ENSIGN GROUP INC ENSG
April 17, 2014 - 3:48pm EST by
glgb913
2014 2015
Price: 42.65 EPS $0.00 $0.00
Shares Out. (in M): 23 P/E 0.0x 0.0x
Market Cap (in $M): 970 P/FCF 0.0x 0.0x
Net Debt (in $M): 190 EBIT 0 0
TEV ($): 1,160 TEV/EBIT 0.0x 0.0x

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  • Potential Spin-Off
  • Healthcare
  • Insider Ownership
  • REIT Transformation

Description

Recommendation: Long The Ensign Group Common Stock (ENSG)

Note: We apologize for the lack of tables. The original pitch was done with graphics and tables and can be found here: <https://dl.dropboxusercontent.com/u/66603715/EnsignGroup_Pitch_4.17.14_VIC.pdf>

Investment Thesis:
The Ensign Group is an attractive special situation equity with ~30% upside to current value and significant near-term catalysts to generate a position IRR of ~50%. The impending spinoff of substantially all of the company’s real estate assets into a REIT will both unlock value through trading multiple arbitrage and leave the remaining operating company with a clean balance sheet, focused and incentivized management and greater transparency to continue on its high-growth trajectory. Additionally, it appears that management took somewhat of a “kitchen sink” 2013 with multiple one-off charges, and that both EBITDA and NI will rebound strongly in 2014 leading to equity revaluation. This upside is supported by a limited and largely industry-wide downside offering several opportunities to hedge out risk. Limited filing surrounding the spinoff and minimal/inadequate institutional coverage has obscured value and left this situation with significant risk-adjusted return potential.

Background:
The Ensign Group is an owner and operator of 119 skilled nursing facilities (SNFs) in the Southwest and California in addition to 9 home health, 7 hospice and 7 urgent care facilities. SNFs are often referred to as “nursing homes”, but are actually versatile facilities that can serve patients at many levels of illness intensity and service intensity including assisted living, inpatient rehab, long-term acute care and even many hospital care functions. The facilities are generally paid a daily rate per patient based on the illness severity, or acuity level, of the patient. Higher acuity patients are typically higher margin, so Ensign repeatedly emphasizes its desire to boost the relative percentage of higher-acuity patients.

ENSG Summary Financial Data and Multiples ($MM)
Mkt. Cap - $970
Net Debt - $190
TEV - $1160
Adjusted LTM EBITDA - $136
Adjusted LTM NI - $55
TEV / LTM EBITDA – 8.5x
P / LTM E – 17.6x
2013 Revenue Growth Rate – 9.9%

Management of the company is very strong, which is supported by 12% insider ownership of the company. Ensign continually outperforms its peers in almost every metric: ROE, growth, margin, skilled mix (percentage of revenue from high acuity sources) and quality mix (percentage of revenue from non-Medicaid sources). Management understands that healthcare is a local business centered on local leadership, and therefore structures its operations into portfolio companies with highly incentivized local CEOs. These CEOs are urged to make their SNFs the local “facility of choice” in the region and have the possibility of excellent compensation if they succeed. Despite this tremendous management performance, compensation has always been very fair, never exceeding $3MM for any individual management member.

Strong management strategy and incentives have also been the key behind the company’s high growth trajectory. The company has grown revenue at a 14% CAGR from 2007, when Ensign went public, to 2013. Much of this growth has stemmed from the company’s New Market CEO Initiative that the company started in 2006, where a new local CEO evaluates a target market, develops a comprehensive business plan and relocates to the target market to find talent, connect with other providers, regulators and the healthcare community in that market with the goal of acquiring facilities and creating an operating platform in that market. In recent years this program has been expanded to include not only SNFs, but also hospice and urgent care facilities.

Spinoff Situation

In November 2013, management announced plans to separate Ensign into a REIT (PropCo) and Operating Company (OpCo). The company will drop all of its real estate assets, 94 SNFs and 3 assisted living facilities (ALFs), into the REIT and then distribute one share of the REIT to each holder of Ensign common stock on the date of the split. The 94 SNFs will then be leased back to the OpCo under triple-net master lease agreements which will be discussed further below.  

