“Extendicare Real Estate Investment Trust (EXE.UN on the Toronto stock exchange or OTC in the U.S. as EXETF) has long caught my eye in the health care space as an owner and operator of long-term care facilities in the U.S. and Canada. The company also provides subacute care and rehabilitative therapy services in the U.S., and home health services in Canada. U.S. operations account for more than two-thirds of revenue, mostly insured by Medicare. Canadian operations are regulated on both the provincial and federal level. The basic business model is fee-based, with rates set by government authorities. Coupled with the generally steady demand for these services and facilities, that adds up to reliable revenue and cash flow over time. And there’s considerable opportunity for further low-risk growth from adding new facilities, as well as by upgrading older ones. Over the past year, management added new centers in Alberta, Michigan and Wisconsin, boosting third-quarter revenue by CAD7.6 million. ...
“Management’s ability to raise capital and deploy it economically for asset growth ensures rising cash flow going forward for Extendicare. And regulation of rates by Medicare in the U.S. and provincial authorities in Canada give revenue something of a utility quality. That’s not likely to change, as both countries’ populations continue to grey and require more such services.
“The company, however, has had a problem translating its asset growth into profits in recent quarters. The main reason has been economic weakness south of the border, which has depressed U.S. occupancy in this country and has pushed the revenue mix to lower- margin services. The company has also been forced to increase its insurance reserves for liability cases and regulatory performance. And it’s had to deal with higher costs that come with expansion.
“On the plus side, Extendicare has been effective garnering ‘strong reimbursement in the U.S.’ from Medicare and other programs. Government ratings in the U.S. under the ‘Five Star System’ have risen noticeably, thanks to an extensive quality control program. Center renovation and new construction, combined with strategic marketing efforts that target needs of individual communities, are slowly but surely pushing the revenue mix to higher-margin services. And the company has been effective at managing its exposure to a rising loonie at its U.S. operations, utilizing natural and financial hedging while taking advantage of low-cost capital to expand.
“All of these measures augur improved numbers from the third quarter of 2010, a generally seasonally weak accounting period for Extendicare. We won’t know how the company did for the full year or the fourth quarter until somewhere around March 16, when numbers are announced.
“But in the meantime, the payout ratio through the first nine months of the year was just 68%, a very comfortable level for what amounts to a government- backed business. That support also extends to financing for growth, as the company is able to issue mortgages backed by the U.S. Dept of Housing and Urban Development (HUD). The company now has capacity to seek USD520.6 million in additional HUD financing. That’s extremely low-cost capital equivalent to more than two-thirds of Extendicare’s market capitalization and half its existing debt load. ...
“Extendicare does expect a slightly negative impact from last year’s U.S. health care legislation as written. And federal matching of Medicaid spending by states is now slated to end June 30, 2011, which could increase risk to state payments. Litigation risk has also increased in some states, though not enough, in CFO Douglas Harris’ words, to ‘consider exiting a particular state.’ The company in the past has pulled back from Florida and Texas on that basis. All of these risks, however, are well compensated for by management’s conservative financial strategy. ... At Extendicare’s current yield and price of just 35% of revenue, the bar of expectations is low and upside great. I’m adding it to the Conservative Holdings as a buy up to USD10.
“Note that Extendicare REIT doesn’t meet the Canadian government’s definition of a real estate investment trust, as needed to avoid SIFT taxation. As a result, it’s been paying these taxes since 2007. That burden, however, has been largely neutralized by the company’s heavy reliance on U.S. income, which doesn’t fall under the SIFT tax. ... Given its generally low tax bill, management saw no value in converting to a corporation. As a result, it will continue to trade under the same ‘-U’ or ‘.UN’ suffix it has since becoming a trust in 2005. There will also be no change to its five-letter U.S. over-the-counter (OTC) symbol EXETF.”
Roger S. Conrad, Canadian Edge, 1/7/11
