Description

I recommend the purchase of the 10.875% Series A cumulative redeemable preferred stock issued by Regional Health Properties, Inc. (RHE).  The Series A preferred is most suitable for a small fund or a PA; trading volume has averaged 10,500 shares per day for the past 90 days.

mrsox977 posted a write-up of the RHE preferred in 2017.  Much has transpired since then, some of which involved management's ongoing dissipation of the liquidation value of the preferred.  However, there are now prospective catalysts to finally unlock the value of the preferred, due to (1) a proposed, remarkably brazen, exchange offer which, if consummated, would result in the current holders of RHE's common stock (currently worth zero) holding over 50% of the company's equity value and (2) the largest holder of the Series A preferred (holding over 14% of the issue) who filed an amended schedule 13D registering his opposition to the terms of the proposed exchange offer.

The Series A preferred (RHE's only preferred stock issue) has a liquidation preference of $25 per share and a cumulative 10.875% dividend to be paid quarterly.  In the fourth quarter of 2017 RHE suspended preferred dividend payments.  Consequently, (1) the holders of the preferred have the right (as of yet unexercised) to elect two directors and (2) beginning in the fourth quarter of 2018, preferred dividends have accrued at the penalty rate of 12.875% per annum.

BUSINESS AND VALUATION SUMMARY

mrsox's write-up and its extensive comment thread provide a good review of RHE's business, and I suggest reviewing that write-up in tandem with this one.  Below is a brief update of RHE's business, properties, capital structure, and the estimated liquidation value of the preferred.

Properties.  RHE is a self-managed real estate investment company that invests primarily in properties purposed for long-term care and senior living.  RHE is a C Corp, not a REIT.  The Company’s business primarily consists of leasing and subleasing healthcare facilities to third-party tenants, who in turn operate the facilities.  RHE currently owns, leases, or manages for third parties a total of 24 facilities, as follows:

• RHE owns 12 properties, consisting of 10 skilled nursing facilities and 2 assisted living facilities.  RHE leases all of these properties to third-party tenants on a triple-net basis.
• RHE leases 9 skilled nursing facilities.  (a) Eight of these facilities are leased pursuant to a master lease with a single landlord.  RHE subleases 6 of the 8 master-leased properties to third-party subtenants on a triple-net basis.  Beginning January 1, 2021, RHE subleases 1 of the master-leased properties to a sub-tenant for a variable rental based on a percentage of facility EBITDAR.  As of January 1, 2021, RHE began operating 1 of the master-leased properties directly.  (b) One of these facilities is leased pursuant to a single property lease with a separate landlord.  RHE subleases this property to a third-party subtenant on a triple-net basis.
• RHE manages 3 properties on behalf of third-party owners, 2 skilled nursing facilities and 1 independent living facility.

Enterprise Value and Capital Structure.  RHE's enterprise value and capital structure are as follows (note that 57% of RHE's aggregate equity value at market rests in the common, which is worth zero under all but the most optimistic assumptions):

Cash Flow.  A rough estimate of RHE's 2021 cash flow is as follows:

Net rents and management fees

While RHE is not on brink of insolvency and can most likely muddle through on its current course for the intermediate term, the company's course is not sustainable for the longer term.  RHE has little margin to address exogenous shocks, and does not generate sufficient cash flow to perform periodic maintenance cap-ex and capital improvements.  That said, RHE's tenuous circumstances are due primarily to seriously inflated SG&A expenses equal to 21% of gross revenues and 10% of aggregate equity value (common plus preferred).  The bulk (if not the entirety) of RHE's value, and nearly all of its cash flow, is attributable to the 12 properties it owns and which it leases to third-party operators on a triple net basis.  Managing triple net leases does not require $3 million plus of SG&A.  The cash flow spread on RHE's 12 owned properties, net of scheduled debt amortization, is $3.8 million against a preferred market cap of $14.7 million and an aggregate equity value of $33.3 million.  The LTV of these properties is 70% at a 10% cap rate and 56% at an 8% cap rate.  There is value here, but it is being consumed by SG&A.

Liquidation Value.  Taking only the owned properties into account, and assigning no value to the spread leased properties or the management fee income stream, a rough estimate of liquidation value is as follows:

Under all but the rosiest assumptions, 100% of RHE's equity value resides in the Series A preferred stock.  For the common stock to show any value requires valuing the owned properties at a 5% cap rate, and at that the common is worth $3 per share.

NOLs.   It has gone unmentioned in previous discussions that RHE has potentially valuable tax assets; specifically, as of December 31, 2020, RHE had federal net operating loss carryforwards of $77 million against a current enterprise value of $84 million.  While the rules regarding the extent to which NOLs can be utilized in the event of the sale or change of control of a company are complex and restrictive, I nonetheless believe that the monetizable value of RHE's $77 million in NOLs is greater than zero.

EXCHANGE OFFER

Proposed Exchange Offer and Charter Amendments.  On June 1, 2021, RHE filed a draft S-4 Registration Statement in connection with its proposed offer to exchange all outstanding Series A preferred shares for newly issued common stock.  Under the terms of the proposed exchange offer, participating Series A holders would receive, in exchange for each share of Series A preferred stock properly tendered and accepted by RHE, 0.5 share of common stock.

