J.P. Morgan North America Credit Research 27 September 2012 •, Kindred Healthcare Initiating Credit Coverage with Overweight; Buy on the 8-1/4% Notes • Kindred Healthcare (KND) is one of the largest healthcare service providers, with LTM revenues of $6.1 billion. Two things have historically made it a difficult credit for many investors. First, about half of its revenues are obtained from long term acute care (LTAC) hospitals, the reimbursement of which Medicare has long suggested should change. Second, a sale-leaseback many years ago means KND has 'double leverage' via unusually high rents. • We think it's a good time to Overweight Kindred. Most importantly, it seems KND will not have to contend with any transformative changes to Medicare reimbursement for the next several years. Medicare took skilled nursing (SNF) payments down sharply a year ago, and it has delayed the 25% rule for LTACs an additional year to 2013, "pending results of an on-going research initiative to re-define the role of LTCHs in the Medicare program." Visibility of 2013 is reasonable, helped by preliminary guidance this month. FCF looks to be adequate, albeit sensitive to small changes in margins. • Management wants to increase the percent of assets it owns vs. leases. After some back and forth with Ventas, its largest landlord, KND now plans to let the leases lapse for 54 SNFs with annual revenues of approximately $550 million. These are generally older assets (average age of 41 years). Between below-average margins and capex required for upkeep the FCF impact of this shrinkage should be minimal. • KND 8-1/4% have underperformed since issued in May 2011. Bonds are a little below par while the market and single-Bs have tightened 40bps and 60bps, respectively. But now that we have anniversaried a full year of lower SNF payments and CMS has said it will review patient criteria, business risk seems much reduced. • We initiate credit coverage with an Ovenveig