The SeniorCare Investor: Bargain Prices In The Market

 
With Recent Drop, Assisted Living Concepts Is Too Cheap

With the overall stock market mostly in decline so far this year, it can be expected that some "values" will materialize as prices started to fall below what, in normal times, would be considered way too cheap. But these are not normal times, and it is difficult to gauge what anything is really worth when you don’t know if there are any buyers out there, especially when most of the financial buyers seem to be on the sidelines. And if there are buyers, from what we hear, many of them don’t know if they can get the necessary financing for a significant transaction, or what the specific terms would be. The result, of course, is that there is very little of that former "M&A premium" in the stock market today (and next to none in the seniors housing sector), which for the past few years had bolstered public equity values on the hope that someone would take a run at a particular company. Financial buyers were always the most interested because of the ability to leverage the real estate component in a seniors housing deal.

In November of 2006, the company now known as Extendicare REIT (TSX: EXE.UN) spun out Assisted Living Concepts (NYSE: ALC) into a separate publicly traded company. In the "when issued" market, the shares were trading in the $8.25 to $8.75 range, but once it began to officially trade, it dropped to a low of $7.44 per share. Since then, it has topped $13.00 per share amid the takeover frenzy of early 2007, propped up, in part, by hedge funds believing the shares were undervalued when compared with the ubiquitous "replacement cost" comparison. In fact, we received many calls asking our opinion on the value and the quality of the company and its assets. We always said that ALC’s particular model, small facilities with the "universal worker" concept, was not our cup of tea, but that at some price it would get interesting. When the company first went public in the 1990s, we were a bit critical of the IPO, partly because of the model and also because the company had less than half a dozen properties. As a result, the lead underwriters had us sit down with the founder so she could explain the model and why it worked, but we walked away unconvinced.

Speculative Interest
Last year, these hedge funds (and others) were looking at the company as a takeover candidate when it was trading above $10.00 per share, and we just didn’t think the interest, let alone a great return, would be there at that level, especially since a buyer would have to pay at least a 25% premium to get the Board interested, or pressured, to sell. One of the aspects that attracted some speculative interest was the fact that ALC owns nearly 75% of its properties, and that is good news for a buyer who wants to leverage up a company in a take-private acquisition, especially if you can buy them at a relatively low cost.

The share price stayed in the $10.00 to $13.00 range until the end of July, when everything started to decline. Obviously, when the values started to drop, we began to watch how low they would go and to look for a low point, at least one that made little sense from a valuation perspective, reflecting an overreaction to events that had little to do with the company and a price that would start to attract the speculators once again. Our target number for Assisted Living Concepts was $5.50 per share, and the shares flirted with that level during the first quarter this year and finally dropped below it, if somewhat briefly, when they fell to $5.46 per share on March 26.

Although we are not really surprised, given the state of the capital markets and how many hedge funds are licking their wounds from a difficult first quarter, the phone has not rung, at least not yet. So, where are those investors who, at $10.00 per share, thought the company was undervalued but at $5.50 per share are nowhere to be seen? The easy answer is, focusing on other things after the market peak, but they do so at their investment peril, because now there is some real upside value, whether ALC is subject to a takeover or not. At $5.50 per share, the market capitalization of ALC is just $363 million, and when you add the debt outstanding and capitalize the leases, the total value comes in just under $100,000 per unit, based on the latest financial figures as of December 31, 2007. So now, if that ubiquitous replacement cost theory comes into play, and the number thrown around for ALC seems to be $125,000 per unit, partly because that is their estimated cost to add units to existing buildings, then the shares are theoretically quite cheap. But it is deeper than that.

Back when Assisted Living Concepts began a new life as a public company 17 months ago, the company’s annualized EBITDAR was $65.2 million, or 54% higher than when it was purchased by Extendicare in January of 2005, and occupancy was 84.8%. Today, annualized EBITDAR is $64.2 million, plus an extra $7.1 million from an acquisition that closed January 1 of this year, and occupancy at the end of last year was a low 74.4%. So, EBITDAR growth is flat from three years ago, but occupancy has declined by more than 10 percentage points. The occupancy drop has been partly by design, as a few years ago the strategic decision was made to "dis-enroll" from as many Medicaid waiver programs as possible, and start to re-fill those units with private paying residents at rates that are, on average, more than 40% higher than what’s available under the Medicaid program. The problem has been that in 2007, while there was a 47.5% drop in the Medicaid census (the goal), there has been only a 2.2% increase in the private pay census (most likely worse than the targeted goal). But where there are problems often opportunities can be found.

