes on the regulatory front have provided investors with an incentive to return to these names. While Select Medical is not coming to market at a bargain valuation by any means (10.4x LTM EBITDA at the IPO mid point vs. 8-9x for its key peers), we believe its proven management team, strong operating track record and opportunities for growth and margin expansion will likely this a sought after holding for investors with a longer term time horizon.
Disclosure: No positions