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Sun Healthcare Group (SUNH): A Value Investment Greenblatt Could Love

September 28, 2010 | About:
Joel Greenblatt makes a strong case in “You Can Be A Stock Market Genius” for investing in companies planning spinoffs. Often inefficiencies exist – especially in the small capitalization universe – whereby a company trades below its breakup value or a division is not fully appreciated by Mr. Market. Splitting the company into two separately traded entities can often unlock value.

Taking a page from Greenblatt’s play book, Sun Healthcare Group is close to executing the spinoff of its real estate operations in the form of a REIT. The value creation opportunity from this event – expected in the next quarter – could lead to an appreciation of around 40% (or more) in the share price (analysis below)

Investment Thesis

Sun Healthcare’s shares represent an opportunity to invest ahead of a spinoff that when it occurs will create significant value for SUNH shareholders. Based on a discount to current comparable Healthcare REIT capitalization rates of FFO (Funds Flow from Operations) applied to Sabra’s FFO and applying a conservative P/E multiple to the net income of New Sun, the combined business is worth over $11.00+/share. In fact, Sabra alone could be worth close to the current share price of consolidated Sun Healthcare.

Deal Description

On May 24, 2010, Sun Healthcare Group announced its intention to restructure its business by separating its real estate assets and its operating assets into two separate publicly traded companies, SHG Services, Inc., which will be renamed "Sun Healthcare Group, Inc." ("New Sun"), and Sabra Health Care REIT, Inc. ("Sabra"). The proposed restructuring is expected to occur during the fourth calendar quarter of 2010. The transaction frees up and values the real estate on SUNH’s books, an asset currently not appreciated by the markets.

Sun Healthcare has already completed a $207MM equity offering on August 12th to paydown existing term loan. On Wednesday, September 29th, the company is planning a $285MM debt offering ($150MM of Term Loan, $75MM funded letter of credit and $60MM of a new revolving credit facility) to refinance remaining debt outstanding.

Upon completion of the spinoff of the REIT, existing shareholders will own one share of New SUN (“SUNH”) and one share of Sabra (“SBRA”).

SHG Services, Inc. Overview

As a result of the planned transaction, New Sun will hold all of the operations and other assets and liabilities (other than substantially all of the owned real property and related mortgage indebtedness). New Sun will retain ownership of four healthcare properties that are located in Georgia, Maryland, Massachusetts and Wyoming as well as administrative office buildings in Albuquerque, New Mexico .

Sabra Health Care REIT, Inc. Overview

Sabra will own and lease to subsidiaries of New Sun the 87 Sun properties that Sabra will own following the REIT Conversion. Following the Separation and REIT Conversion Merger, Sabra will be a self- administered, self- managed realty company that will own and invest in real estate serving the healthcare industry. Sabra will generate its revenues primarily by entering into long- term triple- net leases with local, regional and national tenants and operators throughout the United States. Initially, Sabra's portfolio will consist of 68 skilled nursing facilities, ten combined skilled nursing, assisted and independent living facilities, five assisted living facilities, two mental health facilities, one independent living facility and one continuing care retirement community . As of June 30, 2010, the Sabra Properties had a total of 9,740 licensed beds, or units, located in 20 states. Sabra will lease all of these properties to subsidiaries of New Sun.

Sabra expects to initially grow its portfolio through the acquisition of skilled nursing and senior housing facilities, including assisted living, independent living and continuing care retirement community facilities. As Sabra acquires additional properties and expands its portfolio, it expects to diversify by geography, asset class and tenant within the healthcare sector.

The Math

According to the SEC 425B prosepctus from Sun’s recent equity offering, pro forma for the offering, New Sun will have $0.55/share of 2009 pro forma EPS (roughly equivalent of June 2010 annualized run rate of $0.56/share). New Sun will bear $195MM of debt and sit with $40MM of cash on its balance sheet. It will have transferred its 87 owned properties to Sabra and will pay approximately $70MM in rent expense going forward.

Sabra will have pro forma FFO of around $0.60/share. FFO is a concept used in REIT valuation representing Funds Flow From operations and equals Net Income + Depreciation and Amortization (like EBITDA but with interest deducted). Sabra will bear $355MM of debt which is manageable given it generates significant cash flow ($42MM of FFO) from the lease payments paid by New Sun.

Multiples for Healthcare REITs have continued to rise as market demand for yield has increased. Cap rates for most of the HC REITS are between 6-7% (14-16x FFO). Applying a 30% discount to the low end of the comparables, would imply a 10x FFO multiple - quite conservative, but perhaps warranted due to the fact that the properties are all leased to New Sun and it is certainly a smaller cap REIT compared to some of the comps (Ventas, UHT, LTC Properties, etc.).

Applying a 10x EPS multiple to New Sun gives a value = $5.50/share

Applying a 10x FFO multiple to Sabra gives a value = $6.00/share (already assumes a 30% discount to lower bound of comps)

For a gross sum-of-the-parts value of about $11.50/share less about $0.30/share tax leakage assumed from the transaction for a total $11.20/share. Sun Healthcare currently trades at $8/share (a 30% margin of safety or 40% upside from the current price).

Let's suppose that Sabra does not trade well and actually has a 12.5% cap rate and New Sun trades at a 6.25x P/E (i.e. the same price as the stock today: $4.80 + $3.50 -$0.30 tax leakage = $8.00). You would then be holding a REIT that is distributing substantial annual dividends over 10%/year (very high in this market) and own a very attractively priced skilled nursing facility operator. Not bad.

Business Description

Sun, through its subsidiaries, provides nursing, rehabilitative and related specialty healthcare services principally to the senior population in the United States. Its core business is providing inpatient services, primarily through 166 skilled nursing centers, 16 combined skilled nursing, assisted and independent living centers, 10 assisted living centers, two independent living centers and eight mental health centers as of June 30, 2010. As of that date, our centers had 23,209 licensed beds located in 25 states, of which 22,427 were available for occupancy. Of the 202 centers operated as of June 30, 2010, 112 centers were leased from third parties and 90 centers were owned. SUNH also provides rehabilitation therapy services to affiliated and non- affiliated centers and medical staffing services and other ancillary services primarily to non- affiliated centers and other third parties.

Rating: 3.6/5 (14 votes)


George1357 - 7 years ago    Report SPAM
There will also be a $13 million dividend paid at the time of the spinoff equivalent to about $0.18/share,
Third_derivative_merf - 7 years ago    Report SPAM
That payment is to cover the tax leakage associated with the transaction so the payment actually nets out to $0
George1357 - 7 years ago    Report SPAM
Yes, that's right. There appear to be some clear milestones ahead: 1) shareholders' meeting, 2) financing and 3) spinoff of Sabre REIT (in Q4). The good news is that much of the uncertainty is gone: the company has completed its equity offering, health care REITs are up 16% since the date of announcing the planned spinoff (so the argument for doing this is stronger) and the reimbursement rate picture is clearer. Facility health care stocks have tended to perform well AFTER new rate regimes have been put in place. At $8, there was a 40% upside.

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