On May 10, Bill Simpson wrote an analysis of Skilled Healthcare Group (NYSE:SKH). On May 15, the company sold 16.7 million shares near the high end of the expected range of $14 to $16. The stock closed on May 23 at $15.74.
The text of Mr. Simpson's original writeup follows:
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Skilled Healthcare Group plans on offering 19.1 million shares (assuming over-allotments) at a range of $14-$16. Insiders are selling 10.8 million shares in the deal. Credit Suisse is lead managing the deal, with eight firms co-managing. Post-ipo SKH will have 37.4 million shares outstanding for a market cap of $561 million on a $15 pricing. IPO proceeds will be used to repay debt.
Onex, a Canadian conglomerate, will own 47% of SKH post-offering. Onex will control SKH through a separate share class. Onex is the primary selling shareholder in this deal. Onex brought EMS (NYSE:EMS) public in 12/05. Post-ipo Onex owned 77% of EMS, it currently has an approximately 27% stake. EMS has nearly tripled since ipo debut.
Onex formed SKH in 12/05 by merging together two nursing/assisted living companies. It owned one and completed a leveraged buyout of the other on the merge. Post-merger Onex owned 95% of the combined entity. It also appears as if there was a roughly $100 million dividend payout to Onex in there as well. The result is that SKH was heavily leveraged after the merger. Even after paying off debt on ipo, SKH will still have significant debt on the book of $414 million. Keep in mind that one of SKH's predecessor's filed for bankruptcy in 2001.
I would much prefer to see Onex withhold selling shares on ipo here to allow SKH to offer more shares itself and help the balance sheet.
From the prospectus:
We are a provider of integrated long-term healthcare services through our skilled nursing facilities and rehabilitation therapy business. We also provide other related healthcare services, including assisted living care and hospice care.
As of 4/1/07, SKH owned or leased 64 nursing facilities and 13 assisted living facilities comprising 8,900 beds. SKH owns 75% of its operated facilities which are located in California, Texas, Kansas, Missouri and Nevada. SKH focuses on urban and suburban locations with 67% of locations in non-rural areas.
Higher reimbursed non-Medicaid patients comprised 70% of patients the first quarter of 2007. Medicare patients accounted for 38% of 2006 revenues, while Medicaid patients accounted for 30% of revenues. Medicare patients are reimbursed at a pre-determined rate adjusted for inflation. SKH is seeing downward reimbursement pressure on Medicaid patients due to rapid Medicaid spending growth and slower state revenue receipts. Currently Medicaid is reimbursed at lower rates then Medicare, a trend SKH foresees continuing. Both Medicare/Medicaid tend to be reimbursed at lower rates then private insurance.
Roll-up - SKH has grown via the acquisition route, making 30 nursing home and/or assisted living purchases over the past 4 years. Count on SKH to continue to grow by purchasing (or leasing) additional facilities going forward. I would expect SKH to mimic the 7 1/2 facility per year acquisition pace of the previous four years.
Sector - The U.S. nursing home market is a $120 billion annual business. Growth is being driven by the aging of the U.S. population coupled with longer life expectancies. The annual growth rate of those in the U.S. 65 years of age or older is expected to be 2% over the next decade. The market is highly fragmented and consists of approximately 16,000 facilities with 1.7 million licensed beds. The top 5 operators run only 10% of these facilities. This is a prime consolidation niche and companies such as SKH plan on growing via the consolidation/acquisition route.
Organic growth - In addition to future acquisitions, SKH is constructing two new facilities: a nursing facility in the Dallas/Fort Worth area and an assisted living center in the Kansas City, MO area. The Kansas City location will add 45 beds by 9/08 while the Dallas location will add 385 beds by 4/09.
53% of revenues are derived from facilities in California, 32% from Texas. Occupancy percentage in SKH facilities has been 85%-86% the past few years. 85% of all revenues are derived from SKH's nursing facilities.
Medicare/Medicaid - Approximately 70% of SKH's annual revenues come from Medicare/Medicaid. An ongoing risk for this type of business is the annual budgeting process. In the current budget proposal, there is a 'freeze' on Medicare nursing home payments as well as reduced payments for hospice services. The same budget includes a proposed $25 billion cut in Medicaid over the next five years. SKH expects Medicaid/Medicare cost containment measures for nursing homes to be an ongoing issues for them into the future.
