J. Bruun's  Instablog

I have been long MGM since the middle of June and until today it was the biggest position I had. 

While it has been great and while I do believe MGM has further upside potential in the long run I think for those that have been long so far it is time to take profits and seek higher returns elsewhere.

These are my reasons:
a. MGM's current market cap is just short of 6 bln USD which means
b. MGM no longer trade at below book value but at 1.2
c. Using earnings after tax before extraordinary items of the pre bubble years of 2004-6 averaging 472 that gives a P/E of 12.7. A lot of much less risky companies have similar P/E like Heinz and Microsoft
d. The number of shares have been diluted from 277 to 441 or 60%. This means any past share price comparisons need to be adjusted accordingly as the proceeds from the newly issued shares don't have much valuation impact at high valuations
e. There are rumours of an upcoming impairment charge from CityCenter
f. Lets not forget the obvious being that this company has a rather stressed balance sheet

A lot of positive things can happen for MGM with the opening of CityCenter, convention business returning to Vegas, Macau, repaying debt, rising consumer confidence etc but they all depend on the economy continuing its uptrend.

While I personally believe in that it is an expectation that makes a lot of other companies even more attractive when taking the level of risk into consideration. So in my opinion it is time to look for a faster horse and leave the casino smiling.

Full disclosure: Closed my long position today. Will certainly not exclude going long again in the future. 

Summary

 

Buy recommendation on small healthcare company called Skilled Healthcare Group, Inc – SKH on the basis of stable earnings growth, sensible balance sheet and low P/E.  In the authors opinion on the risks relating to an accounting issue and “Obama’s” health care plans are  that they are overblown.

 

Business model

 

Quote from 2008 annual report: Skilled Healthcare Group, Inc. companies operate skilled nursing and assisted living facilities as well as a rehabilitation therapy and a hospice business. These businesses focus on providing high-quality care to patients and have a strong reputation for treating patients who

require a high level of skilled nursing care and extensive rehabilitation therapy. Headquartered in Foothill Ranch, California, Skilled Healthcare Group has 75 skilled nursing facilities and 21 assisted living facilities located primarily in large urban and suburban markets in California, Texas, Kansas, Missouri, Nevada, and New Mexico.

 

Financials

 

Below numbers are adjusted for the accounting issue that will be discussed later.

 

P/L

 

Below please see a condensed version of SKH profit and loss

MUSD	2008	2007	2006
Revenue	733	634	531
Cost of service	583	504	421
Rent	18	13	10
General and admin	25	20	19
Depreciation	21	18	14
Total operating costs	647	555	464
Operating income	86	79	67
Other expenses
Interest	37	44	46
Premium on redemption of debt		11.6
Interest income	-1	-2	-1
Equity earnings in JV	-2	-2	-2
Income before tax	52	27	25
Tax	18	12	10
Net income	34	15	15
Accretion on preferred stock		-7	-18
Net income att. To common	34	8	-4
Shares out standing	37	27	12

Note the preferred shares have been converted into common shares wherefore there is no further accretion on preferred stock.

SKH P/L is straight forward with the exception of 2007 that contains a charge of 11.6 MUSD for early repayment of an outstanding loan. That aside SKH has strong increases in the annual operating result. The P/E for 2008 is currently around 8.5 and given that SKH expects net income per share of 0.95 to 1.01 for 2009 the forward P/E is slightly lower. 

 

B/S

 

Below please see a condensed version of their balance sheet

Assets	2008	2007
Cash	2	5
A/R	103	106
Other	36	35
Total	141	146
Property	346	294
Goodwill	450	449
Intangibles	30	34
Other	40	42
Total	1007	965
Liabilities
Current lia.	94	95
Debt	462	452
Other long term	46	49
Total lia	602	596
Equity	404	370

 

The only thing that sticks out in my opinion is the goodwill and intangible assets that approximately equal equity. The goodwill mainly results from excess purchase price in what the company refers to as the Transaction being the transaction in 2005 that lead to the creation of SKH in its current form. The goodwill is subject to annual impairment tests but none have so far resulted in impairment charges.  I am not particularly fond of this part of the balance sheet and my suspicion mainly evolves around the P/L not showing the true depreciation. It is however perfectly possible that it does. I just can’t tell.

