MarketThoughts.com Market Thoughts
 
 
Links | Sitemap | Search:   
  Home  > Commentary  > Archive  > Individual Stocks  

A Review of Bill's Stock Picks and KND

(Guest Commentary - December 1, 2005)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks and evaluating companies, it is that time of the month again - the time when we bring in our regular guest commentator Mr. Bill Rempel for a quick discussion of his methods and thought processes.  In this month's guest commentary, Bill will give a brief review of his prior "picks" as well as a detailed analysis on Kindred Healthcare (KND) - a company that Bill is currently studying.  It is with the utmost pleasure that I bring to you Bill's latest guest commentary, entitled "A Review of Bill's Stock Picks and KND" (which he had already sent to me by Monday).  First of all, following is biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill has previously been a guest commentator on our website on a couple of occasions (see "Playing "Chicken" With the Market - Is It a Bright Idea" for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) in back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. Their current portfolio contains (in rough descending order of equity) real estate, individual value stocks, physical gold, a foreign-denominated bond fund, a bear fund, and a precious-metals mining fund. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


As regular readers know, my focus is value stocks and primarily I'm concerned with screening out negative risks through examining the fundamentals involved.  As I've said before, in this column and in the forum, if you can eliminate the bottom 1/3 of the market, it's going to be pretty hard for you not to beat the index over the long term.  Of course, since value investing is a long-term strategy, the returns over the last few weeks or months may not be indicative of what they could be over the next few months to a year.

In my first guest commentary in June, I screened through eight stocks, and since only five months have passed by, I might call the grade on these "partially complete."  I had discarded five of those eight for various reasons.  As of the November 25 close, four of those five discarded stocks were losers, and the average return for all five, including the sole winner, was -7.0%.  I also pointed out three stocks I thought had value in my opinion. As of the November 25 close, two of those three stocks were winners, and the average return for all three, including the sole loser, was 10.0%.  Significantly, the close for the S&P 500 on the day this column was posted was 1,200.73 and the close on November 25 was 1,268.25 for a "market" return of 5.6%.  The Dow went from 10,421.44 to 10,931.62 in the same period, posting a 4.9% return (dragged down in large part by General Motors).

In my October guest commentary, I wrote in some detail about Sanderson Farms (SAFM).  The return on SAFM has been -5.1% from the October 6 close through the November 25 close.  I actually picked up some shares on October 13 for a $0.21 per share increase, showing that I'm getting better at timing my entries, at least.  At two months' time, I would say the grade was still "incomplete," but I will be updating the status of this stock.

In my commentary last month, I mentioned three significant bankruptcy risks, General Motors (GM), Krispy Kreme (KKD), and Calpine (CPN) - although CPN was only mentioned in passing.  GM and KKD have combined for a 0.6% return since then, however, CPN has flamed out quite magnificently at -46.1%.  I just can't wait to see how these stocks are doing in a few more months.

Date of Mention

Name

Ticker

Verdict

Reason

Closing Price on Date of  Mention

Closing Price on Friday 11/25/05

Return

06/23/05

Ford Motor

F

No

poor earnings quality

10.18

8.32

-18.3%

06/23/05

New Cent Fncl

NEW

No

poor earnings quality

46.34

38.90

-16.1%

06/23/05

Countrywide

CFC

No

insider selling

38.65

36.66

-5.1%

06/23/05

D.R. Horton

DHI

No

Negative cash flow

36.70

36.62

-0.2%

06/23/05

Pulte Homes

PHM

No

Negative cash flow

41.20

43.20

4.9%

06/23/05

Overseas Shph.

OSG

Yes

looked like value to me

59.74

51.75

-13.4%

06/23/05

Everest Re

RE

Yes

looked like value to me

90.78

106.78

17.6%

06/23/05

Ingles Markets

IMKTA

Yes

looked like value to me

13.00

16.33

25.6%

10/06/05

Sanderson Frms

SAFM

Yes

looked like value to me

36.40

34.53

-5.1%

11/03/05

Calpine

CPN

No

train wreck in motion

2.30

1.24

-46.1%

11/03/05

General Motors

GM

No

train wreck in motion

26.12

22.86

-12.5%

11/03/05

Krispy Kreme

KKD

No

train wreck in motion

4.90

5.57

13.7%

Switching gears, it has come to my attention that I hit a "value trap" last April, buying a stock with good fundamentals, but its valuations were coming off of peak earnings and technically the stock was overextended.  Ouch.  Fortunately I was able to use the loss to offset some short-term capital gains, and if the stock is still around and still this cheap in a month, I may buy it back. Considering it's near the end of the year, now's a good time to think about the tax implications of your holdings.

