Eminence Capital to Vote Against Merger Between Sabra Health Care REIT, Inc. and Care Capital Properties Inc.

Monday, July 24, 2017 General News
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Major Sabra Shareholder Tells Board That Doubling Down on Skilled Nursing Facilities by Purchasing CCP's Increasingly-Troubled Portfolio Would Hurt Company's Long-term Growth

NEW YORK, July 24, 2017 /PRNewswire/ -- Eminence Capital, LP, which owns 3.9 percent of the common stock of Sabra Health

Care REIT, Inc. (NASDAQ: SBRA), today sent the following letter to the Board of Directors regarding their announced merger with Care Capital Properties Inc. (NYSE: CCP):

July 24, 2017

Richard K. Matros, Chairman  Board of Directors  Sabra Health Care REIT, Inc.  18500 Von Karman Avenue, Suite 550  Irvine, CA 92612

Dear Chairman Matros and Members of the Board of Sabra Health Care REIT, Inc.,

We are writing this letter in regard to your proposed acquisition of Care Capital Properties (NYSE: CCP) ("CCP"), announced May 7, 2017.  Eminence Capital, LP owns 3.9% of Sabra Health Care REIT, Inc. (NASDAQ: SBRA) ("Sabra" or the "Company") and plans to vote against the deal.  Our opinion is predicated on the following:

  1. Skilled nursing facilities ("SNFs") are under tremendous pressure, for various reasons, and we see no end in sight.  CCP is 80-85% exposed to SNFs and, in our view, its SNF portfolio, in particular, is terribly positioned to navigate through this increasingly challenged industry.
  2. These pressures will drive larger rent cuts and more dramatic portfolio repositioning versus what the Company represents, resulting in value destruction for shareholders.  The Company is swapping its own valuable currency for CCP assets that will be worth materially less three-to-five years from now.
  3. In its public filings, the Company makes it clear that asset class diversification is an "achievement."  We therefore have serious questions with respect to the motivation and rationale for this deal.
  4. While we emphasize poor strategic fit as our primary issue with the transaction, the price Sabra is paying is also meaningfully too high.

Below are the specific and significant challenges faced by CCP:

  • As of the first quarter of 2017, 65% of rents were covered at less than 1.2x EBITDAR[1], up dramatically from 38% just one quarter ago and 25% one year ago. In retrospect, Sabra management's claims during its first quarter 2017 earnings call (which was held before CCP released its first quarter 2017 earnings supplement) that CCP's portfolio had not deteriorated relative to the prior quarter were clearly disingenuous.
  • 56% of rents are concentrated in its top-five operators where the combined coverage is 1.1x, and overall portfolio "same-store" cash rents are in year-over-year decline.
  • Signature Healthcare, CCP's second largest tenant representing 15% of rent, is going through significant financial distress and could very likely need to file for bankruptcy protection. Sabra management is well aware of this but, we believe that, based on the continued industry stress, this is not a straight forward situation where coverage needs to be reset at a modestly higher level. Signature could have continued deterioration for years to come that needs to be considered.
  • On its third quarter 2016 earnings conference call and during subsequent follow-up conversations, CCP began talking about some of its tenants requesting rent concessions which, when coupled with the trends in coverage, is very concerning.
  • The CCP portfolio's average "star rating" is among the worst in the industry relative to other large or REIT-owned portfolios, a reflection of poor-quality assets. The "quality rating system" is a program administered by the Centers for Medicare and Medicaid ("CMS"), and is increasingly being used by SNF referral sources as a means to determine which SNFs to partner with and where to send patient referrals. A difficult operating environment makes it extremely challenging to turn these assets around.

These trends and absolute levels of portfolio coverage are particularly problematic given our belief that industry conditions will remain just as poor, if not deteriorate further during the coming years.  Based on extensive primary research, our view is that SNF industry profitability will decline meaningfully over the next three-to-five years.  The primary drivers of this fundamental outlook are:

  • Traditional Medicare (FFS) to Medicare Advantage – SNFs have seen and will continue to see tremendous profit pressure from a mix-shift towards Medicare Advantage, now representing roughly one-third of all Medicare beneficiaries, which carries significantly shorter lengths of stay and lower per diem payments to SNFs. Medicare represents the large majority of industry profitability given its extremely high profit margins relative to Medicaid. We believe the strong growth in Medicare Advantage penetration will continue, as will the consequent pressure on SNF profitability.
  • Value-Based Reimbursement – SNF referral sources (hospitals in particular) are becoming increasingly responsible for, and incentivized around, managing a patient's overall cost and quality of care (i.e. before, during and after the hospital stay). This shift from volume to value exposes waste within the healthcare continuum by forcing hospitals to more strongly consider the highest-quality, lowest-cost sites of care. SNFs are very poorly positioned in this debate – hospitals are cutting SNF referral networks by more than 50% and shortening lengths of stay for patients they do still send to SNFs.
  • Cost Inflation – Labor/nursing, the largest cost item for SNFs, is feeling the effects of wage inflation. Nursing turnover at SNFs can be incredibly high, and these facilities struggle to recruit and retain top talent (a) in a world of staffing supply shortages and (b) given the competitive disadvantages versus deeper-pocketed hospitals. We believe wage inflation has moved from 2-3% to more like 3-4%+, which can be troublesome when SNF revenues are declining.
  • Added Regulatory Burden – The majority of SNFs are 30-40 years old and in need of massive capital investment. These lower-quality, underinvested facilities play a role in the poor quality and compliance controls known to the industry. Not surprisingly, we have witnessed an increased number of government investigations into various players in the space. In addition, newly passed regulations require SNFs to comply with time-intensive and costly mandates.
  • Reimbursement Risk – For years and, to a greater extent, more recently, certain independent advisory groups and regulatory authorities have recommended payment reform for SNFs which, in our opinion, is a function of flaws in the current payment system and misaligned incentives leading to generous Medicare margins. Over the years, SNFs have increasingly billed for the highest categories of therapy, despite key characteristics of SNF beneficiaries remaining unchanged, resulting in billions in overpayments. We believe significant payment reform will take place in the foreseeable future, and that it is likely to be negative for SNFs.
  • Traditional Medicaid to Managed Medicaid – States are increasingly outsourcing the management and reimbursement for SNF patient populations to Managed Medicaid players. Similar to certain effects the shift from traditional Medicare to Medicare Advantage has on SNFs, this shift towards more Managed Medicaid, while still early days, could have a significant effect on volumes, length of stay and payment rates.

