The SeniorCare Investor: American Retirement Corp.: A New Beginning?

One by one, the senior care companies that ran into financial or liquidity difficulties over the past several years have emerged from their troubles and started anew. There are a few companies, most notably Alterra Healthcare (AMEX: ALI) and Integrated Health Services (OTCBB: IHSVQ), that still have a ways to go, but now American Retirement Corp. (NYSE: ACR) appears to be on its way to being able to concentrate on operations instead of capital structure issues. But as they say, it ain’t over ’til the fat lady sings.

Nearly five months ago, ACR announced that it signed a nonbinding letter of intent with a lender to provide approximately $125 million of mezzanine financing that would provide the company with sufficient funds to pay off the convertible bond issue maturing at the end of September. In mid-August, it was revealed that Health Care Property Investors (NYSE: HCP) had agreed to provide $112.8 million in debt financing and make a $12.2 million equity investment in several real estate subsidiaries of ACR.

HCP’s commitment is conditioned, however, on at least 75% of the outstanding principal amount of the bonds being exchanged for new securities, with a deadline of September 12 for the exchange offer, unless it is extended. The debt carries a "stated" interest rate of 19.5%, of which 9% will be payable in cash. The difference will accrue and be added to the principal balance of the loan until maturity in 2007, but ACR will try to pay off the HCP loan some time after three years.
For each $1,000 face amount, ACR is offering existing convertible bondholders Series A Notes in the amount of $839 with a coupon of 5.75%. Since these notes have a maturity of September 30 and are expected to be paid off with the HCP funding, they are in theory close to the equivalent of cash. However, in the event the HCP funding does not close, the new Series A Notes will be senior to any remaining outstanding convertible bonds. In addition, convertible holders will receive $190 of Series B Notes, which will have a 10% coupon and a seven-year maturity. Up to two percentage points of the coupon can be paid in additional Series B Notes. Finally, convertible holders will receive 13 warrants to buy one common share of ACR each at a price of $3.50 per share with an expiration date in 2009.

At first blush, this looks like an attractive offer for the convertible holders. The concept of "attractive" is relative, however, because the only other choice is to force bankruptcy after September 30, since ACR has no other refinancing options currently available. The convertible holders will be receiving notes (most of which should become cash in a few weeks) slightly above par, with the equity kicker of the warrants. If you believe there will be any equity value to the company over the next seven years, these warrants provide some additional value.

The problem convertible holders have, however, is that they have to make a decision before the HCP financing is actually completed. Consequently, some holders may make the exchange and may still have to force bankruptcy if the HCP deal does not close because there is no other source of funds to pay off the Series A Notes on September 30. The only consolation is that their new notes will be senior to any outstanding convertibles that did not make the exchange in the event of a bankruptcy.

Although we have not spoken with any convertible holders, from what we hear senior care industry players appear to be skeptical about the HCP financing, believing that in the long term the company may have been better off with a bankruptcy filing than being burdened with the HCP debt. At nearly 20%, the new debt is expensive, but when looked at as quasi-equity, it is not an atypical return. Besides, management has bought time, something that was going to run out at the end of the month, and shareholders would have lost everything in a bankruptcy.

It is important to remember that the financial cloud that has been hanging over ACR for the past year affects the company differently from a generic assisted living or skilled nursing company. The company has more than 2,600 entry fee units in its CCRCs, and these residents have more at stake financially with a troubled company than a month-to-month resident in an assisted living facility. They are making, on average, a $125,000 up-front investment in the ACR community, and if the company is in Chapter 11 bankruptcy, how many people are going to take that risk, especially when the entry fee concept is new to many of them? In fact, because of the financial cloud, sales of the entry fee units have suffered in the past year, something that management hopes will change with this refinancing. In bankruptcy, they would suffer even more, as it would be even more difficult to convince a potential resident to move into a facility under that sort of cloud.

This is key to understanding the future viability of the company, because if 10% to 15% of the entry fee units turn over each year (which is normal), ACR stands to receive between $15 million and $20 million annually in the nonrefundable portion of the entry fee. This full amount is not included in the income statement because it must be amortized over several years based on an actuarial determination. In addition, there are units that have yet to be sold where ACR will collect the full entry fee payment, also to be amortized. The point is that there is significant cash coming into the company above what appears on the GAAP income statement.

The second part of the financial puzzle involves the company’s freestanding assisted living facilities. The occupancy rate of these facilities, with just over 3,000 units, has been increasing by 300 basis points to 500 basis points in each of the past five quarters, with one of the largest increases in the second quarter this year. If ACR can maintain this pace, stabilized occupancy of 90% could be reached by June of next year. Assuming an average monthly rate of $2,900 and at least 80% of the incremental revenue going to the bottom line, this will result in nearly $4 million per quarter of additional cash flow. Each percentage point above 90% will add nearly $1.0 million of additional EBITDA per year. On top of that can be added rent increases that will be easier to pass on once the facilities are fully stabilized.

The fill-up of the assisted living facilities is crucial because the added cash flow will more than cover the pro forma, as adjusted second quarter $3.8 million cash loss that is presented in ACR’s supplement to the offering memorandum for the exchange offer. What this implies is that, assuming all of the transactions go through, by this time next year the company should be cash flow positive on a GAAP basis, with additional income from expected improved results at the company’s CCRCs, which will also flow to the bottom line. The nonrefundable portion of the entry fees can be added to this and before you know it, liquidity issues may disappear. Obviously, there are a lot of moving parts to this scenario, but since existing shareholders get zero in a bankruptcy, and at a minimum convertible holders receive cash of 84 cents to the dollar (with the HCP deal going through) with obvious upside, other options do not exist.