With October’s Drop, Price Levels Should Be At The Bottom
For some reason, the month of October is often the most volatile month of the year for the stock market, and 2008 was certainly no exception. The difference, however, is that the level of volatility this past October was unsurpassed, with no one really knowing if the Dow Jones Industrial Average (DJIA) was going to go up or down by 500 points the next day, and it often did both in the same day. The losses suffered were historic, and the herd mentality was in full stride.
What happened to seniors housing stocks, however, goes a bit beyond the irrational. It was as if they were viewed by investors as a group of subprime borrowers with asset values sinking faster than the California housing market. As we know, of course, this is simply not true, and other than the situation at Sunwest Management, there really is no systemic problem that we know about that could result in a repeat of the bankruptcies the industry suffered through early this decade.
It goes beyond saying that this past October was the worst month in history for the sector, as well as for the overall stock market, but a 29% drop in the DJIA looks like a decent month compared with the average 51% plunge of the six publicly traded seniors housing stocks, with the best performer being Assisted Living Concepts (NYSE: ALC), which fell by “just” 22%. This precipitous fall was on top of a dismal performance year-to-date, where five of the six had already dropped by 15% to 55% in the first nine months of the year. So, what does this all mean, and is it at all safe to say we are at a market bottom, at least for this sector?
In theory (and maybe in practice), the stock market is forward-looking, and prices reflect the current value of what investors expect the future profits of the companies to be, and the sustainability of those profits. Almost all stock prices have gone down, reflecting the assumption that the current recession will reduce, in varying degrees, future profits. But in seniors housing, the magnitude of the drop in prices seems to be out of whack with the recent slippage in occupancy rates and what we assume will be lower than expected earnings for the third quarter (which will be coming out shortly but too late for this story) and perhaps beyond. The only thing that this tells us is that the market expects this recession to have a longer and larger impact on seniors housing than on most other business sectors, probably because of its reliance on debt for growth and on the wealth of its customers. But perhaps it is telling us something else as well.
In the market crash of 1929, the bubble was created by speculation fueled by very easy credit (10% down to buy stocks) and came to an end for a variety of reasons, but was helped by a return to more “normal” valuations. In seniors housing, we have seen a bubble to some extent, with valuations rising, cap rates declining and the flipping of assets at enormous profits after 12 to 24 months of ownership, often without adding much real value. And all of this was fueled, of course, by easy and abundant credit. Today, that is gone, and we are just beginning to really feel the full impact of it, although seniors housing brokers have been feeling it for about a year now.
Please don’t shoot the messenger, but we suspect that the market is also telling us that it wants to see real earnings. The technology bubble burst in 2000 partly because it became apparent that many of those high-flying Internet companies were never going to make a profit, and growth for growth’s sake is fine until outside funding dries up and you have to rely on your own ability to make money. And when the current stock value is based on the expectation of future profits, it is easy to understand why the tech market crashed and only those with a business plan to make money survived.
So, in looking at our sector, investors may be taking a conservative stance and asking when GAAP profits are going to materialize. Take the case of Brookdale Senior Living (NYSE: BKD), which is the largest of the seniors housing companies measured by market cap, number of properties, revenues, etc. Was the company ever really worth $40 per share? Obviously in the eyes of some, a year ago it was. But because management may have known it would be a long while before it would start making a GAAP profit, it “sold” its value based on “cash from facility operations,” a phrase that became popular with other companies and the analysts who followed them. But from that figure a lot of additional expenses have to be paid, and the bottom line is that there wasn’t much left over for shareholders, and what is left over for shareholders is what the value to shareholders (the stock price) is usually based on, in addition to growth potential.
The point is that eight years ago investors finally said we need to see real profits in the tech sector, and they just may be saying that today as well (but we will admit that eight years ago many of those tech companies had no profits, no cash flow and, in some cases, no revenues). In Brookdale’s case, because its controlling shareholder, Fortress Group (NYSE: FIG), wanted to have a dividend-paying company in its portfolio, the company started paying dividends, sometimes without generating the true cash flow to pay them, and then started growing the dividend at a rate that had no relationship to cash flow generation, let alone net earnings. About 12 to 18 months ago we heard that the Fortress people were even talking about a future $3.00 annual dividend for Brookdale, based on a share price that was expected to be in excess of $75. Brookdale hit the bottom at $6.23 per share in October, and while investors know they will never see a $3.00 dividend, many believe BKD shouldn’t be paying any dividend. Even in this market, however, anything near $6.23 per share is just way too cheap and should be bought.
