Kindred Healthcare: Embrace the Nursing Home Industry

On February 26, The Wall Street Transcript interviewed Matthew J. Ripperger, a Citigroup Investment Research analyst covering healthcare service providers and facilities. Below are key excerpts on Kindred Healthcare (KND), his favorite sector pick:

TWST: As you look at your space, where do you see the opportunities? You have talked about the hospital industry. Are there other names that you find compelling?

Mr. Ripperger: There has been one name that we have been very positive on that I think still is pretty compelling, which is Kindred Healthcare. Kindred is a post-acute care provider, with operations in the nursing home business and the long-term acute hospital business. They have an institutional pharmacy that's the number three institutional pharmacy in the country.

There are a couple of things that make it compelling. They recently got a resolution to a rent reset, which was an overhanging uncertainty related to their five-year anniversary from bankruptcy that could have resulted in a meaningful increase in their annual rent expense. That was resolved favorably for them in October, with only a $33 million adjustment to annual rents. The removal of this uncertainty is significant because for the first time in five years, it gives KND more visibility on their capital structure going forward.

The second thing is that they are moving into a period where they intend to spin off and merge their institutional pharmacy with the spinoff of AmerisourceBergen (ABC) and create a new company called PharMerica, which should become a standalone company around April. That spinoff is going to highlight the value of that company and the attractive valuation of the rest of Kindred that isn't being spun off. That's going to be a catalyst here over the next few months. If one assumes an EBITDA valuation for the spinoff comparable to the closest comparable, Omnicare (OCR), the implied valuation for the rest of the company is in the mid-4 times range off EBITDA and mid-6 times range off EBITDAR. We view these relative valuations ascompelling when compared to their closest comparables.

The third point I would make is that the company now has a pristine balance sheet (excluding the capitalized rents) with modest amounts of net debt, even before they get a $150 million cash dividend from the spun-off company. So with the rent resolution now giving them much more visibility on their capital structure going forward, they are in a good position to start aggressively growing the business and maximizing the margins in both the LTAC and the nursing home business, which has been less visible over the last couple of years because of the uncertainty around this rent adjustment. They do have regulatory exposure on the Medicare side of their LTACH operations; however, the near-term uncertainty has been reduced due to the proposed rule from CMS in mid-January.

TWST: Now that they've stabilized, where are their growth opportunities?

Mr. Ripperger: They have over $2 billion of revenue in their nursing home business, and their occupancy in that business is about 88%, which is about 2% to 3% lower than some of the closest comparables. So they have a nice opportunity in the nursing home business to continue to grow their census and grow their mix away from Medicaid toward Medicare patients, which contributes to revenue growth due to the higher Medicare rates. Every 100 basis points of margin improvement on the nursing home business equates to about $0.30 a share. So the nursing home business and the margin opportunity in that business is going to become a more realizable growth driver over the next few years. This has been an overlooked aspect of KND for the last five years, in my opinion.

Secondly, they are continuing to expand and develop freestanding LTACs, primarily in markets where there is a sufficient need for an LTAC and where there is a broad range of hospitals that are referring patients for this type of service. Though regulated, the LTACH space is desperately needed by acute care providers, and with only 380 facilities in the country, it is hard to argue that the sector is over-developed. So those two areas provide some pretty good growth opportunities going forward.

On the spinoff side, for PharMerica, I think the real opportunity is to take that and grow their market share from the mid-teens level. There really has been an absence of established independent national second options to Omnicare historically, and I think that this company has a pretty good growth opportunity by growing their patient clients and their nursing home client base in the pharmacy business. The pro forma margins on that pharmacy are going to be around 6%, which compares to Omnicare's 11% to 12%. So as they grow their clients and leverage their fixed distribution costs and fixed industrial pharmacy cost, there is a nice opportunity for margin expansion on top of the revenue growth. I think that at a minimum, 8%-9% margins are achievable, which could add roughly $40 to $60 million in incremental EBITDA. So that spinoff is going to be a compelling opportunity as well.

