The SeniorCare Investor: Sunrise Charting A New Course
After Many Mishaps, Sunrise Is Entering A New Era
Sunrise Senior Living (NYSE:SRZ) was founded 27 years ago by Paul and Terry Klaassen when they opened a small, former nursing home in Virginia they purchased for just $325,000. In five months, they remodeled the building with their own sweat and the little equity ($16,000) they had from the sale of their townhouse, and borrowed funds from friends and family. They lived in the facility, ran it, hired the staff, bathed the residents (Paul handled the few men that were in residence) and probably did a little bit of the cooking as well. Against all odds, it was a success, partly because it provided a different type of service in a different setting that the customer actually wanted, and partly because of the grit and mission-driven desire of the two founders to succeed. They knew that there had to be a better alternative to what they had seen in the market and the rest, as they say, is history.
Now, 27 years later, the company manages more than 440 communities in four countries, has revenues under management of more than $2.4 billion, boasts an average same-community occupancy rate that has been at 90% or better for four consecutive quarters and is perhaps the only company in the industry with a national brand name known to the consumer. It was not, however, an easy road to get there (it never is), and changes, many of which are needed, are on the way. As for the founders, we hear that Ms. Klaassen is rarely seen at the company headquarters anymore, despite her various titles, and Mr. Klaassen will be relinquishing his chief executive officer duties at the annual meeting of shareholders in November and will become the non-executive chairman of the board. At that point, Mark Ordan, who was brought in earlier this year as the chief administrative and investment officer (and, we assumed, Mr. Klaassen’s eventual successor) will take over as CEO. And with this change, an era in our industry will come to a close (getting a little sappy, I know).
The company finally filed its 2007 10-K on July 31—the promised date—and the accounting mess that started two years ago is close to coming to an end. We have to say, however, that we were disappointed that the recently filed, and restated, 2005 and 2006 financial statements had to be restated yet again as a result of new interpretations of CCRC accounting rules. CCRCs have been around for a long time and we just don’t understand why Sunrise, or more particularly its auditors, are all having such trouble with these concepts, but that’s probably another story and the financial implications of the changes did not seem to be very significant.
There were a few things in the recently filed 2007 financial statements that surprised us, however, including the fact that total operating revenues last year were basically flat with 2006, and the importance of "buyout fees" to the company’s overall financial performance in both 2005 and 2006. In addition, hospice and ancillary service revenues inceased by 64%, but the associated expenses increased by 80%, causing this business category to go from a small profit to an $8.8 million operating loss. The bigger issue was what happened to what we will call operating EBITDA.
For 2007, Sunrise posted a net loss of $70.3 million, which was after $214.0 million of gains from real estate sales and the company’s share of earnings in unconsolidated communities. These gains and earnings more than offset the combined $166.5 million in unusual cost items such as loss on financial guarantees ($22.2 million), impairment of goodwill and intangible assets ($56.7 million), write-off of abandoned development projects ($28.4 million), impairment of owned communities ($7.6 million) and the accounting and legal cost of the accounting restatement ($51.7 million), most of which we consider to be a waste of money where the company had little choice once it got rolling.
This means that operating EBITDA was a negative $73.4 million, compared with a positive $110.2 million in 2006. That is a downward swing of $183.6 million, caused mostly by the disappearance of the previously mentioned "buyout fees," which were $134.7 million in 2006 and next to nothing in 2007, and represent, we assume, the fees paid by Five Star Quality Care (AMEX: FVE) to Sunrise to buy out Sunrise’s management agreements for properties leased by FVE but operated by SRZ (long story).
The other large item was G&A expense, which increased by a whopping 42.5% year-over-year to $187.3 million but should not include all those costs associated with the accounting restatement. If you do the math, this means that without those buyout fees in 2006, operating EBITDA would have been negative in that year as well, although not as large as 2007. We still have trouble understanding how the management model that Sunrise has adopted can work in this industry if a company can’t make money managing more than 440 properties around the world.