Or take the case of Sunrise Senior Living (NYSE: SRZ), which has had more than its share of troubles and missteps. A year ago, some investors thought the company was also worth $40 per share (and bought it for that), based on its growth potential and profits, even though no one really knew what they were because of the accounting restatement process that dragged on for two years. As some had suspected for many years, Sunrise really made its money by developing and selling its properties, and it did that better than most, if not all companies in the industry. As best as we can tell, it did not, however, make money operating its properties. Today, with its development pipeline significantly curtailed because of the capital markets, and its ability to sell properties at a value it needs, also curtailed by the capital markets, the company is left to rely on making money the old-fashioned way, and that just doesn’t support a stock value anywhere near $40 per share. It doesn’t mean it should trade at $2.57 per share, which it hit in late October, but $40 a share will most likely not be seen again in the tenure of SRZ’s current CEO, Mark Ordan. We hope, however, that management has been aggressive buyers at these low levels.
As the prices of the six publicly traded companies deteriorated significantly in October, despite the comments above, we thought the valuations were just getting absurd, even in this market and even with the economy worsening. As some readers know, we have a self-imposed restriction on buying shares in any company we write about, so unfortunately we can’t put our money where our mouth is. As the next best thing (to prove a point), we created a theoretical portfolio at the end of trading on October 28, the day when the Dow jumped by nearly 900 points and a day that we have picked as the bottom for seniors housing stocks (and in case you are wondering, two did go lower later).
With $50,000 we “purchased” 1,500 shares of Brookdale, 3,000 shares of Sunrise, 2,000 shares of Assisted Living Concepts, 1,000 shares of Emeritus Assisted Living (NYSE: ESC), 1,500 shares of Capital Senior Living (NYSE: CSU) and 3,000 shares of Five Star Quality Care (NYSE: FVE), all at the day’s closing price. Not wanting to put all our eggs we one basket, this is a theoretical bet on the sector, and one we believe is a good one. All but Sunrise increased between the 28th and the end of the month, and so far our portfolio has returned 12%. We will be reporting on the performance every month for a while just to see if our hunch was right.
It is difficult to believe that anything the public companies report with regard to the third quarter could take their stock prices down further, but in this market investors are looking more for an excuse to sell rather than to buy. Still, from what we hear from private companies, occupancy levels do seem to have stabilized and in many cases improved by 50 to 100 basis points from late last spring. What we also know is that there is discounting going on, but we believe that some companies are doing a lot more of it than others, and that private companies, which don’t have to worry about quarter-to-quarter occupancy trends, have not been as aggressive as some of the public companies. Waiving the upfront move-in fee (or a portion of it) or giving one month’s free rent is not a big deal, but in one case in a particular state we have heard of one company effectively discounting a full year’s rent by up to 50% at some of its facilities. That may put heads in the beds, but you can’t properly run a community with residents moving in below costs.
There is another interesting development that seems to be occurring in the market. Although everyone expected the “need-driven” assisted living business to be less impacted by the current economic environment than independent living communities, that may not be the case. First of all, assisted living tends to be 25% to 50% more expensive than independent living, so potential residents and their families may be choosing the cheaper option, with a little home health care when needed. And the IL operators have figured this out as well, offering additional services and competing head on with stand-alone assisted living facilities.
As confirmation of this trend, we heard some interesting trends from A Place For Mom, which is a referral company that has a database of about 14,000 facilities across the senior living spectrum under contract. Based on their volume of placement, the company believes that about 2% to 3% of all industry move-ins come through their system. In business since 2000, they indicated that the percentage of people referred by them who move into a facility has been extremely consistent by property type over time, so they were surprised when, starting in July, there was a solid 200 basis point shift from assisted living to independent living, and this has continued. The conclusion, of course, is that the increase in independent living admissions is a result of economics and residents looking for a lower-cost alternative, at least for the base rent. Consequently, the entire need-driven versus want-driven theories can be, at least in part, thrown out the window in this current economic environment, which can make feasibility studies for new communities even harder to do.
We don’t profess to know what the public companies should be worth, partly because the new investment psychology is still evolving, and partly because we are not sure exactly what is going on internally at some of the companies. That being said, we know that new development will be slow for at least a few years, the elderly population will continue to grow, the residential housing market will eventually bottom out and there is no serious issue with looming debt maturities. Based on that, this may be a once-in-a-decade investing opportunity at these levels. It may take a long time to get back to their highs, and some may never reach them, but with our Gordon Gekko hat on, greed is good at this point in time, and as they say, when the market is fearful, it is time for the investor to get greedy.
The skilled nursing market has not seen nearly the same collapse in prices as the seniors housing stocks, with the exception of two companies, so the bargains are not as plentiful. Our pick at the beginning of the year was Kindred Healthcare (NYSE: KND) because, in our opinion, investors were not giving it enough credit for its LTAC operations. As of August 31 it was leading the group with a return of 24% on the year, but that vanished in the next two months with the market collapse and the announcement that it would not meet third quarter earnings estimates, which alone resulted in a 30% plunge that day. Call us old-fashioned, but Kindred should not be a $14 stock. The other skilled nursing companies have so far been reporting fairly good results, and only The Ensign Group (NASDAQ: ENSG) is giving investors a positive return through October 31.