Five Star Heads Toward a Restructuring

In an 8K filing dated October 23, Five Star Senior Living (FVE) reported that it had received a delisting notice from NASDAQ because its share price had remained below $1 for 30 consecutive days.  On its 2018 third quarter conference call, Five Star disclosed that based upon its cash balance as of Sept. 30 and its expectations of future earnings and cash flows, there is now substantial doubt about its ability to continue as a going concern.

Five Star has taken steps over the past few years to reduce external debt, which has strengthened its balance sheet.  It had only $8 million of (mortgage debt) outstanding at Sept. 30.  Consequently, its current financial problems will most likely be resolved through a negotiation between Senior Housing Properties Trust (SNH), FiveStar’s landlord and the owner of 8.4% of its outstanding shares, and RMR Group,which provides management services to both FVE and SNH and owns 35.6% of FVE’s outstanding shares.  These negotiations could result in either (1) RMR acquiring FVE or (2) SNH acquiring FVE (most likely through a troubled debt restructuring or pre-packaged bankruptcyproceeding).  It is also possible, but unlikely, that FVE could be sold to a third party, as HCR ManorCare was earlier this year to ProMedica.

(In a move that foreshadows a likely restructuring, FVE announced today (Dec. 11) that it has appointed Katherine E. Potter, its General Counsel, as President and CEO effective Dec. 31, 2018, replacing Bruce Mackey.  Mr. Mackey will continue as a non-officer employee until Dec. 31, 2019 to ease the transition.)

In the 2018 third quarter, FVE burned through $15.1 million of cash (i.e. it used $15.1 million of cash flow in operating and investing activities, excluding $6.2 million in asset sale proceeds received from SNH).  Its 2018 third quarter EBITDA minus capital expenditures was negative $26.7 million.  (The difference between the two measures– a source of cash roughly equal to $11 million – was almost entirely due to changes in assets and liabilities.) Annualizing the 2018 third quarter EBITDA minus capital expenditures suggests that FVE must find a way to raise revenues or cut costs by about $107 million per year or just over half the annual rent of roughly $206 million that FVE pays to SNH.

A cut in FVE rent payments of $107 million would almost certainly require that SNH cut its own dividend eventually.  Over the past few of years, SNH has not generated sufficient free cash flow (cash from operating and investing activities) to cover its own dividend (which totals $371 million annually).  It has made up the difference by increasing debt (in 2016), selling a joint venture interest in one of its most valuable properties (in 2017) and through asset sales (in 2018).

Just how much of the dividend SNH may have to cut is difficult to estimate because there are a lot of variables, including (1) FVE’s future performance and capital expenditure requirements; (2) the future performance and capital requirements of SNH’s medical office buildings (MOBs) and managed senior living properties; (3) future fees payable by SNH to RMR including an incentive fee that is currently running at $60 million annually based upon SNH’s relative share price performance vs. peers; (4) the willingness of SNH and RMR to utilize SNH’s existing cash balances or increase debt; (5) injections of equity capital into FVE by RMR to fund FVE’s capital expenditure requirements and (5) future asset sales by both FVE and SNH.

Conceivably, SNH may not have to cut its dividend immediately after acquiring FVE.  It could buy some time by selling assets or with some improvement in the performance of the combined businesses.  In the current environment, SNH and RMR would probably seek to delay a dividend cut as long as possible to play for an improvement in the performance of the combined businesses and also to avoid a potential further decline in SNH’s share price. (The recent drop in SNH’s share price will probably reduce the incentive fee paid to RMR at year-end.)

FVE looks very cheap on a price-to-book value or price-to-sales basis. If a return to profitability is possible, its stock would have significant upside potential.  However, given the current state of the skilled nursing facility business which is suffering from shorter patient stays mandated by government payers and increased competition, it seems unlikely that FVE will return to profitability anytime soon.

Similarly, SNH looks very cheap relative to its peer group.  It is trading at less than eight times projected 2019 FFO vs. 15.0 times for its peer group and its dividend yield of 11.8% is nearly twice the peer group average of 6.7% (but its payout ratio is also nearly the highest among peers).  Assuming that SNH and RMR have the flexibility to manage the situation, as I believe they do, there is a good chance that any near-term dividend cut will be less than feared and that SNH will be able to narrow its valuation gap over the next several quarters.

December 11, 2018.  (This text was contained in a research report published on November 20, 2018 and has been updated to provide current stock price and valuation metrics and the news about the change in Five Star’s CEO.)

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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