A New Path For Emeritus-
Stock Offering, Buy-Backs And Large Merger To Close

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For much of the past 10 years, Emeritus Assisted Living (AMEX: ESC) has been one of the least understood, and least analyzed, companies among its publicly traded seniors housing peer group. And we suspect that was exactly how Dan Baty, the company’s founder and CEO, wanted it to be. Mr. Baty and funds managed by Saratoga Partners have controlled about 65% of the voting stock, so there really was never much room for dissent or outside opinion to shape ESC’s future direction.

Shareholders who invested in the company at its IPO nearly 12 years ago, if they had kept it this entire period, would have had a modest 6.5% annual return. But the real story would have been for those risk-taking investors (or true believers) who bought the stock anytime from late 2000 through late 2003, a period when the share price hit a low of just $0.75, and held on until this year. The annualized returns would range from high double-digits to low triple-digits depending on when you made the purchase. To be fair, the entire seniors housing and care sector was in turmoil during this time period, and practically any investment back then would have reaped outsized returns. Emeritus, however, was often the favorite whipping boy, with very few industry insiders expecting it to surpass $30 per share without posting any profits.

By the end of the first quarter of 2007, when Emeritus announced the acquisition of Summerville Senior Living (SSL), investors sent its shares above $30.00, reaching a high of $39.40 per share in June. We suspect that even Mr. Baty had a little trouble understanding that valuation, and the shares have since declined by 20%. Taking advantage of its lofty valuation, Emeritus completed one of the largest stock offerings ever for a seniors housing or care company in late June, selling a total of 11 million common shares at $31.00 per share, of which 500,000 shares were sold by Saratoga Partners. Saratoga had planned to sell 1.5 million shares in the offering, but since ESC’s share price plunged by almost 18% from the time of the stock offering announcement on June 18 to the pricing, Saratoga probably decided to wait and see if the shares rebounded after the market digested the dilution. The stock offering increased the company’s shares outstanding by 55%, which is an unusually large increase and was one of the causes of the sharp decline in share price. UBS Investment Bank, by the way, was the sole book-running manager for the stock offering.

So what exactly is going on at Emeritus? It is about to complete its largest acquisition ever (Summerville), which will increase the number of units managed by nearly 50% and total revenues by almost 60%; it just completed a huge equity offering which, when combined with the 8.5 million shares that will be issued to Summerville’s owners will double the company’s market capitalization to about $1.2 billion; and it has been engaged in a significant property buy-back program this year. Summerville leases practically all of its facilities, and six months ago Emeritus owned less than 15% of its facilities, which we assume was a strategic decision made years ago when real estate ownership was not seen to be the path to growth for publicly traded companies. That sentiment has changed across the board in the past year or two, and in the first five months of this year, Emeritus purchased 40 facilities from its various landlords. It more than equaled that pace with three transactions in June alone.

In the first transaction, Emeritus has agreed to purchase nine facilities in New York with 711 units that provide assisted living and memory loss services. The price was about $88 million, or $123,800 per unit, plus closing costs, and it is expected to close in the third quarter. Two days later ESC announced the other two property acquisitions. The smaller one involved three facilities in Florida with 431 units that offer assisted living, memory loss and independent living services. The purchase price will be $24.6 million, or just $57,100 per unit. We don’t know why the price was so low, but two of the facilities are part of a cash flow-sharing agreement with Mr. Baty that involves 20 communities.

The final, and largest, deal involves the purchase of 40 facilities with a total of 3,643 units in 19 states from, we believe, Health Care Property Investors (NYSE:HCP), for $482.5 million, or $132,400 per unit. Of the total, 32 facilities with 2,901 units are currently leased by Emeritus, while the remaining eight with 742 units are leased by Summerville, but will all be owned by Emeritus once the merger between the two companies is completed, which should be any day in July. Once the transaction with Summerville is completed and all of these property buy-backs are closed, Emeritus will own just over 40% of its facilities. Most of the proceeds from the stock offering will go towards these property acquisitions, which totaled $595.1 million in just three days. This is a new Emeritus.

When the dust settles and all the transactions close as scheduled, the "new" Emeritus will operate more than 285 facilities with about 24,400 units and annualized revenues of about $725 million. For the first quarter of 2007, Emeritus had a GAAP loss of almost $10 million, and after the Summerville acquisition and property buy-backs, the loss will still be close to that. The big difference, however, is the actual cash flow and cash flow per share. The "previous" Emeritus would have had net cash flow for 2007 of about $20 million, or just over $1.05 per share. But the "new" Emeritus will have annualized net cash flow of almost $60 million, or more than $1.50 per share.

These numbers are rough estimates and do not even incorporate any synergies with the merger and general increases in occupancy and operating cash flow, but they show the power of selling stock at a high multiple, buying back leases and not worrying about a $40 million increase in depreciation. We suppose they can thank Fortress Investment Group (NYSE: FIG) for this strategy with Brookdale Senior Living (NYSE: BKD), which just increased its dividend to an annual rate of $2.00 per share, and current yield of 4.4%, despite continuing to lose money on a GAAP basis. Emeritus hasn’t stated that they plan to start issuing dividends, but if the dividend tax rate remains at 15%, we could see a dividend rate of $0.50 to $0.75 per share, especially if ESC’s operating fundamentals continue to improve. This is all speculation on our part, but it makes sense and also seems to fit in with our assumption that Dan Baty will ease himself out of the "co-CEO" title and hand the job over to Summerville’s Granger Cobb and become chairman emeritus (we just had to use that one again).