EFTA01108670.pdf

J.P. Morgan North America Credit Research 27 September 2012 Kindred Healthcare Overweight Moody's: 81 Outlook: Stable Initiating Credit Coverage with Overweight; Buy on the S&P: 8+ Outlook: Stable 8-1/4% Notes The above ratings are at the corporate level Ticker KND • Kindred Healthcare (KND) is one of the largest healthcare service Healthcare providers, with LTM revenues of $6.1 billion. Two things have David Common, CFA AC historically made it a difficult credit for many investors. First, about half of its revenues are obtained from long term acute care (LTAC) hospitals, the reimbursement of which Medicare has long suggested Jared Feeney. CFA should change. Second, a sale-leaseback many years ago means KND has 'double leverage' via unusually high rents. J.P. Morgan Securities LLC • We think it's a good time to Overweight Kindred. Most importantly, it seems KND will not have to contend with any transformative changes to Medicare reimbursement for the next several years. Medicare took skilled nursing (SNF) payments down sharply a year ago, and it has delayed the 25% rule for LTACs an additional year to 2013, "pending results of an on-going research initiative to re-define the role of LTCHs in the Medicare program." Visibility of 2013 is reasonable, helped by preliminary guidance this month. FCF looks to be adequate, albeit sensitive to small changes in margins. • Management wants to increase the percent of assets it owns vs. leases. After some back and forth with Ventas, its largest landlord, KND now plans to let the leases lapse for 54 SNFs with annual revenues of approximately $550 million. These are generally older assets (average age of 41 years). Between below-average margins and capex required for upkeep the FCF impact of this shrinkage should be •, • minimal. KND 8-1/4% have underperformed since issued in May 2011. Bonds are a little below par while the market and single-Bs have tightened 40bps and 60bps, respectively. But now that we have anniversaried a full year of lower SNF payments and CMS has said it will review patient criteria, business risk seems much reduced. • We initiate credit coverage with an Ovenveight rating on Kindred and a Buy on the 8-1/4% unsecured notes. Table 1: KND Bond Market Data as of 26-Sap-12 Coupon Amt ISmr0 Description Maturity Rating Ma YTW STW Rae 5 250 . 3550.0 Sr Unsettred 1Jun•19 BNB- $98.00 8.65% 768bp Buy Source: J.P. Morgan and Bloomberg. See page 10 for analyst certification and important disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. www.morganmarkets.com EFTA01108670 David Common. CFA North America Credit Research 27 September 2012 J.P.Morgan Company Background Kindred Healthcare (KND) is a post acute care provider, with LTM revenues of $6.1 billion and Adjusted EBITDAR of $846 million. KND acquired RehabCare in June 2011 for $1.3 billion, and obtained 32 long term acute care hospitals, five inpatient rehabilitation facilities, approximately 1,200 rehabilitation therapy sites of service, and 102 hospital-based inpatient rehabilitation units. The company's strategy is focused on the development of cluster market service offerings across the U.S., providing care across the post acute care spectrum, from the highest acute (LTACs) to the lowest acute (home health). Today, KND has 15 cluster markets and has three potential cluster markets. Figure 1: KND Geographic Footprint and Cluster Markets • ••• ,:e- • .brok e. %. • C :'• . • • • • • NE" • • ;JAC Hoe/dais VIII • Inpatient R•habilitabOn Hospdais rei . Moyne, Bawl Acme, roar) Units (1011 • Nursing and Rehabilitation Contins1224) ....1 • RenabCaro Total tines of &nig 12.007 0 Eigeng Cluster