Opportunities Arising In The Current Bloodbath
They say a recession occurs when there are two successive quarters of negative growth, and they say we have entered into a bear stock market when the major indexes drop by 20% from their recent highs. So how are we to respond when four of the six seniors housing stocks (assisted and independent living) drop by 15% to 31% in one month, or in the case of Emeritus Corporation (AMEX: ESC) and Five Star Quality Care (AMEX: FVE), by 9% and 7%, respectively, in one day (June 30)? We might add that four of them hit 52-week lows on June 30, and they just seem to keep on falling.
What, exactly, does it mean when the best performing stock of the group, Capital Senior Living (NYSE: CSU) is down 24% for the year?
Our knee-jerk reaction is that it spells opportunity. Say what? Three months ago, when Assisted Living Concepts (NYSE: ALC) hit a low of $5.46 per share in late March, we had had enough and wrote that at that price level, ALC represented a fantastic buying opportunity no matter what analytical tool you used and whether you liked the company’s model or not. Well, in just over four weeks the share price jumped by 38%, hitting a near-term high of $7.56 per share. What has happened since then? The share price has done nothing but drop, and wouldn’t you know it, the stock hit a new low of $5.42 per share. Call us stupid, but we are beginning to see a pattern here.
The most obvious reason for the recent decline in seniors housing stocks is the overall bear stock market, combined with the fears of what effect the ongoing residential housing market problems will have on seniors housing occupancy rates. During the last week of June, Jefferies & Co. held its annual health care conference in New York City, and one after the other, the seniors housing companies that presented basically said the occupancy weakness of the first quarter had continued into the second quarter, and they didn’t see it easing up.
We hear that the most common phrase used was that we are in a “challenging environment.” Investors don’t like challenges, especially in this market, and we suppose that was sufficient reason for many of them to sell. The problem is that when there are few buyers in a market with little good news, prices drop further than any rational person would expect. The opportunity is that when prices get that low, it is not just Assisted Living Concepts that becomes too attractive to ignore.
It is unlikely that seniors housing stock prices will drop to the levels they did in the 2001 to 2002 period, when you could have purchased Emeritus for as low as $0.75 per share, Capital Senior Living for $1.39 per share and the former American Retirement Corporation for $1.85 per share. High triple-digit returns were had by those investors lucky enough to pick them. The problem was that many of their competitors were heading into bankruptcy, with some disappearing forever, and it is never easy to pick the ones that will survive the latest downturn from the others that won’t, and not many did survive that disastrous period.
There is a huge difference this time, however, and that is the fact that not one of these companies is in the financial distress that was so rampant in the last down cycle. Sure, occupancy has been weak, but eight years ago there were empty buildings and too many newly developed properties that were stuck at 50% occupancy and couldn’t get new residents in the door, even with three months of free rent.
This was an industry-created problem back then, but the issues facing seniors housing providers today have been caused by external problems (the housing market), which means that the demand is still there and the residents will eventually come. The only thing stopping them is that they may need skilled nursing care by the time they sell their house. But there are growing programs to deal with that temporary financial shortfall (hello, Elderlife Financial), and when the logjam does break, there should be a nice bump-up in occupancy.
We won’t go through the financial details again of why Assisted Living Concepts is cheap at $5.50 per share, but our guess is that when the company releases its second quarter earnings results, occupancy will be down from the first quarter as Medicaid residents continue to move out and private pay residents remain at home. This may cause the share price to drop even further in one of those “confirming the worst” moments. Management obviously has to turn the occupancy problem around, and its census issues are quite different, and quite larger, than the other publicly traded companies, but for investors with patience, buying in at under $5.50 per share should pay off nicely…eventually.
One of the things that may have scared investors on June 30 was the lowering of earnings estimates and price targets by Frank Morgan of Jefferies on four of the companies he covers. What investors didn’t focus on was that his price targets, while slightly lowered, were still 30% to 100% higher than the stock price before the Monday massacre on June 30. It just appears to be a classic case of overreaction combined with throwing the baby out with the bathwater.
Take the case of Brookdale Senior Living (NYSE: BKD), which on June 30 hit an all-time low of $20.15 per share. Few people believe the company’s real value ever warranted the high of $54.25 per share it reached in May 2006, but with cash flow from facility operations next year probably topping $2.00 per share, and growing, we wonder how long the price will stay at these low levels. Apparently, the company believes its net asset value (NAV) is about $48.00 per share using a 6.5% cap rate and $41.00 per share using a 7.0% cap rate.
We believe both cap rates are too low in this market, but even taking it up to 8% (don’t shoot the messenger), would in theory yield an NAV of at least $27.00 per share, or 35% above current levels. The point is that BKD is now relatively cheap, and we assume that as it gets below $20.00 per share, investors will be taking a hard look, and they should buy.
The same thing holds true for Emeritus, which a year ago hit $39.40 per share and is now below $15.00 per share. The year-ago price was unrealistic (some might have said silly), and didn’t last for long, but the company is in much better shape today than it was a year ago, both financially and operationally, and is on track to own nearly 65% of its properties. Has occupancy slipped from the first quarter? Most definitely, and maybe by 25 basis points, if not more, but that doesn’t warrant a 31% plunge in value for the month of June.
Apparently, management believes that they can increase occupancy by up to 500 basis points in the next two to three years, which could mean an incremental increase in cash flow of more than $30 million. That alone would, in theory, translate into an additional $10.00 per share increase in value, all else being equal. Obviously, they have to deliver, but even achieving half that goal would be impressive. Keep an eye on SEC filings to see whether Dan Baty becomes a buyer at these levels.
Occupancy and value are a very tricky thing to correlate, but occupancy is not down for all communities, in all places around the country. Although anecdotal, two large private companies with strong census in general have indicated that in their communities (which have a lot of independent living) where occupancy usually runs between 95% and 100%, they have seen no change, but in those communities that historically run between 90% and 95%, there has been a 200 basis point decline, and start-ups are filling more slowly than in the past. This is hardly a desperate situation, and the industry is in much better shape than the public equity investors give it credit for, and in the top markets (95% to 100% occupancy), the housing market may not be having the same negative impact.
Our conclusion, consequently, is that at current levels the sector represents a significant buying opportunity without the same level of risk as eight years ago. The best strategy may be to pick your four favorite stocks and market cap weight them into a basket and ride the market for a while. If they continue to trend down because the overall market sinks further, the buying opportunity will only get better. That being said, if the DJIA hits 7,500, oil is over $200 a barrel and we enter into a near-depression, no one will be moving in for a while and all bets are off.
The skilled nursing sector has avoided some of the market meltdown so far, and the respective returns are much more company-specific than the seniors housing sector where investors have taken the entire group down without trying to differentiate. In the bad month of June, Kindred Healthcare (NYSE: KND) managed to rise a bit and is still up 15% for the first six months of the year, leading all skilled nursing companies (and all companies in the entire senior care industry). It didn’t hurt that Stifel Nicolaus raised its price target by 10% to $33.00 per share. Reimbursement, not occupancy, tends to dominate the chatter for skilled nursing companies, and most investors and analysts seem to believe the sector will weather any storm thrown at them from a Medicare perspective, at least for now.