The SeniorCare Investor: Surise Finally Files $10K --
After Months Of Delay, The 2006 10-K Is Available
Early in the morning on March 24, Sunrise Senior Living (NYSE: SRZ) finally filed a 10-K for the calendar year 2006, which included revised numbers for 2005 and 2004. Even though it has been one of the most awaited SEC filings in recent memory, it is not exactly titillating reading material. In fact, it may be just the cure for those who suffer from a bit of insomnia. But can you imagine what life was like for the poor slobs who had to put the report together? So you will excuse us if we do not provide a blow-by-blow analysis of what was contained in the 10-K, and we have to admit it was tough getting past page 17.
In summary, SRZ’s reported income for the years prior to 2006 was significantly reduced as a result of the accounting restatements, as management had been reporting in its various updates over the past two years. The changes mostly had to do with the accounting treatment of joint ventures and asset sales, and most of those "lost" accounting earnings will be made up in future years, starting, we believe, with 2007, and that 10-K is expected to be released sometime in the second quarter, but we are not holding our breath. One thing that caught us by surprise was the change in cash balances in the prior years. For example, as previously reported, cash and cash equivalents on March 31, 2005 was $158.7 million, but as restated, the balance dropped to $98.5 million. We assume there is a good explanation that any CPA could provide us, but we always thought cash was cash, regardless of the accounting treatment of sales, expenses and gains. Apparently, we thought wrong.
Management had been keeping investors abreast of the write-offs the company has been taking with regard to certain stop-loss guarantees in its Fountains acquisition and joint venture developments in Germany, among others. This has obviously been troublesome as these properties have not performed as expected, and in some cases, not even come close. One new item is that apparently approximately $2.4 billion of joint venture debt can become fully recourse to Sunrise under certain events. We don’t know what rights Sunrise would have to oppose those creditors in the "under certain events" category, which includes fraud, but that would be a devastating blow from a credit perspective. We assume that if the debt were to become fully recourse, the company would have more control over the properties as well. In any event, that would be one legal battle that would generate a lot of legal fees.
But enough of the accounting issues, and let’s get down to the meat of the matter, which is the valuation of Sunrise. Unfortunately, the 2006 financial statements did little to help with valuing the company, as there was little "news" in the numbers, although a few things caused at least one analyst, Jerry Doctrow of Stifel Nicolaus, to lower his net asset value (NAV) for the company by $3.00 per share. The company’s shares went on a wild ride in March, dropping to as low as $16.27 (for a very short while) when SRZ failed to meet the New York Stock Exchange filing deadline and investors feared the shares would be de-listed. After the 10-K was filed, the shares jumped 14% on the news, which was actually 43% above that new low of $16.27 per share. For those who bought on the low, that’s a hefty return in a matter of days.
So what do the experts say? While it may not be a surprise, as the techniques used are somewhat similar, Mr. Doctrow came up with a revised NAV of $34.00 per share, while Frank Morgan of Jefferies & Company came up with approximately $33.00 per share, using two different methods (a cap rate and a per-unit value method), and both of these methods resulted in almost identical values. Obviously there is a severe disconnect in the market, because the shares trade at a 35% discount to the value estimated by these respected analysts. But more likely, investors believe a net asset value (or sum of the parts, as Mr. Morgan calls it) is too theoretical, with assumptions that, given current market conditions, are really theoretical. And don’t forget, investors have not seen any financial statements from 2007 yet.
Both analysts used the same 10x multiple of the management fee business net operating income to arrive at that portion of the value (between $12.00 and $14.00 per share), and the cap rate used for the owned and joint venture facilities ranged from a low of 6.0% (Doctrow for the J/V facilities) to a high of 7.5% (Doctrow for the consolidated facilities), with Mr. Morgan using 7.0% across the board. Some other differences were that Mr. Doctrow valued everything on a full value basis and then deducted the net balance sheet value from the total of the various parts of the business, including giving full value to all assets, when in reality the only thing that ever gets full value is cash. In addition, Mr. Morgan deducted about $277 million in value for various future funding and guarantee obligations (Germany and The Fountains), as well as cost overruns and exposure to an OIG investigation.
