The SeniorCare Investor: Capital Senior Living Buys Big

 

With Large Acquisition, CSU Expands In The ALF Market

The acquisition market has been in the doldrums since last August, seniors housing public equity prices have seen their worst decline in five years, the mortgage market is squeamish and everyone is wondering where values are and how far they will decline in 2008, if much at all. About the only thing everyone seems to agree on is that cap rates have increased. The problem is that no one knows to what extent, and our limited expertise on the subject would suggest that the change in cap rates will be very property-specific, with the best properties seeing a much smaller increase than the B and C properties, and the stabilized facilities being impacted less than the non-stabilized. And, of course, wildly optimistic (even mildly optimistic) pro formas will be discounted by just about everyone in today’s environment.

So upon our return from the winter wonderland of Vermont after the holidays, we were surprised to find out that on the day after Christmas Capital Senior Living (NYSE: CSU) announced it was making its most significant acquisition yet, and one that should pacify a few of its dissident shareholders. Readers will recall that two years ago a major shareholder tried to force an auction of the company to enhance shareholder value (specifically, that shareholder’s value), with one of the complaints being that corporate G&A expense was way too high relative to CSU’s revenues and the company should be part of a larger entity. And late last year, another major shareholder tried to do the same thing. Management has long stated that their platform could handle a significant acquisition without much incremental overhead expense, and shareholders have been waiting. Now they will get their chance to see how the theory pans out.

Capital Senior Living has signed an agreement to acquire the leasehold interests in 32 assisted living facilities operated by Hearthstone Senior Services and owned by Nationwide Health Properties (NYSE: NHP). Hearthstone sold these assets to NHP in May of 2006 for a total price of $431 million, or $196,600 per unit. NHP also had the right to finance the further expansion of the company, but it does not appear that any facilities were added to the portfolio in the past 18 months. NHP’s initial lease rate was 8.06%, with an annual 1% increase plus an annual CPI-based increase of up to 2% together with a revenue-based rent increase starting at 0.54% of revenues in the first year and increasing thereafter. As part of the transaction with Hearthstone, we understand that CSU will renegotiate some of these terms, which is prudent since there are too many increases involved and it is usually better to keep things simple.

At the time of the original sale to NHP, we estimated that annualized EBITDAR would be about $39 million by the end of 2006, which may have been high since the first nine months of 2007 annualized EBITDAR was about $40.3 million, which excludes Hearthstone’s G&A but includes $2.6 million of assumed incremental cost to CSU. What we don’t know is the G&A assumption back in 2006, but that is old news now. The original lease was structured with a 1.0x coverage, which was obviously expected to rise.

Of Hearthstone’s 32 facilities, 15 are in Texas, four in Tennessee, three in Alabama and the remainder in seven other states. Capital Senior Living has 18 communities in Texas, so there is some good geographic overlap, with just four new states coming into CSU’s portfolio. The company has stated it wants to buy a home health care agency in Texas, and with 15 additional assisted living facilities in the state, such an acquisition becomes a larger priority.

The Hearthstone portfolio has a total of 2,192 units with a resident capacity of about 3,800. Approximately 30% of the units are two-bedroom apartments with two unrelated people sharing the living room, 40% are suites that are used by one or two residents and 30% are studios or one-bedroom units designed for single occupancy. While double-occupancy is not our preferred model for assisted living, when it works it can be very successful financially. According to an NIC study a few years ago, double-occupancy assisted living units produced an average of 52% more revenue per unit than private units, or nearly $1,500 more per month. That more than covers any incremental cost for that resident, which is why the Hearthstone portfolio will contribute at least a 39.8% EBITDAR margin to CSU.

Capital Senior Living is paying $35 million for the leasehold interests, or about 7x the adjusted annualized EBITDA of $5 million based on the first nine months of 2007. On a combined basis, the annualized revenue and adjusted EBITDAR for 2007 will be about $289.1 million and $94.4 million, respectively, with $62.2 million of combined lease expense to be deducted.

One problem we have with this analysis, however, is that CSU’s third quarter EBITDAR annualized is about $3.2 million higher than the first nine months annualized, so we assume that Hearthstone’s financial performance in the third quarter, annualized, was also better than the nine months annualized. We were told that Hearthstone’s occupancy has been increasing, so we assume cash flow has as well, which theoretically puts its fourth quarter cash flow even higher, and consequently the purchase multiple below the 7x we mentioned. Although no one can predict what will happen in 2008, our guess is that based on 2008 pro forma cash flow, the multiple comes down to 6x, if not even lower. Except pro formas are a thing of the past, right?

No decision has been made as to how CSU will finance the $35 million purchase price, but whether it is with cash on hand, debt or equity (or some combination), the acquisition is accretive, and hasn’t it been accretive acquisitions that certain dissident shareholders have been demanding of management? Especially large, accretive acquisitions? The transaction, which is expected to close in the second quarter, will increase revenues by 54%, EBITDAR by 74% and resident capacity by 40%, and this is before any financial synergies and higher occupancy levels. The acquisition will change the nature of CSU’s business a bit, however, as assisted living will rise from 22% to 45% of resident capacity. Some people have made an issue of a supposed lack of expertise in the assisted living field, but we disagree that there is a problem. CSU’s management is not new to the area, and so much of “independent living” has come to resemble assisted living that often there is a fine line between the two when you get inside the building.

On the surface, it looks like investors have been under-whelmed by the deal, but that is unfair since the overall market, which has not performed well recently, has been a larger contributor to CSU’s recent share price drop. Regardless of how the company finances the transaction, it will be accretive to earnings immediately—perhaps significantly so in a year or two. It could even be a transforming acquisition because of what it does for residents, units and revenues under management, as well as the company becoming more of a 50/50 assisted/independent living company, instead of primarily independent living.

One thing that is a slight negative in our mind is that this acquisition will lower the percentage of properties owned by CSU, but others do not see this as a problem as long as it is accretive to earnings, which it is. There has been speculation that some short-term investors may not be happy because the deal may make a sale of the company less likely. But for the long term, if it makes for a stronger, more competitive company, what’s not to like? And besides, that G&A expense criticized by some investors will now be under 5% of revenues in 2008. That should bring at least a smile to some shareholders, even those pushing for a sale of the company.