The SeniorCare Investor: Emeritus Taking A Big Step

Largest Acquisition To Date May Result In Changes

For the past few months, we have been teasing readers about several portfolio transactions that were close to being announced, and at the end of March, two of the six were finally disclosed. We will have to wait, perhaps a few weeks, perhaps longer, for a few more of them to materialize in the public domain, and although we have not heard anything, the final two of the six may have disappeared, but we are still waiting. And as it happens, the two deals announced late on March 29 are most likely the largest of the six portfolios.

As the saying goes, timing is everything, and now may be the time for Emeritus Assisted Living (AMEX: ESC) to make a break with its past. One of the largest assisted living companies in the industry, but one that has been somewhat of an enigma over the years, Emeritus just became even larger—48% larger based on units and 59% larger on revenues—with the acquisition of Summerville Senior Living (SSL). Emeritus is issuing 8.5 million shares of common stock to SSL’s owners, principally two real estate funds managed by Apollo Real Estate Advisors, worth about $255.5 million at the time of the announcement. There is no cash payment involved and while we don’t know of any debt that may be assumed, we believe that most of SSL’s properties are leased with annual lease payments that may be between $60 million and $70 million, which would take the capitalized value of the transaction up to about $900 million, or a range of $110,000 per unit to $120,000 per unit if there is minimal debt assumed.

Summerville was founded in 1996 and is based in San Ramon, California. Currently, it operates 81 assisted living facilities with 7,935 units and has a revenue run-rate of about $260 million. The heaviest concentrations are in Florida with 24 facilities and California with 23, followed by Ohio with 10. The rest of the properties are in 10 other states with between one and four facilities each from Massachusetts to Texas. It operates in just two states (Tennessee and Michigan) where Emeritus does not have a presence, while Emeritus operates in 24 states where SSL has no properties. Summerville’s average facility size is 98 units, compared with 81 units for Emeritus, so we assume that SSL has a higher number of independent living units within its portfolio than Emeritus does, while both companies have Alzheimer’s units.

Emeritus was founded in 1993 by Dan Baty, Ray Brandstrom and Frank Ruffo, but with the original name of Assisted Living of America. The company went public in late 1995 at $15.00 per share when it had just 25 facilities with about 2,200 units and pro forma annual revenues of $53 million (those were the days). It was losing money at the time, which didn’t seem to bother shareholders, and it continued to lose money every year thereafter except in 2005 when it realized a substantial gain ($55.4 million) on the sale of its Alterra stock investment. The shares of Emeritus eventually traded down to $0.75 per share in April 2001 subsequent to the collapse of the assisted living market, but rebounded to above $20 per share by late 2005.

Despite continuing to lose money—a loss of $5.3 million in the fourth quarter of 2006 and a loss of $14.6 million for the full year—the stock jumped 19% last year, after soaring by 62% in 2005, and was already up more than 20% before the Summerville acquisition announcement. Even more surprising, shares of Emeritus jumped another 13% the day of the announcement, something that usually does not happen to shares of the acquiring company, especially when using all stock for a deal. To be fair, that initial jump in price occurred with less than 25,000 shares changing hands in what is a very thinly traded stock. But the fact that a sophisticated investor such as Apollo was willing to take shares of Emeritus, shares that were already trading at an all-time high for a company that hadn’t turned an operating profit, gave confidence to investors that the combined entities would somehow break out of the past operating performance and start to make money. Or perhaps it was the "Brookdale effect," meaning that making a GAAP profit is no longer necessary as long as you have positive cash flow and pay it out in dividends, much like what Brookdale Senior Living (NYSE: BKD) is doing. Emeritus already had positive cash flow, but dividends? Hmmm.

Emeritus, even though it is publicly traded, has really been operated more as a private company, with CEO Dan Baty and a Saratoga Partners investment fund controlling 65% of the voting stock. It was the only public company in the senior care space that did not hold quarterly earnings conference calls for investors and analysts, probably because the float was so small and the coverage so minimal that management and the board didn’t see the need, or the point in wasting their time. Shareholders, it seemed, didn’t complain. But that was too bad, because Mr. Baty usually doesn’t hold back and "tells it like it is" more than his peer group, and with some color. Perhaps that is one of the reasons he doesn’t hold those conference calls.