The other lesson I'm trying to learn from that mistake is to include more elements of technical analysis in my stock selection.  I think an investment style should be just like a fighting style; it's well and good to specialize and find the niche that suits your proclivities, but a little eclecticism can be very helpful.  To put it another way, while it's great to be "the Charlie Daniels of the torque wrench," sometimes you need an ammeter. So today I'm perusing at a screen where I looked for some elements of valuation, financial strength, and technical contrarianism.  Specifically, the purpose of the screen was to look for reasonable Price to Book and Price to Earnings ratios, a high Return on Assets, a price below the 200 day moving average, and a short interest with more than ten days to cover.  With this post, I'm gonna put one of those stocks under my microscope and review it from the bottom, up.  Please forgive me if the organization of my investigation is a little scatter-shot, my intention is to reflect my decision-making process when I examine a stock with the idea of taking a position, either long or short.

Kindred Healthcare (KND) closed on November 25, 2005 at $28.15 with a Market Cap of $ 1.1 billion and my eyes on it as a likely addition to my portfolio.  KND has trailing twelve month revenues of $3.8 billion and operating income of $586 million, split between four operating divisions: nursing homes, acute care hospitals, rehabilitation facilities, and pharmacies.  One item I noted when examining the company profile was the shift of capital to the higher-margin hospital business and away from the nursing home business, from year-end 2001 to the twelve months ended September 2005.

1) YE 2001 Op. Income for KND 2) TTM Op. Income for KND

Of course, any time I see a stock tank [1] like KND did, I try to figure out exactly why it went down so much.  In the case of KND, it's a rapid fall on large volume, starting in August of 2005. 

Kindred Healthcare

While Hurricane Katrina did force the closure of KND's hospital in the NOLA area, keep in mind that Hurricane Katrina made landfall near the end of August.  That is, while Katrina may account for the huge short ratio, it certainly cannot explain the falling price in August - before the hurricane hit.  After tracking down the institutional ownership changes, 5% ownership changes, and insider ownership transactions, I was able to rule them out, and thus the insider selling is certainly not anything to be concerned about IMO.  It's possibly related to changes in mutual fund ownership, as I haven't been able to ascertain changes to that since June 2005.

The next thing I checked while trying to find the reason for the descent was the change in analysts' estimates.  Per Yahoo!, current EPS estimates for FY 2005 and 2006 have been revised downwards by 6.8% from 90 days ago.  Again, while this may account for the price action since the September open, it certainly cannot explain the decline in early August.

Furthermore, there is simply a huge short interest on this stock, representing 25.7% of the float and 13.6 days to cover.  If you buy the thesis that shorts will be covering on a widespread basis before the end of the year, this might be a good trade based on that indicator alone. 

At this point, I am still at a loss for why this stock has fallen so much so quickly, but it certainly does look cheap right now, especially when compared to similar-sized and larger players in both the long-term care facility and hospital industry.

