The SeniorCare Investor: Sunrise Senior Living Teeters

The Industry Giant Fights Turmoil In Capital Markets

Who would have ever thought that the Dow Jones Industrial Average would drop below 8,000, a more than 40% plunge from its recent high? Even though in theory there are many buying opportunities in the market today, investors still have more reasons to sell, and it seems as if the hunt is continually on to find the next target to shoot down. The seniors housing industry, at least the publicly traded companies, have been shot down and are severely wounded. During November, it appeared that investors were trying to inflict a few mortal wounds, but we are not sure whether their attempts will bear fruit.

It is fair to say that most everyone watched in shock as the shares of Sunrise Senior Living (NYSE: SRZ) plunged by 91% in the first three weeks of November after dropping by 75% in October. Any time shares of a company drop below $1.00 per share investors are giving the equivalent of an accountant’s "going concern" opinion on the audited financial statements, meaning that there is a 50-50 chance that the company will fail in its present form. Last month, Sunrise dropped to $0.27 per share, or a market cap of about $14 million. The good news is that the share price almost tripled in the last week of November; the bad news is that it still remains below $1.00.

So, out of the numerous calls we received in the past few weeks, the number one question was, Will Sunrise file for bankruptcy protection? The easy answer would be, only if they are forced into it by their creditors. The second easy answer would be, perhaps, if that is the only way the company can remain intact. This latter answer may sound unusual because it is not as if Sunrise has a lot of assets it can sell off to reduce its size, or assets to be sold to raise money to pay off debt and return to its former glory, but as a much smaller company. As a side note, the new CEO, Mark Ordan, just received options to purchase 1.5 million Sunrise shares at an option price of $0.92 per share (the market price when he officially became CEO), so he certainly has an economic incentive to keep the company out of bankruptcy and on the road to at least a single digit stock price.

A year ago, if anyone was asked about the likelihood of Sunrise filing for bankruptcy protection, or its share price trading below $1.00, or even having this conversation, the answer would have been, "Don’t be ridiculous." Even as the shares started to fall a year ago, analysts were trying to find a floor for the share price by completing a "net asset value" analysis, which consisted of valuing the different parts of the business—management contracts, development pipeline, owned properties and equity interests in joint venture properties—and adding them up to derive a value per share.

The problem was that the assumptions being used (mostly cap rates and multiples), which in normal times may have been reasonable, started to bear no relationship to what was happening in the market or, more particularly, what was not happening in the market, which was a big nothing from a transaction point of view. Health Care REIT’s (NYSE: HCN) termination a month ago of its proposed $643.5 million acquisition of a 90% interest in 29 Sunrise-managed properties is a case in point. Values have dropped, cap rates are up, large deals are not getting done and things can change quickly in just a few weeks.

The focus regarding Sunrise, and the primary reason for its price collapse, has been its looming debt maturities and recent covenant violations (temporary waivers have been granted). The company has a total of $209 million of debt maturing in 2009, of which $95 million is from its bank line. There is a January 31, 2009 deadline for a non-bankruptcy recapitalization, and Sunrise believes it will not have access to any additional draws under its credit facility after December 31. Management, however, is taking the public stance that they hope to have everything worked out well before the January 31 deadline, and maybe before the end of the year. Investors, obviously, think otherwise.

Although we have stated publicly over the past several weeks that we believe something will be worked out between creditors and management, primarily because little is gained by a bankruptcy filing, the question we have is, what happens next? Over the years, Sunrise has made its money by developing Class A properties, selling them for a healthy profit and then retaining relatively lucrative, long-term management contracts. It was a win-win situation, especially as the capital providers overwhelmed the market with money, values did nothing but increase in the past five years (until recently) and demand for the seniors housing product remained strong. Unfortunately, if even one of these factors disappeared, it would have hurt, but Sunrise got whacked by all three disappearing in a relatively short period of time, and recovering from that is almost impossible. Unless, of course, a white knight dressed in fresh capital comes to the rescue (which may still happen). But will that be enough?

The problem is that without the rigorous development pipeline (54 development projects were abandoned in the third quarter alone), there is little to feed the beast. Development fees are gone, profits on sales of properties are gone and now the company is basically left with its management fee revenues, and that just isn’t enough, at least, not with the company in its present form. No one knows how long this capital market crisis will be strangling us, but 2010 seems to be the earliest date when liquidity may return to the market in any meaningful way, and that assumes the economy begins to pick up in the second half of next year, an assumption that is a bit risky right now. The issue is, even if Sunrise is able to recapitalize, with or without a bankruptcy filing, it may not be able to keep its development team on staff for another year or two waiting for the markets to improve. And with no new development a year from now, where will the cash flow come from? Even with G&A expense slashed from $70 million in the third quarter of 2007 to $40 million in this year’s third quarter, Sunrise barely had enough cash to cover its interest expense, and this is after removing the hospice business from the P&L, as well as all non-cash expenses and one-time write-offs. The point is that with development gone, the model is broken, and we don’t know what it will take to fix it, with or without capital.