Over the years, the assets in Emeritus have been a moving target. The ownership, management and lease of various assisted living facilities appeared to travel between the company and various Baty-controlled entities or REITs so often that it was difficult to know what was going on and why. As part of one transaction last month, where the company repurchased 12 leased facilities, Mr. Baty personally purchased the $10.8 million loan held by the REIT. But what’s a few million dollars after you have sold your stake in Holiday Retirement Corporation?

From a financial perspective, Emeritus has been steadily improving, and perhaps that has been driving the stock’s performance despite the lack of GAAP profits. Average occupancy in the fourth quarter last year was 86.6%, up 290 basis points from the year earlier period, and it was at 87.0% at year-end. By this time next year it could be over 90%, which we believe would be a first for the company. The operating margin in the fourth quarter was 36.8%, up 390 basis points from the fourth quarter of 2005, but this excludes G&A expense. When G&A is included, the margin was just 27.8% in the fourth quarter, but still 200 basis points above the year-ago quarter. While we certainly would not want to be accused of going soft on Baty, the occupancy and margin improvement in one year is at the top of ESC’s publicly traded peer group, and that’s an accomplishment.

So what’s next? Well, after leasing the majority of its facilities overt the years, Emeritus seems to be embarking on a campaign to gain control over its assets and, at the same time, increase cash flow. In the first three months of this year, the company has repurchased 45 of its leased properties, including the 12-facility transaction mentioned above. In the latest transaction, at the end of March, ESC purchased three facilities in South Carolina for $28.7 million, or about $63,300 per unit, that had been leased since 1996. Capmark Finance is providing a $23.6 million, three-year loan, and the annual cash flow savings will be approximately $1.1 million. While we don’t know what the savings, if any, is on the 12-facility purchase, Capmark Finance provided $88.0 million of first mortgage financing with an interest rate of 6.515% and $13.6 million of second mortgage financing at LIBOR plus 325 basis points, which combined financed the entire acquisition.

We mention these transactions because it is quite possible that Emeritus, and now with Summerville, will focus on maximizing cash flow while somewhat ignoring GAAP earnings (not that it focused on GAAP earnings in the past). If this is the case, we would expect to see a dividend payment sometime by the end of the year or early in 2008, assuming the financial performance continues to improve. There may be some other changes in the future as well. Granger Cobb, the CEO of Summerville, will become president and co-CEO of the combined companies. Dan Baty will remain chairman and will share the CEO role with Mr. Cobb. We believe, however, that within a year or so, if it all works, Mr. Cobb will take over as sole CEO, and Mr. Baty will become chairman "emeritus."

Mr. Baty has so many other economic interests, both in and outside of health care, we suspect he may start to sell his Emeritus shares within a year, and he has already sold his Holiday Retirement shares (that transaction closed February 28). If there is one thing we can say about Mr. Baty, other than his trademark black t-shirt (and sweater), it is that he certainly has a genius for making money. But for now, we don’t believe he has a need for any outside investors for his next ventures (too bad).

As far as the rest of the company goes, we understand that Justin Hutchens, the COO of Summerville, will be the COO of the combined entity, Ray Brandstrom will continue as CFO of Emeritus, Melanie Werdel of Summerville will be EVP of administration, Kacy Kang of Emeritus will be SVP of operations and John Ciucotta of Emeritus will be SVP of sales and marketing. As you can see, this is truly a merger of the two companies, although we assume there will be some trimming of staff. The only thing we haven’t figured out is what will happen to the corporate office, because Emeritus is based in Seattle, Washington. With a combined 34 facilities in California and a much smaller number in Washington, we suspect there may be a gravitational pull southward, but who knows. We also don’t know about the potential for any quarterly conference calls, because for now Mr. Baty, Saratoga and Apollo will control up to 75% of the shares outstanding. But as they shed their interests (if they shed them), we will see a more transparent operating company.