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Anyone following the Advocat Inc (AVCA) situation is probably well aware of the recent shareholders’ concerns regarding management’s proposed capital allocation strategies. The following is a brief rundown of the current situation while a full presentation covering the Company and proposed recommendations is available by contacting Amit Chokshi at amit.chokshi-at-kinnaras.com.

The purpose of the following overview and presentation is to approach the broader investment community to illustrate the value in AVCA as well as possibly prompt a larger, more established shareholder to seize upon this opportunity by becoming a significant shareholder in the Company and seeking board representation. Aside from Wallace Olson, the lack of risk capital on the Board and with Management appears to result in less consideration for shareholder concerns. The firm I represent, Kinnaras Capital Management LLC, does not manage enough capital to affect significant change which is why I’ve approached the broader investment community in this manner.

The actual presentation is far lengthier than this overview and offers more analysis. The purpose of the presentation format was to serve as an easier framework for discussion by current shareholders, prospective investors, Management, and the Board. I’ve already contacted fund managers within my network but felt that canvassing the broader investment community through websites such as Seeking Alpha could yield stronger results. To me this could be viewed as more of a deep value and activist opportunity so I didn’t want to post a lengthy analysis to a large audience base that may have very limited interest. As a result, the following is just a very brief, high level overview of the Company and the current situation. Those piqued by the situation or wanting to see supporting data for some of the points presented here can contact me at the email provided above for the full presentation.

Situation Overview

  • AVCA stock plummeted nearly 30% on March 2nd following FY 2006 results and a conference call with management
  • AVCA operates skilled nursing centers and assisted living facilities located primarily in non-metropolitan Southeast regions
  • 43 nursing centers, 9 of which are owned, containing 4,505 licensed beds and 78 assisted living units with facilities in Alabama, Arkansas, Florida, Kentucky, North Carolina, Ohio, Tennessee, Texas and West Virginia
  • Favorable industry dynamics
  • The Company has experienced a dramatic turnaround since recovering from the brink of oblivion during 1999-2001
  • Systematic of other nursing home operators as Mariner Post-Acute Network, Vencor, Sun Healthcare, and Genesis Healthcare all filed for bankruptcy during that time
  • click to enlarge
    AVCA IMPLIED VALUATION
    AVCA

    Why is AVCA Valued So Poorly?

  • Kinnaras believes there are two main reasons for AVCA’s valuation haircut
  • Market Issues:
  • Confusion regarding the quality of AVCA’s operations
  • Significant confusion regarding AVCA’s forward guidance
  • Agency Issues:
  • Management and the Board’s reluctance to initiate material strategic dialogue with advisers or potential acquirers
  • Management and the Board’s unwillingness to consider shareholder opinions regarding capital allocation decisions
  • Reality regarding the Company’s operations: AVCA’s operating metrics and debt financing are already within industry standards if not greatly superior in certain instances despite having lower occupancy rates and less Medicare census than peers
  • Management also provided guidance that is subject to significant change and is not reflective of the true operating metrics at the Company (outlined in presentation)
  • The Company has been resistant to initiate strategic discussions or consider shareholder opinions
  • In 2006, the Board and Management declined a buyout offer without disclosing this to shareholders until after they had turned the offer down
  • Recent transactions, notably the GHCI sale to Formation Capital and JER Partners, show a very high demand and healthy valuation range for nursing home operators
  • Winning bid in GCHI was almost 25% above the initial offering bid and attracted 14 bidders
  • AVCA wishes to pursue acquisitions but shareholders and analysts generally view this is as a bad strategy
  • An acquisition would likely be dilutive based on the Company’s current price and capital structure
  • Recommendations to AVCA

  • Take advantage of depressed share prices by immediately repurchasing stock at a steep discount to value
  • 2007 free cash flow to market cap (cash flow yield) is 15%
  • Difficult to find alternatives that offer the same return
  • Engage an investment banker to assist in evaluating firm strategy
  • An independent adviser would not support the notion of an acquisition by AVCA given the Company’s depressed valuation
  • A sale of AVCA could be in shareholders’ interests
  • Precedent transactions demonstrate sector appetite by both strategic and financial buyers resulting in an auction process with significant breadth
  • Conclusions

  • AVCA is significantly undervalued
  • Very attractive free cash flow yield
  • Operating metrics and debt capitalization in-line with or better than higher valued industry peers
  • Favorable industry dynamics
  • Recommendations for AVCA should create value
  • Improves capital allocation
  • Immediate share repurchase could enhance shareholder value by 20%
  • Offers a better alternative to potentially dilutive acquisitions
  • Exploring a sale process with the help of an independent adviser will further help realize value for shareholders
  • Recent and relevant precedent transactions demonstrate buyer interest and healthy valuations
  • Recommendations seem to be widely held by shareholders based on recent conference calls
  • Variations by other shareholders on Kinnaras’ recommendations can also enhance value
  • All stakeholders should be engaged in an effort to enhance the Company’s value
  • Current Shareholders
  • Lack of major institutional investor makes it difficult to spearhead a concentrated effort
  • Broader investment community
  • Undervalued situation, microcap stock, and turbulent shareholder base should present an opportunity for activist investors wishing to build upon recommendations and take the lead
  • AVCA Management and the Board
  • Management has demonstrated good operating capabilities but capital allocation decision making is in question
  • Aside from Wallace Olson, insiders (Board and Management) own less than 5% of Company shares
  • Personal/financial accountability for share performance is a better motivator than fiduciary accountability
  • Kinnaras is open to any feedback and revisions to suggested recommendations by current shareholders, AVCA’s Board and Management, and any other potential AVCA investors
  • Disclosure: Author manages a hedge fund that is long AVCA.

    Source: Advocat: An Undervalued Situation Requiring an Activist Touch