I'm Buying More of This "Free" Stock

For a Christmas or birthday, did you ever get a gift that had another gift inside it? You know, like a book that you really wanted but then also another $10 bill tucked away inside? That's what I think we have in the shares of Extendicare (NASDAQOTH: EXETF  ) (TSX: EXE  ) . The stock is priced almost like that gift: You're getting one business, but inside that business is another worth at least $10 per share more.

So that's why my Special Situations portfolio is stepping up to buy more, even though the portfolio already has 30% allocated to the position.

Why I'm back for more -- in numbers
This will be my third purchase of Extendicare. In the first two write-ups here and here, I didn't mention the valuation on the stock and why I thought it made such a compelling opportunity. I had quite a few requests on my discussion board asking for my valuation, since the stock generated a good bit of interest.

So let me run you through the numbers that I've been working with in the tables below. I'm using Extendicare's most recent closing price of $6.35 and using its annualized payout of $0.432. The American unit has 14,311 owned beds, according to the latest filing in November.

Let's work backwards a bit, starting from a estimate price of the Canadian unit and then what that implies about the American unit. We'll get to an American price per bed and compare that to one of my recent picks.

Canadian Parent Stock Price

Canadian Yield

Implied Price of American Unit per Share

American Unit Total (Millions)

American Debt (Millions)

Price/American Bed

Price/Sabra Bed

$6.35

6.8%

$0

$0

$521

$36,406

$122,684

$6.00

7.2%

$0.35

$31

$521

$38,541

$122,684

$5.50

7.9%

$0.85

$74

$521

$41,591

$122,684

$5.00

8.6%

$1.35

$118

$521

$44,641

$122,684

$4.50

9.6%

$1.85

$162

$521

$47,691

$122,684

OK, so let's interpret this somewhat complex table. If the Canadian unit comprises the full value of the combined company today, then you're getting a 6.8% yield and getting the equity in the American unit for $0. But since the American unit has debt of $521 million, the enterprise value per bed comes to $36,406. If you think a 6.8% yield is too low for the Canadian parent, then you can adjust to what you think the yield on the stand-alone Canadian company should be. Any way you slice it, these beds are much cheaper than what they're currently fetching at the publicly traded Sabra.

Now, here's the interesting part. The market is pricing the American beds at less than half -- maybe as little as a third! -- of what it's giving Sabra Healthcare REIT (NASDAQ: SBRA  ) , a stock that I sold from the portfolio last week after notching 21% annualized gains for just over three years.

So what happens if those beds achieve a valuation in the range of Sabra's beds or even lower at $100,000? Here are a couple of scenarios and what the American unit is worth in each.

 

Price at $100,000 per Bed

Price at $122,684 per Bed

Total Enterprise Value

$1,431 million

$1,756 million

Less Debt

$521 million

$521 million

Equity Value

$910 million

$1,235 million

Equity per Share

$10.42

$14.14

So let's add these on to what we might be paying for the Canadian unit and see what we get in our low scenario.

Canadian Unit
per Share

American Unit
per Share

Total

Upside

$6.35

$10.42

$16.77

164%

$6.00

$10.42

$16.42

159%

$5.50

$10.42

$15.92

151%

$5.00

$10.42

$15.42

143%

$4.50

$10.42

$14.92

135%

And then in our high scenario.

Canadian Unit
per Share

American Unit
per Share

Total

Upside

$6.35

$14.14

$20.49

223%

$6.00

$14.14

$20.14

217%

$5.50

$14.14

$19.64

209%

$5.00

$14.14

$19.14

201%

$4.50

$14.14

$18.64

194%

There are a few other details that push my estimate of total value higher, such as splitting the American company into a property company and an operating company, but I'm leaving that out for brevity and clarity.

The valuation here is very compelling. In fact, it's the clearest value that I've seen since I've been running my Special Situations portfolio. You're getting a high dividend yield while you wait for the company to unlock value with the spinoff or sale of its American unit. But let me put it in other terms: You are getting a business for free or nearly free. My estimates suggest you're paying from 0%-13% of the real value of the American unit. And that could lead to gains of least 100% and maybe even 200%. It's like that book with a $10 bill slipped inside it, but it might even be a $10 and a $5.

