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September 6, 2010 Two For The Price of Sun the.knowledge.pile@gmail.com

September 6, 2010

September 6, 2010 Two For The Price of Sun the.knowledge.pile@gmail.com

Two For The Price of Sun

the.knowledge.pile@gmail.com

Sun Healthcare Group Investment Thesis

Sun Healthcare Group Investment Thesis Ticker: SUNH Stock Price: $8.24 Recent Valuation Multiples: ‘ * 5.5x
Ticker: SUNH Stock Price: $8.24
Ticker: SUNH
Stock Price:
$8.24

Recent Valuation Multiples:

*

5.5x 11e EV/EBITDA 5.4x ’11FFO**

Capitalization:

Enterprise Value: $1.1bn Equity Market Value: $618mm

*based on estimated EV/EBITDA for OpCo

**implied FFO based on OpCo

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Strong cash flow generator Recurring revenue streams Recession resistant business
Strong cash flow generator
Recurring revenue streams
Recession resistant business

Leading Skilled-Nursing Services Provider

Embedded in the company are significant real estate holdings

Company intends to unlock the value of real estate properties by spinning out Operating Company

Company has a hidden deferred tax asset that should shield company from income tax for many years

Intrinsic value of company not currently reflected in the market

Company worth significantly more on sum-of-the-parts basis

Company Description

Sun Healthcare Group is a leading provider of long- term, sub-acute and specialty healthcare services
Sun Healthcare Group is a leading provider of long-
term, sub-acute and specialty healthcare services
primarily to senior citizens in the U.S. via a network
of facilities in several states.
The company operates 182 skilled nursing facilities,
12 assisted and independent living facilities and 8
mental health hospitals with 22,000+ beds in 25
states.

Operating Company: A diversified business model

Rehabilitation Therapy Speech pathology, physical therapy and occu ational therapy p p
Rehabilitation
Therapy
Speech pathology,
physical therapy
and occu ational
therapy
p
p
SUNH operates in three business segments:
SUNH operates in three business segments:
Inpatient Services
Inpatient
Services

Daily nursing, therapeutic rehabilitation , social services, housekeeping, nutrition and administrative services

Medical

Staffing

Licensed physical, occupational and

,

s eech thera ists

p

nurses, pharmacists, physicians, etc

~87% Revenues
~87% Revenues
~6% Revenues
~6% Revenues

~7% Revenues

SUNH recently announced it will soon be split into two businesses

Operating REIT Company Skilled nursing, Rehabilitation, Medical Staffing 87 properties 68 SNF 10 mixed
Operating
REIT
Company
Skilled nursing,
Rehabilitation, Medical
Staffing
87 properties
68 SNF
10 mixed
(SNF/AL/IL)
6 AL/IL
2 Mental Health

9500+ beds

SUNH owns 45% of the facilities it operates, most of which will comprise the REIT (“Sabra”).

5

Some terminology

Some terminology 6
Some terminology 6

Terminology

Terminology Medicaid : State and Federal healthcare program for low income individuals or families Medicare :

Medicaid: State and Federal healthcare program for low income individuals or families Medicare: Federal healthcare program for elderly individuals Acuity: Refers to the level of complexity or intensity of patient care Concurrent Therapy: One therapist treating multiple patients at the same time with the patients performing different activities Look-Back Period: Services received within 14 days prior to admission used to gauge reimbursement levels RUG: Group which Medicare patient is classified into based on services needed and functional status Skilled Mix: Refers to all non-Medicaid revenues patient days Quality Mix: Refers to all non-Medicaid revenues Census: Refers to the number of inpatients in a given facility Minimum staffing levels: Sets minimum level of nursing staff required at facility

A little about the industry

A little about the industry 8
A little about the industry 8

Post-Acute Care Industry Overview

Post-Acute Care Industry Overview $100bn/yr+ industry Provides services to patients typically after hospitalization but

$100bn/yr+ industry Provides services to patients typically after hospitalization but before they return home Majority of revenues come from government programs, Medicare and Medicaid Post-Acute care providers are organized based on offering type and subsequently by level of reimbursement, which are determined by acuity/intensity levels of patient care Largest sub-category by expenditure is the skilled nursing facility (SNF) segment

Post-Acute Care Industry Overview (cont’d)

Post-Acute Care Industry Overview (cont’d) SUNH, a skilled nursing facility (SNF), falls at the mid-point of

SUNH, a skilled nursing facility (SNF), falls at the mid-point of the acuity spectrum:

(SNF), falls at the mid-point of the acuity spectrum: Companies can improve profitability and margins by

Companies can improve profitability and margins by moving up the acuity spectrum. SNFs typically have a greater presence in smaller, rural areas, affording them some buffer against less acute services (i.e., the only game in town).

