No. of Recommendations: 30
The news we’ve just received from EXETF is frustrating. The company has sold its substantial American business for a low price, as I figure. While this result is trying and unexpected, it’s compounded by the substantially higher expectations I had for the pick. At $6-$6.50 per share, the stock price figured in, I calculated, little or no equity value for the American business, and even if price discovery on those American beds came in well below the low end valuation of a publicly traded company, I saw significant upside.

I stand by my rationale and process for the pick, and we purchased at reasonable prices such that even at $5.94, the portfolio is down currently on the whole position only in the single digits. Happy? Certainly not. It’s frustrating to have that significant upside potential come to naught, but in the grand scheme, down a few percentage points on one position is objectively not an awful result. Still, it is made subjectively worse by the lost potential. Lest you think I’m not sufficiently interested in a good result here, note that 40% of my personal portfolio is tied up in EXETF, as some of you know. It’s not a position that I take or took lightly. I saw low downside with a good chance at medium upside, at least.

With that preamble, dear members, I want to evaluate the situation more objectively and not just on the (as yet) poor outcome. We always need to differentiate process and outcome. You can have a perfect process and still have a bad outcome. Investing is a probabilistic exercise, and that’s why we look for significant mispricings or messed-up expectations to give us a margin of safety. Over time, good process should lead to good outcomes. In any one instance, that’s not necessarily the case.

As part of that process, there is significant art to valuation. In this case, I figured that despite iffy management, the disparity of value here was so steep and third-party price discovery would reconcile that disparity. Yes, the market discounted that iffy management and American business, but at SOME price, every business is a buy, even if that means you’re literally being paid to take a money-losing operation. I calculated that there was enough margin of safety here for a significant investment.

Why did the stock tank?
The market was not happy with the sale at this price, but there’s more to the outcome here than just the deal price. So why did the stock tank? I think we can point to at least three reasons.

1. The sale price was substantially too low. Even the analysts – usually fairly mild-mannered – on the call expressed or hinted at their dissatisfaction with the price. EXETF sold their beds at $61k each. At its low-end valuation of the last year or so, SBRA’s beds were priced at about $104k per bed. Let me be very clear here: we did not need to see that kind of valuation to receive a very good return here.

There was a gaping disparity between my calculation of the American beds’ pricing and what they could be worth to a good operator. I figured beds were being valued at about the American unit’s total debt, or about $45k per bed. And because of the nature of leverage, a small increase in the per-bed price would lead to an outsize gain in the equity. For example, the total equity component would have moved from about $2.50 per share (what we have now) to about $5 per share, if the per-bed price moved to $77k per bed (rough numbers). So a 26% increase in price leads to a DOUBLE in the equity component. And $77k was STILL 25% below the low end on our range of SBRA’s valuation, which used SBRA’s lowest valuation for the last two years. Now SBRA beds are being valued at something like $170k per bed. Any financial buyer was likely to look at SBRA as the potential endgame valuation for their assets, since REITs receive very high valuations due to tax advantages and lowered cost of capital.

So I think the deal price is well under what we should have gotten. You could hear the nervousness and weaseling in the CEO when he answered hostile questions on the call. He just hemmed and hawed when one analyst tried to get him to justify the per-bed valuation. As the questioning analyst noted and well understands, any new owner is going to get a decent operator into those properties and so trailing EBITDA is not a very good measure of the cash-flow potential of those properties. I will not be surprised to see the American unit broken up into a REIT later on.

2. None of the cash will be returned to shareholders, per management. Yes, management said they’re interested in shareholder value creation, when pressed, but their plans do not lay out anything about returning cash proceeds to shareholders. There’s little reason to believe they will do that. At this point, the market discounts that (pro forma) cash on the balance sheet. Yes, the Canadian operation is solid, with very high occupancy, a solid funding environment, and slowish revenue and EBITDA growth. A payout of some cash – say, $1 or $1.50 per share – would still have left plenty of financial room for management to wiggle, given point 3.

