Markets & Finance

Kindred: A Smart Health-Care Play


S&P thinks the provider of long-term acute care is poised to benefit from demographic shifts and ranks the shares strong buy

From Standard & Poor's Equity ResearchWe believe Kindred Healthcare (KND), recently trading at 28 a share, is uniquely positioned to benefit from the demographics of an aging U.S. population. Kindred is the U.S.'s largest provider of long-term, acute care and third-largest skilled nursing facilities chain. It is also one of the nation's largest providers of rehabilitative care. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

According to the U.S. Census Bureau, between 2007 and 2015 the percentage of the population aged 65 and older is projected to grow from 12.6% 14.5%, eventually reaching 18.2% in 2025. During that same period, according to the Centers for Medicare and Medicaid Services (CMS), total Medicare enrollment is projected to increase almost 23%, from approximately 44 million in 2007 to approximately 54 million in 2015. Given what we see as Kindred's deep market penetration in key markets, breadth of services along a continuum of care, and strong reputation among the physician and hospital referer base, we believe the company is one of a handful of providers who will perform well in this market.

In addition, following Medicare's rate-setting decision in July, which included more favorable than anticipated reimbursement terms for skilled nursing facilities, we view the regulatory environment as more benign and stable than it has been for a while, providing improved visibility to Kindred. As a result of this change, for the fiscal year beginning Oct. 1, 2008, and ending Sept. 30, 2009, the company's skilled nursing facilities will receive a 3.4% rate increase from Medicare, as opposed to a 0.3% cut previously anticipated. We believe this, when combined with the recent long-term acute care hospital rate decision in January of this year, which effectively fixed rates for a 15-month period (because of a transition to a Sept. 30 yearend), provides Kindred with a greater degree of regulatory stability and earnings visibility than it has had in some time.

We also anticipate that Kindred's reinvigorated cluster market strategy, whereby it seeks to penetrate specific geographic markets with multiple service offerings across the post-acute-care landscape (skilled nursing, in-patient rehabilitation, and long-term acute care), will drive revenues and earnings by increasing economies of scale, market reputation, and referral base. Following a period of limited growth during the three years between 2004 and 2006, the company has opened six independent long-term care hospitals since the second half of 2007 and plans to open seven additional hospitals between now and yearend 2010, including two additional hospitals in 2008. Although these moves should initially dilute Kindred's earnings per share, by the second year of operation these new hospitals should allow the company to leverage fixed costs over a broader base, increasing margins and returns, in our view.

Lastly, we believe that the disposal of the company's institutional pharmacy business, as well as the renegotiation of facility leases with principal lessor Ventas, has removed a drain and distraction on management time and talent and has allowed the company to refocus on growing its core operations. For example, because of the renegotiation of the Ventas leases, Kindred is now able to convert a number of facilities that were previously three-to-four bed units geared toward lower-paying Medicaid patients, to one-to-two bed units geared toward higher-paying Medicare patients, which also increases margins.

As a result of all these factors, while we forecast relatively flat revenue and earnings growth in 2008 (reflecting the Kindred Pharmacy Services spin-off), we look for revenues to rise approximately 5% in 2009, but forecast operating EPS growth of approximately 17% given the leverage in the operating model.

Our 12-month target price of 36 assumes that KND trades at a price-earnings ratio of approximately 21 times our 2009 operating EPS estimate, a premium to its historical average given the improved regulatory and operating environment we foresee.

COMPANY PROFILE

Louisville (Ky.)-based Kindred operates through three divisions. As of Dec. 31, 2007, the hospitals division, the largest operator of long-term care hospitals (LTCHs) in the U.S., operated 84 hospitals (6,567 licensed beds) in 24 states, primarily Texas, California, Massachusetts, Florida, and Pennsylvania. The hospitals division treats medically complex patients, including the critically ill, suffering from multiple organ system failures, most commonly of the cardiovascular, pulmonary, kidney, gastro-intestinal, and skin systems. In particular, Kindred has a core competency in treating patients with cardio-pulmonary disorders, skin and wound conditions, and life-threatening infections. Prior to being admitted to the company's hospitals, many of its patients have undergone a major surgical procedure or developed a neurological disorder following head and spinal cord injury, cerebral vascular incident, or metabolic instability.

The health services division, the third largest nursing home chain in the U.S., operated 228 nursing centers (29,106 licensed beds) in 27 states in 2007, primarily Massachusetts, California, Indiana, North Carolina, Kentucky, and Ohio. Through its nursing centers, Kindred provides patients and residents with long-term care services, a full range of pharmacy, medical and clinical services, and routine services, including daily dietary, social, and recreational services. Consistent with industry trends, patients and residents admitted to its nursing centers are increasingly more acutely ill and require a more extensive level of care. At a number of its nursing centers, the company offers specialized programs for residents suffering from Alzheimer's disease and other forms of dementia through its Reflections units. Kindred has also been developing what it calls transitional care units, or TCUs, which typically consist of 12-to-36 beds offering skilled nursing services and physical, occupational, and speech therapy to patients recovering from conditions such as joint replacement surgery and cardiac and respiratory ailments.

