Monday, November 4, 2013

Sunlink: liquidating their way to profits

A common term associated with net-net investing is liquidation value.  In theory a company's current assets minus their liabilities approximates liquidation value, what the company might receive if it were to decide to close down and distribute the proceeds to shareholders.  Often a company's accounting liquidation value is not accurate except in cases where a company's assets are mostly cash, they have no liabilities, and management is determined to return the proceeds with as little friction as possible (read: lawyer/advisor fees).  A liquidation is where accounting value meets real world value, and a company's balance sheet gets a gut check.  Are the values on the balance sheet accurate?

In the public markets companies don't liquidate often, principally due to an incentive mis-alignment.  In many public companies management does not own a majority stake, and the company's ownership interest is divided among many diverse parties, that have never had, or will ever have contact.  A company's management is incented to keep their job, after all that's usually their only source of income. The company's owners usually don't have enough power individually to force a liquidation, and when they do have enough power management can often work against them eroding value.

Sunlink Health Systems (SSY) is in a unique position not unlike many companies on the brink of failure.  The company's management needs to work hard to liquidate balance sheet assets to stave off potential failure.  As management fights to keep their jobs shareholders are rewarded as potentially undervalued assets are sold for market value.

I was first introduced to Sunklink Health Systems through Whopper Investments, he wrote them up as a potential odd-lot tender opportunity.  I received their annual report in the mail, and even though I only own a tiny position for a tender I was compelled to browse their financials.  Browsing their financials led me to read most of the report as I became hooked on their story.

Sunlink Health Systems purchased five hospitals in 2001 with leasehold rights to a sixth hospital.  The company subsequently purchased another two hospitals and three home health businesses.  The company also operates nursing homes and a pharmacy business.  The company currently operates 232 hospital beds and 166 nursing home beds throughout their facilities.  The company's hospitals are primarily in rural locations.

The health care industry landscape has changed dramatically since the company acquired their facilities in 2001.  They went from earning operating profits from their hospitals to sustained losses most recently.  Compounding their losses is the fact that the company took on debt to finance their acquisitions, and it's coming due quickly.  The company doesn't have the means to raise capital, and with their operating subsidiaries generating losses management has been placed in a tough spot.  As a result the company has started to sell off hospitals.

Most recently the company sold two hospitals.  The first was a 50 bed facility in Southeast Missouri for net proceeds of $7.4m.  The company used $5.2m of the sale proceeds to pay down their debt.  The company also sold the Memorial Hospital of Adel, located in Georgia for $8.35m last year.  They used the net proceeds of $7.5m to pay down debt further.

In 2011 the company sold the lease to the Chilton Medical Center to Carraway Medical Systems for a monthly rent of $37,000, and the option to purchase the facility for $3.7m.  Carraway Medical Systems operating license for the hospital was revoked by the Alabama Department of Public Health due to their inability to meet financial obligations.  Carraway defaulted on their lease to Sunlink.  Sunlink tried to re-lease the facility but failed, their lease reverted to the original owner.  This property will be a total loss for Sunlink.

In 2004 the company sold a medical center in Georgia for $40m in consideration.

As of the most recent annual report, the company owned and operated three hospitals, one nursing home, and one joint hospital/nursing home, as well as their pharmacy business.

As mentioned above the company is facing two issues forcing them to monetize their assets, they are losing incentive payments for electronic health record conversion, and they are facing a debt maturity date in the next year.  As such the company expects to sell three of their hospitals within the next year if possible, and apply those funds to their debt, and use the remainder as working capital.  In theory the facilities they are keeping are expected to be profitable in the near future.

It's significant that I haven't mentioned anything related to the company's valuation yet, understanding the background is important to Sunlink.  The company trades with a market cap of $7.5m, but a better measure of value would be enterprise value, which is $23.3m.  The company's book value is $33m, of which $30m is their physical plant, which has an original cost of $64m.  The company has $9.5m of debt due in the next year, with $8.7m due shortly thereafter.

An investment thesis for Sunlink is fairly simple to construct after building out this story.  Are the three hospitals the company plans on selling worth more than $18m?  The two hospitals sold in the past few years sold for about $7.5m apiece (net).  If that figure holds true for the three latest hospitals the company would be able to pay back their debt and have cash left over to finance working capital.  The company is attempting to hold onto their best assets, the profitable pharmacy operations, nursing homes with profit potential, and land that is being redeveloped into a multi-use office park.

A simple scenario for what might happen is as follows: the company sells the three hospitals for $7.5m each net of taxes and fees for a total of $22.5m.  They pay back $18m in debt and then have $6m available as cash and a greatly reduced liability structure.  The company retains their pharmacy segment which is currently profitable, although barely, and the nursing home/hospital that they believe has the best profit potential.

