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National HealthCare Corp: How’s It Lookin’ Doc?
Posted by: Frank Voisin (IP Logged)
Date: April 20, 2012 06:23AM

A reader emailed me about National HealthCare Corporation (NYSE: NHC). According to tear sheet data on a few websites, the company appears to have the following characteristics:

  • Almost no debt: D/E of just 0.016x
  • Lots of cash: $280 million vs. a market cap of $635 million (or $20 per share)
  • Fantastic free cash flows: $4.14 per share
  • Trading for just 1.04x book value
  • Profits every year for the last ten years (and growing)
  • Revenue growth each year for the last ten years
On these points, the company looks great. It trades for $45.80, and if we strip out the net cash, the enterprise value is just $26 per share. With $4.14 per share of free cash flow, the yield is 16%. Combine that with a consistently growing top and bottom line and you’ve got yourself a winner, right? Maybe not.

The problem with looking at the tear sheet created by various websites is that it masks important data which is relevant to investors. So while NHC looks attractive based on the metrics above, consider that about half of its cash and securities is restricted from general corporate use:

Quote:
We also self-insure our employees’(referred to as “partners”) health insurance benefit program at a cost we believe is less than a commercially obtained policy. …

We have set aside restricted cash and marketable securities to fund our professional liability and workers’ compensation reserves. …

The increase in restricted cash and cash equivalents is from NHC and other healthcare facilities paying insurance premiums into NHC insurance companies, which restrict the cash payment. …

Restricted Cash and Restricted Marketable Securities

Restricted cash and restricted marketable securities primarily represent assets that are held by our wholly-owned limited purpose insurance companies for workers’ compensation and professional liability claims.

The company only has this money because it has elected to self-insure its employees. This is fine, but potential investors have to recognize that this is not cash that can be used for general corporate purposes, like paying dividends or repurchasing shares or buying other companies. Any investor purchasing on the belief that 45% of the company’s market cap could be paid out is sorely mistaken. This is not excess cash.

Secondly, while it is strictly correct to say that the company has just $10 million of long term debt, when analyzing a company as potential investors we have to look for other debt-like liabilities. In this case, we see that NHC has 10.84 million cumulative, convertible preferred shares outstanding with a liquidation value of $171 million.

For potential common shareholders, these preferred shares must be treated like debt. After all, they create a fixed charge in the form of about $8 million, and while the timing of payment could be flexible in extreme circumstances, the preferred shareholders stand in front of the common shareholders in the event of liquidation (at which point the preferred are entitled to $171 million plus all accumulated dividends). For all intents and purposes, this is debt. The distinction only matters in liquidation when debt holders stand in front of the preferreds.

Also, by treating preferred shares as debt, equity is reduced from $612 million to $441 million. Suddenly that favourable P/B ratio of 1.04 becomes a less attractive 1.44x.

The preferred shares have another consequence, this time on the Statement of Cash Flows. Dividends are treated as Cash Flows from Financing, whereas interest is treated as Cash Flows from Operations. If we are to rightfully treat preferred shares as debt, then we would have to move dividends to preferred shareholders up to become a use of cash under CFO. This reduces CFO by a bit over 10% last year, and reduces free cash flow by 15% to $3.52.

Before I conclude, there is one more thing to note unrelated to the points above. NHC owns 67.1% of a company called Caris. Despite this high ownership level, the company is not considered to be in control of Caris and so accounts for this investment using the equity method rather than consolidating Caris’ performance. This inflates NHC’s net profit margin as Caris’ revenues and expenses are not included in NHC’s income statement (rather, only NHC’s interest in Caris’ bottom line flows through to NHC’s bottom line as pure profit).

So where does this leave us? Let’s go back to the bullet points above:

  • D/E: 0.016x –> 0.41x.
  • Cash: $280m –> $146m (that can be used for corporate purposes)
  • Free Cash Flow per share: $4.14 –> $3.52
  • P/B: 1.04x –> 1.44x
Converting this information to valuation multiples, we see the following:

  • EV: $365 million –> $670 million
  • FCF: $57 million –> $49 million
  • EV/FCF: 6.4x –> 13.7x

What once looked attractive now appears to be fairly priced.
What do you think of NHC?

Author Disclosure: None



Stocks Discussed: NHC,
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