Mark•I 110 • Henn Health ad ilegokoleal O /gondol Closter alakot (3) antSnsle X12 Source: Company reports. The company has five reportable segments, including the following: • Hospitals — Consists of the company's long-term acute care hospitals as well as its inpatient rehabilitation facilities. As of June 30, 2012, the company operated 118 LTAC hospitals and six IRFs in 26 states. In May, the company renewed (for 10 years) a lease (with Yentas) for 10 LTAC hospitals that was set to expire in April 2013. These LTACs generated $276 million in revenues for FY 2011. Revenues and EBITDAR (pre-corp) for the last 12 months were $2.9 billion and $573 million for this division. • Nursing Center (SNFs) — Consists of the company's transitional care, nursing and rehabilitation, and skilled nursing centers. As of Lune 30, 2012, the company operated 224 SNFs, and six assisted living facilities in 27 states. In February, the company decided not to renew leases for 54 of its SNFs, which generated approximately $550 million in revenues for FY 2011. The current lease expires in April 2013 (though the company has provided Yentas additional flexibility with accelerating the transfer of those assets to new operators). Revenues and EBITDAR (pre-corp) for the last 12 months were $2.2 billion and $294 million for this division. 2 EFTA01108671 David Common. CFA North America Credit Research 27 September 2012 J.P.Morgan • Rehabilitation (RehabCare) — Consists of the company's contract therapy services in hospitals and long-term care settings. Revenues and EBITDAR (pre- corp) for the last 12 months were $969 million and $142 million. • Home Health and Hospice (PeopleFirst) — Provides the aforementioned services from 52 locations in eight states under the "PeopleFirst" brand. The company has been keenly focused on expanding these capabilities. Revenues and EBITDAR (pre-corp) for the last 12 months were $99 million and $9 million. Figure 2: Revenue Mix Rehabilitation 16% Home Health & Hospice LTACH/IRF 1% capitals 47% Skilled Nursing Facilities 36% Source: Company moods. The hospital segment is higher-margined than the other segments, highlighting that LTAC business conditions are still the number one driver of results. Figure 3: EBITDAR (Pre-Corporate) Mix Rehabilitation 14% Home Health & Hospice 1% LTACFUIRF capitals Skilled Nursing 56% Facilities 29% Source: Company resod!. Over 60% of the company's revenues are exposed to government reimbursement, which has been under increased scrutiny (see Recent Credit Profile below). Note that the "Business-to-Business" payor below is from the company's rehabilitation division (contract therapy services). 3 EFTA01108672 David Common. CFA North America Credit Research 27 September 2012 J.P.Morgan Figure 4: Payor Mix usiness1o. Business 15% Medicare 40% Commeraal Insurance/ Private 29% Medicaid 16% Source: Company reporis. History - Separation from Ventas • 1985: Company was founded as Vencare Inc, an operator of LTACHs. • 1989: Company went public and changed its name to Vencor, Inc (based on its early focus on ventilator-dependent patients). • 1995: Vencor made a $1.6 billion acquisition to acquire Hillhaven Corporation, an operator of more than 300 SNFs. • 1997: Balanced Budget Act changes SNF reimbursement from cost-plus to a prospective payment schedule (PPS) leading to uncertainty in future margins. • 1998: Vencor split into two companies, in an attempt to unlock shareholder value by "REIT-ing" the company. Ventas, which took with it the real estate assets, became a REIT and Vencor become the operating company. • 1999: The decline in SNF payment rates exceeded management's expectations, and