Long-Term Care Facilities Industry Mkt Cap P/E ROE % Div.Yld% Debt/Equity Price/Book
Manor Care Inc. 3.16B 19.60 20.42 1.50 1.13 4.14
Sunrise Senior Living Inc. 1.45B 36.29 7.84 NA 0.40 2.54
Bennett Environmental Inc. 1.31B 16.42 29.06 0.00 1.49 3.59
Extendicare Inc. 1.10B 9.99 30.05 1.10 1.67 2.71
Genesis Healthcare Corp. 854.53M 20.53 7.83 NA 0.63 1.43
American Retirement Corp. 757.95M 10.67 109.04 NA 2.59 5.96
Odyssey Healthcare Inc. 610.42M 21.82 17.11 NA 0.00 3.64
Hospitals Industry Mkt Cap P/E ROE % Div.Yld% Debt/Equity Price/Book
HCA Inc. 23.10B 16.17 22.07 1.20 1.46 3.63
Health Management Associates I 5.75B 16.42 16.58 1.00 0.16 2.51
Triad Hospitals Inc. 3.60B 15.41 8.82 NA 0.60 1.26
Community Health Systems, Inc. 3.48B 22.96 14.01 NA 1.34 2.58
Tenet Healthcare Corp. 3.47B NA -75.6 0.00 3.52 2.55
Universal Health Services Inc. 2.65B 11.20 11.86 0.70 0.44 2.16
Lifepoint Hospitals Inc. 2.11B 24.76 8.85 NA 1.24 1.68
Magellan Health Services Inc. 1.05B 10.52 17.62 NA 0.60 1.74
AmSurg Corp. 700.82M 20.08 13.82 NA 0.35 2.45
???? Industry ???? Mkt Cap P/E ROE % Div.Yld% Debt/Equity Price/Book
Kindred Healthcare Inc. 1.09B 9.06 16.54 NA 0.04 1.25

With analyst-estimated 5-yr growth of 12.5% it is difficult to see how the current low P/E ratio of 9.06 can be justified.  Unless, however, there is something fundamentally wrong with the company, and that is the next place I looked.  I will let the following table of calculations speak for itself, for the most part.

Calculated Fields

YE 2001

YE 2002

YE 2003

YE 2004

YE 3Q '05

Revenue Growth

n/a

44.2%

-2.2%

7.5%

8.9%

Total Assets Growth

n/a

9.0%

-3.6%

0.5%

13.8%

Total Liabilities Growth

n/a

10.2%

-2.4%

-11.6%

7.8%

Net Worth Growth

n/a

7.0%

-5.4%

20.4%

21.1%

Profit Margin [Net Income / Revenue]

2.2%

1.0%

-2.3%

2.0%

3.6%

ROA [Net Income / Average Total Assets]

n/a

2.2%

-4.7%

4.4%

7.6%

ROE [Net Income / Average Shareholder Equity]

n/a

5.7%

-12.6%

10.7%

15.9%

Earnings Quality [should exceed 1.00]

1.83

3.76

(5.64)

2.38

1.27

Gross Margin [Gross Operating Profit / Revenue]

71.5%

69.5%

83.1%

83.6%

72.1%

Cash Generating Power [should exceed 1.00]

1.71

1.26

1.84

1.56

0.91

Intangibles as Percent of Assets

0.0%

5.4%

2.0%

2.0%

3.2%

Inventory as Percent of Sales

1.3%

0.9%

0.9%

1.0%

1.1%

Accounts Receivable as Percent of Sales

18.0%

12.5%

13.1%

11.3%

14.9%

Reliance on Financing Cash [should be negative]

-3.9%

-3.1%

-3.4%

-6.0%

1.1%

Total Liabilities / OCF

6.43

4.07

8.28

3.26

4.68

Current Liabilities / OCF

3.61

2.34

4.84

2.16

3.31

Interest / [OCF + Interest]

0.13

0.05

0.08

0.05

0.04

Per Share Measurements

YE 2001

YE 2002

YE 2003

YE 2004

YE 3Q '05

Earnings Per (Diluted) Share

1.72

1.01

-2.08

2.24

4.32

Tangible Book Value Per (Diluted) Share

19.63

15.89

15.67

21.82

25.34

Free Cash Flow* Per (Diluted) Share

2.59

2.79

0.12

2.54

-0.48

Operating Cash Flow Per (Diluted) Share

4.75

7.27

3.30

8.50

6.28

Dividends Paid Per (Diluted) Share

0.00

0.00

0.00

0.00

0.00

*  Because of a marked inconsistency in application of Free Cash Flow definitions, I have decided to use (EBITDA + Changes in Working Capital + Net PPE - Interest Expense, Deflated for 35% Income Tax Rate) as my working definition of FCF in my spreadsheet.  Your mileage may vary.

