After A Four-Year Rally, Most Senior Care Stocks Declined
What a difference six months can make. By June 30, 2007, senior care stocks were performing okay, with only a couple of companies posting significant declines. Just one month later, however, all but four were in the red, and by the end of the year only two stocks posted any real gain for the year, and one of those, Manor Care (formerly, NYSE: HCR), was up solely as a result of the takeover premium. Including Manor Care, the average decline was 5.5%, which does not look too good when the Dow Jones Industrial Average was up 6.4% for the year and the broader S&P 500 was up 3.5%.
But let’s put some perspective on what appears to be a dire situation. For four years in a row, senior care stocks significantly outperformed every stock market index, and usually by a factor of at least two times. Just like in the acquisition market, where buyers (and sellers) expected prices to continue to rise, some thought that may be true with senior care stocks as well. But cycles do exist, and we are in one now.
Because the sale of Manor Care closed in late December, we kept the company in our stock chart and the table on page 2 of the January issue ranking the sector’s stock performance in 2007. With a 43% price increase, the company took top honors last year, but shareholders of Genesis Healthcare, which was purchased in early July, actually had the best return with a nearly 47% price increase after the rather unruly bidding war which was spread out over several months, a fight that provided much color to our editorial pages. With the exception of these two companies, and their respective takeovers, Sun Healthcare (NASDAQ: SUNH) was the only other senior care stock to show any real price appreciation by the end of the year, rising by 36%. The acquisition of Harborside Healthcare certainly helped the valuation, but the company has been sticking to its knitting and concentrating on increasing margins and cash flow without making any mistakes (at least that we know of). Sun also ended the year the closest to its 52-week high, and reached its highest price in more than five years in 2007, with the other skilled nursing stocks ending the year down 10% to 38% from their 52-week highs.
Reimbursement always plays its heavy hand with skilled nursing stocks, and in the 1980s and early 1990s, it was always Medicaid. While Medicaid payments may come into play in the near future as state budgets go from black to red, Medicare has been the payment source of concern for 10 years, and any little whisper from Washington or MedPAC about a reduction or freeze sends SNF investors into a twitter because that’s where the money is.
But skilled nursing providers were spared late last year (did Carlyle use its invisible hand?), and the 3.3% rate increase, which could have been trimmed (and may be in 2008), was encouraging and helped bolster equity prices. However, anyone who thinks that pressure on Medicare reimbursement is going to ease anytime in the next 20 years really needs to see a shrink and find out what happened in their childhood to provide them with such fantasies.
The skilled nursing stocks fared better than the assisted/independent living companies, partly because the former did not have quite the ride up that the latter did in the past few years, and also because the weakness in the housing market, and real estate market in general, has made some investors nervous about the more real estate-oriented properties in the senior care market. Only one company, Emeritus Assisted Living (AMEX: ESC) eked out a small positive return, after being up by about 58% in June. Five of the six assisted/independent living stocks ended the year down anywhere from 30% to 43% from their highs in 2007, but Capital Senior Living (NYSE: CSU) was down only 19%.
The surprise of the group was Sunrise Senior Living (NYSE: SRZ), with any acquisition premium removed from the stock—despite no announcement from the board that they have suspended the “strategic alternatives” search—and with some analysts and investors still valuing the company at a 30% to 40% premium to its current levels.
So what has changed? Not to be cute, but…everything. First of all, after the subprime mortgage meltdown last summer, and the end of the easy-money, private equity deals that became as common as Santa at the mall in December, takeover premiums have all but disappeared, at least in the senior care sector. With few takers for the debt involved in these transactions, or the cost becoming too high to make the economics work, there aren’t many investors expecting to get taken out at a premium in the current environment. And there aren’t many likely targets either.
Now, this may change as public equity prices continue to deteriorate, especially if the economy goes into a recession, the housing market gets much worse and the mortgage market in general becomes as parched as a Georgia reservoir (tune in to our January 31 audio conference on navigating the current seniors housing and care mortgage market). But remember, many of those private equity firms still have a lot of dry powder, and when (if) values get low enough, they will pounce at the first chance regardless of any Congressional investigations into private equity ownership. We still believe those investigations and hearings are a paper tiger and will get lost in more pressing matters, such as budgets, wars, Social Security, Medicaid, Medicare, to name a few, not to mention a presidential election where both parties’ nominees seem to be truly up for grabs for the first time in 50 years.
Second, the overall softening of the real estate market, both residential and commercial, is having its impact on the seniors housing market in more ways than one. We have all heard about the occupancy impact, especially with regard to CCRCs and some independent living communities where potential residents can’t sell their homes at last year’s prices, or at all, but this has not been consistently felt by all operators across the country (yet).
For investors, the impact is more psychological, because when “real estate” gets a bad name, the fallout is larger than it should be. Some readers will remember several years ago when assisted living stocks dropped when there was a threatened cut in Medicare reimbursement, and everyone got grouped together, driving CEOs crazy when they had to explain to some of their more intellectually challenged investors that Medicare does not, has not and probably never will pay for assisted living (if it does, then it will be time to move to Michael Moore’s health care nirvana—Cuba—because our country will truly be bankrupt). The same is true for real estate, and the proverbial baby often gets thrown out with the bathwater.
Where the softening real estate market does come into play with public equity prices for senior care stocks, however, is when the property values start to come down, and those same intellectually challenged investors begin to realize that while cash flow is king, $250,000 per unit is for a very select group of assets for a very select group of buyers in this market, not to mention lenders.
While we “know” that seniors housing property values have come down since last summer, because cap rates have increased by 50 to 150 basis points (take your pick), no one is really sure what exactly that means. But investors have figured out that without the debt markets, specifically securitized debt, and with debt that is available coming at a higher cost with more equity required, premium pricing is gone with the wind, so to speak. How this will impact the TIC market for seniors housing properties, which has grown substantially in recent years, is anyone’s guess, but it can’t be positive.
Third, some cold reality is coming back into the market. While most lenders now want to underwrite on hard numbers, not pro formas midway through the next president’s first term, investors are also joining the bandwagon and want to see the results now. Paying for future results can be fine, and is common, but high price/earnings multiples on earnings forecasts which may become more dubious as the uncertainties in 2008 unfold are getting questioned. And while it is true that it is cash flow that counts, investors, even those intellectually challenged ones, do like to see GAAP earnings, especially when they have to explain to their clients why they invested in your stock which just dropped by 40% in value. In the long run, this will be good for the seniors housing and care industry, but in the short term it will be quite painful.
As we stated after the mid-summer market meltdown, the state of seniors housing remains quite good. That being said, if the economy continues to deteriorate, it is questionable how much longer those 5% to 8% rate increases can be pushed onto residents, especially if new development begins to pick up steam. While that seems unlikely in the current environment, despite the interpretation of some recent statistics, with investment portfolios sagging and housing prices dropping, the customer base will be watching their wallets a bit more carefully this year. And that will mean cost control will be the key this year, not to mention occupancy levels.
Senior care public equity prices may seem low right now, but there is a better than even chance that they will head lower in the first half of this year. It will really have nothing to do with the companies’ financial performance and everything to do with investor sentiment in general, which is growing more negative by the day. At some point, a little bell will go off that says “too cheap,” but trying to time that is difficult, as always. While the opportunities will not be as dramatic as they were four years ago, bargains will be had, money will be made and private equity will return…at some point.