cost-save opportunities turned out to be lower. Vencor filed for Chapter 1 bankruptcy protection, but got about a 20% rent reduction from VTR to reflect the non-arm's length nature of the original lease arrangement. As part of the bankruptcy reorganization, Vencor changed its name to Kindred Healthcare. Recent Credit Profile CMS Rate Reduction for SNFs In July 2011, CMS announced the final SNF rates for FY 2012, an average 11.1% reduction for all SNFs. This rate correction was made to address the spike in reimbursement associated with the introduction of the RUGS-IV (Resource Utilization Groups Version 4) payment schedule. Under the new payment system, the government saw a significant increase in reimbursement, due to a shift in utilization among the therapy modes under the new RUGS-IV that differed significantly from CMS projections. As a result, CMS decided to implement a correction for fiscal 2012. Following the cut, KND appeared to have underestimated the impact over the course of several quarters, increasing the annual revenue impact estimate (to both its SNF and contract therapy businesses) from the midpoint of $102 million in August 2011 to $150 million in February 2012. 4 EFTA01108673 David Common. CFA North America Credit Research 27 September 2012 J.P.Morgan Despite underestimating the revenue headwind, it has been largely offset by cost savings. While management had first anticipated $55 million in synergies for 2012 associated with the RehabCare acquisition, the company has since realized $70 million through 2Q12. Further, the company expects to realize $50-$55 million in cost savings from SG&A reductions over the course of 2012. Management expects 4Q12 to be the first quarter where the full impact of the RehabCare synergies and the SG&A reductions will be evident. RehabCare Acquisition KND acquired RehabCare in June 2011 for $1.3 billion (about 8x pre-synergies EBITDA), and obtained 32 long term acute care hospitals, five inpatient rehabilitation facilities, approximately 1,200 rehabilitation therapy sites of service, and 102 hospital-based inpatient rehabilitation unites. As noted above, while management had first anticipated $55 million in synergies for 2012 associated with the RehabCare acquisition, the company has since realized $70 million through 2Q12. Future Credit Profile Acquisition Growth The company plans to "aggressively" expand home health and hospice services in its cluster markets, services that management sees as "higher-margin growth business." Today, the business is at about a $200 million run rate (post recent acquisitions including IntegraCare discussed below). As KND recently indicated, organic growth rates in home health and hospice are in the 6%-8% range, compared to 2%-3% in LTACHs, and about flat in SNFs. The higher growth rates, in conjunction with the company focused on delivering care across the post acute care continuum, will likely lead to significant expansion in home health and hospice, resulting in a change to the revenue mix in the future. KND expects to be able to grow the home health and hospice business organically (including de novos) by approximately 10% a year, with an additional $75-$100 million of growth per year via acquisitions. Earlier this month, KND acquired IntegraCare, a home health and hospice provider predominantly located in northern Texas, for $71 million (I.0x revenues) plus a possible $4 million cash earn-out. The company generates $71 million in revenues and EBITDA of approximately $9 million. Management expects additional organic growth opportunities through expansion into KND's existing Houston market. Paul Diaz indicated at a recent investor