As might be expected from the recent turmoil in the credit and financial markets, during the first quarter of 2008 merger and acquisition activity in the health care industry slowed from the torrid pace it had been running in 2007. A total of 219 transactions were announced in the 13 sectors of health care we cover, down 27% from the 301 deals announced in the previous quarter (Q4:07) and down 8% from the 237 deals in the year-ago quarter (Q1:07).
The technology segment garnered 113 deals, or 52% of the quarter’s total deal volume, while the services segment posted the remaining 106 deals. The top three individual sectors combined, Medical Devices (35), Pharmaceuticals (34) and Biotechnology (29), accounted for 98 deals, or 46% of the total. At the other end of the spectrum, the three individual sectors with the lowest deal volume, Managed Care (7), Rehabilitation (6) and Behavioral Health Care (3), accounted for just 0.7% of the quarter’s total. The contribution of each individual sector to the quarterly total appears in the table on page 3 of this month’s issue.
Based on prices revealed to date, a total of $27.1 billion was spent to finance the first quarter’s M&A activity. This figure represents a 50% decline from the $54.6 billion spent in the previous quarter, Q4:07, and a 58% decline from the $64.4 billion spent in Q1:07.
The technology segment captured $22.6 billion, or 83% of the quarterly total, in Q1:08, with the services segment accounting for the remaining $4.5 billion (17%). The contribution of each sector to the total amount appears in the chart on page 9. All four of the technology sectors outspent the nine services sectors; four of the latter sectors are aggregated in the chart due to their meager individual results.
The quarter saw eight billion-dollar deals worth a combined total of $14.8 billion. All but one were in the technology sector; the last one was in Home Health Care. This is clearly off the pace set in 2007 when billion-dollar deals appeared at the rate of one per week.
These results clearly point to the fact that the M&A market in early 2008 has declined from the record-setting peaks of activity reached in 2006 and 2007. The annualized deal volume of 850 transactions projected for 2008, the lowest in five years, is down from the 1,051 high set in 2007. The number of billion-dollar deals, annualized for 2008 at 32, is down from the 35 in 2006 and the 50 in 2007, but still above the 27 announced for both 2004 and 2005. But the dollar volume, annualized at approximately $108.0 million, is way off the $268.4 billion in 2006 and the $226.5 billion in 2007, the largest and second-largest years, respectively, ever recorded. The figure projected for 2008 is higher, however, than the $94.1 billion that was actually spent on health care M&A in 2003 as the market worked its way out of the (last) recession.
So what are we to make of these figures? The health care M&A market appears to be in a trough, but the figures still suggest that the situation is not as dire as the recession of 2001-2003. We all know that borrowing has become more difficult, that real estate has become more illiquid and that financial buyers are largely sitting on the sidelines. But we also know that the health care industry is about as close to anti-cyclic as you can get, that the industry remains fragmented and ripe for consolidation and that money is still available for deal making. Companies still want to grow, and they will pursue deals if that advances their strategic goals. As we have been urging in the past few issues, the market is going through a process of “price discovery” to find out what this new market will bear in terms of valuations.
Price discovery applies not just to the stock market but to other markets as well, notably real estate. Health care businesses with a substantial real estate component, such as Hospitals and Long-Term Care, are seeing a slowdown in M&A activity. This, we feel, reflects the fact that since real estate is more illiquid than shares of stock, price discovery takes longer to work out in real estate. But as the markets move toward some equilibrium, at some point, the value drops to a point where it becomes very hard to ignore the bargains. It’s a truism that deals—and money—can be made in bear markets as well as in bull markets. The trick, of course, is knowing all you can about your market.
Assisted Living Concepts (NYSE: ALC), an operator of assisted living facilities, is a case in point. Spun out from Extendicare REIT (PK: EXETF) in November 2006, ALC stock, “when issued,” traded in the $8.25 to $8.75 range, then dropped to a low of $7.44 per share once it began to officially trade. In early 2007, during the takeover frenzy, it topped $13.00 per share. When it entered a trading range of $10.00 to $13.00 per share, it began to be seen as a takeover candidate by hedge funds and others, who in those halcyon days believed they could leverage the real estate (ALC owns 75% of its properties) and, as a result, get the company for a bargain. A few months later, and ALC’s stock is trading at about $5.50 per share. So where are the buyers who thought it was a bargain at $10.00 a share, now that it is at $5.50? True, the hedge funds are licking their wounds from a challenging first quarter, but can investors really avoid the bargain ALC now presents, we wonder, because there is some real upside value.
Once the math is done, adding outstanding debt to the market cap and capitalizing leases, ALC is valued at about $100,000 per (assisted living) unit. This is significantly lower than the replacement cost, which has been calculated at about $125,000 per unit. But there is more potential upside hidden here: occupancy was nearly 85% when ALC was purchased by Extendicare in 2005; now it is closer to 74%. Remarkably, EBITDAR growth has remained flat for three years while occupancy has declined by more than 10 percentage points. If occupancy can be increased, obviously so can EBITDAR. The decline in occupancy is due in part to management’s decision to “disenroll” from as many Medicaid waiver programs as possible with an eye to replacing them with more lucrative private pay. However, private pay increases have, so far, fallen well short of replacing the lost Medicaid census. Sooo, one big problem a potential buyer of ALC will have is determining whether current management can execute this replacement strategy in a timely enough fashion to make investment sense, whether they will have to find new management who can do so or whether it can be done under any management. That’s a big decision to make in a market as skittish as this one, but because it is trading at lower than replacement value, ALC still looks like a bargain to us. A disciplined acquirer will find a way to use the market to his or her advantage, and not be knocked around by the market.