Management simply needs to unlock the value of this business by divesting it, as they've said they have been doing.

Foolish bottom line
Could something go wrong? Absolutely. Lawsuits could whittle down the value of the American unit. More onerous payment terms from health insurers such as Medicare and Medicaid could hurt revenue. More political turmoil could hurt.

But the price for the American unit is so cheap and therefore the odds are so clearly stacked in our favor here, that it's hard to foresee this becoming a permanent loss of capital. That's why I have the confidence to add to a position that already comprises 30% of my Special Situations portfolio. So I'm adding another $2,000 to Extendicare, pushing the stock to more than one-third of my total portfolio.

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Read/Post Comments (4) | Recommend This Article (31)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 28, 2014, at 10:43 AM, TMFHelical wrote:

    Jim,

    Thank you for the additional commentary and analysis. I own shares here as well, but seem to consider them as higher risk than you do. The investment potential does seem to hinge on the item you noted.

    <I>Management simply needs to unlock the value of this [American Unit] business by divesting it, as they've said they have been doing.</I>

    This sounds simple, but may not be. Divestiture is already behind schedule from initial expectations. If unable to unlock in the near term, the US operations will continue to be an albatross. Downside risk may be modest, but with so large a position size you are increasingly reliant on this catalyst for returns.

    I do hope it plays out, as I too have a stake here (albeit a more modest one).

    Ralph

    Helical Investor

  • Report this Comment On February 03, 2014, at 2:05 AM, Haiphen wrote:

    Your hypothesis looks interesting but I am curious about their actual operations. Am somewhat familiar with Extendicare in Montreal Canada from many years ago (admittedly, 30+). I used to visit my dying father there (cancer). And while I have only my own subjective experience to go by, I can say that scenes from One Flew over the Cuckoo's Nest easily come to mind. My father was abused there at least twice (my mother walked in and witnessed it once) and a second time he told us an orderly punched him (he had a broken rib). He was often left alone for lengthy periods and I arrived once to visit him to find him completely naked in a wheelchair, right by the nurse's station(!) with no one attending to him. The stench of the whole place was truly unbearable.

    Other memories burned into my mind were rows of demented elderly people sitting in straight jackets and moaning also come to mind. Needless to say my dad was moved as soon as we could find a better place for him. Maybe they've cleaned up their act since then but doing a quick scan just now of their employees' reviews, there are some pretty damning ones still (Here's a sample: "If you value your nursing license.....RUN" - http://www.indeed.com/cmp/Extendicare-Health-Services,-Inc./....

    Obviously, from my personal experience I wouldn't touch them with a 100 foot pole. After what I experienced of Extendicare, I would not want to ever profit one penny from other peoples' misery and would not want my fellow Fools to do so either. This is not just a for-profit business and a business opportunity, it is an organization that is meant to provide humane care and reduce terrible suffering of the worst kind imaginable.

    Looking at the reviews, they may still be doing a pretty mediocre and sometimes terrible job in a business where they really need to excel.

    To me, that looks like a very high business risk if there ever was one.

  • Report this Comment On February 05, 2014, at 2:32 PM, snilsog wrote:

    Thank you Haiphen for your comments. JR's article had me intrigued until I read your comments. I was a probate attorney (now retired) here in So. Calif. I was often court-appointed to represent patients warehoused in facilities such as what you describe. Unfortunately this is an industry poorly policed, and peopled by unscrupulous operators more than eager to squeeze out a profit at the expense of defenseless people. I for one do not want to profit from such "opportunities", no matter what the return.

  • Report this Comment On February 05, 2014, at 6:47 PM, Ventureshadow wrote:

    The American properties of Extendicare have been in the news often for similar negligence in daily operations. Should we trust the same management to look out for our welfare as shareholders? Nah, I still have to look at myself in the mirror....

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