The end result is that the entire increase in cash during 2007 came from a net $56.7 million increase in borrowed funds. In addition, the company had a negative working capital of $116.3 million at the end of 2007 due to $222.5 million of short-term debt and the current portion of long-term debt. Although we usually don’t get worked up about working capital for Sunrise, when the bank line-of-credit is reduced (which it was in July) because of breeches in loan covenants, it does make one pay closer attention to some of the details.
So what has happened over the past several years to this giant in the industry? First of all, Sunrise is known as one of the best developers, if not the best, of seniors housing properties in the country. It does not, however, win awards for its acquisition acumen. The acquisition of Karrington Health in 1999 was trouble from the beginning. Despite being modeled on the Sunrise prototype, it didn’t quite get the right zip codes, and when they built them, they did not come. Recent acquisitions, such as The Fountains, with its much higher than anticipated revenue-shortfall guarantees, and Trinity Hospice, with its Medicare fraud accusations four months after the deal closed (all before Sunrise purchased it), we wonder whether it is bad luck or insufficient due diligence, or both.
Or take the case of the six Aston Gardens communities in Florida purchased in late 2006 for $460.0 million, or $238,300 per unit. Occupancy was about 95% at the time of the acquisition, which was done in a joint venture format with Sunrise owning 25%. But with independent living representing about 75% of the units, these large communities are suffering from the severe downturn in the Florida housing market, and in July the joint venture received a notice of default from the lender of $170.0 million (the debt, however, is non-recourse to Sunrise). The equity partner also sent a letter of default to Sunrise under their management agreement because of the notice from the lender, and as a result Sunrise has recorded a pre-tax impairment charge of $21.6 million. We chalk this one up to bad luck with regard to timing, even though we heard the original cap rate was quite aggressive (close to 6%), so there appeared to be more downside risk than upside with 95% occupancy.
The best acquisition the company completed, and one that many people believed not only changed the direction of Sunrise but also might have saved it from some troubles at the time, was the purchase of Marriott Senior Living Services in early 2003 for $150.0 million. This transaction gave Sunrise significant bulk, risk-free management fee revenues and some breathing room in its "accounting presentation" that was being attacked from all corners (including this corner) when the company started its property sale-manage back strategy to generate earnings, cash and long-term management contracts. Once the company releases its first and second quarter financial results for 2008 and becomes a "current filer," we assume investors will breath a sigh of relief and hope they don’t hear accounting and Sunrise in the same sentence again.
In looking back over the past five years or so, it seems that the biggest problem was that Sunrise got a little ahead of itself, believing that it was so good that it could take risks that others might not take, with some competitors accusing the company of a certain degree of arrogance. This would include things like revenue guarantees in joint ventures, the expansion into Germany, which has been a financial disaster and a total misread of that market, and the expansion into the seniors condo market, or equity retirement housing.
The seniors condo market problems, however, have more to do with bad timing than a bad idea, and this product type will come back when the housing market improves. In addition, someone at Sunrise decided to get quite aggressive with accounting interpretations several years ago, and it came back to bite them in a big way. Although we have our suspicions, we hardly think it was Mr. Klaassen who, he readily admits, is accounting-challenged.
We also think the company’s expansion into the hospice business was a tremendous strategic concept, and others are doing the same, but Sunrise just got caught with acquiring the previous owners’ problems. Unfortunately, the result has been a $56.7 million impairment charge in 2007, and average daily census has dropped from 1,500 at the end of 2006 to 1,300 at the end of 2007 and just 985 at the end of June 2008 as a result of closing some locations in non-core markets and the focus on the OIG investigations. We believe, however, that it would be a strategic mistake for the company to leave the business at this point. And finally, although the Washington Post had reported that the lawsuit filed by former CFO Brad Rush had been "dismissed," according to the 2007 10-K it was "settled," with neither side admitting fault, which is what we had heard through the grapevine weeks ago (low seven figures).
But enough of the past and on to the future. As management transitions from Mr. Klaassen to Mr. Ordan, which we believe is already in the works, there will be increased attention on cost control, and after the unprecedented increase in overhead expense last year, the company has announced a program to cut between $15.0 million and $20.0 million on an annualized basis beginning in 2009, which will include some "voluntary" employee reductions.