 

C/F

 
Below is the condensed cash flow statement.

 

	2008	2007	2006
Net income	37	17	17
Depreciation	21	18	14
Other ops	14	9	8
Redemption of debt		11.6
BS ops movements	-9	-23.6	-7
Total ops activities	63	32	32
Investing
Acquisitions	-23	-88	-43
Property and equ	-49	-29	-22
Other	4	-5	-7
Total	-68	-122	-72
Various financing	2	92	6
Net changes to cash	-3	2	-34

It is worth noting that the cash flows for investments exceed depreciation. That is not unusual for a growing company but it is rather important what results it achieves from the investments.

 

The first line below table shows the amount the investments exceed the depreciation per year and the rest the increases in the main parameters in the operational part of the P/L. The increase numbers in 2008 is thus increases in 2008 over 2007.

	2008	2007	2006
Investments in excess of depreciation	51	99	51
Increase in operating income	7	12
Increase in percent	9%	18%
Increase in selling rates	4.7%	7.0%
Increase in occupancy	10.6%	11.1%
Increase in revenue	15.6%	19.4%
Increase in ops costs	16.6%	19.6%

 

We know from the guidance from SKH management for 2009 that they expect a slightly higher net result per share. That means in worst case SKH has net invested 151 MUSD to achieve an annual growth in operational income of 19 MUSD over the past three years. That seems to be a reasonable return on their investment to me. Basis this I conclude that while SKH may understate its true depreciation in the P/L, the return on its investment cash flow do not show it. If for instance the true depreciation was much higher then the net investments wouldn’t lead to additional revenue/net income. It should on the other hand also be noted that the growth in income does come at a particularly attractive nor unattractive cash flow cost.

 

Risks

 

Accounting restatement

SKH has realized that it has in 2006-09 been stating certain parts of its A/R incorrectly totaling a after tax decrease in earnings of 8.4 MUSD. They have restated their numbers in June 2009 and it is reflected in the numbers above. A complaint against SKH was filed in District Court for the Central District of California which alleges that Skilled Healthcare and certain of its officers violated the federal securities laws. According to the complaint, Skilled Healthcare misrepresented its income, forcing the Company to restate its financial statements. The complaint also seeks damages for what it alleges were similar misrepresentations contained in Company's Registration Statement and Prospectus issued in connection with Skilled Healthcare's Initial Public Offering of May 14, 2007.

 

Though I have no foundation for evaluating the merits of this complaint I don’t think it can have material financial consequences for SKH and it therefore doesn’t worry me much.

 

Upcoming changes in health care legislation

Obama’s health care reform is in progress. While it is too early to tell what the impact will be I think it will not have a big impact on SKH but more on insurers and the big drug companies. Politically that also seems more like a vote winner than to punish the people/companies that perform the actual care for voters rather than ‘evil’ insurers with their small prints and drug companies charging big amounts for little pills in a box.

 

 

Risks selected from 2008 annual report

 

Changes to Medicare and Medicaid reimbursement rates and coverage.

These two programs account for about 78% of SKH revenue and are thus of paramount importance to the future profitability of SKH. In addition many private payers mirror Medicare. In 2001 SKH filed for bankruptcy partly because of this. It is very hard to say what the future will bring but I think labor price inflation will be the most likely future increase as the main costs in healthcare is labor.

 

Litigation

It is mentioned that SKH has incurred an average liability cost of 350 USD per bed rising to 1,460 in 2007. The risk is that this may increase but I expect it is likely that a successful health care bill will attempt to curb these politically unpopular costs.

 

Ownership

SKH is controlled by Onex and SKH directors and members of senior management through class B common stock that carry ten fold votes.  While some are against controlling shareholders I actually like it as I believe they provide better counter to management. It further in this case seems to align the interest of owner and management.

 

Conclusion

I believe that SKH is trading with such low P/E relative to the industry due to overblown concerns over the pending legal issue relating to the A/R restatement and overblown concerns over the impact of upcoming changes following Obama’s health care reform. I believe in SKH business model as it seems cost efficient to society to move patients out of more expensive hospital beds into SKH facilities and further provide rehabilitation which is much cheaper than treatment. In the long run the demographic trends are also in SKH’s favour.

