National Healthcare Corporation (NHC) is one of the leading providers of senior health care services. With more than 40 years of history and experience, NHC provides health care services to patients in a variety of settings including 68 skilled nursing centers with 8,803 beds in nine states, managed care specialty units, sub-acute care units, Alzheimer's care units, homecare programs, assisted living centers, hospices and independent living centers. The company also provides supporting services such as insurance, management and accounting.
Investment thesis
The majority of the facilities are leased from National Healthcare Investors REIT (NHI), in which NHC owns a minority stake. Approximately 67% of net patient revenues are derived from Medicare, Medicaid, and other government programs. Although private pay and Medicare revenue accounted for 75% of sales, NHC is still strongly influenced by the impact of reimbursements based on healthcare-related legislation, including the Obamacare, which is getting back into spotlight due to being a part of the ongoing debt-ceiling negotiation.
NHC's services will be needed more than ever due to an aging population, with a growing pool of elderly citizens and the high priority of healthcare services on their shopping list, as well as a necessity for the U.S. to somehow manage health care services, whether through setting a framework for a private system or a state-managed system. The nature of health care services virtually ensures that there will be demand for NHC's services 50 or even 100 years from now, whether the system will be financed by individuals directly or through the government agencies.
In the long-run, the government will have to decrease health care spending to help reduce the budget deficit. Hence, the government-controlled reimbursements will copy the inflation at best, and probably lag the inflation rate. On the other hand, this business model of reimbursements at least loosely following the way of inflation ensure that NHC's revenues will at least loosely copy their input prices. The model is similar to utility companies.
I am confident that NHC will be able to use the positive side of the relatively stable and predictable revenue from government-controlled reimbursements which give it partial cost inflation protection and low stock volatility, and accompany this safe, core sales with a privately funded stream, where NHC has a freedom of pricing, documented by YoY comparable revenue increases that surpass the inflation rate (3% YoY increase) and are poised to grow in line with the average inflation in the worst case and faster than inflation on average. The share of this private-source revenue has been steadily increasing and the company keeps being focused on this lucrative area. NHC has great potential to grow the privately funded portion of its revenues.
National Healthcare is a great long-term investment for dividend growth investors with a 10-year, 10.5% annual dividend increase rate, including the challenging 2008-2009 period, which the company weathered extremely well compared to other businesses, and even excluding a one-time extra dividend of $1 per share paid at the end of 2012. The company's common stock pays a regular dividend currently yielding 2.66% and NHC's preferred stock pays an even higher regular dividend with a current 5.5% annual yield and trades 8.5% below its liquidation preference price.
Valuation
From a valuation standpoint, National Healthcare is currently ~25% undervalued and my fair value estimate is approximately $60.90 per share. The downside risk is limited by a strong balance sheet with high tangible book value and the worst-case liquidation scenario would result in a ~33% downside. The steady dividend streams help decrease stock price volatility. The company currently buys back its stock at a 3.5% annual rate which is faster than my long-term 1.5% estimate. The company is authorized to repurchase virtually all of its shares outstanding and if the current faster repurchase rate continues in line with the company's proven past commitment to continuously deliver value to stockholders, the stock offers further 20% upside based on current levels of repurchases.
My valuation is based on the stock price of $48 and 2013 full year EPS estimate of $3.58 that is derived from the real results for the first two quarters, the current YoY sales and EPS trends and the company's outlook for the rest of 2013. I further estimate a very conservative 2% sales growth and 6% EPS growth for the next ten years, followed by flat results.
If repurchases continue at current 3.5% rate
source: author's calculations
Where will the EPS growth come from?
The sales growth will be delivered via slow but steady expansion of the number of beds under management and utilization of facilities that are currently under construction (1% annual sales growth contribution), as well as from sales increased due to an increasing share of private-pay patient services with prices growing faster than inflation (additional 1% annually).
Based on my estimated EPS waterfall, the 6% EPS will be delivered by the basic top line growth described above (2% annually), from improved service mix with higher share of high-margin, private-pay services (1%), as well as from ongoing cost optimization measures (1%). NHC's EPS will be boosted by 1.5% annually from smart uses of its free cash from operations to continue purchasing previously rented real estate at a roughly 14% ROI (purchase price at 7 times the annual rent it used to pay). The final EPS boost of 2% per year will come from a continuous share repurchase program that is under way. Given the company's long and stable history of catering to investors as evidenced below, there is high probability that the share buybacks will continue. The 7.5% gross annual EPS growth will be eroded by a 1.5% fall due to margin pressure and higher leasing costs due to rising interest rates, for a final net EPS growth of 6% per year.
National Healthcare offers 25% to 45% upside potential, growing dividends and strong buybacks
In conclusion of my thesis, the stock is undervalued and offers at least a 25% to 45% upside with slow but steady and resilient growth as well as regular dividend streams and share buybacks.
Based on preference and needs for income or capital appreciation, investors can choose between the common stock that offers unlimited long-term stock price upside potential plus a 2.66% dividend yield and a growing dividend, or a preferred stock with a much higher current yield of 5.66%, but a stagnant dividend which will not increase in the future due to the bond-like nature of this instrument, and a stock price upside potential limited to 8% due to the risk of the stock being redeemed by the company at liquidation preference price. My preference is to simply buy the common stock due to unlimited long-term stock upside potential and dividend growth.