10

Post-Acute Care Industry Overview (cont’d)

.
.

• SNFs typically provide two types of care:

Skilled Medical Care
Skilled Medical
Care
Custodial Care
Custodial Care
Rehabilitation, respiratory therapy, medication
Rehabilitation, respiratory
therapy, medication
More limited services to those who can no longer care for themselves
More limited services to those
who can no longer care for
themselves

• The industry is fairly fragmented SUNH is the 6 th largest SNF operator by bed count (and second largest public one ) but only has ~1.5% market share. Though on a weighted average based on beds-per-state, SUNH has a 6.2% market share.

) but only has ~1.5% market share. Though on a weighted average based on beds-per-state, SUNH
) but only has ~1.5% market share. Though on a weighted average based on beds-per-state, SUNH

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The transaction
The transaction
The transaction

The transaction

The transaction
The transaction
The transaction 12

The Transaction

On May 24 th 2010, Sun Healthcare (“SUNH”) announced plans to split into two publicly traded entities: an operating company and a REIT. The company will spin-out its operating unit (“New Sun”) on a one for one basis and convert the remaining entity consisting of the company’s real estate holdings into a REIT (“Sabra Health Care REIT”). Properties will be leased back to Sun. In doing so, management feels it can unlock the value of the company’s real estate portfolio and afford the operating company flexibility to pursue growth strategies and focus on core competencies with less financial debt . SUN recently raised ~$225mm through a stock offering in order to reduce the company’s debt levels (proceeds used to paydown 9.125% senior sub notes and outstanding term loans). Post spin-off, Rick Matros, current CEO of Sun, will become the CEO of Sabra, while current COO of Sun Bill Mathies will become the CEO of New Sun. All other management will remain unchanged.

Sabra, while current COO of Sun Bill Mathies will become the CEO of New Sun. All
Sabra, while current COO of Sun Bill Mathies will become the CEO of New Sun. All
Sabra, while current COO of Sun Bill Mathies will become the CEO of New Sun. All
Sabra, while current COO of Sun Bill Mathies will become the CEO of New Sun. All
•Stockholders’ rights plan: No single shareholder can acquire more than 10% of the company without
•Stockholders’ rights plan: No single shareholder can acquire more than 10% of the company
without making a fair bid for the entire business so that no single investor can derail the
company’s plans of electing REIT status.
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The Transaction is not without precedence

There was a similar transaction in 1998 when Vencor was split into an operating company
There was a similar transaction in 1998 when Vencor was split
into an operating company and a REIT. The remaining
companies today are Ventas (REIT) and Kindred Healthcare
(OpCo).
When the Carlyle Group took HCR ManorCare private in 2007
for $5bn+, many analysts cited the company’s hidden real
estate value as a key driver for the acquisition.

Transaction Timeline

5/24: 8/17: Oct: Q4 10: 1/11: Transaction $225mm ~$325mm Business Elect REIT share debt Separation
5/24:
8/17:
Oct:
Q4 10:
1/11:
Transaction
$225mm
~$325mm
Business
Elect REIT
share
debt
Separation
Status
Announced
offering
refinancing
completed

The two businesses

The two businesses 16
The two businesses 16

SUN Healthcare (“OpCo”)

Recession resistant business

Experienced management team

Strong market position

Consistently high occupancy rates (~90%)

Predictable, stable and recurring revenue streams

Reliable payer base-US Government as largest “customer”

Good long term prospects (favorable demographics)

High barriers to entry (certificate of needs limitations in 17/25 markets)

Leading provider of skilled-nursing services.

High-quality business operating in favorable demographic/secular environment as the populations ages and there is more accessibility to health care coverage.

Once uncertainty surrounding reimbursement rates settles, company should see expansion of valuation multiples.

Sabra Health Care REIT

Positive Factors Positive Factors
Positive Factors
Positive Factors

High quality tenant

Experienced management team

Strong growth opportunities that

large players may shun (small size, easy to push the dial) Geographically diverse portfolio

Sale potential

Sector expansion/diversification over

time (ALFs ILFs hospitals MOBs) Attractive dividend

,

,

,

Negative Factors
Negative Factors

Single tenant Single property type Small market cap/limited initial appeal to real estate investors Non-investment grade Limited operating history/track record

market cap/limited initial appeal to real estate investors Non-investment grade Limited operating history/track record
market cap/limited initial appeal to real estate investors Non-investment grade Limited operating history/track record
market cap/limited initial appeal to real estate investors Non-investment grade Limited operating history/track record
market cap/limited initial appeal to real estate investors Non-investment grade Limited operating history/track record

Sabra’s only pure comp is Omni Healthcare, a long-term care facility REIT.