conference that he would like to make five more deals like IntegraCare over the next 18 months. LTACHs Get Relief In August, CMS announced the final rates for LTACHs, resulting in a +1.7% update for fiscal 2013. KND management indicated that the net effect (before sequestration) for the company will be a "slight" decline in reimbursement for its facilities. In any case, these rates and the one-year extension of the 25% rule appeared to positively surprise many investors, with KND's equity rising 19% on the day after the proposal in April. Earlier this year, MedPAC recommended no update in rates, with many investors fearing the possibility of CMS incorporating the full impact of budget neutrality (3.9% cut that was set to go into effect in calendar year 2013), and 5 EFTA01108674 David Common. CFA North America Credit Research 27 September 2012 J.P.Morgan the expiration of the very short stay outlier and 25% rule moratoria. Ultimately, the following is the final update for fiscal 2013: • 1.3% budget neutrality phase-in (3.75% over three years). • A payment reduction for very short stay outliers of 0.5%. • One-year extension of the 25% rule, 'pending results of an on-going research initiative to re-define the role of LTCHs in the Medicare program." The announcement of a 1.7% net increase for LTACHs is a win for the industry, as the outcome was arguably at least a 6% swing, from the context of what the rate could have been with the full impact of budget neutrality in place. Furthermore, the delay in the 25% rule is a positive for those with significant exposure to hospital-in- hospital (HIE) facilities, the full impact of which (while challenging to estimate given the number of assumptions) could be in the $50 million context for some of the H1H operators, but the impact to KND would likely be materially lower. It's also possible that the 25% rule could be eliminated in entirety. CMS states that it has delayed the rule "pending results of an on-going research initiative to re-define the role of LTCHs in the Medicare program." We believe that this research initiative is likely referring to patient criteria. Our sense was that industry-sponsored 'criteria' had been sufficiently diluted that they came nowhere near CBO's score of the cost to replace. But even if we don't know the details, the fact that CMS is considering this is a win in itself for the industry. As discussed at an investor presentation earlier this month, KND believes the criteria bill will score $500 million to $1 billion in savings. With the upcoming election taking center stage, we figured 'criteria' would only have an opportunity for inclusion in Congress's "lame duck" session. Real Estate — More Ownership, Less Leasing In recent years, KND has developed a greater interest in developing its asset base, reacquiring leased assets when compelling value propositions present themselves. As noted by management this month, the company has purchased previously leased real estate for approximately $76 million, which includes three LTACHs. Recently, management has addressed its view on acquiring real estate, which per the figure below, is the most expensive decision with respect to capital allocation. Given this and the other materially more accretive opportunities, we would expect the company to focus less on repurchasing its rented assets and continue to build out its franchises (especially home health and hospice; see low multiple and high EPS accretion; further discussed above). 