TWST: Whom do they compete with in this space?

Mr. Ripperger: In the institutional pharmacy space, they compete with Omnicare (OCR) primarily. Omnicare has about 50% to 55% of the institutional pharmacy market, where they provide drug service to nursing homes, assisted living and other institutionalized settings. There still is a very broad range of small mom and pop operators in this sector as well, but on a national basis, Omnicare is the most significant competitor.

On the nursing home side, the remaining company at KND competes with other companies such as Genesis (GHCI) and Manor Care (HCR). This is an industry that remains very fragmented and unconsolidated. On the LTAC side, they compete with private companies like Select Medical, LifeCare, Triumph and other private companies that have an LTAC presence around the country. Right now, there are only about 380 to 390 LTACs in the country, which compares to about 5,000 acute care hospitals.

TWST: Do they have the balance sheet to support continuing growth now?

Mr. Ripperger: Kindred's balance sheet is going to be very attractive. We project them having no net debt going into the spinoff, partly because of what we anticipate to be a strong free cash flow quarter in the fourth quarter, which benefits from some Medicare payments late in the year as well as some asset sales that they have done in the first quarter of 2007 that should give them $40 million of incremental cash. Those two things should get them close to a zero net debt position going into the spinoff.

The spun-off company is going to dividend up $150 million of cash to each of the parent companies. So after the spinoff, we believe Kindred is going to have a net cash position of about $150 million. They are still going to have roughly $2.5 billion of capitalized leases (at a 12.5% cap rate), but those are operating leases. Given that they are not going to have any real debt based on our projections, they will be in a position to selectively grow the business and fund it through internally generated cash flows or incremental borrowings.

TWST: Do they have the management team to do all of this?

Mr. Ripperger: They have a very strong management team and a very strong infrastructure. They have invested heavily in an IT infrastructure that allows them to manage all these different businesses from corporate. To some degree, the operating paradigm for them has changed relative to the last few years, because of the resolution of a number of these uncertainties that have existed over the last year related to the five-year anniversary of their emergence from bankruptcy, i.e., the rent reset and the exercise of 12 million warrants in the $16 range.

So they are in a great position, in my opinion. I believe that Kindred provides one of the most diversified platforms of growth in the whole post-acute care setting, given their presence across a number of these different business segments such as nursing homes, LTACs and rehab services.

TWST: What's the risk here?

Mr. Ripperger: There is always regulatory and reimbursement uncertainty. The LTAC business is about 70% Medicare, and it's an area where the reimbursement has been higher than what you would see in most other settings. They provide care for very medically complex patients that are primarily respiratory or ventilator dependent, where the average length of stay is 25 to 30 days. The care provided in LTACHs is similar to an intensive care unit [ICU]. So the aggregate base Medicare reimbursement is in the mid-$30,000 range, which is higher than acute care providers, inpatient rehab and nursing homes. There is always uncertainty as to whether the government will decide to change that payment level and reduce reimbursement. What's encouraging is that in mid-January, the government proposed relatively flattish rates for 2008, which begins in July of this year. So you do have more visibility on the reimbursement outlook for the LTAC industry for the next year, and that's very encouraging. On the nursing home side, what's encouraging there is that the nursing home is the lower cost setting in the post-acute care continuum, and the government is trying to drive more volume downstream because it ultimately saves them money. Therefore, I don't anticipate much on the nursing home side. If anything, I view the nursing home fundamentals to be some of the best and most stable in the entire provider continuum of care.

TWST: It sounds like the right place at the right time.

Mr. Ripperger: After a number of years of change, the nursing home industry has evolved into a pretty attractive area in the post-acute care setting, and it's reflected in the growing acuity of the patients in nursing homes, as well as the occupancy, which is trending up north of 90% across the industry. It's also reflected to some degree in the underlying value of the real estate that makes up the nursing home industry, which is reflected in some of the acquisitions that you have seen in recent years. The real estate attractiveness of health care has definitely taken hold in recent years and is reflected in cap rate compression and an increase in real estate-oriented investors.

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