The Old and New Five Star

Five Star Senior Living (FVE) and its landlord Senior Housing Properties Trust (SNH) have previously announced a restructuring of their commercial arrangements whereby SNH will cancel the five master leases that cover 181 senior living and skilled nursing facilities currently operated by FVE.  Under the new arrangement, FVE will manage those properties for SNH for a fee equal to 5% of gross property revenues and reimbursement of direct property operating costs. FVE will also have the opportunity to earn an annual incentive fee equal to 15% of the excess over targeted EBITDA for the properties up to a maximum of 1.5% of gross property revenues.

The new arrangement was forged in response to FVE’s inability to pay the full rent due under the master leases because of declining occupancy at the properties.  In the quarters preceding the new deal, Five Star incurred significant losses that raised substantial doubt about its ability to continue as a going concern.  The two companies needed a new arrangement that fit with current and expected future market conditions.

In the interim, until the new arrangement is finalized, SNH has provided substantial relief to FVE:  It has reduced the monthly rent due under the master leases from $17.4 million to $11.0 million.  That allowed FVE to return to profitability in the 2019 second quarter.  In addition, SNH purchased from FVE unencumbered fixed assets and improvements on SNH’s senior living communities for $50 million.  FVE used the proceeds to repay all of the borrowings its revolving credit facility.  SNH has also extended a $25 million credit facility to FVE which remains undrawn.

Solid Improvement in 19Q2 Financial Performance. With the reduction in rent and other modest improvements in its business operations, FVE reported 2019 second quarter net income of $4.2 million or $0.08 per share.  That was a substantial improvement from the loss of $20.9 million or $0.42 per share that it reported for the 2018 second quarter.  Besides the reduction in rent, FVE reported that senior living revenues rose 1.4% to $274.5 million, thanks primarily to a 160 bp increase in occupancy to 83.0% and a 0.8% increase in the average monthly rate received from senior living customers to $4,745.

The increase in occupancy was especially welcome, as Five Star had seen its occupancy levels fall steadily from 86% in 2014 to 82% in 2018. By my count, this was the third consecutive quarter of improving year-over-year occupancy for FVE.  (Occupancy also improved sequentially in three out of the past four quarters.) The gains were driven both by a suspected bottoming out of industry occupancy rates and the company’s efforts to boost occupancy, including a revised revenue management policy that leans more toward filling the space rather than obtaining the highest possible rates.

Besides the gains in revenues from senior living occupancy, FVE has reported rapid revenue growth for Ageility, its wellness and rehabilitation services division, which operates inpatient and outpatient physical therapy facilities, many (all?) of which are located within FVE’s senior living communities.  Ageility’s revenues rose 27% to $11.1 million in the 2019 second quarter.

On the expense side, wages and benefits costs rose 3.2% to $145.2 million in the quarter, keeping pace with revenues, as FVE has taken steps to boost wages to reduce turnover.  With stiff competition for professionals driven by the recent expansion in industry capacity, FVE aims to keep more of its staff in place, which will reduce its reliance on costly contract labor to fill gaps when employees leave.

Partially offsetting the rise in wages and benefits, FVE reported that other senior living expenses declined 4.2% to $72.6 million, due to a reduction in maintenance and repair costs and a decline in consulting and other purchased services expenses. General and administrative expenses rose 11.4% to $20.5 million, primarily due to $1.1 million of costs related to the Transaction Agreement and $0.4 million of costs associated with the departure of its former CEO.  Rent expense, as noted, fell 36.2% or $19.8 million to $33.3 million.  Depreciation and amortization expense also fell 67% to $2.9 million, as a result of properties sold to SNH over the past year.

With the rise in revenues and reduction in operating expenses, FVE’s profitability rebounded sharply from an operating loss of $20.2 million in 18Q2 to operating income of $3.7 million in 19Q2.  EBITDA also reversed from negative $10.9 million to positive $6.8 million.  Excluding the one-time costs associated with the Transaction Agreement and executive severance, adjusted EBITDA was $8.6 million in 19Q2.

Removal of Going Concern Qualification. Along with the return to profitability, FVE announced that its auditors had removed the going concern qualification. The reduction in rent and repayment of bank debt were clearly the key factors in this determination. While this does not guarantee that FVE will report a profit every quarter going forward, it does suggest that the company will more likely than not record sufficient profits and cash flow going forward to sustain its business and avoid a bankruptcy filing.

FVE Share Price Volatility. FVE’s shares, which have been volatile in 2019, soared on the quarterly earnings report, which was released on August 7.  To put some perspective on this, the stock had plunged in value from about $1.30 a year ago, as the market became increasingly aware of the immediacy of the company’s financial difficulties.  After bottoming out at $0.31 at the end of 2018, the stock soared to a peak of $1.06 in anticipation of a restructuring of its leases with SNH.  However, when the deal was announced in early April and the market learned that restructuring would be accompanied by a substantial dilution of the existing shareholders’ stake, the stock plunged again to around $0.45.  Following the positive 19Q2 earnings report, it has since rebounded to $0.75 before falling back to the current price around $0.50.

Proposed Sale of FVE Stock to SNH. Under the Transaction Agreement, SNH and its shareholders will receive 85% of FVE in exchange for a payment by SNH of $75 million. SNH will keep its existing 8.2% stake in FVE, equal to 4.24 million shares, and receive, according to my estimates, 102.29 million shares to bring its stake to 34%. SNH shareholders will receive 160.16 million shares, also according to my estimates, equal to 51% of pro forma shares outstanding. In total, FVE will issue 262.45 million shares for $75 million or $0.29 per share.