Today’s Valuation
So what is ALC worth today? At $5.50 per share, the company is trading at an adjusted P/E ratio of nearly 9.6x, which assumes capitalizing the leases at 10%, $129 million of debt and annualized EBITDAR of $71.3 million. That is certainly the lowest of its peer group, with the exception of Five Star Quality Care (AMEX: FVE), which has a significant skilled nursing component that brings its multiple down. Another way of looking at it is to cap the current annualized EBITDAR at 8.5%, which results in a value of approximately $838.5 million. After deducting the capitalized leases ($191 million) and debt ($129 million), you arrive at about $518.5 million, or $7.85 per share. So the company looks cheap on a simple valuation basis (at least 25% below where it theoretically should be) as well as a per-unit basis (20% below replacement cost).

Now, remember that the company’s EBITDAR is about where it was three years ago after cutting its Medicaid census by about 341,000 resident days per year, so far. As we mentioned, the expansion of the private pay census has not happened yet, but we assume it takes a while to move Medicaid residents out or, in some states, through natural attrition, so it is expected that there would be a lag in terms of filling empty units with residents at the higher rate, and it is probably taking longer than management expected. In Texas, where the company operates just over 40 facilities, the Medicaid census dropped quickly when most of the residents were moved to other facilities.

One has to assume, however, that management did its due diligence in the markets where they are getting out of the Medicaid waiver program and found that there was sufficient demand to fill at least half of the newly empty units, if not more. Consequently, using the one-half assumption (or 500 units), at ALC’s average private pay revenue per unit of $100 per day, there would be an additional $18 million of revenue which, at an incremental margin of at least 60%, would yield incremental EBITDAR of close to $11 million, or just over $129 million of additional value. That takes the company’s value up to about $9.80 per share, or close to 70% above where it is today.

But those extra resident days from filling up 500 units only takes the company to an occupancy level of just over 80%, which is far below ALC’s peer group, and far below where any company expects to be. An additional 500 units would increase overall occupancy to 86% and take the theoretical value to almost $12.00 per share. And keep in mind that filling 500 units is the equivalent of just two to four residents per facility, depending on certain assumptions. The point is that there is great upside value for a stock trading below $6.00 per share, if you think that the model can work and if you think that management can execute the private pay strategy. And we admit, these are two crucial "ifs."

For those who do not particularly like the 40-unit model (count us among them, other than for Alzheimer’s facilities or very small markets), the company is trying to expand its facilities where it can. Currently, about 20 properties have 20-unit expansions in process that are expected to open in the third quarter this year, for a total of 400 new units at a cost of $125,000 per unit. After deducting capital costs and assuming they will be filled (all one-bedroom units), the incremental EBITDA could be about $5 million, or almost $60 million of value. Once again, the key will be filling these units as well as the newly emptied ones, and that will entail a lot of marketing, which is something we did not factor into any cost assumptions, although we believe our incremental profit margin of 60% is conservatively low.

Risks
We hope that we have established that no matter how one looks at Assisted Living Concepts, at its current price it is just too cheap and should be purchased and, if it trends lower than our $5.50 per share target, an opportunistic buyer may take a run for it at a 25% to 35% premium. Other than the obvious macroeconomic risks, which no management team can influence, there are some risks to an investment in the company. The company’s CEO, Laurie Bebo, is young and relatively new in her job, and it is unclear whether she will be able to execute such a bold strategy in a reasonable amount of time. There could not have been a worse time to try to fill units with higher paying self-pay residents than during the worst housing market in decades, with the days on the market stretching into many months (and years, in some cases). At least ALC’s rates are usually at the low end of the spectrum. However, that may actually work against them in the sense that for the real wealthy, their homes represent a much smaller percentage of their net worth, with less of a reliance on selling it. But in her defense, the strategy will only work if the markets are there and if they have the line people in place in those markets to execute the strategy. The universal worker concept, however, may be at odds with that.

We also don’t know whether the markets where ALC operates will be able to assimilate all the new "private pay" units, especially since in some areas the company’s reputation may have been tarnished a bit by some bad publicity when they were accused of essentially evicting Medicaid residents. It also may not be easy to change a local reputation for having lower-income residents. We believe this is more of a length of time issue than anything else and one that will eventually work its way out. A big test will be how quickly they can fill the new one-bedroom units they are building at 20 of their existing sites. In addition, there are about 1,000 Medicaid-waiver occupied units left, and if they continue on their path, overall occupancy may decline further if these units are emptied and not filled by private-pay residents. It says a lot for ALC’s cost structure that the company can still be profitable when occupancy is under 75%. If it goes below 70%, however, there will be some real problems and the Board will have to re-evaluate what management is doing and give them a timetable to successfully execute this strategy. At that point they may also start wondering whether it was a mistake to get out of the Medicaid business, and instead concentrate all their growth in the private pay side of the business through acquisitions and development. But at $5.50 per share, this is a buying opportunity that should not last long.