It has been somewhat customary to use the hotel management industry as a proxy for what management fee income is worth in the market, and that is where the 10x multiple comes from. The problem we have with that is that this is not the hotel industry, and it is about the same as comparing apples to oranges, even though there is nothing else to use. For those who listened to our most recent audio conference on the new math in seniors housing and care valuations (currently available on CD), the question was posed to the panelists as to what the market multiple would be today to purchase a group of management contracts, or a management company. Other than the stony silence that followed, the unanimous response was that they did not know, partly because there have really not been any comparable sales to give them a hint, and partly because those that were buyers had little interest in management contracts only. The bottom line was that the "paid" acquisition appetite for management contracts is quite thin to non-existent in our industry, so it becomes very difficult to accurately derive a realistic "market" multiple for that part of SRZ’s business. We don’t fault the analysts, because they have to use something, but if you cut that multiple by a third for the reasons mentioned above, you shave more than $4.00 per share off the NAV, getting you to the $29.00 to $30.00 range.
Now, in Mr. Doctrow’s analysis, he uses a 6% cap rate on $258.5 million of EBITDA from the stabilized joint venture properties, which produces a value of $4.3 billion. The good news is that this is based on actual 2007 operating performance statistics (with a few assumptions), and not pro forma cash flow. The bad news is that there aren’t many buyers willing to buy on a 6% cap rate anymore, and there aren’t many lenders willing to lend on a 6% cap rate, especially when you talk about mega-deals. Obviously, there are different joint venture partners and there would not be one $4.3 billion deal, but remember that SRZ’s ownership interest averages between 18% and 20% in these joint ventures, and a minority discount has not been applied to the valuation. You can’t assume that the controlling investor will want to sell, and if SRZ were to ever try to sell its fractional interest to someone for full value, well, all we can say is, good luck. Consequently, the net value (after deducting the associated debt) for the stabilized joint venture properties goes from about $4.00 per share to $2.00 if you use a 7% cap rate even without applying any minority discount. This now takes us down to the $27.00 to $28.00 per share range, which, we admit, is totally theoretical.
With a few other changes in the assumptions used, the NAV quickly approaches the current market value today, which has been in the $21.00 to $23.00 per share range. We are not trying to find fault with the analysts, as they are doing a good job with the limited (and old) financial data they have in a capital market environment that is about as unsettled as we have seen in a decade or two. But the reality is that when it comes to valuing a company as complex as Sunrise, with many moving parts, various ownership interests, uncertain off-balance sheet obligations and OIG investigations, combined with a management team that was abruptly removed, a remaining management team that has been forced to focus too much of their attention on the accounting restatements and other problems, plus a lousy housing and credit market, it is no wonder that there are widely differing opinions as to what Sunrise is really worth (other than the two analysts who seem to be in close agreement). And that may be one of the reasons why the company never found a buyer last year, even though rumors persist that they are still in "discussions."
So this brings us to, What’s next? First, more current financial statements need to be reviewed, and that will happen within the next several months. Second, what should be read between the lines, if anything, regarding the hiring of Mark Ordan as the company’s new Chief Investment and Administrative Officer? He has been the founder and/or the CEO of several companies, a few of which have been sold, so is his mission to prep Sunrise for a sale now that the accounting restatements are largely done? Or has he been hired as a result of the Board’s new succession plan policy to eventually take over for company founder and CEO Paul Klaassen, who has got to be worn out from the battles of the past two years? Or has he been hired to truly take the day-to-day administrative functions of running the company (as the title implies) from Mr. Klaassen, allowing him to focus on the big picture of new markets and development opportunities, which we suspect he prefers anyway, and which is really his forte. Since we have been unable to bug the Board room walls, we really don’t know the answer. At this point, all we can say is that the company is worth what the market says it is worth.