For the past two years, the Long-Term Care sector has consistently posted the highest deal volume in health care services. Within the sector, however, deals have lopsidedly favored the assisted and independent living end of the senior care acquisition spectrum, to the neglect of skilled nursing. True, National Senior Care made headlines last year by buying Mariner Health Care (OTCBB: MHCA) for $1.0 billion, but that was largely an exception to the general trend.
The winds of change appear to be shifting now. After a few significant but expensive sales of skilled nursing facilities, or SNFs, toward the end of 2004, the country’s largest operator of SNFs, Beverly Enterprises (NYSE: BEV), has become the target of a group led by Formation Capital in a deal that could top $2 billion. The market responded favorably. Within days of this announcement, BEV’s shares were up 33%, exceeding the preliminary price of $11.50 per share on the table. And on this news, other nursing facility stocks jumped as well.
After the initial shock, we realized that a bid for Beverly should not have been that big a surprise. Long the subject of many takeover and breakup rumors, BEV’s name has often surfaced, particularly when its stock price drops. In the late 1980s, it traded below $4.00 per share, provoking rumors of a potential bankruptcy filing. During the 1990s, the share price mostly stayed out of single-digit territory. But by 2000 it had dropped to $2.31 before jumping back up to over $12.00, only to plunge to $1.60 per share in 2002 and then rise to a high of $9.41 in 2004.
Despite this roller coaster ride, Beverly was one of only three major publicly traded long-term care chains that did not file for bankruptcy protection during the time of troubles from which we have recently emerged. Whenever the shares plunged, analysts took to their calculators to see what the “breakup” value was, trying to figure out a reasonable per-bed valuation, which states should be sold off and how to finance the theoretical acquisition. But ultimately their calculations were filed away, until now.
The Biggest Player in Skilled Nursing
Once upon a time, Beverly had three times the number of facilities as its closest competitor. But realizing that size was just not enough, the management that built BEV to more than 1,000 facilities started to downsize. When new management arrived four years ago, asset sales continued, and with some reasonable success. At last count, Beverly was down to 369 facilities, all but 18 of which are SNFs. Some ten years ago, BEV’s market cap was $1.2 billion when it had 725 facilities (and with a lot more debt than today as well). Now it finds itself just above that mark as a result of the acquisition talks.
Formation Capital Makes Its Move
Unlike previous exercises in number-crunching, the current bid has to be considered a serious one. The investment group has already purchased more than 8 million shares of Beverly on the open market, now worth more than $100 million, and they have also stated they will put up to $375 million of equity into the deal. The major investors, led by Formation Capital, include Appaloosa Management LP, Franklin Mutual Advisors LLC and Northbrook NBV LLC.
The investment group has offered to pay $11.50 per share, which yields an equity investment of about $1.25 billion. However, when debt ($570 million) and leases capitalized at 12% ($258 million) are factored into the equation, the total (and theoretical) deal value rises to $2.07 billion. In perspective, that price tag would make this the second largest long-term care deal in history, coming in second after the $2.9 billion acquisition of Manor Care in 1998 by the former Health Care & Retirement Corp., now Manor Care (NYSE: HCR). If Formation Capital’s initial price per share were hiked to $13.00, the total value would reach $2.2 billion.
BEV’s annualized third quarter EBITDA is about $185 million, before any adjustments, so at the lower per-share price, the deal would be valued at just over 11x EBITDA and $51,800 per bed. Now, no one seriously believes that BEV’s beds are worth $50,000 a pop, so some part of the value obviously comes from its hospice and therapy divisions, which are growing and produce significantly better margins than the SNFs. The Formation Capital group has estimated the ancillary businesses may be worth $4.00 per share, or more than $400 million, which is about 1.6x estimated 2005 revenues and 6.0x EBITDA.
Admittedly speculative, this valuation still lies well within the realm of possibility. So if we remove these ancillary businesses from the valuation, the price does come down to almost $42,000 per bed, which happens to be the average price paid in the market from 1996 through 1999. While prices have been a lot lower since then, our readers will shortly learn that, based on our 2004 statistics due out next month, a significant jump in average prices can be expected from the dismal results of 2003.
How High Can They Go?
Even so, no one believes a deal will go through at $11.50 per share, especially since the market has already taken the shares above $12.00. Despite the investor group’s stated willingness to sweeten its initial offer, that leaves little room to maneuver since anything over $13.00 per share begins to get problematic, especially for any new financial buyers with little experience navigating the vagaries of reimbursement and liability insurance.
Wringing Out Beverly’s Untapped Value
With such little wiggle room, what’s the attraction? One of the main keys to this deal will be the assumptions made on liability insurance accruals. Legg Mason has assumed a $45 million annual savings for someone like the Formation Capital group, which adds $350 million to $450 million in value depending on what multiple you want to use. There is another key to be turned to make sense out of this deal, but one that only a few buyers will be able to recognize, or put to use effectively.
One constant feature in the criticism of Beverly over the years, particularly when it was double its current size, is that it makes more sense to break the company up into two or three smaller operating units in order to get operations— and margins—under better control. Beverly suffers from relatively low margins in the industry, some 50% lower than Manor Care’s. And since it is a truism that health care delivery is a local matter, a more localized approach to Beverly’s operations could help improve margins and, by the same token, occupancy.
Combining occupancy increases with margin expansion can have significant financial ramifications, as Formation Capital knows firsthand. Three years ago, an affiliate of Formation Capital purchased 49 skilled nursing and four assisted living facilities in Florida from BEV for $165 million. Formation then hired newly formed Seacrest Health Care Management to operate the facilities while Formation acted as landlord. In just three years, the occupancy for the portfolio has jumped from 84% to 92.5%, and revenue has grown from $285 million to just over $400 million. Margins have increased while deficiencies have declined, and the return on investment has almost certainly been spectacular (and not public). But it seems more than likely that the profitability was disclosed to the investors backing Formation’s current bid, and that may have played no small part in their interest in participating in the deal.
However, it is difficult to predict at this point how BEV would be divided up into leaner and more profitable operating units. The company maintains a large presence in such difficult states as California, Minnesota and Indiana. Still, a more local management structure will help to improve operations. So any analysis as to what the Beverly portfolio is worth has to include some assumptions about occupancy and margin improvements beyond any cuts in liability costs. No one outside the Formation Capital group knows what they are assuming, and for all we know, that is just the gravy (or the cushion) on top of what their minimum expectations for Beverly are. But if past is prologue, they will separate real estate ownership from operations, and let local management teams take over.
Greenmail
Though this saga will play itself out over the next several months, the jockeying has just begun. Formation Capital’s first formal letter arrived on Thursday, December 23, but BEV was closed for a four-day holiday weekend, so management apparently didn’t see it until Monday the 27. Then during January, in its second letter, Beverly said they would respond on February 4, knowing full well that the next day was a deadline to get on the agenda for the upcoming annual meeting, effectively blocking the investor group from making their case to shareholders. However, Formation Capital managed to slot in a letter with six nominees to the board by the deadline. The slate includes turnaround specialists, restructuring experts and crisis management gurus. You can imagine how they will view the bid.
Such ploys and counterploys are common enough in the M&A business, but it will all boil down to what makes sense for shareholders. They may likely find that roller coaster rides are best left to amusement parks, approve the stock valuation in Formation Capital’s bid and back a sale to the highest bidder.
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