Assisted Living Concepts (“ALC”), an operator of 211 senior living residences, is likely to be bought this quarter for $24.77/sh, 48% above the current price of $16.70.  The sale of the company is not widely known and has been over shadowed by recent negative news, which culminated in an 8-K filed last week that Ventas, Inc. (“VTR”), which owns 8 of the 211 properties operated by ALC, “instituted a lawsuit against [ALC] seeking a declaratory judgment that [ALC] has breached its obligations under the lease and forfeited its right to possession of the leased premises.”  This caused ALC to delay its earnings release and the stock to decline 12%. 

While it was a difficult week for ALC, the lawsuit and earnings delay have little financial impact on the value that will be realized in the current sale process (detail is provided below; the maximum loss to value is $1.83/sh).  If we’re wrong about the sale process, we think it’s unlikely the stock trades below $14.87/sh, 11% below the current price.

Most of ALC’s 211 senior living residences are operated as assisted living facilities serving the needs of seniors, who average 85 years old and need help with 3 daily activities (e.g., taking medicine, daily hygiene, etc.).  Most operators lease the majority of their facilities, but the opposite is true for ALC which owns 7,163 of its 9,325 units (77% of units vs peers at 25%). 

Most operators accept Medicaid patients, but ALC has been phasing out Medicaid patients for several years and at year-end 2011, just 0.3% of ALC units were occupied by Medicaid patients (25 of ALC’s 9,325 total units occupied by Medicaid residents; one leased facility must accept Medicaid residents, but all other facilities have no obligation to accept Medicaid residents).  While private pay rates are 50-70% higher, typically 20-30% of residents are Medicaid residents.  Most peers have financed their facilities with Fannie/Freddie mortgages with occupancy covenants of 80% or more.  Accepting Medicaid allows operators to keep occupancy high as private pay is typically ~60-70% of a middle market assisted living facility.  Ignoring the benefit of Fannie/Freddie 4% mortgage debt, ALC argues that Medicaid residents are unprofitable as they typically have more health issues making them more expensive to care for and generate negative sentiment with private pay residents as Medicaid rents are lower.  As ALC transitioned to 99%+ private pay residents, occupancy declined from 85.0% in 2006 to 62.4% in 2011, while EBITDA grew from $44.2mm in 2006 to $66.6mm in 2011. 

While a financial success, the move to private pay was a difficult transition as seniors received notices giving 90 days to vacate and find a new place to live, which caused bad press and complaints from government authorities.  At the same time, increased unemployment from the recession resulted in family members out of work and able to care for an ailing parent/grandparent.  In addition, the recession’s impact on financial assets and home prices weakened the affordability of monthly rent that averages $3,500. 

Sale Process

ALC is controlled by Chairman David Hennigar through his 56% voting interest (14% economic interest as he owns Class B shares) and is reviewing strategic alternatives given the significant valuation discount to peers.   The five publicly traded peers are Brookdale Senior Living, Inc. (“BKD”), Capital Senior Living Corporation (“CSU”), Emeritus Corp. (“ESC”), Five Star Quality Care, Inc. (“FVE”), and Sunrise Senior Living, Inc. (“SRZ”).  The peer with the most similar product offering is ESC, which trades at 13.1x 2012E EBITDA despite owning just 36% of its units.  Much of this value discrepancy is the result of ALC’s low leverage as net debt/EBITDA is 1.2x vs. ESC at 9.6x (peers average 6.3x).  The majority of ALC’s owned properties are unencumbered allowing for a significant increase in property level mortgage debt and/or corporate level debt.  

Given the potential for a significant increase in leverage, we inquired about the value of ALC’s real estate.  As it includes past real estate transaction values, Sidoti’s analyst directed us to The SeniorCare Investor monthly newsletter.  We signed up for a free trial and received our first magazine, which can be found at: http://www.scribd.com/doc/92619331/Senior-Care-Investor-Newsletter-April-2012?secret_password=kpaipw02m5zfqly7pup (we request that if you contact the editor to not mention that the newsletter was posted on a message board).  We were stunned to see the lead story “Assisted Living Concepts on the Block” and called editor Steve Monroe who told us that he was “99.9% sure” that ALC had engaged Citi in February and that best & final bids from 3 remaining interested parties were due on Thursday, April 19^th.  ALC has not commented publicly about the sale process, but a conversation with the Chairman two weeks ago gave a strong impression that he is open too selling the company.

