The SeniorCare Investor: 2005: The Year of the Bull, And for 2006?

So here is the question. If 2003 was the best year, in terms of price performance, for senior care stocks, followed by 2004 as the second best year, what are we supposed to look forward to in 2006 when 2005 ended with yet another stellar performance, beating every stock index by significant margins? A bull market has been great for the industry, but contrary to the belief of some people that the senior care industry is not cyclical, it is, and we have lived through a few cycles in the past 20 years.

We are now three years into the strongest bull market our industry has ever seen, with everyone eyeing 2011, when the baby-boomers start turning 65, when we will see some real froth in the market. It would be unusual, however, not to have a correction before then, especially with valuations so high in both the public equity market as well as the property acquisition market.

We have been accused in the past of trying to throw cold water on a party that is going strong, showing the negative, the glass is half empty, side of our personality. We like a party as much as anyone else, but at some point it is time to sober up and face the reality of the next day, and the risks that everyone faces. To our dismay, too many people are hesitant to remove their rose-tinted glasses, perhaps afraid to be left behind, perhaps with the earnest belief that the time has finally come for the senior care and housing market to be in the longest bull market of its life. This may be true, if the participants are careful not to spoil it, but there will still be cycles within that long stretch, with winners as well as losers along the way.

On that sobering note, let’s take a look at the results for 2005, and the best thing that can be said is that the assisted/independent living sector as a whole was the winner last year. In 2003, almost every skilled nursing company stock doubled or tripled in value and captured the top six spots in percentage return. By 2004, the price performance of the skilled nursing and IL/AL stocks were evenly mixed, but last year the top five spots were taken by the IL/AL sector. We all have our moments of glory.

Taking the top spot in 2005 was American Retirement Corp. (NYSE: ACR) with a return of 113%, and this after more than tripling in value the previous year as the number two performer. ACR was followed by Capital Senior Living (NYSE: CSU) with a total return of 83% and Emeritus Assisted Living (AMEX: ESC) with a return of 62%. Both of these companies are still trying to find their way to consistent profitability excluding gains on asset sales, and despite CSU’s stellar price performance last year, there is at least one shareholder still not happy (more on that later).

The top skilled nursing company was Beverly Enterprises (NYSE: BEV), with a total return of just 28% despite the flurry of activity associated with the unwanted takeover attempt, the formal auction of the company and the disappointing final results. BEV’s stock closed the year at just $11.67 per share, despite an initial agreement at $13.00 per share and a final deal cut at $12.50 per share. Many investors still believe the company is worth more than that, but the way that the board and management handled the final few months of the process, it made it difficult for a true alternative investor to jump back into the fray. Most of the other skilled nursing companies did not fare as well last year, but for the most part because of company-specific reasons, either missed earnings results, lease reset overhang issues or still cleaning up the mess from the 1990s. If it is spared any shocks from Medicare and Medicaid, this sector should perform better this coming year.

Speaking of auctions, when looking back on 2005, the past 12 months can be best described as "The Year of the Auction," and we are not talking about the Beverly Enterprises deal. Although a formal auction process has been used for some of the larger single-property asset sales, it has become quite prevalent with the portfolio sales, and we have had a record number of portfolios coming on the market in the past 18 months. The two-step process, involving a preliminary bidding round, which is really an indication of interest without the normal due diligence of a final offer, is followed by a second and "final" offer round, where the top five or six bidders are picked from the first round to participate.

At this stage, buyers are often told a price range that they must meet to possibly be the winning bidder, and this is where some of the controversy has been. If told that they have to top $100 million, for example, to walk away with the deal, buyers have offered $101 million (perhaps more) and still gone away empty handed, feeling that they had been misled by the intermediary because they did what they were told was necessary. The problem is that everyone else was told the same thing, and this can result in a variety of bids above the $100 million mark. And then, once those top bids are in, the unofficial third round takes place where the top two or three bidders are asked to really sharpen their pencils if they want to come out on top. We are sure this happens even when there is just one top bidder, but the broker is simply trying to squeeze the highest price possible for his or her client, which some people forget is the seller, and not the buyer. In a rising market, when several high-end portfolios are coming into play for the first time in years and financial buyers are more aggressive than ever, this strategy has helped push prices higher and higher, sometimes to levels that even the sellers thought were unattainable.

Some buyers (operators) have opted out of this process, believing the only way they are going to win is by overpaying, and figuring that it is not worthwhile to spend the required time on due diligence when the likelihood of coming out on top is slim. The financial buyers, however, are much more comfortable with this sort of process, and it really has become a numbers game with many of them, with less attention to the actual operating side of the business, and the associated risks. The acquisition market, in fact, has become much more of a strict financial play than at any time in the past seven to eight years, and although some may say it is similar to what happened in the mid- to late-1990s, it is different in this environment because there is more real equity being put into the deals with less of the 110% financing that occurred in the 1990s.

The increasing role of the financial buyers has also resulted in the widest spread in prices paid between single property sales and portfolio sales. Although we will not have our year-end statistics available until early March, our guess is that the spread in the IL/AL market may be as high as $75,000 to $100,000 per unit. This reflects both the willingness of buyers to pay up for bulk as well as the overall higher quality of the assets in those portfolios. The high quality, as well as the unprecedented demand, is expected to result in record prices paid for assisted living and independent living units in 2005, which will be detailed in our forthcoming publication, The Senior Care Acquisition Report, 11th Edition.