Description

Adcare Health Systems (ADK) is a microcap special situation whereby the company is transforming itself from an owner and operator of healthcare properties into an owner and lessor (effectively a dividend paying REIT).   This Transition will be accomplished through a series of leasing and subleasing transactions and is intended to maximize cash flow and shareholder value.   Once this Transition is complete (expected by year end), we expect the company to eventually be sold because the company will be too small to remain public and has a shareholder base that would likely be supportive of a sale/exit.  The company intends to initiate a cash dividend later this year (5.8% yield on 2015 dividends) so investors will be paid to wait for the eventual sale.  We believe the shares are undervalued because it is microcap, doesn’t screen well (no dividend, bad/confusing reported financials, levered), and is complicated story; however, we see several catalysts in the near term which we expect will create shareholder value, not to mention the potential/eventual sale of the company.  We believe there are likely buyers for this company and believe a buyer could achieve significant savings (refi debt, refi 11% preferred, eliminate virtually all g&a).  The stock is trading at 12x PF Free Cash Flow.  If you add back some conservative savings an acquirer could get (g&a and assume the preferred is refinanced at 5%), the implied valuation is 8.8x.

While the stock is illiquid, we believe there are opportunities to purchase blocks from holders of the converts.  In addition, there are some attractive 2015 options one can play (long the calls, short the puts).  

ADK currently owns/operates 34 healthcare facilities (mostly skilled nursing facilities) in Alabama, Arkansas, Georgia, Missouri, North Carolina, Ohio, Oklahoma, and South Carolina.  Under the previous regime, the company had a checkered past and did a poor job of operating its facilities.  It is also highly levered and has some expensive debt.  Years of underperformance ultimately led to several large holders filing 13Ds and, after some changes at the Board, a commitment to explore strategic alternatives (with the assistance of SunTrust Robinson Humphrey).  While the proxy filed on 8/29/14 gives additional background, we believe Board realized it could sell the company (likely to another REIT) for a higher price once ADK leased/subleased its properties, thus making it a cleaner acquisition target.  This plan also enables the company to monetize its sizeable $25mm NOL. 

The following presentation gives a good overview of the Transition Plan, which was announced July 23rd: http://www.sec.gov/Archives/edgar/data/1004724/000100472414000087/adkstrategicpresentation.htm

As part of the Transition Plan, the company announced a plan (and recently reconfirmed it) to pay a dividend in the first quarter of 2015 and increase it over the following few quarters.  The initial dividend is projected to be 5c and increase 1c sequentially until it is at 10c in the 2^nd quarter of 2016.  Investors should receive 26c in dividends in 2015, implying a 5.8% yield. 

As you can see on page 7 of the Presentation, under the New Model runrate, the company should generate :

                        EBITDAR                                24.3 (assumes no rent increases)

                        Rent                                         (6.5)

                        Interest                                     (11.3)

                        Taxes                                       (0.0)

                        Add back:

                                    Non cash interest         1.8 (included in the amount above)

                                    Non- cash rent             0.2 (included in the amount above)

                        Cash from operations              8.5

                        Less: Pref dividends                (2.6)

                        Free cash Flow                                   5.9

                        Plus:  interest from converts    1.7

                        Adjusted Free Cash Flow       7.6

                        Plus: interest from refi             2.0 (conservative / expected over NTM as it delevers)

                        PF Free Cash Flow                 9.6

The above figures include $2.5 million of g&a, which may be a bit high for a company which will only have a few employees and public company expenses.  We also assume zero capex since it will be negligible.

The $24mm of 10.875% preferred (publicly traded) are callable at par Dec 2017 or upon a change of control.  We expect an acquirer (or ADK itself) will be able to refinance this paper at a much lower rate.  

There is always execution risk in these type of situations.  However, since announcing the Transition Plan, the company has had several announcements that give us confidence they are making good progress on implementing the plan.  The announcements include:  

1)      Announced it has “commenced discussions with regional operators to lease 18 of the Company's 34 facilities. Furthermore, certain regional operators in other markets have contacted the Company to discuss leasing the Company's facilities in these regions. “

2)      Announced they expect to complete the Transition by year end, if not earlier.

3)      Announced the leasing of the two facilities in Alabama on Sept 24^th.

4)      On Oct 3^rd refinanced $12 mm of debt under a 30 year, HUD backed financing at 3.75%, versus the ~6% rate on the old debt

5)       Announced the resignation of its CFO, Ron Fleming.  We believe Fleming was a leading candidate to be the CEO, but since he felt the company would be sold in the not too distant future, he left the company for a more permanent job (CFO at a private equity portfolio company).  We have spoken with Ron since his departure and do not believe his departure was related to any questionable issues regarding financial statements, etc.

6)      Announced the hiring of a new President/CEO, Bill McBride  (http://finance.yahoo.com/news/adcare-appoints-william-mcbride-iii-200000396.html)  McBride, 54, is an experienced executive who came out of retirement to take this job.  He has more than 30 years of industry experience. This is an important hire as the company has been a bit stagnant since announcing the Transition plan, perhaps because his predecessor was 76 (and reportedly dealing with some health issues) and the CFO was pursuing another jobs. 

7)      Added a new Board member, Brett Morrison.  Brett has capital markets experience and also adds a younger member to the Board.  The current Board has some 70 year old members, although we expect one of them may resign after the 10k is filed.

The company’s has some large shareholders who are actively working to create shareholder value:

            Chris Brogdon  -          9.3%                Ex officer and still involved in implementing Transition

            Doucet Asset -                         7.8%                13D filer

            Park City Capital -       6.5%               13D filer and Board Member

            Dave Tenwick -                       2.5%                Chairman

Enterprise Value:

     Share count:           

            17.5     shares outstanding (june 2014)

            1.1       2010 Converts at $3.73 due aug 2014

            1.9       8% 2012 Converts at $3.97 due July 2015

            1.4       10% 2014 converts at $4.50 due april 2015

            4.6       Options/warrants  

            26.5     Total Shares

            $4.45   Current Stock Price

$118.0 Equity market capitalization

            18.3     Cash

            17.6     Options/warrants proceeds

            118.0   Debt (excluding converts)

            24.0     11% preferred

            224.1   Enterprise value

Thus the company is trading at 12x PF Free Cash Flow.  If you add back the g&a and assume the preferred is refinanced at 5%), the implied valuation is 8.8x

ADK’s stock price has traded down lately with the market, with selling of some convert holders as well as some frustration among shareholders from a lack of news.  We expect the news flow to increase as the company makes progress implementing the Transition.  We expect the stock to trade up as management announces more leases and refinancings, and the declares the 5c dividend in Q4, payable in 1Q 2015.

As mentioned, we believe there is upside if/when the company is sold.  Integrating an acquisition would be relatively easy (it is just leases) and a buyer could generate significant saving (relative to the size of the acquisition) by eliminating the 2.5mm of G&a, refinancing the 11% preferred (which the company pays $2.6mm annually), both of which are meaningful to the $9.6 million of PF free cash flow mentioned above.     

Catalyst