An investment in Sunlink works out if the company is able to sell their hospitals for $7.5m or more each.  If they can do that then this is a much slimmer company, with no interest payments, and a remaining collection of assets that are profitable, or will be soon.  If the company can't sell their hospitals for $7.5m it's possible they will enter receivership.  A bankruptcy receiver might sell the company's hospitals, but it's likely shareholder recovery would be much smaller.

Investors seem to love lottery ticket investments, and Sunlink qualifies as such.  Investors have an additional factor on their side, the company's management is highly incentivized to sell the three hospitals, if they don't they will likely lose their jobs.  If they do they will keep their jobs, but also reap the benefits as the share price rises, and their stock options vest.

Disclosure: Long an odd-lot.

4 comments:

  1. This is an excellent and balanced summary of the risks and potential posed by Sunlink. I think that a few points that you mention are worthy of particlar attention: The company's stated book value is $3.57 per share, of which only $0.05 is goodwill. The stock is currently trading @ $0.78 or just 22% of its stated net worth. On July 28, 2011, the Company made a private placement of 1,329,000 shares of common stock to officers and directors @ $1.90 per share. The proxy statement that was released in October indicates that officers and directors currently own 54.1% of the company, so their interests are well-aligned with those of outside shareholders in addition to their jobs being dependent on Sunlink's viability.

    You mention that Sunlink's physical plant is currently carried on its balance sheet at approximately $30 million after deducting $34 million in cumulative depreciation. Although it is possible that none of the company's remaining hospitals will find a buyer at any price (leaving some of those communities without a single hospital, which I would think is unlikely), It is certainly also possible that the $34 million in cumulative depreciation exceeds the actual decrease in the value of the company's hospital buildings and physical improvements.

    The biggest danger, as you point out, is the $8.728 million in debt that comes due in 2014. You state that the remaining $8.7 million in long-term debt becomes due "shortly thereafter" which is not quite right: $2.558 million becomes due in 2015-2018 with the rest due thereafter. This brings up one possibility which is, I think, worth considering: If Sunlink succeeds in selling even one of its remaining hospitals in the upcoming months and if the carrying value of those hospitals is not greatly exaggerated on their balance sheet, then Sunlink could buy itself four or more years to complete its liquidation or right-sizing. With a stated net worth of four and one-half times its stock price, that may be a risk well worth taking.

    As you mention, the physical plant is valued at approximately $30 million after accumulated depreciation of $34 million.

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  2. I inadvertently omitted the following disclosure at the end of the post that I just made:

    I am a Sunlink shareholder.

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  3. Sunlink turned down a $5.00 per share cash acquisition proposal in April 2004 and a $7.50 per share cash acquisition proposal in November 2007. The company then tried to reduce its number of shareholders below 300 in February in order to terminate its registration with the S.E.C. as a publicly reporting company by making a $1.50 per share plus $100 bonus to its odd-lot holders. The offer failed to reduce the number of shareholders of record sufficiently. From the company's press release:

    "In accordance with the terms and conditions of the Offer, SunLink has accepted for purchase a total of 2,705 common shares of SunLink tendered by 68 holders pursuant to the Offer. As a result of the completion of the Offer, immediately following payment for the tendered shares, the Company expects that it will have approximately 9,443,334 common shares issued and outstanding and held by approximately 480 stockholders of record.

    Because the Offer failed to accomplish the objective of reducing the number of record holders to fewer than 300, SunLink anticipates that it will take further actions to reduce the number of holders of record of the Company’s common shares in order to permit the Company to deregister the common shares with the SEC. As previously disclosed in the Company’s offer to purchase, the Board will likely consider other alternatives to achieve that result, including a further tender offer, a reverse stock split or cash out merger (in which a new corporation is formed to merge with the Company and holders of a limited number of Company shares are cashed out), so long as the Board continues to believe that deregistration remains in the Company’s best interests.

    Accordingly, the Company may, in the future, purchase additional shares in tender offers, including a potential follow-on tender offer open to all holders of SunLink shares. Subject to compliance with applicable law, the Company may also purchase shares in the open market subject to market conditions, in private transactions, or otherwise. Any tender offer or other purchases may be on the same or different terms than the terms of the expired odd lot offer including the per share price but exclusive of the bonus. Any possible future purchases by the Company and the timing thereof will depend on many factors, including the market price of the shares, the Company’s business and financial position, its liquidity and capital resources, including its borrowing ability and its compliance or non-compliance under existing loan agreements as well as general economic and market conditions."

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  4. Hello Nate;

    Any idea why 12% increase today?

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