Five Star and DHC Restructure Their Agreement

On April 9, Five Star and DHC announced a restructuring of their management agreement whereby DHC will transition the management of 108 smaller senior living communities (SLCs) with a total of 7,500 units to other operators by the end of 2021.  Five Star will reposition its senior living management business to focus on larger independent living (IL), assisted living (AL) and memory care communities, as well as stand-alone active adult and IL communities. It will also exit the skilled nursing facility (SNF) business.

Five Star has disclosed that the exited communities represent 40% (or roughly $25 million) of the $63 million of management fee revenues earned in 2020.  It also disclosed that the 120 SLCs that it will continue to manage have an average occupancy that is 110 bp higher than the average for the total DHC managed portfolio and EBITDA margin that is 280 bp higher.

Nevertheless, the magnitude of the net reduction in Five Star’s profitability is unclear, since the loss of management fee revenue will likely be offset partially by an unspecified reduction in overhead costs.  Five Star will also close an undisclosed number of its Ageility rehabilitation clinics that are located at the SLCs that are being transitioned, which will further reduce its revenues and profits in the near term.  The company intends to provide more detail on this new arrangement on its 20Q1 conference call on May 6.

Besides the transition out of the 108 communities and the loss of Ageility outpatient clinics, DHC has agreed to change the terms of the management agreement to give Five Star the potential to earn more on the 120 communities that it will continue to manage for DHC by lifting the cap on the incentive fee.  DHC will also provide Five Star with some protection against further reductions in managed communities by agreeing to pay a termination fee for communities sold in the future and modifying DHC’s rights to terminate for performance.

Wall Street has reacted negatively to the news.  On the day of the announcement, Five Star’s stock closed down 13.7% from $6.36 to $5.49.  In the seven trading sessions since the announcement, the stock has fallen an additional 13.1%, closing yesterday at $4.77.  Over the four trading sessions (to April 22), the stock to my eye looks like it is trying to find a bottom.

Although there are still considerable uncertainties going forward, the 25% drop in the stock price looks like an overreaction.  Clearly, Five Star will earn less in 2021 than originally anticipated, but changes in its operating structure should position it for profitable growth and give it the potential to earn a higher incentive fee, which should offset this year’s earnings decline over time.  Beyond 2021, Five Star now has improved revenue and earnings growth prospects from managing the 120 communities more efficiently, gaining management contracts at other larger communities to its existing base (either with DHC or others), and continuing to grow its Ageility rehabilitation and wellness business after resetting its clinic count in 2021.

My 2021 projected EPS will almost certainly have to be cut.  Likewise, my current price target on FVE’s stock over the next 6-12 months will probably come down (or extend out beyond 12 months perhaps to two years).  Despite the anticipated reductions, the sharp fall in Five Star’s stock leaves plenty of room for the stock to earn a return that exceeds the broader market averages, even with a meaningful reduction in my price target. I will update my projections and price target after the company reports 21Q1 earnings.

My recent reports on Five Star, dated March 12, 2021 and April 21, 2021, are available upon request.

April 22, 2021

Stephen P. Percoco
Lark Research
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