While you might think it’s not possible for The SeniorCare Investor article to go unnoticed, Monroe told us that with the exception of a few friends in the industry, we were the only person that called him on the article.  Note that it didn’t hit any news providers – it’s not on Bloomberg, CapitalIQ, google finance, mentioned in yahoo message boards, or noted on VIC or SumZero.  On the day it was published, April 9^th, ALC closed down 0.9%.  ALC dropped another 1.1% the following day.  The article notes that the prior month’s edition included a brief article that ALC had hired Citi so perhaps some reaction was already priced into the stock, but this doesn’t appear to be the case as YTD performance is +12.2% (with a beta of 1.2 and the S&P 500 +9.7%, ALC’s YTD return of 12.2% shows it has tracked the market).  The Sidoti analyst did not mention the article noting that ALC is for sale when referring us to The SeniorCare Investor so he likely no longer has a subscription or hasn’t caught up on past issues.  Lastly, while ALC was posted to VIC in 2006 and 2007, the current shareholder base is incredibly sleepy.  Of the top 10 shareholders, just one is a hedge fund.  Unless you have a subscription, you don’t have access to the article and it’s not surprising that there isn’t much of a reader base for a monthly newsletter titled The SeniorCare Investor.

In case The SeniorCare Investor article isn’t sufficient, a few tea leaves:

1. ALC repurchased stock every quarter between coming public in late 2006 through Q2 2011.  This resulted in the repurchase of 19% of shares outstanding, but in Q3 and Q4 2011 there were zero repurchases.  In a conversation with CFO John Buono we were given the impression that the company did not repurchase stock in Q1 2012.  Recent questions on quarterly conference calls questioning the logic of repaying the L+2.50% credit facility (after tax cost ~1.5%) rather than buying back stock with a 8.9% FCF yield have left management tongue tied.  We find this timing odd after nearly 5 years of consistent share repurchases.  Our guess is that the company has had information that would restrict it from share repurchases.
2. In a phone conversation with Chairman David Hennigar, we noted that the 10K highlights that REITs with a lower cost of capital are a risk to ALC’s ability to make acquisitions and that if ALC wishes to buy leased properties, as it has in the past, it should also convert to a REIT and he noted, “All kinds of things being considered, nothing outside of possibility.”
3. In a conversation with CFO John Buono we asked specific deal and tax questions (e.g., ability of a controlling shareholder to sell properties to a REIT while retaining super voting shares) and were given immediate answers.  In our past experience, this is not the level of detail that the CFO of a small cap has unless he’s currently working on a transaction. 
4. Every conference call for at least the last 5 years has taken place at 10:00am est, which is during market hours.  The conference call that was supposed to occur for Q1 2012’s results last week was scheduled for 6:00pm est.  This doesn’t guarantee that the company was going to announce that the business was sold, but it seems that they were planning to discuss information that cannot be disseminated during market hours.
5. Competitors have been asked about the potential to make large acquisitions on recent conference calls.  Generally when a company is asked about making a large acquisition, they note they’re not interested as they suspect shareholders will view it negatively.  On the other hand, BKD’s management noted last week that they expect 2012 to be “a year with a fair amount of transactions” and they hint that they may make a large acquisition noting “large portfolio acquisition opportunities are relatively rare” and they “certainly look at those.”

While the above five data points are reading tea leaves, in combination with The SeniorCare Investor, it seems likely that ALC is pursuing a strategic transaction.

Estimated Deal Value

ALC’s free cash flow generation, minimal exposure to Medicaid, unlevered balance sheet, and ownership of 77% of its units leads us to believe there is a wide universe of potential buyers, including competitors, healthcare focused REITs, and private equity firms.  As private equity would pay the lowest price, we use a private equity value as a conservative case for what we believe ALC is worth. 

There are three data points we use to triangulate to $100k/unit in value for ALC’s owned facilities:

1. In February 2011, ALC refinanced its credit facility with 1,313 units collateralizing the revolver.  The credit facility has $125mm of availability and was written at 70% LTV, which implies $136k/unit.  While we believe this is too high of a value for ALC’s entire portfolio as the bank likely selected choice properties, it is well above the $100k/unit we estimate. 
2. ESC’s property level mortgage debt is $97k/unit.  We have spoken with 3 people that have visited ALC facilities and they have each noted that the physical premises are very similar to ESC properties.  Considering that ESC has debt of $97k/unit, a value of $100k/unit for ALC’s properties seems reasonable. 
3. The CFO has told us twice that he believes the fair value of the owned properties is $100k/unit. 