6 EFTA01108675 David Common. CFA North America Credit Research 27 September 2012 J.P.Morgan Figure 5: KND's Capital Investment Opportunity Set I Ilamewsla I. Mapco $0200 10. NO DefiesITIVI*1KNOW (0...11 SO 090 I LIACMI Pleapsel Dow Natal Mixdb11.1484 $0. ss0 SO t20 a SOW Pit ants. Marltet Acssieltles 10010 a. soap IbtotelPurchs I Delailadonlex • web 50020 ""Co 1224 10x Ompoimilitia/Develormat Mao", Nei a Renato. owlNowa fixassleIs..smr Exforpfle• Vas* y 11111WARI Source: Company repcils. SNF Divestitures As mentioned above, in February, the company decided not to renew rental contracts for 54 of its SNFs, which generated approximately $550 million in revenues for FY 2011. The current contract for these facilities expires in April 2013 (though the company has provided Yentas additional flexibility with accelerating the transfer of those assets to new operators). 2013 Guidance Earlier this month, KND reaffirmed 2012 guidance and introduced preliminary guidance for 2013. Please see the guidance below: Table 2: KM) Guidance 2012 2013 $mm (ex - EPS) Updated Previous New Revenues 62 billion No change 5.9 Mien EBITDAR 868 to 884 No change 806 to 825 Rent 432 No change 389 DBA 201 No change 190 Interest Exp. 107 No change 110 EPS 1.35 to 1.55 per share No change 1.20 to 1.40 per share CF from Opt 260 to 280 240 to 260 230 to 250 Routine Capex 135 to 145 125 to 135 120 to 130 Discretionary FCF 85 to 90 No change 90 Source: Company repots. The guidance for 2013 assumes a reduction in revenues due to Medicare reimbursement rate reductions of $90-$100 million (due to LTACH budget neutrality phase-in and sequestration). We would expect sequestration and budget neutrality to result in revenue reductions of approximately $65 million and $30 million, respectively. Further, it assumes that the results of the 54 SNFs (whose rental agreements expire in April 2013 and are not being renewed) are classified as discontinued operations as of January I, 2013. 7 EFTA01108676 David Common. CFA North America Credit Research 27 September 2012 J.P.Morgan Kindred Healthcare, Inc. KND FINANCIAL SUMMARY ($ ten) Fiscal yesnend December Actual Actual Actual Actual Actual Actual Actual Actual Aebal Estimate Estimate Estimate Estimate Actual Ful Year FW Yeae 1011 2011 3011 4011 Ft1 Yet 1012 2012 3012 4012 FLI1 Yea, FulYeae LTM Mon statement BY to EYE 20)9 FYE 2010 3141m-11 30-An.11 3040.11 31-Deol1 FYE 2011 3144a,.12 30-Ati.12 30-Se -12 31-Deol2 FYE 2012 FYE Z113 5/Jun12 Total revenues I $4270 KILO 11.192 51283 $1314 11323 $5.512 11480 11.538 51423 51.562 16202 $5,891 16.153 /tStmth 21% 9.4% 1/5% 418% 3(2% 267% 325% 188% 26% 26% 123% 50% 3/.6% S3bneS, AlgtS benefils $2483 52.K6 $679 $765 $901 $911 $3.255 $945 $907 $896 $501 $1650 $1434 5.16131 Suptits $333 $342 $80 $97 $108 $108 S 02 $111 $108 $107 $109 $436 $412 $435 Real $348 $357 $81 $96 $106 $107 I C$399 Q $108 $108 $107 $109 $432 3389 $428 Obit M6141/15 openses $886 $919 $259 $287 $305 $313 11.164 $311 $313 $316 $323 $1263 $4257 $1.242 WpyrrerldWgeS $0 SO $0 $0 $27 $103 $129 $1 $0 SO 50 II $0 $130 Total Operating expense 14.154 11.120 11245 1140 11411 55.351 114711 11.436 11428 11.444 55382 $1492 UV) % Olsen (events 9(9% 953% 919% 95.3% 954% 101.2% 969% 914% 915% 916% 924% 922% 93.2% 95.9% Adstsiod OMAR $578 $574 $171 $182 $211 1101 1761 $215 $219 DM $231 5873 $800 $846 E1317/146 Mavis 115% 732% 114% 14.1% 119% 132% 138% 116% 1(3% 13.6% 14.8% 14.7% 73.6% 117% Y/Y [toot -0.6% 17.8% 211% 70.9% 27.4% 332% 2Se% 206% .1.6% 152% 14.7% .63% 42.0% Aqrated EBITDA 1229 $217 MO 118 $105 $94 1365 $107 $112 $161 $122 $111 $411 1418 ESIMA AtzuMt 54% 50% 67% 61% 69% 62% 66% 6.8% 7.3% 66% 7.8% 7.1% 7.0% 6.8% WY Groot -16% 318% MI% 2086% 40.9% 667% 319% 29.7% -(4% 29.5% 20.8% .68% 741% AdjAntents $10 $11 $7 $38 $37 $112 $151 $3 $12 $3 $3 $22 $12 $185 EMMA 12C6 $73 $68 018) $171 $104 $100 $98 $119 $419 $399 $253 EBITDA Manta 4.7% 6.7% 3.7% 4.5% 41% 31% 46% 45% 64% 7.6% 48% 6.8% d.1% Depreoalta sed antelainen $126 $122 $33 $38 $47 $48 $49 $50 $49 551 $199 $191 $194 EBIT $94 144 $10 $10 $22 ($87) $5 $55 $50 148 $68 $221 $208 $80 ENT Lamp 2% 2% 3% 1% I% .4% 0% 3% 3% 3% 4% 4% d% 1% Net Intent Expense Ise) (57) $6) ($23) 0 26) 036) 081) 0 27) 027) (128) (s28 ($109) (51111 1$1051 Otte $16 $13 53 $3 $3 $3 $12 $3 $3 $0 $0 $6 50 $12 EEO $102 $90 138 (110) RN 0 901 (63) $31 $28 $20 140 $118 198 (134) lyre Imes $39 S34 $16 03) 02) 017) 0 7) $13 $11 $7 $14 $45 $34 $4 Mean ear rate 35% MO% 0% 34% 163% 19% 11% 47% 41% 35% 35% 35% 35% •13% bloat* from eating operations $63 $55 $22 (17) $1 0 73) 056) $19 $15 $13 $26 $73 $63 0 311 Ovate ilass) kat CiSCCrlited o;erakes. net of name $1 $1 ($o) $1 $1 $1 $3 $0 0 0) $0 50 $0 $0 $2 Can Ibis) al doesbl.re operstom 0 23) (SO) 50 $0 $0 $0 50 $0 $0 $0 50 $0 $0 $0 Net Mem* 140 156 122 ($1) 12 0 72) 054) $19 $15 $13 $28 $73 163 0361 Loa antulate renCentrelEl; tere-StS 50 SO 50 $0 0 0) 30 50 (SD) $0 $0 $0 iiso) $0 ($0) lemma (ass) attributable to Kindred 140 $56 $22 ($8) 12 0 73) ($53) $18 $16 $13 128 $73 $63 11361 Bate Mures Atsts-fin2 38 3 357 39.0 1-12 51.3 51.3 613 51.6 51.7 51.7 51.7 51.7 52.7 51.7 Banc EFS -naninurg $105 51 46 $057 0013) 9103 01401 (stio) 9115 $0.30 $025 $051 $1.41 $1.19 00.71) Elleced shales outstanelng 385 336 39.5 432 51.4 51.3 *62 51.6 51.7 51.7 51.7 51.7 52.7 51.7 DAted EPS catering cps_ 5t,04 51 46 $056 (91131 9103 01401 ($1.16) 9115 50.30 $025 $551 41.41 $1.19 00.71) Cub love snatnis Net Income (toss) 40 58 22 PI) 2 172) (SI) 19 15 13 26 73 63 1361 Delman:a and anteltakei 126 172 33 38 47 48 168 49 50 49 51 p 193 191 151 Fronton la denbliel acccuols 19 24 6 8 8 13 7 8 7 7 18 28 31 Otte 43 33 2 (13) 27 115 2 (6) 6 6 9 las Meting espial Is) (25) 1161 7 117) 159) (0) 113) 19 34 (30) 1451 prat Cash low from optalira activities 234 210 6 57 36 154 131 63 96 124 260 236 152 Maintenance Own (102) 009) 125) 0 4) 137) C38) (133) (( 12) (29) (45) N5) (140) (125) (125) E(scregonary ICE 132 101 22 RN 30 121 21 (26) 24 50 80 118 111 27 Dscretinlare Casex 44) (513). 110 (14) 144) 118) (11) 112) 191 Nt (401 1251 1851. Free Caste Flow 88 33 11 (43) 011 120)r62 al 6t 71 11 12 71 le 88 (581 Anse Snow. aro Ovntettextei 8 EFTA01108677  North America Credit Research 27 September 2012 J.P.Morgan Kindred Healthcare, Inc. FINANCIAL SUMMARY IS mn) Ads Ads Actual Mewl Mewl Actuai Meal Actual Actual Egoista Estimate fellmeee Estna% Ads rj Yea FyI Veer 1011 2011 3011 4011 F‘c Yew 1012 2012 3012 •012 FYI Yes F‘4 Yea IN Babno: shed data FvE 2339 EYE 2010 3188811 30%4811 30.Sea 31.008,1 EYE 2011 314.4N.12 30.An.72 33.Set:2 31.0=42 FTC 9112 PIE 2013 30an.12 ter011c(1148' tonditriti 516 —fir 5I9 $52 $42 2 $40 $35 1 $151 1151 $129 Teal Sr See debt $141 $361 $351 5590 $149 $899 $199 11.114 11.104 $UN f1.106 $1.1•1 Wit 51.104 smiler SW 1141 $36, $351 $1,410 $1,499 $1541 $1149 $1,644 $1954 $1,161 $1154 SUSI $1154 $36, Total OM SharcidesequN Total eneltalltation 1141 5967 $1114 $1.011 $1,357 $351 11.058 $1,406 $1,410 $1.379 $2.019 $1,499 $1390 RAU $1541 $1221 $2961 $1.549 $1,321 $2.669 $1,644 $1.337 $3101 $1954 $1,362 UM6 $1,161 $1.38S $3921 $1154 51.392 We $1154 $1 485 $1.111 Iwo 5125 1711 $1154 $1.112 $3.006 Net Elea $131 6118 5332 51.488 51,484 $1507 $EW 51.524 51418 $1575 $1303 $1503 1817 $1.816 Credit Stallsecs 6131TDA, Item Carte alx 3056 2086 SIN 6.9x 456 31N 4.01 31. 4.04 80Y 3.76 006 ESITOA. 018E6:4101415.90ree 1066 5.6x 436 20. tax 186 171 288 24 244 241 23x 286 Sena Seared DetnE811DA 0,36 1.7s. 156 3.31 216 2.76 274 24 2/6 2.71 254 26 2.76 2.136 ToNIORCERTOA 0.66 I ix 156