The SeniorCare Investor: First Quarter Earnings Results:

Occupancy Is Down, But Results Could Have Been Worse

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All of the first quarter earnings reports are now out, and while
the numbers were not particularly good, they could have been a lot worse. Keep in mind that the first quarter often has some softness with occupancy as the annual flu season usually takes its toll. On the flip side, a lot of icy weather can certainly bolster the rehab units of skilled nursing facilities.

All in all, given the state of the economy and the housing market, the first quarter results for the assisted and independent living companies were mostly acceptable.

We focus on the public companies because they can be used as a good, real-time barometer on what is happening in the market because of their combined size and national breadth. Almost every company reported a year-over-year decline in occupancy, as well as a drop sequentially from the fourth quarter on a same-store basis, except for Emeritus Corporation (AMEX: ESC), which does not report same-store occupancy results. Year-over-year occupancy at Emeritus actually increased by 40 basis points, mostly because of the acquisition of Summerville Senior Living in September of last year, but sequentially occupancy was flat, beating the results of its peer group. In this market, that can be considered a big success.

One of the problems with looking at overall occupancy levels at these publicly traded companies, and using these results to make a judgment on the state of the industry, is that out of a portfolio of 100 properties, fewer than 10% of the facilities can be having difficulties, either as a result of key personnel leaving (marketing director, executive director), bad local press because of an "incident" (see below) or renovations that temporarily result in a lower census. The other 90% or more may be doing just fine, even increasing their census a bit, but it is the other ones that can bring the total average down. Does that mean trouble is brewing? Not necessarily, and Sunrise Senior Living (NYSE: SRZ) is an example of where a small percentage of joint venture properties caused the total of 147 JV properties to experience a year-over-year 100 basis point occupancy decline, even though the rest were doing just fine.

Occupancy, of course, is just one side of the equation, with rental rates and expenses the other. The seniors housing industry has been coping fairly well in these difficult times by being able to achieve attractive annual rental increases. For the most recent quarter, the year-over-year same-facility rent increases for these companies have ranged from about 4.4% to 8.3%. While good, they have also been coming under attack by some consumer groups, and it is questionable how sustainable these increases will be unless the economic climate improves. Also, these rate increases have been implemented during a several-year period when new developments have been somewhat minimal in most markets, and it is unclear what will happen when development starts increasing to meet the growing demand. In addition, for some companies expense growth has outpaced revenue growth, and that can’t go on for too long. With basics such as energy and food costs rising well above the "general" inflation rate, we are not sure what is going to happen. What are they going to do, institute a 5% "fuel surcharge" like so many service providers have done in the past few years in your town and mine?

One of the bellwether companies to watch is Brookdale Senior Living (NYSE: BKD), given its size, national presence and variety of property types. The company’s same facility year-over-year occupancy declined by 150 basis points to 89.8%, most of which has occurred since the fourth quarter of last year. Same facility revenue per unit increased by 8.7% from a year ago, some of which must be coming from the roll-out of therapy services at the Brookdale legacy facilities, in addition to rent increases. But they need to have a healthy revenue increase, because the year-over-year same facility expenses increased by 7.1%, with total facility operating expenses jumping by 8.6% from a year ago. Part of this is a result of adding more than 50 marketing people, so when times are better some of this additional expense could go away.

On an earnings basis, the first quarter results sent a mixed message. The EBITDAR margin dropped by 34 basis points from a year ago, while the EBITDA margin increased by 85 basis points. But since cash flow is king, the funds from facility operations increased by more than 19% to $38.6 million in this year’s first quarter. The company finally lowered its dividend by 50%, something that should have been done months earlier, and it has recently announced that the board has authorized a stock buy-back program of up to $150 million. While we understand that this helps bolster the price with market buys, as well as valuations by decreasing the number of shares outstanding, we always view this device, in any industry, as a negative statement on the company’s business, especially when management says they can get the best return on capital by buying shares.

What does this say about the future prospects of the business, that they don’t have any good investment possibilities, such as acquisitions, development…growth of any kind? We don’t mean to pick on Brookdale, but isn’t this somewhat similar to paying a dividend, in terms of it being a "benefit" to shareholders? If they cut the dividend because they needed the cash, why is it just going to be used to buy back shares, as opposed to investing in the company’s facilities and people? Meanwhile, both Stifel Nicolaus and Jefferies & Company have Buy ratings on the stock and price targets 33% above current levels.

