Value Investors Club / Kindred Healthcare Inc. (KND)

Description

KND—

Thesis—

A healthcare sell off, fear over the impeding implementation of LTAC criteria, an OIG report on SNFs,

and a weakening high yield market have sent KND shares down ~50% in the last several months. These

fears provide the opportunity to buy a diversified post-acute provider at 7x 2015 guidance for adjusted

eps, 6x 2016 FCFe and <5x managements post synergy FCF guidance for 2017. On a sum of the parts, the

current valuation implicitly creates the LTAC segment at ~3x 2017 EBITDAR even after assuming a 15%

EBITDAR decline in that segment which takes into account the risks but not the potential benefits of the

implementation of LTAC criteria. In 2016, the absence of transaction and integration costs related to the

Gentiva and Centerre acquisitions will reveal the true cash generative abilities of Kindred and shares will

re-rate materially higher. I believe $21-25 per share is a reasonable 18 month price target based on 10-

12x 2016E FCF.

Background—

Historically Kindred was primarily a skilled nursing (SNF) and Long term acute care (LTAC) provider, but

has significantly diversified by shuttering money losing SNF operations burdened by legacy Ventas leases

and expanding into more attractive home health, hospice, and inpatient rehab (IRF) segments through

recent acquisitions of Gentiva and Centerre. The new Kindred is now more hedged from a

reimbursement perspective and better positioned to deal with the industry transition towards bundling

and ACO’s. Synergies and incremental growth from Gentiva and the Rehab segment will lead to better

organic growth rates for the consolidated company following any choppiness related to LTAC criteria

implementation.

Reimbursement—

Investors in healthcare services bear the risk that the most important customer is CMS. That said, in the

context of the recent past, the reimbursement visibility today for KND is good compared to just 2 years

ago before congress legislated the codification of LTAC criteria in late 2013. Prior to the codification of

criteria, investors feared that LTACs could go away completely. While 2016-2017 could be choppy for

the LTAC division, the opportunity to backfill compliant patients should allow the LTAC business to

continue its strong FCF generation over the long run. No existential risk exists in the business today, and

KND has significantly diversified into more attractive post-acute segments in the past two years, leaving

the company better positioned from a reimbursement perspective than it has been in many years. While

the LTAC segment produces less than 35% of my EBITDAR estimate for F2017, the implementation of

LTAC criteria that begins in hospital fiscal 2016 has been a source of extreme investor consternation and

is a major part of why KND is attractively valued at today’s prices.

LTAC Segment—38% of Pro forma EBITDAR

An in-depth discussion of the nuances of LTAC criteria is beyond the scope of the write up; however,

several analysts have published extensive 50-100 page reports that are worth reading. To keep it

extremely simple, it is my opinion that the stock already reflects a worst case scenario arrived at

reducing reimbursement for Kindred’s census of non-compliant patients and assuming no capture of

incremental compliant patients (roughly 25% decline in segment EBITDA). On the other hand, there are

several offsets to criteria which have a high probability of allowing KND to mitigate the EBITDAR losses

that investors fear and even grow EBITDAR in the long run. For reference, management has guided to

keeping LTAC EBITDA relatively flat through the transition. While this could be slightly optimistic, one

misunderstood aspect of criteria is that it should cause a mix shift towards higher acuity higher CMI

patients which carry higher margins so replacing lost census is not one for one. Additionally, the removal

of the 25 day LOS requirement for MA patients should open up incremental patient opportunities for

the LTAC operators and the 50% rule should force non-profit and regional providers out of the market

which should drive census KND and SEM’s LTACs which already serve a higher acuity patient than the

rest of the industry. Additionally, post-acute services investors will remember the benefits that the

codification of criteria had in the IRF industry starting in 2004 that was significantly beneficial to

industry. Some industry participants believe codification will lead to increased utilization of LTACs by

referral sources as previously doctors were unsure exactly which patients CMS wanted to treat in LTACs.

In the valuation section I will demonstrate that the intense fear around LTAC criteria is already priced

into the stock and there are several reasons to believe that post- criteria results will be better than

feared.

Kindred at Home (KAH)—31% of Proforma EBITDAR

Home health reimbursement has unprecedented visibility as we are entering the later years of rebasing.

Hospice margins are relatively high but commentary from CMS is positive. Organic volume growth in

home health of 6.5% in Q2’15 demonstrates the growth opportunities for this business. Hospice

volumes are a potential opportunity to improvement as they have recently stabilized census following

challenging integrations at the predecessor GTIV. While I use EBITDAR above, it is fair to say that KAH’s

contribution to FCF is actually higher than EBITDAR due to the lower rent and capital burden that

characterizes the home health business.

Rehab (IRFs + contract therapy)—19% Proforma EBITDAR

IRF reimbursement was codified in 2004. There should be natural continuation of volume growth in IRF

as well as growth opportunities through additional IRF JVs that will come on line over next few years.

While bundling could impact this business, these tests are still very early and KND should be well

positioned given their emphasis on integrated care. The contract therapy business was weak in Q2, but

that was due to consolidation in the space and should be 1x in nature.

Skilled Nursing (SNF)—12% of Proforma EBITDAR

While the OIG recently issued a report on SNFs, OIG has put out similar reports in the past without any

changes and SNF represents <15% of KND proforma EBITDAR and reduction in SNF census likely pushes

increased patients towards Kindred’s home health segment.

Valuation—

With F2015 guidance for core EBITDAR of $1.025B, KND is ~5x levered on an EBITDAR basis (@6x) and

trades at ~6x 2016 consensus EBITDA and EBITDAR. On an adjusted cash EPS basis KND is guiding to

$1.80 in F2015 or 7x adjusted proforma earnings.

On a FCF basis KND put out guidance for 2017 when they made the GTIV acquisition. Using 86m shares

the low end of that range equates to $2.67 in FCF or a 20% FCF yield on current equity. FCF is my

preferred valuation metric and if KND can exceed $2 in FCF I believe there is upside to the stock.

Source: KND Presentation

Source: Susquehanna Financial Group

I typically do not favor sum of the parts valuations but given this one was nicely prepared by

Susquehana I borrowed it. I am comfortable with the multiples used and

the conclusion that we are creating the LTAC business at 3x EBITDAR, leaving significant margin of safety

regarding the LTAC transition.

Risks—

1. LTAC Criteria: The implementation of LTAC criteria could create choppiness in LTAC results

which on the surface could drive volatility in KND stock but I don’t believe is enough to

completely break the stock. I estimate a low $2s FCF number for KND in 2016. Assuming the

worst case scenario $100m EBITDAR shortfall occurs that could take my FCF number to $1.40

which is still a greater than 10% FCF yield on KND equity which I believe is roughly fair value. In

this case the thesis wouldn’t play out, but I believe downside would be relatively contained.

2. Major changes in post-acute reimbursement. If CMS were to adopt more of an MA model, that

could create some uncertainty in KND’s business. Providers like KND could restructure costs in

order to make money and CMS understands the value of post-acute care (where else would

these patients be cared for?) but reimbursement is a risk to investing in healthcare services.

3. Management fails to achieve the GTIV synergies: I believe the synergy targets are reasonable

but should management fail to execute going forward that would likely reduce upside.

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

Catalyst

Free Cash Flow

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			2015	2016
Price:	13.40	EPS	1.80	2.10
Shares Out. (in M):	86	P/E	7	6
Market Cap (in $M):	1,150	P/FCF	0	0
Net Debt (in $M):	3,025	EBIT	0	0
TEV (in $M):	4,361	TEV/EBIT	0	0