For elderly investors, buying NHC stock can serve not only as a sound long-term defensive stock investment but also as one of the options to hedge part of their future rising health care costs by owning a company that will benefit if healthcare costs rise.
Significance of recent events for the company's strategy
As the reimbursement system is moving from a fee-for-service toward a bundled payment system for a defined medical treatment state or period and as the private payment segment provides better growth opportunities than the government-reimbursement segments, the company has been undertaking numerous steps to increase future revenues and profitability. NHC increased its stake in Caris Healthcare, L.P., a hospice company, from 64.9% to 75.1% in 2012. Recently, Caris has been expanding in its line of business through acquisitions.
The company also announced an alliance with TriStar Health to focus on hospital re-admissions and integrated intervention strategies. NHC also initiated construction of two skilled nursing facility projects with a total 140-bed capacity. In December, the company also announced an agreement to purchase six skilled health care centers from National Health Investors ("NHI"). The centers have been leased by NHC since 1991. Moreover, NHC also announced the extension of its master lease with NHI through December 31, 2026, for 38 skilled health care centers and three independent living centers. Furthermore, the company announced a settlement of disputes with two non-profit organizations regarding the fairness of prices it paid for purchases and leases of properties from the two non-profits.
Excellent financial management and catering to investors
NHC shows a number of activities that prove excellent cash and capital management, as well as long-term devotion to creating shareholder value. NHC has had virtually zero long-term debt in the past five years. As it generates cash from operations, it deploys it to pay regular and increasing dividends to common and preferred shareholders, and recently NHC even approved a stock buyback program. In the second quarter of 2013, the company repurchased common stock worth $100M, translating to a roughly 3.5% annualized percentage of common stock outstanding. Under the ongoing program enacted in 2012, NHC is allowed to repurchase virtually the entire amount of shares outstanding, and I expect the repurchases to continue.
Moreover, the company has switched six additional health care centers from renting to owning by purchasing them from NHI, the REIT from which it leases most of its properties under long-term contracts. The purchase price of $21M was only seven times the annual master lease payment of $3M, which means NHC has bought the properties at a very lucrative price at a roughly 14% annual return on investment. The company should definitely continue using its future free cash to purchase additional facilities instead of renting them, and I am convinced NHC will do so, as the company has options to purchase most of its leased properties in the future. The company has also started building two new health centers. All these activities are beneficial for the shareholders, as they properly manage cash and assets and continue increasing shareholder value. Some great news is that the company can keep increasing all these activities in the future if it generates cash.
Also, did I mention that the management compensation as a percentage of net income generated to shareholders is one of the lowest I have seen?
Financial performance and future outlook
As mentioned above, and as evident from a long-term annual overview of the most important income statements and balance sheet figures, the company has been a conservative and steady grower of earnings and dividends.
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source: company SEC filings
The most recent 10Q SEC filing for the second quarter of 2013 reveals that net income for the second quarter was $0.88 per common share, a 7% YoY increase. Revenues were $192M, a 2.3% YoY increase despite the automatic 2% cuts known as "sequestration" that began on April 1, 2013, for Medicare providers. Operating results for the second quarter of 2013, compared to the same quarter last year, were favorably impacted by an improved patient mix, as well as the continued effort to implement cost-saving measures to reduce expenses in NHC's skilled nursing facilities.
Medicare and managed care per diem rates (per day rates) at NHC's owned and leased skilled nursing facilities decreased 0.8% and 3.7%, respectively, compared to the second quarter a year ago. Medicaid and private pay per diem rates at NHC's owned and leased skilled nursing facilities increased 3.0% and 3.3%, respectively, compared to the quarter a year ago.
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To sum up the financial results, NHC is showing continued resiliency by managing to grow top line and bottom line YoY despite sequestration cuts, tough general economic environment and one-time legal settlement costs. The government-controlled revenue is falling, whereas the private pay sales are rising above inflation rates on a per diem and per patient day. Private pay is where the future lies for the company, as can be evidenced from the future growth activities that company has in the pipeline.
Growth activities
The company plans to undertake many activities to boost revenues from the private pay segment. In addition to past activities already mentioned, the company expects to begin construction on a 92-bed skilled nursing facility. NHC also entered into a joint venture to build and operate an 85-unit assisted living community. The property is currently under construction and plans to open in the first quarter of 2014. NHC also entered into a joint venture to develop and operate a 14-bed psychiatric hospital focusing on geriatric care, projected to open in 2014.
Moreover, during the rest of 2013 and in 2014, the company will apply for Certificates of Need for additional beds in its core markets and also evaluate the feasibility of expansion into new markets by building private-pay health care centers or by the purchase of existing health care centers. NHC is also evaluating the feasibility of construction of new assisted living facilities in select markets.
Risks
Two-thirds of NHC's revenues are earned under government-controlled programs and are subject to review by the Medicare and Medicaid intermediaries. In the long-run, the government will try to reduce spending to balance the budget, resulting in reimbursements and allowances most likely rising at a slower rate than average inflation.
Conclusion
National Healthcare stock is undervalued and offers at least 25% upside potential under my very conservative growth estimates and 45% upside if stock repurchases continue at the current rate. NHC is an excellent long-term buy-and-hold investment with growing dividends and an attractive and more than sustainable 2.66% dividend yield.
For investors heavily oriented on income, the NHC also offers a preferred stock (trading under the ticker NYSE: NHC.PRA), currently yielding 5.5%, but offering no dividend increase and only a limited 8% long-term preferred stock upside potential.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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