 

I’d aim for a 50% appreciation and review the situation once above two key issues are out of the way.

Disclosure: Long SKH since Tuesday this week. 

Close your eyes and answer this question - which company is worth more, Apple or Microsoft?

I suspect most of us would say Microsoft without any hesitation. This is also correct but probably by a much smaller margin than you'd expect. MSFT's market cap is 219 BUSD vs AAPL 153 BUSD. 


There is a lot of great things to be said about both companies. I'll try to sum it up below from my perspective:

MSFT
One/two very superior products with very deep market penetration and competitive 'moats' in Windows and MS Office. A number of other products with varying successes from Xbox to bing with the latter just not being any match to competition.

Risk and opportunities
Especially to Windows I don't see any risks on the horizon and the opportunities are mainly in markets like India and China where the number of people working behind a PC and in a company that is so big that they can't use pirate versions has a long way to grow. On top of this is their usage of Windows at home.  I don't have any strong feelings for the future of MSFT's other products other than they are a more ordinary player however with a strong 'parent'. It is however tempting to think that some of all that money they keep channeling into things like bing will eventually be more successful than they currently are.

AAPL
Who doesn't love the iPod, iPhone, iMac, MacBook. They seem to have it all. They are functional, the most elegant and by far the hippest. With the iPhone they seem to have made the bridge between a full-blown laptop and a mobile phone - and it even works well.

Opportunities and risks
There is obviously a lot of people who don't yet have an iWhatever who will buy one in the future and this may drive revenue in the short to medium run. Is there room for a product between the iPhone and the MacBook. I don't think so. What will be the next thing that is going to excite me? That I can operate it by talking to it? That it can read hand writing? A better camera? Remotely control my fridge? Be a credit card? I'm not a techie but I just don't really feel too many of us has the need for any of this. I frankly rarely use all the current functionalities to begin with.

Meanwhile the people at RIM, Nokia, Samsung and Motorola are not sleeping and will try their best to catch up. Further if I'm right with above guess that the speed of progress in the number of functionalities future iPhone like devices should have will decline, then they will catch up even faster. Anyway remember how cool the Nokia 8110 phone that 'Neo' used in 'the Matrix' was or just shortly ago how you needed a BlackBerry? Being the incumbent normally isn't something that lasts when it comes to consumer electronics/phones.

A second aspect of the competitors catching up is one of competition on price with it's obvious consequences.

Financial comparison
If we take a look at the numbers they come out like this (taken from Yahoo Finance):

	MSFT	AAPL	Ratio
Market cap/BUSD	219	153	1.44
Equity	40	21	1.88
Annual result	14.6	5.2	2.81
Revenue	58	32.5	1.79
Result/revenue	25%	16%	1.57
P/E	15	29.3	0.51
Dividend yield	1.8%	0%	n/a

AAPL has a P/E that is twice as high. What does it take to get there? Well MSFT sells 80% more, has 57% higher result on its per USD sales but is only worth 44% more. Another way to say it that its results are simply almost 3 times higher but it is only 44% more worth. 

While both companies have a lot of good things going for them I find that when comparing them MSFT comes out cheap and AAPL expensive while they operate in the same or similar fields. While MSFT is priced as if they may not be able to uphold their current levels of profitability AAPL is priced as if they can increase it significantly and then keep it there. I think both are wrong. I think MSFT can increase theirs moderately without much effort while AAPL will have to soon fight tooth and nail to keep and increase theirs while being at the mercy of consumers' changing wishes. 

On top of this I'd like to remind you that anyone that has tried to switch from Windows to Mac will agree that this a whole lot harder than switching from an iPhone to another phone will ever be. 

Maybe I should also mention that MSFT pays a dividend of a little less than 2% a year and has further spent 9 BUSD a year in the last two years (being the lowest in the last 4) which combined is equivalent to 6% dividend yield a year vs AAPL's 0%. 

Conclusion
Buy MSFT and sell AAPL short. Do it for a moderate amount as AAPL is on a strong trend upwards and you don't want to not be able to hold the position until you have achieved a satisfactory return. I'd aim for 25% or alternatively until you feel the hype over AAPL has faded.

Disclosure
I am long MSFT and short AAPL.