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An Activist Position in AdCare Could Cause the Stock to More Than Double by TMFDeeJ aka Jason Knapp

AdCare $ADK is an interesting special situation that I have been writing about and have owned for nearly a year now. There was a new development at the company today that I am about to discuss, but first here’s some background on the company for people who are not familiar with it. The following is an excerpt from my August 1, 2014 article on the company: From 0.0% to 8.5%, the World’s Greatest Secret Dividend Growth Story.

 AdCare
AdCare

“The other day I came across possibly the best dividend growth story in the market today. Better yet, it’s a secret. OK, it’s not really a secret, but it’s a small cap stock that is completely transforming itself that not many people are talking about.

Adcare Health Systems is in the business of acquiring and managing senior living facilities, i.e. assisted living facilities, independent living facilities retirement communities, etc… Historically, the company has not done a good job at managing its facilities, so the it has decided to change its business model. After the transition later this year, Adcare will no longer managed these facilities, but instead it will own them and lease them out to operators who might be more competent. These assets have value, that is not being fully reflected in the company’s stock. The move will allow it to begin paying a dividend to current investors and potentially eventually be sold to a healthcare REIT.

According to the company’s press release, it will begin paying a quarterly dividend of $0.05 starting in Q4 2014. At today’s share price, that is equivalent to an annual yield of 4.25%. Yawn. Wait, it gets better…the company will increase this dividend by $0.01 every quarter after that for “the forseeable future.” If Adcare successfully executes this plan, that would put its dividend at a much more attractive 7.7% annualized in Q4 2015 and 11.6% in Q4 2016 (assuming that it can keep increasing it at that pace).

After reviewing the presentation, the company states that it will have an annualized dividend of $0.40/share in Q1 2016. That’s equivalent to a yield of around 8.5% based upon today’s share price. Let’s look at how this yield stacks up against similar companies:

CareTrust REIT, Inc. (CTRE): 4.9%

Sabra Health Care REIT, Inc. (SBRA): 5.3%

Health Care REIT, Inc. (HCN): 5.0%

Omega Healthcare Investors Inc. (OHI): 5.5%

Aviv REIT, Inc. (AVIV) 5.0%

This implies that there’s 50%+ upside in the stock once the dividend hits this attractive level a year and a half from now plus you will be able to collect the dividend along the way while you wait once it starts later this year. Plus additional potential gains if the company was to be bought out by a bigger healthcare REIT, which there’s no shortage of today and it has expressed being open to.

With NewCastle (NCT), Extendicare (EXETF), Ensign Group (ENSG) and CareTrust REIT (CTRE) already in my portfolio I wasn’t exactly looking for another senior living play, but you take what Mr. Market gives you. At least the sector has tremendous demographic tailwinds. I definitely do find this one very interesting. Of course, there’s always execution risk associated with this sort of transaction. Also, one has to question of a management team that was so terrible at managing these facilities can successfully complete this transition.

Here’s the company’s official announcement: AdCare Announces Strategic Plan to Transition to a Facilities Holding Company; New Business Model Designed To Optimize Cash Flow and Unlock Shareholder Value and my favorite, an investor presentation.

Here’s a link to an excellent Value Walk article that first brought this situation to my attention: AdCare Health Systems: NOLs, REIT Conversion, Cash Allocation.

Since I wrote this post, despite a significant improvement in the company’s operations its share price has dropped 28% versus a gain of 6% in the S&P 500.

Companies this small, a market cap of only $69.1 million, don’t often attract the attention of activist investors. So I was pleasantly surprised when I saw this afternoon that someone had filed a Schedule 13D on AdCare. For those of you who are not familiar with 13Ds, any individual or firm that purchases more than 5% of a company’s stock must file a 13D with the Securities and Exchange Commission. 13Ds can be an important tool for individual investors to find out what savvy investors or activist investors are buying.

A 13D was filed on AdCare today, causing the stock to rise by more than 4%. The filing was made by a firm called Doucet Asset Management, LLC. I am not personally familiar with Doucet, but I have reached out to the firm’s founder Chris Doucet to see if he is willing to discuss the new position in AdCare. In the meantime, here’s the text from a letter that Mr. Doucet sent to AdCare’s Board of Directors with emphasis and comments added by myself:

“Dear Board, First, I want to commend the Board on hiring Bill McBride as AdCares CEO last fall. He had the difficult challenge and task of navigating the Company through its transition to a property holding company. Based on conversations with several reputable REIT experts, they have all confirmed what I already suspected-Bill has done an exemplary job executing on the initiatives set forth by the Board. He has virtually completed the Company’s transition in leasing or divesting its portfolio of 40 properties to new operators while negotiating favorable triple-net leases with long terms and standard annual escalators. In addition, Bill is making strides in addressing the Company’s capital structure. This has significantly improved the optics of the Company to prospective acquirers as AdCare is simply a plug and play target at this point. Most impressively, Bill has done this with little disruption to the Company’s operations and little to no deterioration in patient care. The long awaited benefits of Bills efforts should be imminent.

I am convinced the Board made the right decision to hire Bill and convert AdCare into a real estate holding company. Nonetheless, the successful transition from an operating company to a real estate holding company has not been reflected in the price of AdCares common stock. I believe the combination of successive capital raises with little clarity on the use of proceeds coupled with the rising short interest in the stock have relegated ADK to ridiculously low levels.