While REIT conversions and REIT and OpCo splits are often questioned as a trendy pieces of financial engineering for yield-starved investors, it has been quite successful in terms of stock price performance (recent successes include AMT and PENN, GLPI to name a few). This is likely to also be the case for ENSG, where healthcare REITs often trade at twice the multiples of the consolidated companies. Additionally, management has stressed that this transaction is not only financial engineering but also allows the 2 companies to continue with separate strategies on high-growth trajectories. The OpCo will be left with a clean balance sheet and excess cash to continue its strategy of highly accretive regional acquisitions and double-digit growth, while the REIT will assume all ENSG debt and pursue the goal of becoming a rapidly growing, diversified healthcare REIT.

It is also important to note that all senior management will stay onboard with the OpCo except for the EVP, Gregory Stapley, who will become the CareTrust CEO and Chairman. Ensign CEO, Christopher Christensen, will be the only Ensign manager on the REIT board of directors and will stay onboard as CEO of the OpCo with the rest of the management team. The ongoing relationship between the companies will be informal. The OpCo has said that it intends to continue acquiring facilities and real estate, and does not plan to drop it down into the REIT. It seems that the company wants to continue the business model that it has been executing since 2006, using the ability to acquire and turnaround the real estate as a competitive advantage that smaller regional competitors with less capital can’t use. However, management has also guided that the OpCo will see better deal flow as CareTrust will include it as a tenant in new, larger developments and acquisitions.

While the spinoff has been widely discussed by management since November, there isn’t an abundance of information on the pending move. The spin was initially targeted for Q1 2014, but management has moved its guidance to Q2. In February 2014, the company received a private IRS ruling letter, eliminating a major hurdle for the transaction. In terms of financials, the company has only published a pro forma income statement and balance sheet for 2013 in their Form 10 filings, far from comprehensive. Even a popular online list of stock spinoffs lists Ensign at the bottom with more info as “None Yet”<http://www.stockspinoffs.com/upcoming-spinoffs/>. The lack of totally transparent information may discourage some investors, but has also left an opportunity for savvy investors willing to do their homework.

 “Kitchen Sink” 2013

ENSG consolidated EBITDA was $92MM in 2013, significantly below the $107MM and $114MM in 2012 and 2011, respectively. This is also in the face of strong topline growth with revenues of $905MM, $823MM and $758MM in 2013, 2012 and 2011, respectively. These differences in EBITDA are largely due to one-time charges that should lead to a strong rebound in EBITDA and NI in 2014:

  • A one-time DOJ settlement from an outstanding case from 2006. The company was accused of billing Medicare for unnecessary therapy, but has admitted no wrongdoing and settled in 2013 to avoid continuing legal costs. Management stresses that this was a one-time issue that has lingered for a long time, and that the company has beefed up compliance and training to prevent another incident. - $33MM in 2013 and $15 MM in 2012
  • Legal costs associated with the DOJ settlement - $1MM in 2013 and $2MM in 2012
  • Settlement of a class-action lawsuit related to staffing ratios in California - $1.5MM in 2013 and $2.5MM in 2012
  • Expenses related to the REIT transaction - $4MM in 2013
  • Losses incurred by a newly constructed facility during on-boarding - $3.5MM in 2013 and $1.5MM in 2012

Backing out of these charges for 2013 and 2012 reveals EBITDA of $136MM and $128MM in 2012, significantly higher than listed EBITDA. It is possible that other investors were deterred in the face of declining EBITDA or failed to recognize all of the one-time expenses buried in the financials in 2013.

In many ways, this thesis involves understanding and placing a value on two separate businesses. This write-up will therefore focus first on the REIT then move onto the OpCo before finally bringing everything together and discussing risks and catalysts.

CareTrust REIT Analysis:
Industry Overview

The healthcare real estate industry, particularly the SNF space, is large and highly fragmented. Most estimates place the SNF market at $100B with 15,000 facilities, 1.7MM beds and 2,500 operators in the U.S. Aviv REIT estimates that approximately 88% of SNFs are privately owned, many of them by “mom and pop” owners. This presents a tremendous opportunity for growth by acquisition for both operators and REITs in the space.

REITs in the healthcare space operate on a triple-net basis, where the operator, or tenant, of the property pays for all expenses of the real estate, including utilities, property taxes, maintenance capital expenditures and insurance. Master lease agreements are often long term, 10 to 15 years with several 5 year extension options, due to the specialized nature of the tenants and high level of integration with the real estate. REITs must be highly selective with their tenants for the same reasons, and typically try to build a significant adjusted net operating income (ANOI) coverage ratio (1.5x-2.0x) into the leases so that the operator has to take a huge hit before defaulting on the leases.