Given Sabra’s single tenant/property type, balanced with its high quality tenant and strong growth potential, Sabra should trade at a discount to OHI’s valuation multiples (~12x fwd FFO, ~8% cap rate), though this gap should close over time.

Lease Terms

Master lease on all facilities 10-15 year term, with 5 year renewal options (at existing
Master lease on all facilities
10-15 year term, with 5 year renewal options (at existing
rates)
Lesser of CPI or 2.5% escalators
1.6x lease coverage
Management maintains that the transaction will not restrict its operating
flexibility or ability to conduct renovations or capital improvements.

Deferred Tax Asset

Deferred Tax Asset SUNH also has potentially valuable DTA’s that will shield income taxes far into
SUNH also has potentially valuable DTA’s that will shield income taxes far into the future.
SUNH also has potentially valuable DTA’s that will shield income taxes far
into the future.

$227mm in net operating loss carry-forwards that can be applied to future earnings (as of

6/30/2010)

Utilization amounts subject to IRS Section 382 Limitations

High Quality Management Team

High Quality Management Team Extensive experience Rick Matros has been the CEO of three Healthcare companies

Extensive experience Rick Matros has been the CEO of three Healthcare companies Handled turnaround/bankruptcy emergence operations Operated in many different market and operating environments Conservative mindset World class operators Entrepreneurial spirit Shareholder oriented

A secular tailwind

A secular tailwind 22
A secular tailwind 22

Favorable Demographics and Industry Structure

Favorable Demographics and Industry Structure The number of certified care facilities continues to decline, presenting a

The number of certified care facilities continues to decline, presenting a favorable supply/demand imbalance.

Trends in certified nursing facilities, beds and residents
Trends in certified nursing facilities, beds and residents

Favorable Demographics and Industry Structure (cont’d)

Favorable Demographics and Industry Structure (cont’d) While elderly population growth… US Seniors Population Trends

While elderly population growth…

and Industry Structure (cont’d) While elderly population growth… US Seniors Population Trends (70+ years old) 24
US Seniors Population Trends (70+ years old)
US Seniors Population Trends (70+ years old)

Favorable Demographics and Industry Structure (cont’d)

Favorable Demographics and Industry Structure (cont’d) …is likely to continue to outstrip new facility supply Senior

…is likely to continue to outstrip new facility supply

Senior housing construction starts in Top 31 Metros (units)
Senior housing construction starts in Top 31 Metros (units)
So what is the company worth? 26
So what is the company worth? 26

So what is the company worth?

OpCo Valuation

2011E 2011E EBITDAR 250 250 Current Rent 75 75 Incremental Rent 70.9 70.9 EBITDA 104.1
2011E
2011E
EBITDAR
250
250
Current Rent
75
75
Incremental Rent
70.9
70.9
EBITDA
104.1
104.1
Multiple
5.5
6
Enter rise Value
p
572 55
.
624 6
.
Less Debt
198.00
198.00
Equity Value
374.55
426.60
Shares Outstanding
75.00
75.00
p 572 55 . 624 6 . Less Debt 198.00 198.00 Equity Value 374.55 426.60 Shares

Sabra REIT Valuation

PropCo Pro-Forma Rent Payments 70,200 Value G&A 2,400 FFO Multiple Per Share D&A 23,681 9x
PropCo
Pro-Forma Rent Payments
70,200
Value
G&A
2,400
FFO Multiple
Per Share
D&A
23,681
9x
5.5
10x
6.1
Interest
22,190
Total Costs
48,271
Dividend Yield*
9x
10.00%
10x
9.00%
EBT
21,929
Taxes
-
* Assumes 90% FFO payout
Net Income
21,929
FFO
45,610
Pro-Forma Shares
75,000
FFO Per Share
0.61

Combined Valuation

EBITDA Multiple (OpCo) 5 5.5 6 6.5 8 9.17 9.86 10.55 11.25 9 9.77 10.47
EBITDA Multiple
(OpCo)
5
5.5
6
6.5
8
9.17
9.86
10.55
11.25
9
9.77
10.47
11.16
11.86
10
10.38
11.08
11.77
12.46
11
10.99
11.68
12.38
13.07
12
11.60
12.29
12.99
13.68
EBITDA Multiple
(OpCo)
5
5.5
6
6.5
8
11.23%
19.65%
28.07%
36.49%
9
18.61%
27.03%
35.45%
43.87%
10
25.99%
34.41%
42.83%
51.25%
11 33.37%
41.79%
50.21%
58.63%
12 40.75%
49.17%
57.59%
66.01%
FFO Multiple
FFO Multiple
(PropCo)
(PropCo)

Value Per Share

Potential Upside

Information asymmetry: valuation gap between intrinsic and trading value likely exists as the situation is
Information asymmetry: valuation gap between intrinsic and trading value
likely exists as the situation is too complex for most retail investors and the
company too small to interest most institutional investors.

