The SeniorCare Investor: Sunrise And Marriott: Bumps In The Road To The Altar?

In an unusual announcement, Sunrise Assisted Living (NYSE:SRZ) revealed what everyone already knew: that the company was in discussions with Marriott International (NYSE: MAR) regarding a possible cash purchase of Marriott Senior Living Services (MSLS), the subsidiary that operates 130 retirement and assisted living facilities. Although we had heard a few weeks ago that a competing bidder (Brookdale/Fortress) had dropped out, Sunrise did mention that it believes Marriott is also in discussions with "at least one other party."

In SRZ’s third quarter conference call, management alluded to being in discussions with entities involving one or two large management contracts, which most everyone assumed included the Marriott assets. But when a spat between MSLS and one of its landlords became public on Thanksgiving Eve, with Sunrise named as the principal company in negotiations with Marriott, it became apparent that SRZ could not remain quiet. Ordinarily, Sunrise would not make an announcement relating to a specific acquisition unless it had already come to terms.

The mention by Sunrise of at least one other bidder was a surprise and we have not been able to determine who that may be. Sunrise also disclosed that there was a "co-bidder" who is in discussions to buy the 18 communities that are still owned by MSLS and who would then hire Sunrise to manage them. Although no one was named by SRZ, we hear that CNL Retirement Properties could be involved, except CNL usually leases the properties as opposed to entering into a long-term management contract. Alternatively, Sunrise could activate its joint venture with the private equity group of Deutsche Bank Real Estate, a venture that was set up last January to acquire up to $200 million of senior living properties. The 18 Marriott-owned properties, however, could command a price in excess of that commitment. But through its asset sales program Sunrise has developed enough contacts that the co-bidder could be any of a number of financial entities.

Currently, MSLS operates approximately 130 communities with just over 23,500 units/beds. Of the total units and beds, 40% are assisted living, 34% are independent living, 16% are skilled nursing and 10% are Alzheimer’s/dementia. In its third quarter conference call, SRZ did mention that the company would like to expand into the independent living market, and with more than 7,800 IL units, the Marriott deal would certainly fulfill that goal. But the 3,805 skilled beds represent quite another issue for the assisted living provider, even though they are all on CCRC or ALF campuses.

Rumors about total purchase price have ranged between $300 million and $500 million, but the likely figure is in the bottom half of that range. The problem is that there are few reliable facts about the two distinct parts of the acquisition (real estate and management contracts) to help in estimating a potential value. The real estate alone may be worth between $250 million and $300 million, but there are few comparables in determining the value of the management contracts.

Complicating the deal is the potential for any of the landlords to try to cancel the management contracts upon a transfer to Sunrise (or anyone else). This problem is occurring already, as Senior Housing Properties Trust (NYSE: SNH), which owns 31 MSLS-managed facilities, and Five Star Quality Care (AMEX: FVE), which leases the 31 facilities from SNH, have claimed that MSLS is in "material breach" of the management contracts (sounds a bit like a speech from "Dubya") and have sent notices of termination to MSLS.

SNH and FVE have claimed, among other things, that MSLS has allocated insurance costs using formulas that put an increased financial burden on the 31 SNH-owned facilities, and that certain home office charges have been allocated to the facilities as opposed to coming out of the management fee earned by MSLS. Marriott has filed a lawsuit seeking to prevent the termination of the management contracts, and that is where it stands today.

Earlier this year, the parent of MSLS was the subject of some lawsuits from the owners of various Marriott hotels claiming similar financial maneuverings. In the case of SNH and MSLS, it is difficult to determine if the claims have merit or if there is an ulterior motive on the part of SNH and FVE. One motivation, of course, would be to get the 31 properties under the management of struggling Five Star. Currently, FVE gets to keep anything left over after paying the management fee to MSLS and the lease payment ($63 million per year) to SNH. Keeping the management fee would certainly be accretive to FVE, and the company is in need of some earnings, the lack of which is revealed by its stock price hovering below $2 per share.

Alternatively, this could all be a legal ploy by SNH to create enough of a stink to potentially derail the sale of MSLS in order to obtain some financial leverage from Marriott. This could be anything from changes in the management contracts to allowing SNH to close a few of the worst-performing assets without paying any kind of penalty to MSLS. The penalty would represent the value of the unpaid management fees on the closed facilities. Sunrise, however, has stated that this litigation should not preclude a transaction with MSLS. This means either that they assume it is more of a nuisance lawsuit that will go away or that they can do the deal without taking over the 31 SNH/FVE properties, which may be a blessing in disguise (for Sunrise).

One of the issues brought up in the SNH/FVE litigation is SRZ’s lack of experience in managing CCRCs and skilled nursing beds, especially since the founder of Sunrise does not believe in the concept of a "continuum." In an April 2001 editorial in Assisted Living Today entitled "Continuum of Care Serves Providers, Not Customers," Mr. Klaassen compared the traditional continuum of care model to the old-fashioned way of delivering babies, when the mother would be moved from a labor room, to a prep room, then to the delivery room, the recovery room, and finally the maternity ward. If Sunrise starts to manage Marriott’s CCRCs, senior management will have to get religion and find a new way of looking at the traditional continuum in order to serve their new customers, as well as their new landlords.

Irony aside, since there are few logical buyers of MSLS, Sunrise will most likely end up with the deal. It will be a transaction that will completely change the nature of Sunrise, putting it, at least from a size perspective, in a class of its own with more than 300 properties under management and almost 40,000 units. In addition, by doubling the size of SRZ, the acquisition will further lessen the earnings impact of, as well as reliance on, the company’s controversial asset sale program. The Marriott assets have not been stellar performers in the past year or two, so Sunrise will have to invest significant management time to both understand the operations and improve occupancy rates. Not an easy task, even for Sunrise.