There are 16 major REITs in the healthcare space. Historically, these REITs have traded at a slight discount to other industrial REITs, but lately the market has caught onto the large market for growth with cap rates and yields on some of the smaller REITs contracting as the market sees higher accretive growth potential. This trend is also supported by a very low interest rate environment with investors clamoring for yield.

Most of the smaller healthcare REITs have attempted to diversify across tenants, states and facility types, buying long-term care hospitals (LTCHs), medical office buildings (MOBs), inpatient rehabilitation facilities (IRFs), ALFs and ILFs. However, they tend to have a core holding in a particular asset type. For the purposes of analyzing the CareTrust REIT spinoff, we have focused on analyzing the 4 REITs of similar size that focus most heavily on SNFs. Below is some of the key qualitative and quantitative information on these REITs.

Financial metrics listed as [TEV | P/FFO | P/AFFO | Implied Cap Rate | TEV/EBITDA]

Aviv REIT - Owns 295 properties in 29 states. 85.7% of portfolio rent is from SNFs with the balance from ALFs. Highly diversified. No tenant represents more than 14% of revenue. [$1,875 | 17.7x | 15.6x | 7.5% | 16.0x]

LTC Properties - Owns 217 properties with 18,150 beds in 30 states. The properties are 55.3% SNFs and 37.3% ALFs. Highly diversified. No tenant represents more than 12% of asset base. [$1,641 | 17.2x | 16.8x | 6.4% | 17.6x]

Omega Healthcare Investors - Owns 538 SNFs with 61,178 liscensed beds in 37 states. Highly diversified. No tenant represents more than 14% of revenue. [$6,304 | 14.1x | 15.8x | 6.6% | 16.0x]

Sabra Health Care REIT - Sun Healthcare REIT spinoff in 2010. Owns 121 properties with 12,468 licensed beds in 27 states, 86.6% of which are SNFs. 60% of 2013 revenue derived from Genesis. This figure was 84% in 2011. [$1,981 | 19.5x | 19.9x | 6.8% | 16.3x]

Spinoff 2010 Sabra Health Care REIT - Sun Healthcare REIT spinoff in 2010. Owns 87 SNF properties with 9,740 beds in 20 states. Spun on 11/15/10 and priced 11/8/10. All revenue derived from Sun Healthcare Group, the OpCo of the REIT. [$777 | 13.7x | 13.2x | 9.0% | 12.3x]

Aviv, LTC and Omega are larger, established players that have highly diversified state and tenant bases but are very focused on SNFs and ALFs. These are included in the aspirational REIT comps for CareTrust as it grows and diversifies. Sabra is likely the best comp for CareTrust, because it was spun off from Sun Health in 2010. The spin had risks that Ensign doesn’t have, such as a poorer operator and lower rent coverage, but was still a similar transaction. Therefore, the base comps for the CareTrust spin are the averages of current Sabra and 2010 Sabra immediately following the spin.

Company Analysis

Following the spinoff, CareTrust will own substantially all of Ensign’s real estate consisting of 94 SNFs and 3 ALFs. The 94 SNFs will then be leased back to the OpCo under triple-net master lease agreements. These leases have a fixed base rent based on a 1.85x coverage ratio on TTM ANOI of the properties and an annual escalator at CPI with a cap at 2.5% per year. While the lease terms don’t screw either the REIT or the OpCo, it is clear that, overall, the OpCo is coming out slightly ahead here. The escalator on the lease terms is low compared to peers. The lease coverage ratio is quite conservative meaning that OpCo rent payments will be lower than peers but also should benefit the REIT by lowering default risk.

In terms of financials, management has guided that rent payments will be $55-56MM from the parent in 2014, with an additional $2MM from the ALFs. The pro forma financials for the transaction are slightly lower for 2013 historicals, but were used to derive FFO, AFFO, NOI and EBITDA for the valuation below. It is also worth noting that the REIT will have to issue a purging distribution following the spin in 2014 for IRS tax purposes. This distribution will be equal to the accumulated earnings attributable to CareTrust, but should not come into play for the company’s current valuation.

