two for the price of sun

8/8/2019 Two for the Price of Sun

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Sun Healthcare Group Investment Thesis

Leading Skilled-Nursing Services ProviderStrong cash flow generatorRecurring revenue streamsRecession resistant business

Embedded in the company are significantreal estate holdings

Company intends to unlock the value of real estate properties by spinning outOperating Company

Company has a hidden deferred tax assetthat should shield company from incometax for many years

Intrinsic value of company not currentlyreflected in the market

Company worth significantly more onsum-of-the-parts basis

Ticker: SUNH

Stock Price:$8.24

Recent ValuationMultiples:

5.5x 11e EV/EBITDA*5.4x 11FFO**

Capitalization:EnterpriseValue: $1.1bnEquity MarketValue: $618mm

*based on estimatedEV/EBITDA for OpCo

**implied FFO basedon OpCo


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Company Description

Sun Healthcare Group is a leading provider of long-term, sub-acute and specialty healthcare servicesprimarily to senior citizens in the U.S. via a networkof facilities in several states.

The company operates 182 skilled nursing facilities,12 assisted and independent living facilities and 8mental health hospitals with 22,000+ beds in 25states.


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Operating Company: A diversified business model

SUNH operates in three business segments:

Inpatient

Services

Rehabilitation

Therapy

Medical

Staffing

Daily nursing,therapeuticrehabilitation,social services,housekeeping,nutrition andadministrativeservices

Speech pathology,physical therapyand occupationaltherapy

Licensed physical,occupational andspeech therapists,nurses, pharmacists,physicians, etc

~87% Revenues ~6% Revenues ~7% Revenues


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SUNH recently announced it will soon be split into two businesses

OperatingCompany

REIT

Skilled nursing,Rehabilitation, MedicalStaffing

87 properties68 SNF10 mixed

(SNF/AL/IL)6 AL/IL2 Mental Health

9500+ beds

SUNH owns 45% of the facilities it operates, most of which will

comprise the REIT (Sabra).


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Some terminology


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Terminology

Medicaid: State and Federal healthcare program for low incomeindividuals or familiesMedicare: Federal healthcare program for elderly individualsAcuity: Refers to the level of complexity or intensity of patient careConcurrent Therapy: One therapist treating multiple patients at the sametime with the patients performing different activitiesLook-Back Period: Services received within 14 days prior to admissionused to gauge reimbursement levelsRUG: Group which Medicare patient is classified into based on servicesneeded and functional statusSkilled Mix: Refers to all non-Medicaid revenues patient daysQuality Mix: Refers to all non-Medicaid revenues

Census: Refers to the number of inpatients in a given facilityMinimum staffing levels: Sets minimum level of nursing staff required atfacility


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A little about the industry


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Post-Acute Care Industry Overview (contd)

SUNH, a skilled nursing facility (SNF), falls at the mid-point of the acuity spectrum:

Companies can improve profitability and margins by moving up the acuityspectrum.SNFs typically have a greater presence in smaller, rural areas, affordingthem some buffer against less acute services (i.e., the only game in town).


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The transaction


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The Transaction

On May 24 th 2010, Sun Healthcare (SUNH) announced plans to split intotwo publicly traded entities: an operating company and a REIT.The company will spin-out its operating unit (New Sun) on a one for onebasis and convert the remaining entity consisting of the companys realestate holdings into a REIT (Sabra Health Care REIT). Properties will beleased back to Sun.In doing so, management feels it can unlock the value of the companysreal estate portfolio and afford the operating company flexibility topursue growth strategies and focus on core competencies with lessfinancial debt.SUN recently raised ~$225mm through a stock offering in order to reducethe companys debt levels (proceeds used to paydown 9.125% senior subnotes and outstanding term loans).Post spin-off, Rick Matros, current CEO of Sun, will become the CEO of Sabra, while current COO of Sun Bill Mathies will become the CEO of New

Sun. All other management will remain unchanged.

Stockholders rights plan: No single shareholder can acquire more than 10% of the companywithout making a fair bid for the entire business so that no single investor can derail thecompanys plans of electing REIT status.


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Transaction Timeline

8/17:

$225mmshareofferingcompleted

1/11:

Elect REITStatus

5/24:

Transaction

Announced

Oct:

~$325mmdebtrefinancing

Q4 10:

BusinessSeparation


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The two businesses


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SUN Healthcare (OpCo)

Recession resistant businessExperienced management teamStrong market position

Consistently high occupancy rates (~90%)Predictable, stable and recurring revenue streamsReliable payer base-US Government as largest customerGood long term prospects (favorable demographics)High barriers to entry (certificate of needs limitations in17/25 markets)

Leading provider of skilled-nursing services.

High-quality business operating in favorable demographic/secular environment asthe populations ages and there is more accessibility to health care coverage.

Once uncertainty surrounding reimbursement rates settles, company should seeexpansion of valuation multiples.


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Sabra Health Care REIT

High quality tenantExperienced management teamStrong growth opportunities thatlarge players may shun (small size,easy to push the dial)Geographically diverse portfolioSale potentialSector expansion/diversification overtime (ALFs, ILFs, hospitals, MOBs)

Attractive dividend

Single tenantSingle property typeSmall market cap/limited initialappeal to real estate investorsNon-investment gradeLimited operating history/trackrecord

Sabras only pure comp is Omni Healthcare, a long-term care facility REIT.

Given Sabras single tenant/property type, balanced with its high quality tenantand strong growth potential, Sabra should trade at a discount to OHIs valuationmultiples (~12x fwd FFO, ~8% cap rate), though this gap should close over time.

