The SeniorCare Investor: Sunrise Trying To Survive
The Loss Of Management Contracts May Grow
It has not been an easy couple of years for the CEO of Sunrise Senior Living (NYSE: SRZ), Mark Ordan. He arrived in the middle of a major accounting restatement which took longer than anyone expected, watched a deteriorating situation with the company’s German subsidiary get worse and was forced to watch the economy and capital markets close down, which resulted in the shutting down of the company’s once thriving, and profitable, development business. Add to this the series of past-acquisition blow-ups, which include Trinity Hospice (shut down), Greystone Communities (sold back to the original sellers at a fraction of the original purchase price), The Fountains and Aston Gardens and so on.
At the time, we thought some of these acquisitions were bold if not brilliant (the first two), and in the case of Trinity the demise had everything to do with some bad decisions of the prior owners, and in the case of Greystone it had much to do with not listening to the expertise purchased coupled with the deteriorating development market. The other two deals were just expensive acquisitions with guarantees that were based on the booming times mentality that should not have been provided. It is no wonder that the former CFO, Rick Nadeau, chose to leave last month and move on to a much less depressing environment, and job. We wonder, however, how long Mr. Ordan will remain in the Sunrise hot seat, because unless he is a glutton for punishment, it can’t be much fun to go to the office every day, especially when he is told it’s Jay Flaherty on the line. "Now Mark, about those management contracts…."
With the deteriorating financial situation at Sunrise last year, it was no secret that landlords and others were becoming increasingly uncomfortable with Sunrise as the manager, both because management’s focus seemed to be on financial survival and because landlords and lenders were concerned that the financial plight might keep residents away, not to mention whether Sunrise would be forced into bankruptcy. It was also not a secret that HCP, Inc. (NYSE: HCP), of which Mr. Flaherty is the CEO, wanted to get some new blood running the 101 properties it owned where Sunrise was the manager. Late last year, HCP was able to remove Sunrise as manager from 11 of the properties, claiming that they had not complied with certain financial covenants, and transitioned these facilities to Emeritus Corporation (NYSE: ESC). They have revealed that the financial performance has already improved.
In mid-June, we reported that HCP announced the termination of the management contracts on the 15-property "EdenCare" portfolio that had been managed by Sunrise. These contracts will end effective October 1, 2009, and although HCP has not disclosed who will be the new manager, a good guess is Emeritus, though Florida-based Horizon Bay Senior Communities has been mentioned as a possibility as well. HCP claimed that Sunrise did not meet certain financial thresholds on this portfolio and will not have to pay any termination fees. Our estimate is that Sunrise will lose at least $3.0 million of annual management fee revenue from the EdenCare portfolio.
On June 29, HCP made its bombshell announcement that it had filed complaints in the Delaware Chancery Court against Sunrise and its subsidiaries alleging that Sunrise had systematically breached various contractual and fiduciary duties, including "operating the properties in a manner that impermissibly favored the interests of Sunrise and its affiliates at the expense of HCP and its tenants." HCP stated that about six months ago it notified Sunrise that it was in default of its obligations under the agreements for the remaining 90 communities it managed for HCP, to which Sunrise responded that it was not in violation of its agreements in any material respect. HCP claims that the periods in which Sunrise could cure the "defaults" have now expired.
In addition to equitable relief and monetary damages related to the alleged defaults, HCP is seeking judicial confirmation of their right to terminate the management agreements on the 64 properties that are included in the complaint. Sunrise’s response to this recent complaint was that the performance of the communities named have been steadily improving and that HCP has continually expressed a desire to terminate the agreements. Investors responded by sending Sunrise’s shares down by 23% when the news broke. We assume that the management fee income from this group of 64 is above $15.0 million annually, and not a revenue source that Sunrise will walk away from without a fight.
But is a fight really necessary? It has been known (or assumed) in some circles that HCP has had an offer on the table for several months to buy Sunrise out of its management agreements with the HCP-owned communities. We don’t know what the offer has been, or whether it has gone up at all during the year, but cash today, especially given Sunrise’s recent liquidity issues, certainly looks appealing. It is possible that Mr. Ordan believes HCP is merely trying to take advantage of a wounded Sunrise and that the offer on the table is below market, whatever "market" may be in today’s world.