2013A Pro Forma ($MM)

Rental Income from Parent                53.7
Other Revenue                                    2.4
Total Revenue                                      56.1

Operating Expense                              2.1

SG&A                                                      5.7
DD & A                                                   23.4

Operating Income                                24.8

Net Interest Expense                           (23.8)

Earnings                                                 1.1         

EBITDA   48.3
FFO         24.5
AFFO      25.7
NOI         53.9

Moving forward, the REIT strategy is to aggressively diversify the tenant, geographic and facility type profile. This will lower the company’s cost of capital over time. It is important to note that in this situation, management won’t even have to complete accretive transactions to lower their cost of capital and raise their share price, as long as the transactions provide significant diversification.

REIT Valuation

REITs trade almost exclusively based on yield, AFFO, FFO, Cap Rate and to a lesser extent EBITDA multiples. For this reason, we thought that a DCF would be almost useless in this situation, as the main investors in this asset class likely don’t use them, there is an extremely low cost of capital and it is difficult to forecast accretive acquisition growth. Below is the valuation summary for CareTrust REIT based on the comparable multiples.

For each case, the values will be listed as [ P/LTM FFO | P/LTM AFFO | Cap Rate | TEV/EBITDA  ]

Bear Case Multiples [ 13.7x | 13.2x | 9.0% | 12.3x ]

Base Case Multiples [ 16.2x | 16.1x | 8.0% | 14.1x ]

Bull Case Multiples [ 16.8x | 16.7x | 6.9% | 16.2x ]

Multiplying these valuation multiples by the CareTrust Pro Forma LTM metrics above and taking an average, yields the following [ Equity | TEV  ] valuations for each case. Each case uses cash of $84MM and total debt of $359, both given in the company’s pro forma balance sheet.

Bear Case [ $328 | $604 ]

The bear case uses 2010 Sabra immediately following the spinoff as the only comp. We feel that this is pessimistic for several reasons. First, Sabra’s coverage ratio was only 1.60x ANOI, compared to CareTrust’s 1.85x. This in combination with a much weaker operator made Sabra riskier. In addition, the industry faced severe Medicare cuts in the summer of 2011, something that is highly unlikely to occur in the current legislative environment. We are confident that the bear valuation provides a floor for CareTrust.

Base Case [ $403 | $678]

The base case uses the average of 2010 Sabra and current Sabra metrics. This is where CareTrust should trade within the first month of the spin.

Bull Case [ $463 | $738 ]

The bull case uses the basket of all of the SNF REIT comps. While this is aspirational, it is certainly possible that the company trades in this range after even a few transactions, as investors see the significant growth potential and diversification of CareTrust. As mentioned above, it may behoove some investors to hold onto CareTrust following fair valuation as it converges with peers based on multiple expansion alone due to diversifying, non-accretive, transactions.

Our value inclination does not lead us to trust market REIT valuations as we feel that REITs are highly dependent on capital markets and offer little to no margin of safety. However, we do note that the market is consistent in pricing REITs based on yield as can be seen in the low standard deviations of yields and trading multiples. We are therefore confident that the CareTrust REIT will price according to the valuation methodology above, and believe that the REIT valuation should be hedged out with a net short or put position in a basket of the names mentioned above to reduce the risk that the asset class is re-evaluated.

Ensign OpCo Analysis:
Industry Overview

SNFs provide short-term skilled nursing and rehabilitation services to patients after their stay in an acute care hospital. SNFs are part of the broader post-acute care (PAC) ecosystem: LTCHs, IRFs, SNFs, and home health agencies (HHAs) comprise all of the venues that treat the 35-40% of hospital discharges admitted to post-acute care. SNFs and HHAs represent the bulk of Medicare spending on PAC, accounting for $30.4 billion and $18.6 billion, respectively, out of total spending of $62.1 billion in 2012.  While PAC venues are supposed to be segregated by patient severity, with LTCHs treating the most severe and HHAs the least, there is considerable overlap in the types of patients treated in each setting. This is partly the result of providers of PAC having considerable latitude for which patients they admit.

The skilled nursing industry is highly fragmented, comprised primarily of local and regional providers. There are roughly 15,000 skilled nursing facilities across the country. The large national providers, such as Genesis Healthcare, The Ensign Group (ENSG), Kindred Healthcare (KND), Extendicare and Skilled Healthcare Group (SKH), in total operate roughly 950 of these skilled nursing facilities.