Although some questioned the choice of Mr. Ordan, who has been referred to as a "grocer" as a result of two of his past positions, it appears that he is bringing a hard-nosed approach to running a large business that got out of control in recent years. In addition to cost controls, the company will be cutting its development pipeline by up to 50% until the market improves, which certainly makes a lot of sense to us even though they (and Holiday Retirement) were the only companies that maintained a rigorous development program through the highs and lows of the market over the past decade. Management acknowledged that obtaining construction financing on acceptable terms had become a bit difficult, and if Sunrise is having that problem, you can only imagine how other companies are faring.
Sunrise was the first company to come out with some preliminary second quarter operating results, and investors have been waiting to see where occupancy for the industry has gone. The good news was that for Sunrise, same-community occupancy in the second quarter was 90.0%, or 10 basis points higher than the year-ago quarter, and just 30 basis points lower than the first quarter of 2008. In this market, that’s an accomplishment, and investors pushed the stock price up a bit on the news. Curtailing the development pipeline was also viewed as a positive, because the company needs to conserve its cash and it really doesn’t need to start 25 to 30 new projects a year, especially when the targeted zip codes can’t be as fruitful as the ones five and 10 years ago.
As the company transitions to the post-Klaassen era, we do have some advice for Mr. Ordan (bold as we may be). The first would be to listen to the market. We have been hearing for well over a year now that some institutional partners have not been happy about the performance of some of their properties, and some, we have heard, will not hire Sunrise again. Since Mr. Klaassen and Sunrise were really the ones initially responsible for bringing institutional equity into the seniors housing market, and no one can take away the importance of that accomplishment, it is time to find out what may have gone wrong directly from these entities.
One complaint we hear about is the packing on of expense reimbursement after expense reimbursement that drives some of them absolutely nuts, as well as public statements from Sunrise that Sunrise makes money no matter how the properties perform, leaving some to wonder how concerned the company is about performance. That wouldn’t give anyone a warm and fuzzy feeling, and even though we realize that these statements are for the benefit of the public equity investors, it really sounds a bit crass, and should be stopped.
In addition, while overall same-community occupancy fared reasonably well in this market, some joint venture partners might wonder why the same-community occupancy decreased by 50 basis points year-over-year at the 146 JV communities while company-owned communities had a 140 basis point increase in occupancy over the same period. There could be a simple and logical explanation, but given everything else, it just doesn’t look good.
Second, while you (Mr. Ordan) are concentrating on cutting overhead costs, the other complaint we hear is that management is not paying attention to operations at the local level, especially once a community is stabilized and Sunrise is just managing it. Quality of care is crucial, especially for the industry leader, and you don’t want what happened in Pennsylvania last year to happen again, anywhere. With less focus on development over the next 12 months, there should be renewed focus on operations. While it is great that Sunrise has grown to 440 properties under management, that itself may be part of the problem. This industry has some great leaders, but when you scratch beneath that, all we hear is that there is a huge management void, and we hear this from operators themselves.
There are going to be challenges, not the least of which is the relationship between cost increases and rate increases at the community level. In the second quarter, average rates increased by 5.4% while expenses increased by 6.7%, allowing same-community operating income to increase by $3.3 million. But if average rate increases drop by 100 basis points to 4.4%, which could easily happen if the economy and housing market continue on their current course, and average expenses increase by just 30 basis points, Sunrise will have zero growth in same-community operating income, and that will really give investors something to think about. Maintaining these levels of rate increases will be one of the many challenges facing the industry in this difficult environment. Fortunately for Sunrise, the company is in a good position to maintain its relatively high price points in the market, and for a high-end provider, it may have the industry’s highest double occupancy rate, a fact that still surprises us.
Mr. Klaassen should be proud of what he has accomplished for his company and for the industry, but Sunrise is in a new stage of its corporate life, a stage where Mr. Klaassen’s tremendous strengths and vision will have less of an impact on day-to-day operations. Getting one’s hands around a 440-community gorilla takes exceptional administrative and financial skills, and that is why we believe the board brought in Mr. Ordan this year. But we also believe that with the accounting nightmare coming to an end, a more sober look at development and a focus on less risky financial agreements, the company is beginning to right itself, even though it will not be clear sailing just yet.