The Only Book Value Bargain in the Healthcare Sector and Why You Should Avoid It

Source: Flickr user Alan Cleaver.

If you've been an investor for any length of time you've probably become accustomed to the volatility witnessed in some sectors and the lack thereof in others.

For example, investors in the utilities sector are usually going to sleep just fine at night because utilities' revenue and profits are very predictable. Utility rates are often locked in for a measurable length of time, allowing Wall Street and investors to pretty accurately estimate how much a utility will earn on a quarter to quarter basis. In addition, utilities provide a basic necessity: electricity. Regardless of whether the economy is on solid footing or falling through the floor consumers still need electricity.

On the other end of the spectrum we have the markets most volatile stocks such as technology and healthcare companies. Healthcare stocks can be especially volatile since much of the value of healthcare companies is built not around their profitability, but instead the perception of how well a developing drug, medical device or diagnostic test could eventually perform. Being built around promise leaves a lot of room for emotional trading and volatility.

So much to my amazement when I ran a stock screen looking for book value bargains in the healthcare industry with a market value of more than $1 billion and a price-to-book value of one or less I actually found one.

The only book value bargain in healthcare The company in question is Kindred Healthcare , an operator of assisted living facilities and rehabilitation centers throughout the United States, and it's currently valued at just 93% of its book value.

Source: Kindred Healthcare.

"Why is this noteworthy?" you might wonder. Aside from it being incredibly rare to see any healthcare stock trading below its book value, a price-to-book below one could imply to value investors that Kindred's been overlooked by Wall Street. The perception here being that a company trading below its book value is unlikely to head much lower in a market swoon since it's already relatively cheap, making it a potentially attractive reward-versus-risk candidate.

Source: Kindred Healthcare.

It's also been an exceptionally exciting year for Kindred Healthcare with the company announcing the purchase of rival Gentiva Health Services for $720 million in cash and stock in October. Inclusive of Gentiva's debt Kindred is spending about $1.8 billion to acquire Gentiva. The move will expand its presence across the U.S. and put the company in better position to take advantage of an aging baby boomer population. With Americans living longer than ever, the need for home-health and assisted-living healthcare services is only likely to grow.

This is far from a bargain But, just because Kindred is the only book value bargain in the healthcare sector doesn't mean it's a stock you'll want anything to do with.

If you've ever heard the phrase, "A stock is cheap for a reason," this would be the perfect example.

Source: StockMonkeys.com via Flickr.

For instance, Kindred Healthcare was already carrying a substantial amount of debt prior to its Gentiva Health Services purchase. At the end of its latest quarter it was lugging around $1.5 billion in debt and just $177 million in cash. However, Kindred just closed on $1.35 billion in fresh debt as financing for the Gentiva purchase, implying it's now sporting around $2.85 billion in debt. Lenders are well aware of the risks involved, too, with Kindred paying a whopping 8% on the $750 million due in 2020 and 8.75% on the remaining $600 million tranche due in 2023. This is a potentially crippling debt load if Kindred doesn't grow its bottom-line as projected.

In addition to debt demons, the Affordable Care Act could wind up having a negative effect on home-health and assisted living companies like Kindred and Gentiva.

The ACA, or Obamacare as it's more commonly called, has a number of purposes. These primarily include reducing the number of uninsured in the U.S. and helping to spread the cost of medical care across a greater percentage of the adult population in order to minimize medical cost inflation.

In addition, Obamacare is aimed at cutting the government's involvement in supporting the private sector vis--vis Medicare and Medicaid. What this means for companies like Kindred and Gentiva is that the Centers for Medicare and Medicaid Services, which proposes reimbursement rates annually, is likely to pare back on government-sponsored suggested payouts. Unless these companies can deliver plenty of privately insured client growth it could be increasingly tough to grow profits.

The lesson to be learned If there's a lesson to be learned here it's that value is in the eye of the beholder. Yes, price-to-book and other metrics can be a good starting point for investors seeking a good value. However, more important than just comparing financial metrics is acquainting yourself with what makes a business really tick.

While the combination of Kindred and Gentiva might make sense on paper, and the long-term story of baby boomers aging and these companies seeing an uptick in home-health services would appear to make sense, the actual business prospects right now don't look very encouraging. When the merger is complete we could be looking at roughly $2.4 billion in net debt and shrinking government-sponsored payments, which is a perfectly good reason for a company of this size to be trading at or near its book value.

The article The Only Book Value Bargain in the Healthcare Sector and Why You Should Avoid It originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.