ALC’s owned real estate provides the ability to finance a private equity purchase.  And if we assume an equity check of 25% of deal value (below the ~40% average of the past couple years), the implied stock price is $24.77, 48% above the current share price.  This is 9.4x consensus 2012E EBITDA of $71.0mm and 11.7x 2012E EBITDA-Maint CX of $57.0mm.  While not absolutely cheap multiples, the valuation is below peers and yields an IRR for a 5 year equity investment of 22% (assumptions: private pay occupancy increases 1.4%/yr (as it did in 2011), maintenance capex of $14mm/yr (well above peers), 7.5% average interest expense, and a 40% tax rate).  I spoke with a friend that is a partner at a private equity fund focused on healthcare investing to inquire if he thought ALC would make an interesting buyout.  His response was the significant % of owned assets that are dramatically under-leveraged made this an ideal buyout.  He added that he thought private equity firms would see upside scenarios based on improving occupancy during a 5-7 year holding period through either hiring talented managers or the economy improving.

The Bear Case

As noted in past VIC Q&A and The SeniorCare Investor, the bear case is two-fold: (i) occupancy is low because ALC is over-priced; and (ii) margins are inflated because ALC runs an excessively lean operation. 

We disagree with the first point.  ALC charges private pay rates (~$3,500/mth) similar to competitive offerings (~$3,750/mth) and has private pay occupancy similar to industry average.  At December 31^st, ALC had 5,603 private pay residents – it’s not logical to think that a commodity offering could have thousands of residents if the price differed significantly from peers. 

Moving to the second point, we partially agree – the lean operating structure of ALC has resulted in recent regulatory issues caused by management stretched too thin.  For example, the issues cited in VTR’s complaint should have been remedied.  Our understanding is that Georgia implemented new assisted living facility rules in 2012 that ALC hadn’t adjusted for.  But given the customer base, this is an industry that is going to have complaints/issues.  We took a look into all the facilities in ALC’s two largest states – Texas (41 facilities) and Indiana (23 facilities).  In 2011 the average across ALC’s facilities in Texas was 1.1 health inspection violations and 1.7 life safety inspection violations.  This compares to a Texas assisted living care facility average of 4.0 health inspection violations and 5.1 life safety inspection violations, significantly above ALC’s average violations.  In 2011 the average across ALC’s facilities in Indiana was 4.9 survey violations compared to a state average of 3.7.  In Indiana, ALC is worse than average, but not dramatically worse. 

It’s important to note that ALC is not accused of under-spending on facilities.  Because ALC owns its facilities, it spends annual maintenance capital expenditures of $1,500/unit, more than double the industry average.  While occupancy is low, the properties have not been neglected and can be used to finance a transaction. 

We believe that the low occupancy and regulatory issues of ALC are an opportunity for a new owner.  “Under New Management” banners could be displayed across troubled facilities and simple improvements, such as improving the quality of food, would go a long way.  As the incremental EBITDA margins to additional residents are >50%, if a new owner can grow occupancy, EBITDA will dramatically increase.

While we think that the bear case is well known, we don’t believe that the sale process is well known, which creates the attractive investment opportunity.

Recent Events and Earnings Delay

Recent events and the lack of clarity from management (they have not returned buyside or sellside calls) have spooked shareholders. 

• 2/13/2012 – Notified by the Georgia Department of Community Health of the State’s intent to revoke the permit of its Tara Plantation facility.  This facility is leased from VTR.
• 3/21/2012 – VTR notifies ALC that the receipt of a Notice to Revoke Permit constitutes an event of default according to the lease agreement.
• 3/27/2012 – Notified by the Alabama Department of Public Health of the State’s intent to revoke the permit of its CaraVita facility.  This facility is leased from VTR.
• 3/30/2012 – Notified by the Georgia Department of Community Health of the State’s intent to revoke the permit of its Peachtree facility.  This facility is leased from VTR.
• 4/17/2012 – Stifel releases a negative note on the company highlighting recent regulatory issues at 3 facilities in Idaho, Indiana, and Georgia.
• 4/26/2012 – VTR files a lawsuit against ALC in the Northern District of Illinois.
• 5/3/2012 – ALC announces that Q1 2012 results will be delayed.  No explanation given.
• 5/4/2012 – ALC releases an 8K revealing the VTR lawsuit and that the Board was “determined to investigate possible irregularities in connection with the Company’s lease with VTR and retained counsel for such purpose.” 