As part of the exchange offer, RHE is requesting that its preferred and common shareholders approve certain amendments to RHE's articles of incorporation.  The completion of the exchange offer is contingent upon shareholder approval of all proposed charter amendments, i.e., if any of the proposed charter amendments are not approved by the requisite vote of shareholders, then the exchange offer will not close and none of the charter amendments will be effective.  (Conversely, if all of the charter amendments are approved by the requisite vote of RHE's shareholders, then the charter amendments will be effective regardless of whether the exchange offer is consummated.)

Specifically with respect to the preferred shareholders, RHE is requesting that the Series A preferred shareholders vote to amend RHE's articles of incorporation to, among other things, (1) reduce the liquidation preference of the Series A preferred stock to $5.00 per share, (2) eliminate accumulated unpaid dividends on the Series A preferred stock, (3) eliminate future dividends on the Series A preferred stock, (4) eliminate the right of holders of Series A preferred stock to elect directors upon the occurrence of a penalty event, and (5) reduce the redemption price of the Series A preferred stock in the event of a "change of control" to $5.00 per share.  To effectuate these amendments to RHE's articles of incorporation requires the affirmative vote of the holders of at least 66-2/3% of the outstanding Series A preferred shares.

Economic Effect of the Proposed Exchange Offer.  The simple math of the proposed exchange offer is as follows – post exchange, current holders of RHE's common stock (currently worth zero) would own 55% of RHE's aggregate equity value.

The value that the exchange offer would transfer to the current common shareholders from the current preferred shareholders is illustrated below.  The common goes from a zero to twice the value of a senior security – well done if you can pull it off.

Opposition of Largest Preferred Holder.  On June 3, 2021, Charles Frischer, the holder of 397,982 shares of the Series A preferred (14.1% of outstanding Series A shares), filed an amended schedule 13D registering his opposition to the proposed exchange offer.  Specifically, Frischer stated that the proposed exchange offer "is the worst deal I have ever seen in my entire investing career," and that the proposal is "dead on arrival" with respect to voting his Series A preferred shares.

As a result of Frischer's opposition, if only another 20% of the holders of Series A preferred do not vote to approve the applicable charter amendments, the exchange offer will fail.  Put another way, Frischer's opposition means that over 77% of the remaining preferred shareholders must vote to approve the applicable charter amendments in order for the exchange offer to be consummated.  This seems unlikely.

Management's Options.  RHE's current path is not sustainable over the longer term, a fact acknowledged by management in its exchange offer proposal.  If, as seems likely, the proposed exchange offer on its current terms is a non-starter, management has several options.

• One, management can sell the company outright (or sell assets piecemeal with the objective of liquidating the company).
• Two, management can continue to muddle along RHE's current path until, inevitably, RHE can no longer meets its obligations and must restructure, by which time the value of the preferred may have dissipated to zero.
• Three, management can embrace sleaze and prime the preferred, either by (1) arranging for (unnecessary) debt financing at the corporate level as a precursor to an ultimate restructuring that gives 100% of the equity to the new debt financing, eliminates the preferred overhang, and gives management a fresh start with newly issued options or (2) arranging a pre-packaged restructuring with DIP financing with the same end result.

Four, management can improve the terms of the exchange offer, preferably in negotiation with Frischer, with the result that the charter amendments are approved, the exchange offer is consummated, and the preferred overhang is eliminated.

Option one, assuming a competent sales process, would obviously benefit the preferred shareholders.  However, common shareholders would probably receive nothing, and management would probably be out of a job.  As such, option one is unlikely.  Option two also seems unlikely, with the caveat that management's actions to date demonstrate that it can't be ruled out entirely.  Option three would be a win for management, if it could be executed cleanly.  But it's not a given that it could be done cleanly, or even at all.  I would expect preferred shareholders (or at least Frischer) to litigate, and my non-expert opinion is that their case would not be frivolous.  At a minimum option three is messy and, in my opinion, it is not certain that it would work.

That leaves option four.  An exchange offer done on terms attractive enough to ensure preferred shareholder acceptance would (1) allow preferred holders a profitable exit (compared to today's price), (2) remove the preferred stock overhang thereby making the common stock a viable security, (3) provide a recovery to current common shareholders greater than the zero they would receive under options one through three, and (4) allow management to keep their jobs.

Below is a schedule showing the respective payouts to common and preferred shareholders under various exchange ratios.  An exchange ratio of 2x is still too generous to the current common shareholders, while an exchange ratio of 4x begins to look reasonable.

In short, there is a path by which the preferred shareholders can receive most of the corporate value to which they are entitled while preserving some recovery for the common shareholders.  Although I don't think it's justified to say that management can be trusted to do the right thing, hopefully they can be trusted to do the obvious thing.

RISKS

Management continues with the exchange offer on its current terms (or insufficiently improved terms) and the required charter amendments are approved and the exchange offer is consummated.

Management abandons the exchange offer and reverts to plodding towards an eventual restructuring.

Management primes the preferred.

Catalyst

Management proposing an exchange offer on improved terms followed by consummation of the improved exchange offer.