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Risk factors

Risk factors 30
Risk factors 30

Risks and Mitigates

g Oct
g Oct

Some downside risk remain, though the company is actively addressing them

Uncertain and challenging reimbursement environment ~75-80% of revenues are from government sources as States face budgetary issues

Medicare RUG IV revisions comin 1, 2010; impact uncertain (see next slides)

High debt levels from historical acquisitions, capitalized rent

Unsettled capital markets

Reduced demand due to economy (delaying surgeries, avoid co-pays)

Much already priced in with depressed multiple Geographically diverse portfolio limiting the impact of any one state’s economic health Diversified business model

Company is confident it can cope; history supports this view Moving towards shorter stay, more complex higher acuity and higher reimbursement patient

Equity raise has reduced financial leverage considerably

Exogenous risk

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Cannot be delayed indefinitely

RUGs IV (Resource Utilization Group Version 4)

RUGs IV (Resource Utilization Group Version 4) Medicare currently classifies patients into 1 of 54 categories.

Medicare currently classifies patients into 1 of 54 categories. 13 new categories to be added. The upper-nine RUGs are the highest paying. New RUGs classification system scheduled to be implemented on Oct 1, 2010. Categories are based on minutes of therapy required, need for special services and an index base on the ability to perform four activities of daily living (eating, toileting, bed mobility and transferring). An opportunity for growth? Transition to higher paying patient types Could take several quarters to play out Top nine RUGs were intended to be ~20% of Medicare patient days, actual number close to 26% as SNF’s targeted patients requiring higher intensity, acuity and complexity.

RUGs IV: Strategy and historical perspective

RUGs IV: Strategy and historical perspective SUNH successfully navigated RUG III changes, increasing its upper-nine RUG

SUNH successfully navigated RUG III changes, increasing its upper-nine RUG utilization over time.

increasing its upper-nine RUG utilization over time. It will likely take several quarters for SUNH to

It will likely take several quarters for SUNH to able to refocus on more medically complex patients, but history shows management is capable of doing so. The company does not believe it will be negatively impacted over time and the OpCo/PropCo transaction should be seen as a vote of confidence.

33

RUGs IV Changes

ddi i t ona l i i
ddi i
t ona
l
i
i

costs assoc ate w t

Eliminates concurrent therapy and Look-Back Period Centers for Medicare & Medicaid Services (CMS) would prefer to see concurrent therapy used as more of a supplement.

CMS is proposing time is allocated between all patients,

not

as individual time.

Analysts estimate this should only impact 4% of patients.

R ea

l

i

i

h i

l

ncrementa

mpact s a

therapists. Look-Back Period: Five services were used as a proxy for acuity/complexity. Patients who met these requirements qualified for upper-9 payment rates. Patients will only qualify if they receive these services AFTER admission, whereas before it was within the past 14 days. There will also be some additional rehabilitation requirements.

The start of a trend?

The start of a trend? 35
The start of a trend? 35

Potential follow-on opportunities

Potential follow-on opportunities If the transaction is successful, other companies could follow suit. SUNH’s
If the transaction is successful, other companies could follow suit.
If the transaction is successful, other companies could follow suit.

SUNH’s transaction creates comparable for other long-term care providers who wish to monetize their real estate portfolios. This offers a pool of similar opportunities and the potential to “wait out” the SUNH transaction and pursue similar, future ones. Potential candidates include:

Skilled Healthcare (SKH, 74% owned real estate) Ensign Group (ENSG, 63% owned real estate) Brookdale Senior Living (BKD, vast majority owned real estate) Privately held ManorCare and Golden Living already have an OpCo/PropCo structure and may look to explore IPOs and use them to support acquisitions or alternatively, may conduct reverse mergers.

Risk: new accounting rules calling for operating leases to be capitalized may present an obstacle.

A potentially repeatable investment theme.
A potentially repeatable investment theme.

Conclusion

High quality business with recurring revenue streams, secular tailwinds and a great management team Trading
High quality business with recurring revenue streams,
secular tailwinds and a great management team
Trading at a significant discount to fair value on a sum-
of-the parts basis
Spin-off opportunity presents catalyst to realize value
Shares do not currently reflect upside potential of OpCo/PropCo
structure and transaction should unlock value
Potential pipeline of other similar, attractive opportunities
Upside potential: 27-43% + value of DTA

Appendix

Appendix SUNH’s revenue breakdown by payer type: 38

SUNH’s revenue breakdown by payer type:

Appendix SUNH’s revenue breakdown by payer type: 38

Appendix

Appendix SUNH’s per day patient rates by payer: 39

SUNH’s per day patient rates by payer:

Appendix SUNH’s per day patient rates by payer: 39