The SeniorCare Investor: Assisted Living Concepts: Past, Present and Future

Last month, Extendicare Inc. (NYSE: EXE) announced that as part of its restructuring, which will include converting its skilled nursing operations into a Canadian REIT, the assisted living component, Assisted Living Concepts (ALC), will be spun out into a separate New York Stock Exchange listed company. We thought this merited an in-depth look, especially since the company has probably gone more than the full cycle of birth, growth, death, re-birth, and now as offspring, so to speak. The timing of the spin-out will be interesting because the market may have peaked, at least for now, and investor interest in a relatively small company may be tepid, at best.

In late November 1994, Assisted Living Concepts opened the market for publicly traded assisted living companies with a 2.0 million share initial public offering priced at $9.25 per share. Many more companies followed its entry into the public market with mixed results. Lead-managed by NatWest Securities, the initial pricing range was between $13 and $15 per share, so it was obviously a tough sell initially, mostly because the company really had no assets and minimal revenues. There was a lot of hype about “assisted living,” and the offering had more to do with Wall Street’s ability to sell an idea, and investors taking the bait than about substance and prospects for real cash flow. But growth was the name of the game, and ALC did grow.

Of the $17 million of net proceeds from the IPO, ALC used $3.5 million to purchase five assisted living facilities in Oregon with 137 units (27 units per facility) to get started, and the company began a development program, with its 30- to 40-unit model, around the country. By August 1997, it owned or leased nearly 100 facilities with more than 3,600 units and was just starting to become profitable. At about this time, ALC’s share price hit a pre-adjusted peak of $44.75 per share (there was a 2:1 split in 1997) and the market cap, at more than $300 million, was more than 10 times greater than it was when the company went public.

But rapid growth takes it toll, and quality of care issues began to surface, and by the end of the decade the entire assisted living industry began to suffer from overbuilding in many markets and the lack of trained staff for so many new facilities. After peaking in 1997, ALC’s share price tumbled to less than $1.00 per share in about two years. At the time of its bankruptcy filing in September 2001, the company had 185 facilities with an average occupancy rate of 84.2%, an average monthly rate of $2,056 and a facility-level operating margin of a respectable 33.4%. Its share price, however, was $0.07.

With a prepackaged bankruptcy filing, it didn’t take long to emerge from bankruptcy protection, and ALC started trading again in January 2002 at about $3.00 per share, where it languished for more than a year. But as the assisted living industry perked up, with occupancies and cash flow rising, so did ALC. By the second half of 2003, its share price topped $8.00, and with Steven Vick brought in to lead the company in early 2002, ALC’s financial health and stock price continued to improve. By January 2004, with its stock price approaching $10.00 per share, Mr. Vick opened preliminary discussions with the board about a potential leveraged buyout of the company. There were some issues regarding a group of leased properties, so the discussions ended, but five months later an unsolicited offer arrived, setting in motion a controlled sales process of the company by Jefferies & Company, the financial advisor to ALC.

By mid-October 2004, Extendicare was revealed to be the winning bidder at $18.50 per share plus assumed debt for a transaction value of $280 million. Capitalizing the leases took the entire value to about $382 million, or a cap rate of close to 11% based on annualized EBITDAR. While expensive back then, it looks a bit cheaper now given the direction cap rates have taken in the past two years. Although billed as a merger with significant geographic overlap, the reality was quite different. At the time, there were only four states where both companies had five or more facilities each, and 65% of ALC’s facilities were in states where EXE had five or fewer facilities, including seven states where EXE had no presence. And, ALC’s largest concentration was in Texas with 40 properties, compared with just two for EXE. One common denominator was that both companies had about the highest proportion of owned properties in the senior care industry. The acquisition closed on January 31, 2005.

There really has not been enough time (less than 18 months) to see what impact EXE had on the acquired assisted living operations, but even in that short time period, a new strategic direction began to take place. ALC, under the guidance of its founder, Karen Brown Wilson, originally targeted its development program in states with Medicaid waivers for assisted living facilities. The facilities were small and in most cases relatively affordable on the private pay side, and management figured that in some states they would attract up to 20% of the census from Medicaid.

One of the problems, of course, is that it can be difficult to make money in small facilities (30 to 40 units) with no economies of scale, but when you throw in lower paying residents (usually $1,500 to $1,800 per month), the result can be mixed. The average spread between ALC’s private pay rate and its Medicaid rate in the nine states with Medicaid residents is just over $27.00 per day, with a range of $20.11 in Indiana to $45.56 in Idaho. For some operators, that difference would be their operating profit.

Occupancy has decreased at the ALC facilities since the acquisition in early 2005, mostly by design. First quarter 2005 occupancy at the ALC facilities was 90.1%, but this fell to 85.9% by the first quarter 2006. Management was trying to increase its private pay mix and residents with lower care needs while decreasing its Medicaid census. During this same 12-month time period, the average monthly rate has increased by more than 10% to $2,682, so the strategy seems to be working in part, although the company needs to work on getting the overall occupancy, at the higher rates, back to the 90% level or better.

The company’s financial prospects have continued to improve, and annualized first quarter 2006 EBITDAR was about $64.4 million on revenues of $227.1 million. This includes the original ALC facilities plus the approximately 30 assisted living facilities previously owned by EXE that will be combined in the spin-off. The EBITDAR margin of 28.4% isn’t going to get many investors excited, and with a 6.1% G&A expense, considered rather low, the margin may decline a little when management has to deal with the expense of being an independent public company.

As far as valuation is concerned, using a cap rate of 8.5% on annualized EBITDA (after deducting lease payments) yields a value of about $590 million, so after deducting the debt, the net value would be closer to $460 million. Using an adjusted P/E ratio of between 12x and 14x (see table on page 3 for the definition of adjusted P/E), which would seem to be a market comparable, we derive an equity value of between $390 million and $500 million. And finally, using a per-unit value of between $75,000 and $85,000, we derive a value for the owned properties (153) of about $380 million net of debt, plus whatever value one wants to assign to the leases.

It appears that the exchange to EXE shareholders will be one share of the new ALC for each share of EXE, which would be about 68 million shares. That would put the share price at between $6.00 and $7.25, with a little wiggle room at both ends. This does not pass the sniff test for a NYSE company, so we assume there will be a 1:2 reverse stock split at some point to double the effective per share price, making it more palatable to investors. As we mentioned last month, in spin-offs of this type, the original shareholders often sell off the shares of the spin-off and keep their original shares (in this case, EXE shares). This would have the initial effect of driving down the new ALC’s share price, at which point it could become a “bargain.” ALC’s management will still have to overcome the burden of small facilities in an investment market where they are not popular, as well as an operating market where economies of scale are important, especially when utility and staffing costs are rising so fast. The timing is good, however, because it appears that the overall senior care market may be peaking this summer. The unknown is whether management will stick with the small facility model or broaden out with acquisitions of regional operators with a different approach. That would seem to make sense, but our guess is that they will move slowly.