Keeping the development team is one issue, but we hear that above and beyond the voluntary staff reductions, there has been a bit of a brain drain going on at the company at every level. Consistent staff turnover at the property level is never good for operations, and in an operating environment like the one we are in now, that can hurt a community’s competitiveness, especially if quality is compromised. This gets to the crux of the problem. If Sunrise, with or without a bankruptcy filing, simply becomes a management company, they have to become the best operator out there, and that will take a lot of work. It is fair to say they have been number one in the business for site selection, and close to number one (if not number one) as a developer, and there is a strong correlation between that ranking and where they made their money. The profits never came from operations. Consequently, with development gone, hospice gone, asset sales gone and diminishing values for its retained minority interests in properties sold in the past, how much is a company worth that makes between $160 million and $200 million in management fee revenues? While there is no "easy button" here, the easy answer is that with 50 million shares outstanding, it is unlikely that the price will ever reach $10 per share again (and that may be generous), at least not until (or if) the development pipeline can fill up again. This also assumes that the overhead expense comes down from the recent $40 million per quarter.

This may be the reason why there has not been a white knight equity investor ready to come in, pay off the banks and take a majority interest in the company. Just because you have stayed the "execution by liquidity crunch," it doesn’t mean that funds will be available for new development, that investors will be waiting to buy the 80% interest of newly built properties or that if you build it they will come in this environment. The two companies most frequently mentioned that have the financial wherewithal to complete some sort of recapitalization of Sunrise, both of which have substantial investments in Sunrise-managed properties, are Ventas (NYSE: VTR) and HCP Inc. (NYSE: HCP). In a perfect environment, the two REITs would get together and try to work something out, if it made economic sense for them. The problem is that there is a bit of bad blood between the two companies (to say the least), and people aren’t really sure whether a Sunrise bankruptcy filing would make much of a difference to either one of them. They already own the properties, most of which are performing well, so why invest in the management company?

Ventas could theoretically provide a quick fix, which has been mentioned frequently. The REIT could offer to buy the 15% to 25% interest in the 61 Sunrise-managed properties that Sunrise retained when they formed the Sunrise Canadian REIT that was subsequently purchased by Ventas. At the time of that transaction, those minority interests were worth, in theory, about $250 million, based on what Ventas paid for the majority interests and the full ownership of 18 of the properties. But that acquisition came with a 6.2% cap rate and a $350,000 per unit value (grossed up to 100%). That deal would not get done today, as evidenced by the Health Care REIT termination, so the conclusion is that those minority interests are worth a lot less today. The problem is that Ventas really has no incentive to buy out Sunrise’s interests, unless it wants to replace them as manager and that was the quid pro quo.

In addition, valuing those interests in this market would be difficult, and when you apply the "minority discount," we are not sure what value they really have today (try to find it on the balance sheet). Besides, the ubiquitous word from Ventas these days is "liquidity," and our guess is that using $50 million of its cash (to pick a number) to buy these minority interests is not something management wants to present to the board. And, of all the health care REITs, Ventas and HCP have been punished the most by investors, primarily because of their "exposure" to Sunrise (we assume), so capital will be dear to them, especially as the economy continues to tank. On the other hand, if those properties are performing well enough and if they could pick up those minority interests for a "discount," say the equivalent of $50,000 per unit, then that purchase could make economic sense since the earnings of the properties flow through to Ventas. The Sunrise portfolio owned by Ventas has an overall occupancy rate of 91% to 92% excluding the recently opened communities, and the net income after management fee for the portfolio was $35.2 million in the third quarter, or just above the net income in the year ago quarter. The bad news is that the average daily rate per resident fell slightly while operating expenses increased. Sunrise’s strength has always been the ability to maximize revenues, while its weakness has been in the area of expense control, so we assume that part of this is incentives and discounts. While our guess is that the portfolio is not performing quite as well as originally expected, its performance is certainly nothing to complain about in this market.

We have no idea what will eventually happen with Sunrise, but from an industry perspective it would be a big blackeye for it to file for bankruptcy protection, even with a pre-packaged filing. Whether you like the company or not, in many ways Sunrise has been the face of the assisted living industry, especially in the 1990s, and it is the only company with anything approaching a brand name with the consumer. On the positive side, occupancy is relatively strong for this dismal market environment, helped we are sure by price discounting and other incentives, and the operating margins in the third quarter were better than a year ago.

In addition, the Sunrise communities are often the best in their markets, or at least number two, but they are also usually the most expensive, which will prove to be a growing hindrance in the coming months. The task for Mr. Ordan and his team is to find a way to make money managing the U.S. portfolio until the development market comes back, which won’t happen until the economy and capital markets improve. This, of course, is after they figure out a way to restructure their debt before the January 31 deadline. Although Sunrise is the biggest operator to be facing this problem, there will be more to follow in 2009, and that is when the acquisition market, at least for those with money, will begin to get exciting.