Our biggest concern is the delay in earnings, but there is a logical explanation.

On September 22, 2011, the company disclosed a correspondence letter with the SEC (http://www.scribd.com/doc/92621088/SEC-Correspondence-Letter-With-ALC-August-5-2011?secret_password=1ht98gawbuigup22b9xs) highlighting that noncompliance with covenants of the CaraVita operating lease (properties leased from VTR) could have a material adverse impact on operations.  Looking at the company’s 2011 10K, it notes that failure to meet covenants in the CaraVita operating lease could give the lessor the right to accelerate the lease obligations and terminate the company’s right to operate all or some of the properties, which would constitute a material adverse effect. 

On February 13, 2011, ALC was served with a Notice to Revoke Permit for the Tara Plantation facility by the Georgia Department of Community Health, which VTR considered an Event of Default under the lease agreement with VTR (see VTR letter to ALC on March 21, 2012: http://www.scribd.com/doc/92619790/VTR-Notice-of-Default-to-ALC-March-21-2012?secret_password=11sum0kfxxtyuo5m6km3). 

While quarterly earnings are not audited, auditors do review the earnings release.  With the auditor having recently signed off on ALC’s 10K that required ALC to include an estimate of the present value of the remaining obligations under the CaraVita lease ($16.7mm as of December 31, 2011), the auditor likely flagged to the company the materiality of this breach causing the company to delay its earnings and release a form 8-K highlighting the VTR lawsuit.  We spoke with VTR’s IR who noted that VTR attempted to negotiate with ALC’s management team, but this issue wasn’t receiving the attention they believed it deserved and therefore they decided to initiate litigation.  When asked if she was aware this caused ALC to delay earnings, it was clear that VTR was aware of this dynamic as she noted that these 8 leases are immaterial for VTR at less than 0.5% of NOI, but they are considered material to ALC. 

Our speculation is that the initiation of a sale process has stretched ALC’s lean management structure too thin over the past few months to give appropriate attention to the VTR situation.  While this has thrown a wrench in the deal process, we do not believe this is an issue that will cause an ALC deal to break especially since the liability amount is known and can be reserved for.  We believe ALC was ready to announce a strategic transaction before the delay in earnings.

Worst Case Financial Impact

ALC has 3 days to report and file Q1 2012 results.  While it’s possible that results will be delayed, our understanding from a former auditor is that the following needs to occur:

1. General Counsel and the Board need to estimate the likelihood that a default has occurred in the VTR lease.
2. If it is determined that a default has more likely than not occurred, auditors need to determine the size of the potential liability of the accelerated rent.  This should be fairly easy to do given the company included an estimate of the liability as of December 31, 2011 in their 2011 10-K.
3. If it is determined that a default has more likely than not occurred, auditors need to determine if an impairment needs to be charged against the asset value recorded for the 1/1/08 purchase price for the operating rights of the VTR properties.   

This former auditor’s opinion is that it is possible to complete this before May 10^th, particularly as ALC has already been working on it for a few days and the numbers aren’t large.  But, we want to highlight the potential for more negative headlines to the VIC community. 

In a worst case scenario where VTR repossesses its properties, we believe this impacts the sale price by $1.83/sh resulting in a private equity takeout value of $22.94/sh, 37% upside.  We think $1.83/sh is the worst case as it seems unlikly that VTR gets both the properties back and an accelerated rent payment, but anything can happen. 

Downside

If we are wrong about a deal process, and ALC loses the 8 facilities leased from VTR, we see the stock trading down to $14.87/sh, 11% down.  At that price, we would not feel terrible owning a stock trading at 7.6x EBITDA-MCX, a 2.7% dividend yield, and earnings leverage through increased occupancy.  In the event that a sale does not occur, it is also likely that share repurchases are resumed accreting value to shareholders. 

Conclusion

The high likelihood that ALC is in the late stages of a sale process that is masked by the delayed earnings release and VTR lawsuit positions ALC as an attractive risk-reward.  We see downside of 11% and near-term upside of 41% (or more if the buyer is not a private equity firm).    

Risks

1. Non-timely filing of ALC’s first quarter results and 10-Q. 
2. Sale process takes longer than expected.
3. Economic environment deteriorates causing further occupancy declines at ALC facilities.  We view this as unlikely in the near-term given occupancy at an all-time trough.
4. No settlement is reached with VTR resulting in one-time payment to VTR and the loss of the earnings stream from the 8 leased facilities.