Medicare pays SNFs a pre-determined daily rate; these prospective payment system (PPS) rates are designed to cover all operating and capital costs that efficient facilities would incur in furnishing most SNF services. The payment rates begin with a base rate and then adjust for geographical labor cost differentials and case mix. The base rate is updated annually based on the market basket index, which accounts for changes in input prices to furnish care, and a productivity adjustment, as mandated by the Affordable Care Act.

Most SNFs are dually certified as nursing homes, which provide less intensive, long-term care services that Medicare does not cover. Medicaid is the primary payor source for these services, and its reimbursement rates are generally the lowest of all payor types. Medicare and managed care are the primary payors for high acuity patients—those who typically require a higher level of rehabilitative care. As a result, Medicare and managed care-covered SNF patients typically comprise a small share of a facility’s total patient days but a large portion of facility revenue. The industry refers to these percentages as the skilled mix—the percentage of patient days or revenue attributed to Medicare, managed care, and other skilled patients. Quality mix is the percentage of non-Medicaid revenue or patient days.

The SNF industry is an extremely difficult space to operate in. Uncertainty surrounding government reimbursement—primarily characterized by shifts in Medicare’s PPS—requires SNFs to be efficient in their operations to protect margins. The highly fragmented industry is rife with inefficient providers: according to MedPAC, while Medicare margins for all freestanding SNFs was 13.8% in 2012, the bottom quartile had an average margin of 4.8%, compared to the top quartile’s 23%. Many of the smaller, regional providers are inefficient due to their lack of scale: small SNFs (20-50 beds) had average Medicare margins of 4.6%, while large SNFs (100-199 beds) had average margins of 15.3%. Efficient providers also must be agile in their patient admission strategy. SNFs with the highest margins had high shares of intensive rehabilitation therapy and low shares of medically complex days, reflecting Medicare’s relatively greater reimbursement for the former.

Despite these difficulties at the facility level, the SNF industry is poised to keep growing. The ongoing shift of higher acuity patients from the acute care hospital setting to the lower-cost PAC setting should continue, as Medicare budgets remain under pressure. Given that SNFs are much lower on the cost curve compared to other PAC platforms, the SNF industry is in a prime position to take advantage of increased demand as our population rapidly ages over the next decade.

Competitive Position

Ensign is an A management team operating in a B- industry. Over the years, the strong management team has shown that they are adept at rolling with the punches and changes in the industry. In fact, the company uses many of the industry hardships as a boon to shareholders, often serving as distressed buyers for SNF assets. Management’s historical strategy for growth has been use existing portfolio companies and the New Market CEO Initiative to buy up distressed operations, always under 0.5x-0.6x revenue, and turn them around. This has proved to be a fruitful endeavor and allowed the company to grow rapidly, and management has explicitly mentioned an attractive pipeline for continued growth as an impetus for the spinoff.

In turning around distressed properties, management highlights what makes them so competent. The process is managed by highly-incentivized regional CEOs and facility presidents who have been trained extensively at the “Ensign School” at company headquarters. These leaders start by getting to know regional regulators and other healthcare operators and invest heavily to improve the acquired facilities and upgrade them to serve high-acuity patients, improving them from CMS 1 to 2 star facilities to CMS 4 to 5 star facilities (50.4% of the company’s facilities have 4 or 5 stars). This ultimately allows them to attract and receive referrals for higher-margin patients that need higher levels of care. From Q1 to Q5 of an acquisition, the company improves occupancy by 312 bps, skilled mix by 732 bps and quality mix by 301 bps, on average.

At the heart of the competitive dynamics of the business is the recognition that this is a local business that can build local economies of scale alongside meaningful customer captivity. Ensign’s business is based on using a cluster system, where geographically proximate locations share clinical practices, financial data and other resources to control costs and improve operations. As Ensign comes in and consolidates the smaller distressed operators in the business, it builds relationships with providers, regulators and the healthcare community. This makes them the “facility of choice” as patients are discharged from hospitals and into SNFs. Long-term care customers are also highly captive, so it is important to acquire these patients through local fixed-cost marketing and relationship initiatives that are spread out over a local community. This has also allowed Enisgn to be one of the lowest cost SNF operators, with margins well above the first quartile listed by MedPAC.

Looking at a map of Ensign’s operations shows various clusters of between 5 and 15 facilities throughout the Southwest.

