Investors Challenging A Deal--
Capital Senior Living Shareholders Say No To Purchase

West Creek Capital has been joined by another major shareholder, Boston Avenue Capital (with control over 1.9 million shares), in calling for the board to terminate the acquisition negotiations, hire an investment bank to investigate "strategic options" for the company (sale of the company or divestiture of the assets) and put a major shareholder on the board. They have not been happy with the strategic direction of the company, are upset that none of the independent directors have a significant economic stake in the company (something we don’t see as relevant, or a bit self-serving, as we have never heard that buying stakes in a company was a pre-condition of going on the board as an independent director), are disappointed that their input, especially on the Hearthstone transaction, has been largely ignored and do not like the fact that there are too many states where the company operates a single community, something they think works against a proper strategic direction for a company that should either be regional in scope or national with significant penetration in each state.

We doubt anyone has been happy with the recent share price performance of Capital Senior Living, but we don’t believe anyone has been happy with the entire sector over the past year. To put things in perspective, if you want to measure a management’s success by stock price performance, over the last five years CSU’s performance has mirrored the industry’s. In 2003, it posted a 131% return (second best out of six), followed by a slight decline in the following year (worst of five), then an 83% return in 2005 (second of six), a slight increase in 2006 (fourth of five) and a 7% decline last year (third of six). So, the company seems to be in the middle of the pack in a sector that, in some ways, still hasn’t quite found its way, at least with public equity investors and how they value the industry.

Another way of looking at the company’s recent performance, relative to its peer group, is to see where the current share price stands relative to its 52-week high. The range for the sector is a decrease between 55% and 33%, and CSU is at the bottom of the range trading at a 37% discount from its 52-week high with four of the other five down further. So, one might say that the performance has been average, but the entire sector has been overly punished because of the residential housing market downturn and its potential impact on occupancy rates, as well as a turn away from real estate-oriented stocks in general. However, the company has always had a middle-of-the-road approach, targeting mid-market properties in largely secondary markets with what one might call average rental rates. The high-end market was never the company’s focus, and this brings us back to the Hearthstone acquisition, which we view as a mid-market portfolio, especially with its high double occupancy unit mix.

The dissident shareholders believe the capital structure (the high lease payments based on a high price paid 18 months ago near the top of the market) of the Hearthstone portfolio is too risky and values the assets at a point that could not be reached today. They believe that a 2% to 3% drop in occupancy would result in a breakeven cash flow, and that any further drop would require CSU to use its cash reserves or other operating revenues to make the lease payments. According to our math, the average Hearthstone resident produces about $2,500 per month in revenue, and a 1% decline in occupancy is equivalent to losing about 34 residents, or close to $1.0 million in annual revenues. Assuming this occupancy decline is spread across the portfolio, we also believe it would result in a dollar for dollar drop in EBITDA as well, since there would be minimal cost-cutting with the loss of one resident per facility. However, with a decline of five residents per facility, some costs would be cut, and our guess is that CSU would have to see a broad occupancy drop of at least 6% to 7% not to be able to cover the lease payments without using any other cash reserves.

In addition to the capital structure, the dissident shareholders have a problem with the "eye-popping" price per unit of $191,000 paid by Nationwide Health Properties (NYSE: NHP) to acquire these properties 20 months ago (and the quote was from this newsletter back then). But since between 50% and 70% of the units are semi-private, the actual price paid was equivalent to about $124,000 per resident, or $110,000 per resident capacity. That certainly puts things into some perspective, and since these were purpose-built, relatively new properties, Hearthstone was obviously able to capture a certain part of the market which is quite profitable, with a 39.8% adjusted EBITDAR margin compared with CSU’s margin of 28.8%. The second resident in those shared rooms is quite profitable, whether you like the model or not. And people often forget that in the high end of the market, Sunrise Senior Living (NYSE: SRZ) has about the highest double occupancy census in the industry, which means that the model can work across various price points, as well as across different management teams.

No one really knows where cap rates are in today’s market, especially for portfolios, because there has been little "new" activity and next to zero movement in the large portfolio market. We are told that Hearthstone’s annualized EBITDAR based on the nine months ended September 30, 2007 would be about $40.3 million, but we believe that the current run rate is higher than that by up to $1.0 million, and perhaps more. Using the historical number, a 9% cap rate puts the theoretical value at about $447 million, and a 10% cap rate at $403 million, which means that the price originally paid by NHP is right in the middle.

The dissident shareholders think this sort of analysis is largely useless, since there is no market for a portfolio of this size because of the severe limitations on financing it. While we agree that it is theoretical because of current market conditions, there is a certain lack of consistency for these shareholders to then want to sell Capital Senior Living as a whole or divest its assets in this market. It would seem that if there is a theoretical market for one, there is a theoretical market for the other, so we are left with a draw (have you heard of having your cake and eating it too?). They make the argument that a few of the other public companies could use their stock for a purchase and not worry about the current state of the debt markets. But we wonder if the independent directors of those companies, whether they have a significant economic stake or not, would want to use their shares as acquisition currency when their shares are all trading near their 52-week lows. Hmmm.

They also believe that with the Hearthstone portfolio Capital Senior Living would be less appealing in the acquisition market. In today’s market, perhaps, but in a few years, assuming the cash flow of the portfolio increases and CSU is able to find some complementary deals, we don’t believe it would have a negative impact, and quite possibly could be positive. Unfortunately, practically every crystal ball is quite cloudy right now, and the reality is no one really knows. But we have never seen a company go into an acquisition assuming the cash flow of the target entity would decline.

Getting back to the Hearthstone transaction, we understand that up to 50% of the "purchase price" may be going to NHP as part of the negotiation for changes in the lease terms. We assume that some of the potential changes will involve the escalators and rent re-sets, but let’s not forget that NHP is getting something from the deal as well. They will be exchanging one tenant that is basically a shell company formed after the sale of all the assets to NHP in 2006 for a publicly traded company with a more diverse asset base and better access to capital. It is not rocket science to figure out which tenant NHP and its shareholders would rather have in their portfolio, and there is some value in that in addition to the $17.5 million they may receive.

It will be necessary to see what changes to the lease terms will be negotiated before we can really pass judgment on all the merits of the deal. And although we are not attorneys, it would seem possible that CSU could put the Hearthstone assets in a bankruptcy-remote subsidiary to protect shareholders from a potential occupancy disaster. For now, we hear that some of the shareholders are thinking about a proxy fight, but until we know all the details, it is a bit premature. It would help things if CSU’s management would give shareholders an update on Hearthstone’s current occupancy, annualized cash flow based on the fourth quarter’s results and a look into 2008 with synergies and new rates in place. That, along with news on the lease negotiations, may persuade some shareholders that the deal is better than they thought.

Capital Senior Living is not the only public company having some problems with a major shareholder. Advocat (NASDAQ: AVCA) received a letter from a 5% owner, Bristol Capital Advisors, with some of the same issues around corporate governance, lack of economic interest in the company by independent directors, a desire to have at least two institutional shareholders nominated to the board and to hire an investment bank to review alternatives to enhance shareholder value. The last request, which was to eliminate acquisitions unless they "trade at a more favorable valuation than the Company’s common shares" is a new one to us. While we think we know what they mean, comparing the "valuation" of an acquisition to the company’s common shares is a bit awkward, other than if the acquisition is accretive, which we don’t believe is what they are saying. We can’t wait for the fourth quarter earnings conference calls this year!