The results at a completely different type of company, Assisted Living Concepts (NYSE: ALC), were not exactly what investors were hoping to see, especially after we touted the stock as being way to cheap when it hit $5.50 per share two months ago. Year-over-year, same-facility occupancy plunged by 1,260 basis points to 71.1%, most of it by design as the company "disengages" from the Medicaid waiver program in most states. The problem has been filling those former Medicaid-occupied units with residents at the higher private pay rates. A year ago, there were 5,219 private pay units filled, but in the first quarter of 2008, on a same-facility basis it was just 5,065 units, representing a 3% decline. This is not the direction you want to go when your Medicaid census has declined by 50% in 12 months.

Despite these problems, operating margins did not decline, thanks to some cost-cutting as well as a $2 million deferred income tax credit. In fact, the EBITDAR margin increased by 110 basis points, helped by an acquisition with higher margins. Management has stated that some of its private-pay residents have moved out to be cared for at the home of relatives, but that there should be a turnaround in the private census starting sometime in the second half of the year. They will need to do this just as the additional 400 units they are adding to 20 facilities start to come on stream, doubling their marketing needs. Perhaps they can borrow some of Brookdale’s new marketing staff.

The company trades at a premium to its peer group when looked at as a multiple of cash flow from facility operations, partly because of the expectation that private-pay occupancy will start to rise, and also because ALC has about the highest percentage of owned facilities among its peer group. Jefferies & Company maintained its Buy rating, but lowered its price target from $9.25 to $8.50 per share. Unfortunately, management will have to deal with the bad press it continues to get, such as the story about a 99-year old woman who, after spending about $330,000 over nine years at an ALC facility and running out of money, has been asked to leave because they will not accept any more Medicaid residents because they have reduced the number of Medicaid beds at this facility in Washington state. ALC apparently filed an eviction notice but then canceled a hearing on the eviction.

If you want to keep away from Congressional hearings, there is a better way to handle it than this. In fact, in addition to the Elderlife Financial Services consumer financing program we mentioned last month as a way to increase census, there is another financing mechanism that is just coming on to the market. This one is different in that it does not involve borrowing money, but selling the potential resident’s life insurance contract, called a Life Settlement. Institutional investors will pay the policyholder more than what the stated cash surrender value is on the policy, which is often just 2% to 5% of the face amount, compared with 25% to 60% with a Life Settlement.

Unfortunately, this concept gained favor 20 years ago among AIDS patients with high medical bills and a short life expectancy. In the case of an elderly resident, with the market value of the policy often greater than the cash surrender value, it can be a win-win if they need the proceeds from the sale of their house before moving into a seniors housing residence, or even affording it. The investor who purchases the policy continues to pay the premiums as well, so after receiving the lump-sum payment, there is no additional cash outflow for the resident.

The company that is launching this Life Settlement product is Maine-based Life Care Funding Group (www.lifecarefunding.com), which was founded by Chris Orestis; a recently released white paper on the concept should be available at the web site. The company has already signed up some regional operators, such as Epoch Senior Living, Continuum Health Care, North Country Associates and Schooner Estates, but more are expected in the near future. When we say "signed up," it is really more getting their name to the marketing director at a company’s facilities and making sure, when going over a resident’s financial profile, they let them know that there is a company that can step in and buy out a life insurance policy at a much greater value, providing the resident with the cash she or he may need to live in an assisted or independent living facility. It is the awareness of this availability that is key, and providers do not want to lose potential residents because of the cost when they may not realize the true value of an asset they have. Combined with the Elderlife financing program, there are a lot of ways providers can help residents make the financial decision to make the move. And that will help census.
On the skilled nursing side of the business, it is usually not expected that economic woes and a declining housing market would impact occupancy levels, and they didn’t. Year-over-year, most of the companies posted increases in overall occupancy, as they did sequentially. Kindred Healthcare (NYSE: KND), posted its best occupancy results in a few years with an 89.2% census in the first quarter of 2008, up 140 basis points from the fourth quarter and up 100 basis points from the year-ago quarter. With the skilled nursing industry, it’s all about reimbursement, especially Medicare reimbursement, and despite a proposed 0.3% Medicare cut, it is expected that providers will be able to adjust their census mix to partially offset this.

Even though we have heard of more instances of states increasing their Medicaid rates, or making a commitment to not lowering them, if the housing market and economy get worse, which is a good bet, many state budgets are bound to be seeing red ink by 2009. In that case, the pressure will be on. For now, however, investors have liked what they have seen with the publicly traded skilled nursing operators after the first quarter earnings were announced, as can be seen on page 3 in their stock price performance in May. All moved up, with three companies increasing by more than 10%.
 

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