We now have confirmation that the hot seniors housing
market is not simply a real estate investment market phenomenon, although
real estate and its yield are always prevalent. In the first true initial
public offering of a seniors housing or care company in many years,
Brookdale Senior Living’s (NYSE: BKD) IPO was priced late in the day
on November 21 at $19.00 per share, which was the high end of the $17.00
to $19.00 per share expected range.
The underwriters could have bumped the issue price above
$20.00 per share, but we hear Fortress Investment Holdings, the
primary shareholder, wanted to give a nice return to the new shareholders
and have a more than successful debut for BKD, something that is
relatively common in the IPO market. We also heard that the demand, at the
$19.00 price, was up to 10 times the shares actually available for sale.
A total of 11,072,000 shares were sold, but only 6.9
million of them were new shares, with the rest from selling shareholders.
We expect, however, that the full underwriters’ over-allotment option of
1.66 million shares will be fully used. If so, Brookdale will have 66.56
million shares outstanding and a market capitalization of about $1.7
billion based on the recent price, surpassing Sunrise Senior Living
(NYSE: SRZ) as the largest publicly traded seniors housing company. Not
bad for a company that owns about 15% of its assets and is the result of
the recent merger between the former Brookdale Living Communities
and fresh-from-Chapter 11 Alterra Healthcare.
The IPO was obviously extraordinarily popular, with the
opening price of $23.00 per share a 21% premium to the offering price.
This resulted in the usual number of “flippers” selling their shares for a
quick gain, with trading volume a robust 6.2 million shares on the first
day. The shares continued to rise, hitting a high of $27.15 per share
after the Thanksgiving weekend, but that excess demand at $19.00 per share
has dwindled to where daily volume now averages less than 500,000 shares,
which we suspect will drop to under 200,000 shares, if not lower.
Although we have heard contradictory opinions, we believe
that investors were attracted to the Brookdale IPO because of its scarcity
value, meaning there are too few seniors housing equities in the market of
any real size, and other than Sunrise, this is the only one with a market
cap greater than $1.0 billion. This goes hand in hand with the fact that
the seniors housing market is hot now, as evidenced by the record high
per-unit prices being paid and the record low cap rates in the acquisition
market.
Finally, and this is where there is some apparent
difference in opinion, Brookdale is paying a $0.25 per share quarterly
dividend which, at the offering price of $19.00 per share, translated into
an annual yield of 5.26%. That is quite high for a corporate dividend
yield, and is just 100 to 200 basis points lower in yield than all of the
health care REITs, with the exception of Ventas (NYSE: VTR). But REITs are
interest rate sensitive and at times can trade more like bonds.
Brookdale’s shareholders should not want the stock to be interest rate
sensitive, unless the goal is to act more like a utility with consistent
management fee cash flows with little property ownership. With the run-up
in share price, BKD’s yield has dropped to 3.8%.
The dividend is problematic because it will mean more than
$66 million of cash will have to be paid out each year, and right now the
company does not make that much. For the nine months ended September 30,
2005, the pro forma as-adjusted EBITDA was just $49.6 million, with the
third quarter only $12.8 million. Interest expense will eat up more than
half that amount, which does not leave $66 million of annual operating
cash flow to pay the dividend.
We hear that one way to make up the difference will be to
reduce G&A expense by 10% to 20%, and while we don’t know what will be
cut, the current expense as a percent of revenues is too high, so there
has to be some fat after the merger of the two companies last June.
Acquisitions and additional management contracts are also expected to
increase cash flow, but it just seems a little risky to start out with
that dividend rate with the cash flow track record.
One area of G&A expense that is artificially low is senior
management salaries. The top six executives have salaries ranging from
$150,000 to $200,000, with “targeted” bonuses roughly matching the
salaries. These are about the lowest salaries in the industry for publicly
traded companies (other than Dan Baty), and are at the bottom for New York
Stock Exchange companies. But, because of the generous dividend payout,
the “real” income for the executives will be two to four times their
salary, plus bonuses, because they all own anywhere from just over 100,000
shares to 700,000 shares. So the double benefit is that EBITDA is spared
$2 million to $4 million of extra compensation expense, since dividends
are not included, and the executives receive a large portion of their
total compensation in the form of dividends taxed at the much lower rate
of 15%.
The people at Fortress have certainly been around the
block a few times so we assume this was all by design, but as far as a
long-term strategy goes, we have our doubts. And speaking of Dan Baty, his
Emeritus Assisted Living (AMEX: ESC) sold its remaining 2,086,000
shares of Brookdale, acquired with the previous investment in Alterra with
Fortress, in Brookdale’s IPO for net proceeds of $36.8 million. Including
the sale of Alterra shares last June, Emeritus will have booked a total
gain of $55 million on its investment of $7.7million in Alterra. Now, Dan
Baty has made some good investments in the past, but this one may have
exceeded even his expectations.
We have always liked the original Brookdale model, with
its concentration on large, mostly urban/suburban and up-scale retirement
communities, which, by the way, are about the hottest thing in the
acquisition market now. When Fortress took control of Alterra and its
assisted living facilities out of bankruptcy, and then merged the two
companies last June, we figured it was a marriage of financial convenience
to create enough bulk to go public.
Even though current management at Alterra has been doing a
good job of continuing the cleanup they inherited from the disaster of
rapid growth with insufficient resources, both human and capital, in the
1990s, we still don’t see the synergies of the two models other than a
large seniors housing company serving different markets. We suspect it
will be like an old-fashioned marriage, with separate bedrooms for a
while.
That being said, timing is everything, and Fortress could
not have picked a better time for Brookdale’s IPO debut. Seniors housing
valuations are at an all-time high, investment demand for quality
properties greatly exceeds the supply, capital is abundant and the return
expectations for investors of any stripe are, as of now, lower than they
have been in years. And the “D” word was even brought out of the closet
(as in demographics), even though the baby boomers won’t help the seniors
housing industry for at least another 10 years. So, our hats are off to
Fortress.
The rest of the industry may be tipping their hats as
well, with what may be called the “Brookdale effect” (or the Brookdale
Bull, but that may be too cute). Shares of American Retirement Corp.
(NYSE: ACR) soared by almost 29% in November and Capital Senior Living
(NYSE: CSU) by 26%, as analysts began to revise their price targets and
multiples after Brookdale’s pace-setting IPO performance. Unfortunately,
we are not comfortable valuing Brookdale until they have a few more
quarters under their belt as a merged entity, and we see expenses
decreased and true cash flow increased well above the dividend payout
rate. If they succeed, and everyone hopes they do, it will be great for
the industry. If not, the next IPO will be looked at a bit more carefully.