A final important aspect to the economies of scale is the complexity of the business and importance of management in this business. With the increasing regulatory and compliance complexity, the advantage goes to companies that understand the system and can communicate important changes down to the facility level. In many ways, this serves as a large economy of scale, in addition to consolidated back-office functions, and illustrates why many of the smaller SNF operators are becoming distressed sellers. Management has figured out the successful formula for buying and consolidating these smaller distressed sellers, and is in the position to be the most flexible and thoughtful as the industry changes.

Business Valuation

In valuing the OpCo, we chose to use a DCF model. This can easily be supplemented with standard P/E and EV/EBITDA metrics, but we wanted to explicitly model out the relationship between CapEx, acquisitions and growth. The main driver of growth is operational beds. We model acquisitions at the historical price paid for an operational bed, $43,000 plus an additional $20,000 of improvement CapEx. These beds are then classified into three categories, same facilities, transitioning facilities and newly acquired facilities based on the company’s turnaround and financial history. Each category then breaks down the occupational beds into actual patient days based on historical occupancy percentages, and then breaks each day down into revenue and COGS based on payment type and skill mix.

We used an equity cost of capital of 10.0%, which is conservative compared to the 8.5% derived with CAPM based on a 0.66 average historical levered Beta. The base-case valuation is based on a strong growth schedule slightly below management guidance of revenue between $1,005-$1,025MM for 2014. The bear case is based on across-the-board Medicare reimbursement cuts of 15% with base case growth. It is important to note that an actual bear case would allow the company to grow much more aggressively, as the whole industry would be thrown into distress and therefore provide very attractive acquisition opportunities. Finally, the bull case represents an optimistic, but feasible, growth schedule.

Valuations use a net cash position of $71MM which was provided in the Form 10 pro forma financials.

Bear Case Valuation - $614

Base Case Valuation - $855

Bull Case Valuation - $1,048

We understand that without looking at the DCF model, assumptions and output tables you will likely not trust the valuation work. Below is a supplemental multiple valuation.

Multiple Valuation

To drive 2014E NI and EBITDA, we started with a topline of $1,000. This conservative given management guidance of between $1,005-$1,025MM. COGS was driven with a conservative gross margin of 20% and rent expense was kept flat pro forma for the spinoff. SG&A was kept at the historical normalized 3.9% of sales and their effective tax rate of 38.5% was used.

Total Revenue                      $1000.7

EBITDA                                   $93.9

Net Income                           $48.5

We feel that an 18x forward P/E and 9.0x EV/EBITDA multiple is reasonable for a company with a long runway of high return, double-digit growth. Management has said that they think that the pipeline for highly accretive deals is among the best that they’ve seen in the past 10 years, and they also think that there is significant room for growth in their ancillary home health and urgent care businesses. Given the high and consistent growth over the past 7 years, we think that management will deliver on their growth promise, especially with excess cash on their balance sheet following the spinoff.

Forward P / E Valuation

14x - $681
16x - $779
18x - $876
20x - $974

Forward EV / EBITDA Valuation

7.0x - $642
8.0x - $724
9.0x - $806
10.0x - $887

Putting It All Together:

Summing up the equity valuations of both the REIT and the OpCo for each of the cases yields the following valuations:

Bear Case  - $942, in line with current market cap

For OpCo, assumes 15% across the board Medicare reimbursement cuts and the Base growth schedule. For REIT, assumes that the company prices identically to SABRA immediately following its 2010 spinoff. This is a serious downside situation that would imply widespread distress across the industry.

Base Case  - $1,258, 30% upside from current market cap

For OpCo, assumes flat Medicare reimbursements and Base growth schedule, in line with management guidance. For REIT, assumes that the company prices based on the average of current and post-2010 spinoff SABRA.

Bull Case - $1,511, 60% upside from current market cap

For OpCo, assumes flat Medicare reimbursements and more aggressive growth schedule. For REIT, assumes the company prices based on a basket of mature peer SNF REITs; more likely after 2 years of trading

These valuations use our DCF outputs, but are very close to the valuations from using multiple valuation on the OpCo. The base case offers upside of 30%, with an IRR estimated at 50%.

IRR for the base case is estimated by assuming that the REIT prices under the base case assumptions within the first 2 months of trading, allowing it to be sold. The holding period for the OpCo should give the market significant time to reconsider its growth and valuation with increased stand-alone filings and transparency and we estimate that this will happen by the time that the company files its full year 10-K for 2014 in February 2015.

