Advocat, Inc.: Management-Shareholder Standoff Presents Compelling Value

Advocat, Inc. (AVCA) is an operator of nursing homes. The stock has been badly beaten down recently as management has failed to reveal a bid for the company until after they had turned the bid down. The company has a shareholder rights plan which prevents takeovers over the management’s objections, as well as a staggered board. However, the sell-off has been overdone to such a degree that I believe Advocat now presents compelling value.

Having rescued the company from near-bankruptcy in 2001, and done a remarkable job in the past few years, CEO William Council seems to now resent shareholder meddling in business affairs. My guess is that he views Advocat as an unfinished job, since there is still much room for improvement, in both patient mix and occupancy rates, and resents selling out to a buyer at this juncture. His case is not helped by the fact that he holds only 6900 shares, while the dominant shareholder on the board (Wallace Olson, with 1.2 million shares, some 20% of outstanding shares) has remained curiously silent during the entirety of the shareholder-management spat.

Fundamentally, Advocat is a well-run company, with some 43 nursing homes in Texas. Aging demographics dictate that nursing home usage will increase. Advocat has an occupancy rate of approximately 77% (most homes average 90%), and an unfavorable patient mix (most homes have 70% of patients covered by Medicare, which is more profitable than Medicaid or HMOs; Advocat has only 40% of patients on Medicare). Despite these disadvantages, operating margins are in-line with other nursing home operators, averaging above 7.7%. Management recently acquired an additional 7 facilities in Texas at a price of 4x EBIDTA, financed with a term loan with an interest rate of LIBOR plus 2.5%, which will also be used to retire other more expensive debts. This deployment of capital looks reasonable just based on financial metrics, and looks even more favorable given the synergies and market power that will accrue from the nursing homes being in the same area. Management appears to be divesting facilities outside of Texas (selling 11 nursing homes in North Carolina in May for $11 million), and employing a strategy of regional concentration of nursing homes for cost synergies.

Risks include the inherent uncertainty of Medicare reimbursement rates (state Medicaid and private insurers typically take their cue from Medicare). However, the latest resetting of Medicare rates saw rates for hospice care increase 3.4% over FY2006. In the future, it would not make sense for Medicare to set rates at a level which would bankrupt most nursing homes, especially with the aging population now dramatically rising with the retirement of the baby boomers. Other risks include the Advocat’s longstanding reliance Omega Healthcare, a healthcare REIT that owns all of Advocat’s leased nursing homes. Omega Healthcare is a large healthcare REIT that leases out facilities or provides mortgage financing to operators of nursing facilities. As such, it has long-term relationships with a number of nursing home operators including Advocat. Omega seems to be in reasonable financial health to me, and most of Advocat leases are long-term ones running for 4-10 years anyway. Lastly, Advocat has a significant debt load at $24 mil, some 4 times that of equity, and is self-insured for professional liability claims, which are intrinsically unpredictable.

Looking at Advocat’s cash flow statement, cash flow from operations has increased steadily for the past few years, with the latest quarter ending March 2007 registering yet another increase in cash flow from ops. Maintenance cap-ex runs at $4-5 million annually, and EBIDTA is running at $19-20 million. (The non-cash $5.18 million expense for stock-based compensation and $4.8 million benefit due to a write-down of reserves for self-insured professional liability conveniently cancels out each other.) Using an EBITDA of $19.5 million, an annual cap-ex of $4.5 million and interest payments of $4.5 million yi elds a pre-tax earnings of $10.5 million. Since Advocat has substantial tax NOLs going forward and won’t be paying taxes for quite a few years, let’s assume a reduced tax rate of 20% for the next 10 years. At $8 million owner’s earnings, and reasonable PE ratios of 10-14 for a stock with revenue growth of 3-7%, AVCA is worth $13-19 per share. Note that this valuation does not take into account revenue from the 7 facilities newly acquired in a bankruptcy fire sale, which is expected to be immediately accretive to earnings. Valuations can take a further jump if occupancy rates and patient mix improve.

There has been a modest amount of insider buying by the CEO and other company officers in recent months, which suggests that management feels that it can handle the debt load and risks. Increasing dissent from shareholders may finally prompt management to return some cash to shareholders via share buybacks or dividends. Even if that fails, the impact of the newly acquired nursing facilities and aging demographic make this stock an attractive long-term holding. Hence, I have recently bought a full position in this stock at $10.

Disclosure: Author has a long position in AVCA

AVCA 1-yr chart