In recent presentations, the Company has illustrated rent cut scenarios for the CCP portfolio.  We view this as an attempt to reassure shareholders that the portfolio can withstand a rent cut and the deal would still be modestly accretive to funds from operations ("FFO").  However, we believe the Company's analysis is deeply flawed, and that near-term accretion will turn into significant long-term earnings dilution:

  1. Sabra is underestimating the risk – The Company's scenarios suggest that CCP may see a rent cut of approximately 5-10%.  In our view, the cut should reasonably be 20% or greater.   We believe Sabra management is overly focused on the near-term issues at Signature as the only major problem. 
  2. We see no end in sight for the industry pressures.  We believe there will be continued pressure on rent over the next three-to-five years and, given CCP's poor relative positioning, its portfolio will witness trends that are at least as bad as what we predict for the industry.

Over the years, Sabra's management and board have done an admirable job recognizing the need to diversify the Company's portfolio and executed on this strategy.  In its 2016 proxy statement, the Company discussed this success as "achievements related to diversifying the investment portfolio."  In its first "highlight" supporting this demonstrated success, it reads "we further diversified our investment portfolio by tenant, asset class and geography."  In continuing to discuss further diversification success from its largest tenant, Genesis Healthcare Inc. ("Genesis"), Sabra goes on to say "upon completion of the [Genesis] sales, these asset sales and amendments will have the benefit of reducing our revenue concentration in Genesis and skilled nursing facilities…"  The proxy makes it very clear that the Company views asset class diversification as a clear success.  Yet despite this prudent strategy applauded by both shareholders and the board, management is unjustifiably reversing course by increasing its SNF exposure back to 73% (from 50%).  We have a very hard time understanding the rationale or motivation behind such a deal.  Two possible theories could be:

  1. Sabra is extremely worried about its largest tenant, Genesis.  The Company is desperate to diversify away more quickly and/or plug the hole in FFO, and is obtuse to the fact that less exposure to Genesis does not make sense if its new exposure is even more problematic.  The belief that Sabra's cost of capital over the long-term will be lower if it diversifies is misguided because they are embarking on a flawed strategy of swapping one bad hand for one even worse.
  2. Acquiring CCP will increase Sabra's market cap by 2.4x.  Per the proxy, the Compensation Committee benchmarks management compensation against a list of companies that are of a similar size.  A material increase in the market cap would leapfrog Sabra into a peer group with a larger market cap and correspondingly higher range of compensation.

Given our views on the SNF industry and CCP in particular, we would have a very hard time justifying a price at which this deal makes sense.  We would, however, be remiss to not mention our view that the Company is significantly overpaying for this asset, even putting our strategic concerns aside.  Management has said that it paid an initial cap rate of 8.4%.  However, when adjusted for potential near-term rent cuts that re-base coverage merely to industry averages, that falls to the mid-7% range (per management).  Relative to the 9-11% range where we believe other SNF portfolios trade in the marketplace, Sabra is paying a huge premium. 

Finally, while this deal may be near-term accretive, we strongly believe it will be decidedly dilutive after larger rent adjustments and continued industry pressures.  As Sabra shareholders, we recommend that the Company take an alternative path – one similar to the previous strategy of diversifying away from large tenants, SNFs and government reimbursement, and we welcome the opportunity to discuss this further.

Sincerely,

Ricky C. Sandler  Chief Executive Officer and  Chief Investment Officer

About Eminence Capital, LP  Eminence Capital, LP ("Eminence") began in 1999 and currently manages approximately $6.7 billion on behalf of institutions and individuals.  Eminence utilizes a fundamental bottom-up research driven investment process that utilizes a combination of industry research, rigorous financial analysis and dialog with company management as part of its rigorous investment process.

This material is for general informational purposes only and is not intended to be relied upon as investment advice. The opinions expressed are those of Eminence as of July 24, 2017 and are subject to change at any time due to changes in market or economic conditions.

The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Eminence to be reliable and are not necessarily all inclusive. Eminence does not guarantee the accuracy or completeness of this information. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

The discussion of securities should not be viewed as a recommendation to buy, sell or hold any particular security.

Eminence is not soliciting proxies relating to the CCP or SBRA special shareholder meeting and does not have the authority to vote your proxy. Eminence is not asking for your proxy card and cannot accept your proxy card. Please DO NOT send us your proxy card.

[1] "EBITDAR" is defined as earnings before interest, taxes, depreciation, amortization and rent.

For More Information Contact:  Scott Tagliarino/Taylor Ingraham  ASC Advisors LLC  (203) 992-1230

 

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SOURCE Eminence Capital, LP



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