Referral Network - SKH relies on a hospital referral network for a portion of its new business. SKH believes forming alliances with leading medical centers improves its ability to attract high-acuity patients to its facilities because an association with such a medical center typically enhances SKH's reputation. Current alliances include Baylor Health Care System in Dallas, Texas, St. Joseph’s Hospital in Orange County, California and White Memorial in Los Angeles, California.
Debt is the issue here, $414 million post-ipo. Nearly a third of this debt is at a rather high interest rate of 11%. Debt servicing in 2007 will be $40 million, approximately 50% of operating profits. That is substantial and more than I'm comfortable with.
Negative book value post-ipo
2006 was SKH's first year of operations as a combined entity. SKH was kind enough to 'back in' acquisitions as if they occurred 12/31/05, as well as take into effect alterations based on ipo. Essentially the following 2006 numbers take into account how the company will look post-ipo. All numbers then are pro forma, but a better indication of public SKH than the actual numbers. Revenues for 2006 were $564 million. Gross margins were 25%. Operating margins were 14%. Debt servicing is the killer here eating up substantial operating profits. Net margins after debt servicing and taxes were 4%. Earnings per share were $0.56. On a pricing of $15, SKH would be trading 27 X's 2006 earnings.
SKH is adding 500 beds just in time for the 2nd quarter of 2007. Following numbers take that into account but do not take into account any future acquisitions in 2007...of which I've no doubt there will be a few.
2007 revenues should be in the $625 range, an 11% increase over 2006. Gross margins should be in the same 25% ballpark as 2006. Operating margins also should be in the 14% range. Debt servicing will still be in the $40 million ballpark, but due to greater operating earnings, it will be less a % which will help net margins slightly. Debt servicing is still hefty here, make no doubt. I believe debt servicing in 2007 will ear up close to 1/2 of all operating profits. I would anticipate net margins in the 4 1/2% range. Earnings per share should be in the $0.75 range. On a pricing of $15, SKH would be trading 20 X's 2007 earnings.
Competitors include Manor Care (HCR) and Sun Healthcare (NASDAQ:SUNH). In the same general sector is 2005 IPO Brookdale (NYSE:BKD). BKD focuses more on senior living and senior communities but does also operate low to mid acuity assisted living centers. SKH and BKD are not 'apples to apples' comparables as BKD is not nearly as reliant overall on Medicare/Medicaid as SKH. BKD has done well, even though it came public heavily leveraged.
BKD - $4.5 billion market cap
Pretty simple business model. This is a rather low margin business with very little gross/operating margin improvement potential. 70% of revenues come directly from Medicaid/Medicare and if margins look a little high, they'll slash reimbursements next cycle. Also we're currently in a budget deficit with both the Executive/Legislative branch looking for places to cut.
The 30% non direct Medicare/Medicaid is often indirectly linked to Medicare rates. Pretty much any way you look at it this is not a business in which gross/operating margins are going to improve much. To lay more money on the bottom line, facility operators are looking to acquire and consolidate what is a very fragmented sector. That is the SKH plan, to grow through acquisition as well as constructing new facilities in key areas.
Thus far that plan is working for them; SKH is on pace to have a strong operational 2007. The issue here for me is the debt. I'm not comfortable with the debt levels here, particularly in a sector that had a rash of bankruptcies just 6-7 years prior.
The pluses: SKH appears well managed and operationally should put together a strong 2007. This ipo is being brought public by Onex, which also brought public EMS. EMS is up 3 fold since 2005 debut. Also in the same general 'senior living' sector, another heavily leveraged ipo BKD has performed quite well over the past 1 1/2 years. 20 X's 2007 earnings here is not unreasonable at all considering SKH growth patterns.
The negatives: The debt. Debt servicing will eat up nearly 50% of 2007 operating revenues. Also should something occur to slash either Medicare/Medicaid funding, the drag on SKH's cash flow could potentially cause repayment issues. Also current debt levels could slow future growth.
Without the debt, this would be a strong recommend in range. I can't recommend a company leveraged this much. I like the niche and I like the business and growth plan. In range I think this deal works. However keep in mind this is a heavily leveraged company, and it doesn't take too much bad news before a leveraged operation runs into trouble.