While FVE received approval for the stock issuance from shareholders at its annual meeting in June, it did not simultaneous ask for approval of a reverse stock split. Consequently, I suspect that the company will do so at its next annual meeting, to bring its share price back above $10 per share, a key threshold for attracting institutional investors.

The New FVE. Investors probably bid up FVE shares because of the removal of the going concern qualification. The actual profit recorded in 19Q2 is not relevant because of the changes proposed in the Transaction Agreement. Most of the revenues and profits that FVE recorded in the quarter will go to SNH under the new management arrangement. Instead, FVE will receive a 5% fee (plus the incentive) for managing the properties.

Of course, FVE’s future revenues and profits will ultimately drive its valuation and share price. However, there are still unanswered questions that make it difficult to estimate FVE’s future profitability with a desirable degree of precision. Here’s what I know so far:

The conversion from leased to management properties will give FVE an estimated $62.8 million in baseline annual fee income. That’s down from an estimated pro forma $75 million in annual fee income primarily due to the anticipated sale of some senior living communities and skilled nursing facilities by SNH.

Besides the 5% management fee income, FVE will continue to derive revenues from other sources, including 20 senior living communities that it owns, four HCP-owned properties that it operates on lease and Ageility. On a rolling 12-month (R12) basis, the 20 owned properties generated revenues of $74 million. I estimated that the four HCP-owned properties produced revenues of about $9 million. Ageility’s R12 revenues were about $40 million; but its revenues have been growing at a solid and accelerating pace, up 15.2% in 2018 and up 27.1% in 19Q2.

On the cost side, as already noted, both FVE and SNH are in the midst of raising staff salary levels to reduce turnover. That process will continue probably for the balance of the year. So far, revenue increases have offset higher wage and benefit costs, but FVE’s profit margins could still get pinched in the short run, as the cost increases continue. On a longer-term basis, the anticipated reduction in turnover and operating efficiency gains should help boost revenues and margins in the long run.

FVE’s future general and administrative expense will also be a major determinant of its profitability. I estimate the current G&A expenses run-rate, excluding the one-time costs, to be about $76 million. Anticipated sales of senior living properties should allow FVE to reduce G&A costs. The company will also undoubtedly pursue other cost reduction opportunities.

Based upon these assumptions, I estimate pro forma annual revenues for the new FVE of $185.2 million. I also estimate, on a pro forma basis, annual combined senior living costs (wages and benefits and other operating expenses) of $95 million, rent expense (on the HCP properties) of $1.8 million, G&A expense of $76 million and depreciation and amortization cost of about $7.6 million.

That results in operating income of $4.7 million and after-tax profits of $3.7 million or about $0.01 per share. If the company is able to reduce its G&A expense by $4 million or 5.3%, its pro forma EPS would be $0.02 per share.

Pro Forma Valuation. At the current share price around $0.50, the pro forma P/E multiple is therefore about 50 times. If the company is able to reduce its G&A expense as noted above, its pro forma P/E multiple would be 25 times.

FVE’s pro form enterprise value, which consists of $7.7 million of (mortgage) debt and an equity market capitalization of $164 million, is $171.7 million. With pro forma adjusted EBITDA of $12.3 million, its enterprise value-to-EBITDA multiple is 13.9 times.

Importantly, this valuation does not consider the $55.8 million fair value of cash and investment or the anticipated $75 million in cash proceeds from equity issuance to SNH. That puts a lot of cash at FVE’s disposal. FVE also has an undrawn $65 million secured bank credit facility and an undrawn $25 million credit line from SNH.

That cash could be put to work in a couple of ways. First, it could be used to help fund cash flow shortfalls that might arise during this transition period, as it recalibrates staff wage levels across the company and possibly upgrades its existing 20 properties to make them more competitive. The cash and unused borrowings could also be used to acquire (or even build) senior living properties, either from SNH or from third parties.

Summary and Conclusion. With key questions still unanswered – including whether, in fact, industry occupancy rates have bottomed, whether the company can reduce its G&A expenses and what it intends to do with its cash and unused borrowing capacity, FVE’s stock remains a speculative investment.

Yet, the company has a lot to work with here. While the competitive environment is still challenging, both FVE and SNH are making a strong effort to improve the competitive positioning of its senior living communities. The recalibration of wage levels is one important step. Other initiatives include capital improvements at its existing properties, efforts to enhance its name recognition (for example by sponsoring the 2019 National Senior Games and receiving J.D. Power’s Senior Living Community Certification at three of its properties) and new initiatives to modify or even redefine the senior living experience (through its recently announced collaboration with MIT’s AgeLab).

While the pro forma valuation does not look cheap at this time, the stock should still have upside potentially from reducing G&A expenses, growing revenues in several ways – including the SNH EBITDA incentive fee, continued scaling up of Ageility’s operations, purchases of new communities or upgrades of existing ones and hopefully, continuing improvements in occupancy. Longer-term, the expected growth in population aged 65 and older should be an increasing tailwind to support both occupancy levels and growth.

August 20, 2019 (Revised August 28, 2019)

The August 28 revisions were based upon my more detailed assessment of the combined revenue of the Managed SLC properties of SNH and FVE. Previously, I had estimated pro forma combined revenues of $1.4 billion; but based upon further analysis, I have revised this down to $1.26 billion. As a result, my estimated pro forma management fee revenue is now $62.8 million, rather than $70 million. I have revised my valuation analysis to reflect this lower estimate. I have also used the most recent price of FVE shares ($0.50 vs. $0.60 on August 20) in that valuation analysis.

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 975-0250

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