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.