It definitely looks like a major hiccup occurred in 2003, and a minor one in 2005.  On the positive side, there are also lots of positive trends I can point to, including generally increasing ROA, ROE, book value growth on an absolute and tangible per-share basis, and EPS.  On the negative side, the company resorted to share issuance for financing in 1Q2005, saw an increase in Accounts Receivables, a decrease in OCF, FCF, and cash generating power in YE 3Q2005.  At this point, I need to decide whether I believe the changes in 2005 are just temporary blips, or whether they are indicative of a deteriorating trend.

One of the things that popped out at me when reviewing KND versus the competition was the very low debt to equity ratio on KND's balance sheet.  There is a good reason for that, since the company emerged from bankruptcy on April 20, 2001, having entered bankruptcy on September 12, 1999.  One of the things I like to see when evaluating a post-bankruptcy candidate is a shift in the business model, which I think is partially evident from their pattern of growth through organic means and acquisition, as well as the change in source of earnings since YE 2001.  Also, if the bankruptcy looked like shenanigans may have been involved, I would like to see significant turnover in the boardroom.  A review of the boardroom changes and pertinent documents is my next stop [2].

Page 56 of 342 on the 10K is where I found the listing of executive officers. 

  • The current chairman joined the company in November 1998 as COO and director, after having been chairman and CEO of Living Centers of America for five years.  Significantly, LCA was acquired by a rival in late 1997 and this may be why he was available to run KND.

  • The current president and CEO joined the company in January 2002 after spending some time with a private investment and consulting firm specializing in healthcare restructurings.

  • The current EVP and CFO joined the predecessor company in 1995.

  • The current SVP of compliance and government programs was also spent time with the predecessor company - joining in 1996, after leaving ten years of private practice.

  • The current EVP and president of the hospital division had also been with the predecessor company since 1992.

  • The current president of the health services division joined the company in 2001.

  • The current CIO has been with the predecessor company since 1997.

  • The SVP of corporate legal had been with the predecessor company since 1996.

  • The current president of the pharmacy division joined the company in 2000.

  • The current general counsel joined the predecessor company in 1995.

So, why the bankruptcy?  The "predecessor company" was Vencor, which was split into Ventas and Vencor in 1998 to protect assets from bankruptcy as a result of alleged abuse and fraud in the nursing home units.  It seems to me that the assets to be protected were moved to Ventas, and that the turnover in the boardroom of Vencor/Kindred was related to the cleanup effort.  For example, in July 1998, Vencor announced that co-founder and chief operating officer Michael Barr and chief financial officer W. Earl Reed III had been removed from its board.  Page 54 of 342 in the 10K shows a related lawsuit against a former executive officer and director, who significantly was CEO of both Ventas and Vencor.  Truly it's a fascinating story [3] of rapid growth through acquisition and deal-making, driven predominantly by one man, and (to me at least) somewhat reminiscent of WorldCom.  All of this history brings me back to one of my first points in this article, which is the continuing shift in KND's revenue and income to focus more on hospitals, pharmacy, and rehab.

The purpose of this piece is not so much to come to a verdict on KND, but to demonstrate a process, a level of due diligence, that I personally believe is essential to good investing.  Also, I hope you enjoyed reading it!

Notes

[1] It's hard for me to say "stock tank" and live in Texas without picturing a man-made pond with cattle drinking out of it.

[2] http://www.kindredhealthcare.com/KHMapped/documents/10k-2004.pdf
http://www.kindredhealthcare.com/KHMapped/documents/AnnualReport2004.pdf
http://www.kindredhealthcare.com/documents/IP%20November%202005.pdf

[3] http://www.uow.edu.au/arts/sts/bmartin/dissent/documents/health/access_vencor.html
http://www.uow.edu.au/arts/sts/bmartin/dissent/documents/health/vencor_outlines.html
http://www.uow.edu.au/arts/sts/bmartin/dissent/documents/health/vencor_lunsford.html

Article Tools

Subscribe to this FREE commentary

Discuss this page

E-mail this page to your friends

Printer-friendly version of this page

  Copyright © 2010 MarketThoughts LLC. | Privacy Policy | Terms & Conditions