Bill has made it clear on recent conference calls that his main desire is to use part of the Company’s $35 million in recent raises to make accretive acquisitions of nursing home properties. The market has shown its disappointment in the lack of success in accomplishing this goal by selling the common stock off by nearly 25% over the past 90 days. However, during the same timeframe, fundamentals of the Company have clearly improved suggesting there has been a marked disconnect between the operational performance of the Company and the stock price.

So what can the Company do in the near term to take advantage of this short term dilemma and help restore investor confidence in Bill, the Board, and the stock? One answer is to use some of the cash on the Company’s balance sheet to initiate a buyback of the Company’s stock and augment the Company’s current strategy of growing the value of the enterprise by making accretive acquisitions. [Jason here, I personally do not agree with $ADK issuing preferred stock that yields 10.75% to buy back stock, even at the current depressed level. I also am not sure that I trust $ADK management to make new acquisitions. But…since the horse is already out of the barn and AdCare has already issued the preferred and has the money just sitting around I guess that they’re better off doing something with it.]

According to Bloomberg Analytics, the average cap rate for the healthcare REIT universe is 6.3, while the average FFO multiple in the space is 13.8. So what does this mean for ADK valuations? If one sifts through the press releases, 8Ks, 10Qs and 10K since July, 2014, investors can make several relevant projections, apply multiples to those projections and make certain value assumptions:

– Revenues $28.834 million (assumes conservative assumptions on three remaining properties)

– Convert Debt $7.7 million (assumes $7.5 million note is not converted by 7/31 and is paid off)

– Mortgage Debt $111.086 million (assumes the Company pays down four mortgages in the amount of about $18 million and brings $1 million in proceeds in excess of the mortgage amounts and $2 million in restricted cash onto the balance sheet)

– Preferred Debt $53.830 million Bank Debt 0 Cash $17 million (assumes $7.5 million note is not converted by 7/31 and is paid off)

– Estimated Annualized FFO $.34 (beginning annualized FFO in Q415 assumes no acquisitions and G&A and lease expenses projected on July, 2014 have not changed)

Based on the above assumptions and corresponding multiples, ADK would be worth $4.65 on an FFO basis and about $9.00 on a fully diluted basis. [Jason again. I completely agree that the company’s stock is significantly undervalued at the current level and that it theoretically will make an excellent acquisition candidate once its transition is complete]. The latter would only be realized if the company was sold to a strategic buyer who liked the properties, leases and the operators. However, a price of $4.65 and an FFO of $.34 annualized by Q415 assume interest costs remain at the very high current cost of capital of about 7.29% and the Company is not successful in adding accretive acquisitions which would of course add to the FFO. For every 1 million shares the Company is successful in purchasing at current levels, the Company would add over $340,000 to FFO or about $.017 per share. This increase in FFO would give the Company the ability to increase the dividend by $.0136 per annum or about 40 basis points to investors (assuming the Company continues their dividend policy of paying out only 80% of FFO in the form of earnings).

Most REIT investors understand and appreciate the Company’s strategy. Simply put, convert the existing portfolio to a holding company, reduce G&A to a nominal level, use the cash to make accretive acquisitions, and ultimately sell the portfolio to a larger REIT at a synergistic multiple for both parties. However, while the broader market fully appreciates the power of the model the Company is creating, the stock has been relegated to orphan status due to the aforementioned successive raises combined with the inability of the Company to close on a single acquisition. As such, you should ameliorate your current strategy. Take this as an opportunity to buy ADK stock on the open market at significant multiples discount to its peers, exploit the current dislocation in the market and any others that may occur in the future. The Company can in essence invest in properties it knows very well at a 10 cap and ultimately sell the company at a much lower cap rate at some point in the future. This would be appear to be a good way to augment your current strategy in the short term, regain investor confidence and build long term value. Buying back stock would also be a low risk method of building value as the Company is more familiar with each of these properties than its competitors. The Company would also avoid transaction costs and associated transition risks typically associated with the purchase of a new property.

I am happy to discuss my analysis in more detail at your convenience.

Sincerely,

Chris L. Doucet CEO,

Managing Partner Doucet Asset Management, LLC”

Great letter. Kudos Mr. Doucet. It’s fantastic that a significant shareholder is taking a stance and criticizing AdCare’s management for the company’s stock’s recent lackluster performance. The company’s transition from a terrible operator to a real estate holding company has been going even more smoothly than I had expected. It now has agreements in place to lease out 37 of its 40 healthcare facilities:

AdCare Reports Continued Progress in Strategic Transition; Receives HUD Approval for Five Facilities; Company Completes Transfer of Operations for North Carolina Facility.

Furthermore, I have not seen any recent evidence of any of the what I considered to be questionable insider dealing with the Brogdon family that I have seen in the past. Investors who buy $ADK today can take advantage of what I believe is a temporary selloff in the company’s shares caused by its transition to a new type of investment and a general selloff in REITs as a result of investors fear of higher interest rates. Should the AdCare take Chris Doucet’s advice and actually put some of the unnecessarily expensive funds that it raised to work the stock could really take off. In the event of a takeover, which I think is ultimately likely in this consolidating industry, AdCare’s stock could be worth more than twice the level that it is trading at today.

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Full letter from Doucet dated Feb.

Full letter from Doucet dated Jun.