3. The company will be (pro forma) underleveraged, and it will take a while to put that cash to work. You could see analysts’ skepticism on the call, when they pressed management. Any type of ground-up build-out would take years. Perhaps the acquisition of an already-operating business would be more likely on this point, since it gets cash flowing immediately, and I won’t be too surprised to see that. In any case, they’ll be re-investing more in the their current properties.

More perspective
So I think together these were the three largest issues that explain the market’s disdain for the deal. But even that needs perspective. As Frank noted, the stock traded 6x average daily volume, a high amount, but if you look at total shares traded, it’s a paltry 2.5%. The stock market is an auction market with the marginal price determining the price for all shares. So right now, just 2.5% has determined the stock’s trading price and the whole company’s valuation. How does that compare?

On a complete blow-up, it’s not unusual to see a stock trade 15%,20%, 25% of its outstanding shares in a day (or two). That’s a broad-based signal of a significant change in investors’ perspective. Here, it’s a mere 2.5% on the first day. Will there be follow-through on Monday? It won’t surprise me. But it also won’t surprise me if the stock goes up either, we did see the bottom-feeders scoop up shares starting at $6 and move the stock back up close to $6.40 before the stock settled back to $5.94.

Undoubtedly, that selling was due to people (reasonably) expecting a much better deal outcome. They didn’t get it and so their investing discipline is to sell and move on to the next idea, regardless of price or future. Still, that was just 2.5% of shares on Friday, though it may be more on Monday. And now this deal creates more uncertainty, because it raises questions of how they reinvest the proceeds, for example.

Still more perspective
The fact that the American unit was sold to a financial buyer allows us to draw several conclusions.

But first, let’s distinguish a strategic buyer from a financial buyer. The former is a company that intends to own the asset and run it more or less indefinitely. That usually means another industry rival, but might mean someone who’s looking to get into that business. In any case, because their profit may come from synergies (they actually do exist sometimes!), cost-cutting, ongoing profits, and other positional advantages due to the acquisition, they can afford to pay a higher price. They have a longer investment horizon and a smart acquisition can offer many benefits.

On the other hand, a financial buyer is an investor such as private equity that intends to temporarily own and run the asset. They have an investment hurdle (ballpark range: 15%-20% annually) that they want to exceed, and so any price they pay has to factor in their profit margin. A typical game plan at private equity is to buy companies with pristine balance sheets, leverage them highly, and pay themselves a huge dividend. Then 3-5 years down the road they sell the business to someone else, often back to the public via IPO at a significantly higher price. They take advantage of the market’s shortsightedness and emotion.

In the case of EXETF, they sold to a financial buyer, Formation Capital. The American unit is already reasonably leveraged, so that avenue of value creation is more or less out in the short term, and only unless they can grow EBITDA will they be able to take advantage of it long term. At 5x leverage, every $1 of increased EBITDA can be turned into $5 of dividend that they can pocket. Ultimately the point is that Formation is buying because they see substantial upside (at least 15% annually and more likely 20%). One of the ways they do this is by buying underpriced assets. And that implies they think they’ve spotted a deal here. Well, I agree with them. That’s why I bought the stock.

In short, Formation sees significant upside in the American business, as I did.

The go forward
So where do we go from here?

I’m spending my weekend figuring that out, Fools. What kind of company do we have left here, assuming the deal closes? On a pro forma basis, we have a solidly performing Canadian business with high occupancy and slow but reasonable revenue growth in a stable funding environment. At $6 per share, the business will have more than $2.50 per share in cash and some reasonable investment options to put it to work. The dividend should remain the same in the near term and over time has the potential to grow 3-4% per year perhaps. The company is priced at 9.3x EV/EBITDA when comps are trading north of 12x. So there are a lot worse options.
But the real question is: from today where is the best place to put our money? We have a number of stocks already in the portfolio that have substantial long-term upside: TFSL, FFNW, GPT, HTZ, NSAM. These are all excellent picks with very good reward-risk profiles. And we’re looking at other stocks that are not yet in the portfolio. I’ll be evaluating EXETF in light of our other opportunities.

So, Special Ops and Fool One members, I’ll be spending the rest of the weekend figuring out how we go forward and make the best returns for you from here.

Ad astra per aspera

Jim
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