The share price stayed in the $10.00 to $13.00 range until the end of July, when everything started to decline. Obviously, when the values started to drop, we began to watch how low they would go and to look for a low point, at least one that made little sense from a valuation perspective, reflecting an overreaction to events that had little to do with the company and a price that would start to attract the speculators once again. Our target number for Assisted Living Concepts was $5.50 per share, and the shares flirted with that level during the first quarter this year and finally dropped below it, if somewhat briefly, when they fell to $5.46 per share on March 26.

Although we are not really surprised, given the state of the capital markets and how many hedge funds are licking their wounds from a difficult first quarter, the phone has not rung, at least not yet. So, where are those investors who, at $10.00 per share, thought the company was undervalued but at $5.50 per share are nowhere to be seen? The easy answer is, focusing on other things after the market peak, but they do so at their investment peril, because now there is some real upside value, whether ALC is subject to a takeover or not. At $5.50 per share, the market capitalization of ALC is just $363 million, and when you add the debt outstanding and capitalize the leases, the total value comes in just under $100,000 per unit, based on the latest financial figures as of December 31, 2007. So now, if that ubiquitous replacement cost theory comes into play, and the number thrown around for ALC seems to be $125,000 per unit, partly because that is their estimated cost to add units to existing buildings, then the shares are theoretically quite cheap. But it is deeper than that.

Back when Assisted Living Concepts began a new life as a public company 17 months ago, the company’s annualized EBITDAR was $65.2 million, or 54% higher than when it was purchased by Extendicare in January of 2005, and occupancy was 84.8%. Today, annualized EBITDAR is $64.2 million, plus an extra $7.1 million from an acquisition that closed January 1 of this year, and occupancy at the end of last year was a low 74.4%. So, EBITDAR growth is flat from three years ago, but occupancy has declined by more than 10 percentage points. The occupancy drop has been partly by design, as a few years ago the strategic decision was made to "dis-enroll" from as many Medicaid waiver programs as possible, and start to re-fill those units with private paying residents at rates that are, on average, more than 40% higher than what’s available under the Medicaid program. The problem has been that in 2007, while there was a 47.5% drop in the Medicaid census (the goal), there has been only a 2.2% increase in the private pay census (most likely worse than the targeted goal). But where there are problems often opportunities can be found.

Now, remember that the company’s EBITDAR is about where it was three years ago after cutting its Medicaid census by about 341,000 resident days per year, so far. As we mentioned, the expansion of the private pay census has not happened yet, but we assume it takes a while to move Medicaid residents out or, in some states, through natural attrition, so it is expected that there would be a lag in terms of filling empty units with residents at the higher rate, and it is probably taking longer than management expected. In Texas, where the company operates just over 40 facilities, the Medicaid census dropped quickly when most of the residents were moved to other facilities.

One has to assume, however, that management did its due diligence in the markets where they are getting out of the Medicaid waiver program and found that there was sufficient demand to fill at least half of the newly empty units, if not more. Consequently, using the one-half assumption (or 500 units), at ALC’s average private pay revenue per unit of $100 per day, there would be an additional $18 million of revenue which, at an incremental margin of at least 60%, would yield incremental EBITDAR of close to $11 million, or just over $129 million of additional value. That takes the company’s value up to about $9.80 per share, or close to 70% above where it is today.

But those extra resident days from filling up 500 units only takes the company to an occupancy level of just over 80%, which is far below ALC’s peer group, and far below where any company expects to be. An additional 500 units would increase overall occupancy to 86% and take the theoretical value to almost $12.00 per share. And keep in mind that filling 500 units is the equivalent of just two to four residents per facility, depending on certain assumptions. The point is that there is great upside value for a stock trading below $6.00 per share, if you think that the model can work and if you think that management can execute the private pay strategy. And we admit, these are two crucial "ifs."

We also don’t know whether the markets where ALC operates will be able to assimilate all the new "private pay" units, especially since in some areas the company’s reputation may have been tarnished a bit by some bad publicity when they were accused of essentially evicting Medicaid residents. It also may not be easy to change a local reputation for having lower-income residents. We believe this is more of a length of time issue than anything else and one that will eventually work its way out. A big test will be how quickly they can fill the new one-bedroom units they are building at 20 of their existing sites. In addition, there are about 1,000 Medicaid-waiver occupied units left, and if they continue on their path, overall occupancy may decline further if these units are emptied and not filled by private-pay residents. It says a lot for ALC’s cost structure that the company can still be profitable when occupancy is under 75%. If it goes below 70%, however, there will be some real problems and the Board will have to re-evaluate what management is doing and give them a timetable to successfully execute this strategy. At that point they may also start wondering whether it was a mistake to get out of the Medicaid business, and instead concentrate all their growth in the private pay side of the business through acquisitions and development. But at $5.50 per share, this is a buying opportunity that should not last long.