Reasons for Misvaluation

It is always fun to speculate on why a market like the U.S. might be leave an opportunity for outsized risk-weighted profit, but important to understand from a value perspective. Here are some possible reasons, most of which have been mentioned above:

  • Limited financials, filings and information surrounding the spinoff
  • Suppressed EBITDA and NI due to one-time charges in 2013
  • Small size (Mkt. Cap. < $1B) in tandem with a poison pill limiting ownership to 9.8% (necessary to qualify as a REIT) make the maximum opportunity size only $90MM
  • Only 5 sell-side analysts cover the stock, and very little of the coverage is high-quality

Risks:

There are some serious headline risks with this stock. It is important to note that almost all of the risks are industry-wide, providing mitigants and opportunities for hedging.

REIT Spinoff Risk – There are a few risks associated with the REIT spinoff. First, the transaction may not be completed. This is highly unlikely given management focus and commentary, the IRS private letter ruling and previous transactions of this nature. Additionally, on 4/14 CareTrust announced that the Enisgn Board of Directors has approved the spinoff. Second, the REIT may not immediately price as expected due to investor concerns about tenant consolidation. As mentioned above, this gap will ultimately close as the company completes transactions that don’t even need to be accretive to diversify. Finally, there is risk that REITs as an asset class may be revalued or interest rates may rise abruptly or significantly. We view this as a serious risk, and recommend that investors take a net short position in the basket of CareTrust comps to hedge this risk.

Government Reimbursement Risk – With ~70% of Ensign’s revenue derived from Medicare and Medicaid, any cost-containment measures implemented by government can have an adverse impact on Ensign’s top line. This risk is mitigated by the industry’s proven ability to be adept at modifying their practices in response to policy changes. In 2010, freestanding facilities increased their payments per day by more than 5% despite payment reductions of 1.1%, primarily by furnishing more intensive rehabilitation therapy. In 2012, when rates were lowered by 11% to correct for an overpayment in 2011, average payments per day declined only 6.3%. Additionally, as distressed buyers of SNFs, Ensign will likely see more buying opportunities in the wake of severe cuts in reimbursements. For example, after the announcement of the 11% rate reduction, Ensign purchased 13 long-term care facilities and a home health business in the quarter (2011 Q3) and grew revenue by 9% and adjusted net income by 10% for the year, marking one of the biggest growth spurts in its history. Shorting other SNF operators like KND and SKH might help to protect from some of this government reimbursement risk.

Payment Mix – The growing shift of beneficiaries to managed care has the potential to reduce SNF’s facility revenues. Managed care companies attempt to control healthcare costs by contracting with healthcare providers to obtain services on a discounted basis. As a result, the managed care patients tend to have lower payment rates, in addition to shorter stays. However, since managed care companies are focused on cost control and increasingly determine where their patients are treated, SNFs will attract a greater portion of managed care beneficiaries, as they are one of the lowest cost providers of post-acute care. As Ensign continues to grow, it will also have the potential to leverage its local economies of scale to gain bargaining power in negotiations with managed care companies over rates. Longer term, there is reimbursement uncertainty regarding integrated care. Integrated care represents the bundling of acute and post-acute care under entities such as accountable care organizations (ACOs), which span the entire care continuum. This will take much more legislative and regulatory change, and may be more unlikely given the opportunity to reduce spending by continuing to shift care to lower-cost PAC settings. Additionally, since SNFs comprise a significant portion of the PAC space and represent one of the lowest cost providers, they are bound to be a part of any integrated model.

Labor – Another long-term industry trend that accompanies demographic aging is a shortage of skilled nursing talent. This could cause labor prices to rise. Additionally, skilled nurses could possibly unionize, ultimately raising labor costs. The company has taken a harsh anti-union stance and will continue to resist any attempts to organize its labor force.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Management originally stated that it planned to spin off CareTrust in Q1 2014. This clearly has not happened yet, though management is still pursuing the process actively. Based on the filings with the SEC for CareTrust and management guidance, we expect that this spinoff will occur in mid to late Q2 2014 and that this will catalyze a significant amount of value, especially for the REIT. The Ensign Board of Directors approved the transaction on 4/14/14. It is likely that the REIT will become fully priced quickly after the spinoff, as has happened with similar spinoffs like Sun Health in 2010, at which point it can be sold.

It may take longer for the market to recognize the value of the standalone OpCo. We think that the latest that this revaluation will occur is February 2015, when a full year of standalone financials is available and the market can appreciate the value of the business. 

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