Skilled nursing facility operator Ensign Group (NASDAQ:ENSG) is a good example of a good property in what can be a rough neighborhood. Almost any healthcare service provider that has to rely upon Medicare and/or Medicaid will find itself faced with significant challenges from time to time, as the government tries to contain healthcare spending while healthcare costs continue to rise. Through acquisitions and a differentiated decentralized management approach, though, Ensign has been able to show better growth and profitability relative to many other skilled nursing service providers.
Now the question would seem to be whether management can keep up the momentum. The announced separation of Ensign into two new companies (one focused on the skilled nursing/assisted living operations, the other a REIT that will own the facilities) could unlock some value, but it's a one-time opportunity and Ensign will still be dealing with the challenges of rising costs and stingy reimbursement in an environment where demand ought to be growing in the coming years. With that, the shares don't look like the greatest bargain anymore.
From One To Two
Ensign not only recently announced its third quarter earnings, but also a long-awaited (at least from some analysts and investors) plan to separate the company into two new companies. A multi-year acquisition program has led to Ensign owning over 90 facilities and now the company is looking to take advantage of the differences in valuation and tax treatment for healthcare-related real estate investment trusts (REITs) by splitting the company into an asset-light (or at least significantly lighter) operating company that will continue to operate as Ensign Group and a healthcare REIT that will operate as CareTrust.
CareTrust will own nearly 100 facilities at its start, acquiring most of those from Ensign. Ensign will in turn lease 94 facilities from CareTrust. This transaction (with is being structured as a tax-free spin-off) will greatly reduce Ensign's debt and will allow the company to focus more attention on its core operating responsibilities. CareTrust will benefit not only from the special tax treatment afforded REITs, but will also be able to raise funds as a REIT and benefit from what has been a higher market multiple for healthcare REITs relative to healthcare service operating companies (nearly double on an EV/EBITDA basis, as per Ensign's presentation materials).
A Good Move, But Challenges Aren't Going Away
I don't have any particular objection to Ensign's announced spin-off, even I do believe that investors tend to overvalue and over-dramatize these events. Simply put, if the market is willing to assign a higher value for Ensign's properties under the aegis of the CareTrust REIT, then they should go for it. Even so, there are definite challenges to this business that shouldn't be ignored.
The basic idea behind skilled nursing facilities is solid. Skilled nursing facilities allow the healthcare system to transfer patients who need ongoing (but not necessarily highly sophisticated) care from acute-care hospitals to these other locations. The most common underlying conditions for skilled nursing facility patients include major joint reconstruction (recuperating after a hip replacement surgery), sepsis, serious kidney or urinary tract infections, heart failure, and pneumonia, and these patients are often transferred to skilled nursing facilities once they are stabilized in a hospital setting.
The problem, though, is that while everybody wants high-quality care, nobody really wants to pay for it. About 40% of Ensign's revenue comes via Medicaid and roughly another third comes from Medicare - neither of which have been notably generous lately with reimbursement. At the same time, the cost of drugs, devices, and skilled workers continues to rise.
To that end, revenue growth has been pretty good of late (up 8% in the second quarter, and up 11% in the third quarter), but adjusted EBITDA has been down 2% and 1%, respectively, with adjusted EBITDAR down similarly (down 2% and 0.5%). Some of the negative operating leverage can be tied to working out a settlement of the Department of Justice investigation, preparing for the spin-off, and integrating new facilities into the company, but that doesn't explain all of it. While adjusted non-GAAP revenue rose almost 7% in the third quarter, the cost of services rose about 150bp more.
Consolidation, Mix Shift, And Cost Containment Will Be Important
The skilled nursing industry really isn't all that much different than the home health care market in which Amedisys (NASDAQ:AMED) and LHC Group (NASDAQ:LHCG) operate in terms of consolidation and lack thereof. The top 10 providers in the industry account for about 15% of total beds, while the top 20 accounts for about 20%.
Ensign Group only operates in 11 states (all of them west of the Mississippi), with California and Texas accounting for more than 55% of the business combined. That leaves a wide swath of the market in which the company could act as a consolidator - paying relatively modest premiums for private facilities that lack operating scale and are often underperforming and then generating better revenue and operating leverage over time.
I think it's also important to note that Ensign operates its facilities differently than most of its rivals. Ensign's senior management gives a lot of power and authority to facility-level management, enabling them to better maximize the economic/business circumstances of the local market. At the same time, there is a company-wide effort to grow into new service areas (including home health and hospice) while also driving better utilization (more patients using the company's beds) and a higher-value mix of services.
Demand Not Really The Issue, But Profitability Is A Big Unknown
I have little doubt that Ensign Group is going to see strong demand for its services in the coming years - the "graying of America" thesis has been reiterated almost to the point of cliché. That ought to be good for Ensign's capacity utilization, though the prospect of always-tough reimbursement from Medicaid and Medicare looms over the top-line growth story. Even more important will be the company's ability to manage costs and continue to deliver high-quality levels of service, and deliver them profitably, in that environment. To that end, I'm looking for post-spinoff revenue growth of more than 6%, with free cash flow growth in the 8% to 9% range.
The Bottom Line
On a discounted cash flow basis, Ensign doesn't look like any particular bargain today, and that's not a big surprise after the large move in the shares (up 56% over the last year). The stock is a little cheaper on an EV/EBITDAR basis, but even then it's hard to argue for a fair value above the low-to-mid $40s. With that, Ensign is a decent enough hold today, but not a really compelling new buy idea.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.