The reality, however, is that HCP’s complaint is probably meant to get some movement out of Sunrise on the buyout offer. However, Mr. Ordan was recently quoted as saying that Sunrise was not "going to back off, cave in and put our residents in harm’s way." Somehow, we don’t think Mr. Flaherty wants to put them in harm’s way, either; he just believes they can be operated more efficiently with new management. And, it seems that both sides are posturing a bit, and Mr. Ordan has had a lot of experience with that in his dealings with creditors over the past 12 months.
Losing the contracts on the first two, smaller groups is not that big of a deal for Sunrise, but when you add in the additional 64, the financial pain will be evident at a time the company can least absorb it. The combined contract losses would mean its U.S. portfolio of managed properties would decline by more than 20%, which would be a financial shock as well as a blow to the company’s image. Further reductions may come as a result of a potential sale of a portfolio of U.S. properties that Sunrise still owns. We hear that Goldman, Sachs is about to go to market with a portfolio of 27 Sunrise properties with just over 1,800 units, of which 22 are owned by Sunrise and five are leased. While they will entertain an outright sale or a sale/manageback, if it is the former, the incredibly shrinking Sunrise will become even smaller. We have also heard that the portfolio was up to 40 properties, but perhaps there are two groups and Goldman may or may not be involved in the smaller one.
Most of the properties are over 10 years old, with a few over 15 years, and with a relatively small average size (under 70 units), we assume many of these are the former Karrington Health properties picked up by Sunrise in the late 1990s and modeled as sort of mini-Sunrise mansions. Nearly a third of the units are for Alzheimer’s care, and occupancy is quite good in this environment at well over 90%. One issue is operating margin, and perhaps because of the relatively small size of the buildings (a few are under 60 units), the economies of scale are marginal. We believe that the group has a margin under 25%, which is quite low (even for this environment), especially when occupancy is over 90%. Our guess is that part of Goldman’s sales pitch will be the margin expansion potential (you would be a fool not to), but we hope some people understand the irony there, since that is precisely the argument that HCP is making with its Sunrise-managed properties.
This portfolio, assuming our intelligence is correct, will be a great test of the market conditions at this mid-year point. If you assume an 8.5% cap rate on the owned properties (and there are many who believe the number should be in the 9% to 10% range), the result would be a price of about $150,000 per unit, which is a far cry from what Sunrise used to sell its developed mansions for a few years ago. That is why we believe many of these may not be the original Sunrise buildings. Their relatively old age will impact the valuation as well. We do not know if the group has to be sold as a package or whether the properties can be split up, which may make more sense and could result in a higher total value in this market. We understand that there is a large amount of assumable debt, perhaps up to half the value, with a very low average interest rate, but the maturity is less than five years. What we don’t know is how many of the properties are encumbered by the debt, which would impact the amount of equity that would be required.
We can’t recall a time when Sunrise sold stabilized properties with an 8.5% cap rate, and we assume that Goldman (and Sunrise) will be targeting a lower cap rate, most likely between 7% and 8%, especially if modeled with the low-cost debt. But this is a geographically diverse group (with a Midwest concentration) that may not be appealing to a great number of buyers, and there has only been one deal above $100 million completed this year. That said, we believe the sale will get done if the price expectations are reasonable. What Sunrise and Goldman are defining as reasonable is anyone’s guess, however. The cash proceeds from a sale will certainly help, and so will the $9.8 million Sunrise is now set to receive from the former shareholders of the Trinity Hospice acquisition that went down the drain last year. With a few mid-size portfolios we are hearing about, we may start to get better clarity about pricing by the fourth quarter. Even so, there always seems to be some unique characteristic of a sale (distressed, low-cost assumable debt, etc.) that makes it difficult to say this is where the market is today. For that, we may have to wait until 2010, when everyone hopes the credit environment will improve.