Positive Factors Negative FactorsPositive Factors


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Lease Terms

Master lease on all facilities10-15 year term, with 5 year renewal options (at existingrates)Lesser of CPI or 2.5% escalators1.6x lease coverage

Management maintains that the transaction will not restrict its operatingflexibility or ability to conduct renovations or capital improvements.


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Deferred Tax Asset

$227mm in net operating loss carry-forwards

that can be applied to future earnings (as of 6/30/2010)Utilization amounts subject to IRS Section 382Limitations

SUNH also has potentially valuable DTAs that will shield income taxes farinto the future.


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High Quality Management Team

Extensive experienceRick Matros has been the CEO of three HealthcarecompaniesHandled turnaround/bankruptcy emergence operationsOperated in many different market and operatingenvironments

Conservative mindsetWorld class operatorsEntrepreneurial spirit

Shareholder oriented


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A secular tailwind


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Favorable Demographics and Industry Structure (contd)

While elderly population growth

US Seniors Population Trends (70+ years old)


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Favorable Demographics and Industry Structure (contd)

is likely to continue to outstrip new facility supply

Senior housing construction starts in Top 31 Metros (units)


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So what is the company worth?


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OpCo Valuation

2011E 2011EEBITDAR 250 250Current Rent 75 75

Incremental Rent 70.9 70.9EBITDA 104.1 104.1Multiple 5.5 6Enterprise Value 572.55 624.6

Less Debt 198.00 198.00Equity Value 374.55 426.60Shares Outstanding 75.00 75.00

Equity Value4.99 5.69


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Sabra REIT Valuation

Pro-Forma Rent Payments 70,200 G&A 2,400 D&A 23,681 Interest 22,190 Total Costs 48,271

EBT 21,929 Taxes -Net Income 21,929

FFO 45,610 Pro-Forma Shares 75,000 FFO Per Share 0.61

FFO Multiple

PropCoValuePer Share

9x 5.5 10x 6.1

Dividend Yield*9x 10.00%10x 9.00%

*Assumes 90% FFO payout


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Combined Valuation

Information asymmetry: valuation gap between intrinsic and trading valuelikely exists as the situation is too complex for most retail investors and thecompany too small to interest most institutional investors.

Value Per Share

5 5.5 6 6.58 9.17 9.86 10.55 11.259 9.77 10.47 11.16 11.86

10 10.38 11.08 11.77 12.4611 10.99 11.68 12.38 13.07 12 11.60 12.29 12.99 13.68

Potential Upside

5 5.5 6 6.58 11.23% 19.65% 28.07% 36.49%9 18.61% 27.03% 35.45% 43.87%

10 25.99% 34.41% 42.83% 51.25%

1133.37% 41.79% 50.21% 58.63%

12 40.75% 49.17% 57.59% 66.01%

F F O M u

l t i p l e

( P r o p

C o

)

EBITDA MultipleO Co

EBITDA Multiple

O Co

F F O M u

l t i p l e

( P r o p

C o

)


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Risk factors


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RUGs IV (Resource Utilization Group Version 4)

Medicare currently classifies patients into 1 of 54 categories.13 new categories to be added. The upper-nine RUGs are thehighest paying.New RUGs classification system scheduled to be implementedon Oct 1, 2010.Categories are based on minutes of therapy required, needfor special services and an index base on the ability to

perform four activities of daily living (eating, toileting, bedmobility and transferring).An opportunity for growth?

Transition to higher paying patient types

Could take several quarters to play outTop nine RUGs were intended to be ~20% of Medicare patientdays, actual number close to 26% as SNFs targeted patientsrequiring higher intensity, acuity and complexity.


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RUGs IV: Strategy and historical perspective

SUNH successfully navigated RUG III changes, increasing its upper-nineRUG utilization over time.

It will likely take several quarters for SUNH to able to refocus on moremedically complex patients, but history shows management is capable of doing so.The company does not believe it will be negatively impacted over time

and the OpCo/PropCo transaction should be seen as a vote of confidence.


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RUGs IV Changes

Eliminates concurrent therapy and Look-Back PeriodCenters for Medicare & Medicaid Services (CMS) wouldprefer to see concurrent therapy used as more of asupplement.CMS is proposing time is allocated between all patients,not as individual time.Analysts estimate this should only impact 4% of patients.Real impact is additional costs associate with incrementaltherapists.Look-Back Period: Five services were used as a proxy foracuity/complexity. Patients who met these requirementsqualified for upper-9 payment rates. Patients will only

qualify if they receive these services AFTER admission,whereas before it was within the past 14 days. There willalso be some additional rehabilitation requirements.


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Potential follow-on opportunities

SUNHs transaction creates comparable for other long-term care providers whowish to monetize their real estate portfolios. This offers a pool of similaropportunities and the potential to wait out the SUNH transaction and pursuesimilar, future ones.Potential candidates include:

Skilled Healthcare (SKH, 74% owned real estate)Ensign Group (ENSG, 63% owned real estate)Brookdale Senior Living (BKD, vast majority owned real estate)

Privately held ManorCare and Golden Living already have an OpCo/PropCostructure and may look to explore IPOs and use them to support acquisitions oralternatively, may conduct reverse mergers.

Risk: new accounting rules calling for operating leases to be capitalized may present an obstacle.

A potentially repeatable investment theme.

If the transaction is successful, other companies could follow suit.


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Conclusion

High quality business with recurring revenue streams,secular tailwinds and a great management teamTrading at a significant discount to fair value on a sum-

of-the parts basisSpin-off opportunity presents catalyst to realize value

Shares do not currently reflect upside potential of OpCo/PropCostructure and transaction should unlock value

Potential pipeline of other similar, attractive opportunities

Upside potential: 27-43% + value of DTA


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Appendix

SUNHs per day patient rates by payer:

two for the price of sun

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