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Shares of Gentiva Health Services (NASDAQ:GTIV) spiked upwards on Thursday's trading session after the provider of home health and hospice services announced the acquisition of Harden Healthcare in an attempt to mitigate the negative impact of the introduction of Obamacare.

The strategic deal takes place at fair multiples, and brings much needed diversification. Despite the great deal, I remain on the sidelines as the company remains highly leveraged, making the company vulnerable for a further reduction in reimbursements or dilution.

The Deal

Gentiva announced that it has entered into a definitive merger agreement to acquired Harden Healthcare Holdings.

Gentiva will pay $408.8 million to acquire certain assets of Harden. It will pay for the deal with $355 million in cash and the remainder $53.8 million in stock.

Harden is a leading provider of home health, hospice and community care services. Note that Gentiva will only acquire its home health as well as community care business, as Harden's shareholders will retain the long-term care business.

Chairman Rod Windley commented on the rationale behind the deal, "This transaction is a great strategic fit for Gentiva and we believe it will provide significant long-term value for our shareholders. I consider the Harden transaction a milestone in the continued Gentiva growth story. The increasing healthcare needs of an aging population and ongoing rate pressures will fuel industry consolidation and Gentiva is positioned to be a leader in this effort."

The acquired activities generated annual revenues of $476 million in 2012. The deal is expected to be accretive to adjusted earnings per share, excluding one-time costs, within the first year of closing.

The deal has already been approved by the board of directors of both companies, and by Harden's shareholders. The deal is subject to normal closing conditions, including regulatory approval, and is expected to close in the fourth quarter of this year.

Valuation

Gentiva ended its second quarter with $185.1 million in cash and equivalents, and $910.2 million in total debt. As such, the company operates with a net debt position of around $725 million.

The $355 million cash component of the deal, will increase the net debt position towards $1.08 billion. A new $855 million term loan facility will be used to fund the deal, and refinance existing debt.

For the first six months of the year, revenues came in at $830 million, down 3.9% on the year before. Gentiva reported a $200.5 million loss on the back of a $224.3 million goodwill and asset impairment charge.

Factoring in gains of 10%, with shares trading around $12 per share, the market values Gentiva at roughly $380 million.

Given the large debt position, and low operating earnings, Gentiva does not pay a dividend at the moment.

Some Historical Perspective

Long term holders in Gentiva have seen poor returns. Shares had steadily risen from $12 in 2004 to highs of around $30 in 2011, but fell to lows of $4 later that year as reimbursement cuts hit the company hard. From that point in time, shares have steadily risen to a current price of $10.

Between the calendar year of 2009 and 2012, Gentiva has increased annual revenues by a cumulative 53% to $1.71 billion. The company has reported modest profits with exception of 2011 when it took large "one-time" charges.

Investment Thesis

The deal is of a strategic rationale, and is necessary for Gentiva. "Obamacare" has resulted in lower reimbursement for Gentiva's traditional activities, spurring it to diversify further into home health and community health serves.

So while many hospital are merging ahead of Obamacare to handle greater patient streams, not all healthcare providers are benefiting from the healthcare changes as this merger proves. With the deal Gentiva will reduce the dependency on just Medicare. The patients in the activities are both eligible to Medicare as well as Medicaid.

So the deal will create much needed diversification as well as earnings accretion. Following the deal, Gentiva will derive 72% of total revenues from Medicare which compared to 86% last year. Roughly half of the revenues will come from home health, 40% from hospice and the remainder from community care.

On a pro-forma basis the company should be able to generate revenues between $2.1 and $2.2 billion, while adjusted EBITDA should come in between $210 and $220 million, excluding share-based compensation.

Given that Gentiva reported adjusted EBITDA of $78 million for the first half of this year, a simple extrapolation leans that full year EBITDA could come in around $155 million. This implies that Harden could add some $60 million in annual EBITDA. As such the $409 million deal values Harden's activities at 0.85 times annual revenues and an estimated 7 times adjusted EBITDA.

The equity of the new firm is valued around $400 million. Including the $1.1 billion estimated net debt position following the deal, the new enterprise value comes down to some $1.5 billion. Therefore, the pro-forma activities are valued at 0.7 times annual revenues and around 7 times EBITDA.

The deal makes sense, as it brings much needed diversification at a reasonable price. The deal could provide a long term safety net for the company, but for now investors should expect more volatility ahead as leverage keeps increasing. If things turn for the best, the leveraged balance sheet and low multiples leave much upside for shareholders in the long term. This obviously works both ways, as equity could be wiped out if investors receive more nasty surprises.

This is a bit too speculative for me, as I have too little knowledge about the industry and future changing legislation, so I have to pass on this one. I remain on the sidelines, but will definitely keep an eye for the next quarterly report.

Source: Gentiva Health Services's Excellent Acquisition Of Harden Healthcare