The rehabilitation services division provided rehabilitative services to 502 nursing centers, 87 hospitals, and 55 other locations in 40 states under the name Peoplefirst Rehabilitation. The company's rehabilitation division provides contract therapy services, including physical, occupational, and speech therapies, to residents and patients of nursing centers, assisted living facilities, and hospitals. In addition to the standard physical, occupational, and speech therapies, Kindred provides specialized rehabilitation programs designed to meet the specific needs of the residents and patients it serves. It has specialized care programs designed to address dementia and Alzheimer's disease, wound care, pain management, and pulmonary rehabilitation therapies.

As of Dec. 31, 2007, the hospitals division accounted for 39% of revenue; the health services division 44%; and the rehabilitation division 8% (with the balance provided by discontinued operations). A key driver of profitability is the payer mix, or the percentage of a facilities' or division's revenues coming from Medicare, Medicaid, private payers (typically commercial insurance), or other. As of December, 2007, Kindred's hospital payer mix was Medicare 68%, private and other 18%, Medicaid 10%, and Medicare Advantage 4%; and its health services payer mix was Medicare 34%, private and other 22%, and Medicaid 44%.

INDUSTRY OUTLOOK

Medicare is by far the largest payer for long-term acute-care hospitals, accounting for approximately 60% of reimbursements to providers, according to industry sources. As a result, we believe one can get a fairly good estimate of industry growth by looking at Medicare spending on long-term acute-care facilities. According to MedPAC, the Medicare advisory commission to Congress, spending on long-term acute-care hospitals increased over 11% between 1992 and 2005, but has slowed recently to only 1% between 2005 and 2006. According to the CMS Office of the Actuary, Medicare payments to long-term acute-care hospitals are estimated to increase to approximately $4.8 billion in 2008, from $4.6 billion in 2007, and to rise to approximately $5.4 billion in 2012, a compound annual growth rate (CAGR) of 3.3%. Consequently, after extrapolating these forecasts and adjusting for other non-Medicare payers, we estimate a total market size of approximately $8.0 billion in 2008, growing about 5% per year.

Similarly, government payers also dominate spending for skilled nursing facilities. However, for skilled nursing facilities, Medicaid is the dominant payer. According to the Managed Care Digest/Senior Care Digest, a collection of health-care publications, Medicaid represents 62.3% of payers, while Medicare payments currently represent only 13.6% of payments for nursing facilities in 2007. Further, according to MedPAC, Medicare spending on nursing facilities services equaled $21 billion in fiscal 2007, up more than 9% from fiscal 2006, but modestly slower than the approximately 11% increase in nursing-facilities spending seen between 2000 and 2007. Nevertheless, Medicare reimbursements are superior to both Medicaid and private payers, at $429 per patient per day (PPD) for Medicare, vs. $355 PPD for managed care, and $162 for Medicaid. After extrapolating Medicare payments as a percentage of the total market and adjusting for Medicaid's lower reimbursement rates, we estimate a total market size of approximately $134 billion in 2008, growing approximately 5% per year. Still, given that Medicare has found nursing homes to be a more cost-efficient provider with similar, if not superior patient outcomes, we would expect to see the percentage of Medicare payments to nursing facilities increase in the near future, representing potential upside to our growth estimates.

VALUATION

Our 12-month target price of 36 assumes that the shares trade at a target price of approximately 21 times our 2009 operating EPS estimate of $1.76, a premium to Kindred's five-year historical average p-e ratio of about 17, given the improved regulatory reimbursement environment and operating focus we see. Our target price equates to an enterprise value/EBITDA multiple of approximately 5.7 times on our 2009 EBITDA estimate, a discount to Kindred's publicly traded peers.

CORPORATE GOVERNANCE

Overall, we have a favorable view of the company's corporate governance practices.

We view positively that independent outsiders make up more than 75% of the board of directors; that all members of the compensation committee are independent outside directors; that the board has a committee that reviews corporate governance issues and that it has met within the past year; and that there were no related party transactions between the company and the CEO or the company and any other officers and directors of the company.

We view negatively that the chairman is an insider, that the board is authorized to increase or decrease its size without shareholder approval, and that the board may amend the bylaws without shareholder approval.

INVESTMENT RISKS

Risks to our recommendation and target price include unanticipated changes in reimbursement rates from Medicare, Medicaid, or private payers. In addition, Medicare continues to evaluate the so-called Resource Utilization Groups, or RUGs, case-mix weight, by which Medicare calculates payments, in order to adjust for a previous forecasting error. This adjustment could potentially lower reimbursements, which would negatively impact the company.


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