Nursing Facilities and Healthy Returns

12/27/2016 8:00 am EST

Focus: REITS

Douglas Gerlach

President, ICLUBcentral, Inc.

We look for growing companies trading at reasonable valuations, and this firm — which owns and operates over 200 skilled nursing facilities — fits our selection criteria nicely, explains Doug Gerlach, editor of Investor Advisory Service.

Ensign Group (ENSG) has a presence in 14 states. Management stresses the local nature of its business, marrying the flexibility of a local business with the resources of a large enterprise.

Facility leaders typically have business backgrounds and are charged with managing their location as if they own a small business.

Facilities are grouped into regional networks where leaders can share best practices. Workers are employed directly by Ensign, rather than outsourced from a staffing company.

An ever-increasing regulatory burden -- combined with Medicare’s evolving reimbursement schedules -- has made it difficult for small operators to keep up with the changing times. This trend creates advantages for acquirers like Ensign Group.

The current reimbursement landscape appears to be somewhat mixed, with reimbursement rates for skilled nursing facilities generally trending higher, but with Medicare also testing bundled payment strategies that shift more risk to providers, especially hospitals.

Ensign believes its facilities are well positioned to benefit from bundled payments, as hospitals look to discharge patients earlier and seek to partner with discharge facilities that offer a high level of post-acute care.

Through the first three quarters of 2016, revenue is up 26% but operating income is down 19%. Much of the difference is one-time costs associated with shutting down underperforming facilities along with higher-than-expected legal settlements.

It is unusual for acquisition-heavy business models to produce the kind of steady earnings growth we really like to see in a growth stock.

That said, the trailing P/E of about 24 seems to reflect investor optimism that the business has been under-earning compared to its potential.

We model 11% compound EPS growth, which would generate EPS of $1.79 in five years. That figure combined with a high P/E of 25.6 generates a high price of $46.

For a low price, we use trailing twelve-month GAAP EPS of $0.86 and a low P/E of 14.8, which generates a low of $13. On that basis, the upside/downside ratio is 3.1 to 1.

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