Assisted Living Concepts, Inc. (“ALC”) is an overlooked spin-off with important related management incentives trading at a price with a margin of safety despite significant profit enhancement opportunities.

ALC is one of the largest operators of assisted living facilities in the United States, with 207 assisted living facilities consisting of 8,310 units in 17 states. Assisted living is an alternative for seniors who can not live independently but who do not require the medical attention provided by a skilled nursing facility. ALC, a U.S. company trading on the New York Stock Exchange, was spun off on November 10, 2006 from Extendicare, Inc., a Canadian company trading on the Toronto Stock Exchange that simultaneously converted to a REIT.

 

The transaction’s unusual structure created particularly strong incentives for management to foster conditions that might contribute to a lower stock price. The ALC distribution, unlike most spin-offs, was taxable. Parent company Extendicare, 43% of whose stock is voted by an entity owned by the Jodrey family (a member is ALC’s Chairman), would be deemed to have sold its shares in ALC, incurring a gain calculated using the weighted average trading price on November 10^th. Every $1 reduction in ALC’s initial trading price would save Extendicare $27 million in taxes. The actual tax bill was $124 million, representing 17% of Extendicare’s market capitalization.

 

Interestingly, the Board appeared to confirm my judgment that the stock price did not reflect the company’s value.  It decided to postpone the pricing of the CEO’s new stock incentive package until systematic selling by Canadian shareholders ceases so as not to overcompensate her. The CEO, who held the position of COO prior to the spin-off, is neither a Jodrey family member nor an ALC Director.

 

A number of other factors may have contributed to ALC’s attractive initial trading price, including its below industry average occupancy and private pay customer mix. The only published research recommendation, which rated the shares a “hold,” argued that ALC deserved a discounted valuation “because management has provided little communication and guidance for investors prior to the spin-off, which leads to greater uncertainty with respect to estimates.” The analyst also noted, without irony, that “given the taxable nature of the spin-off, current Extendicare shareholders could actually benefit financially if shares of ALC initially trade at a lower price.”

 

Furthermore, market participants may not have fully appreciated opportunities to improve financial results. ALC had not been operated with a profit maximizing strategy prior to its January 2005 acquisition by Extendicare; ALC’s founder was motivated, instead, by family experiences that led her to “a professional and personal quest to change the face of long-term care.” ALC had targeted lower profit Medicaid patients, provided private pay residents with below market rates and accepted higher acuity residents whose care needs were outside the scope of its programs. In the first year of current management’s tenure, EBITDAR increased from $36 to $47 million giving us further confidence that payor mix and occupancy improvements can be made.

 

Private payors currently constitute only 71.5% of ALC’s units versus 95% at competitors. Since the average length of stay for all patients is 18-24 months, and since Medicaid patients are typically higher acuity resulting in shorter stays, it should not take long to achieve industry average payor levels. Incremental revenues from this shift are fully converted to pre-tax cash flow, potentially adding $20 million annually.

 

Management also believes that the sales force under prior management was not motivated to maximize occupancy, resulting in an 84.5% rate versus 90% at competitors. One-half to three-quarters of incremental revenues from occupancy are converted to pre-tax free cash flow, potentially adding $8 million. Were ALC to achieve industry average private pay and occupancy levels, EBITDAR would improve from the $64 million reported during the twelve months prior to the spin-off to approximately $92 million.

 

ALC provides investors with a margin of safety against permanent capital loss because it has minimal debt and owns 152 (73%) of its facilities (comparable companies own only 27% of their facilities). The replacement costs of these (empty) facilities alone would justify the current stock price and management has indicated that its 55 leased properties have additional value.

 

ALC could support another $300 million of debt, assuming leverage similar to its peers based on trailing profits. Although there is no indication the company will borrow such a large amount, it is worth noting that capital can be allocated very profitably to repurchase stock at attractive levels (without the restrictions associated with tax-free spin-offs). Management has indicated it could add incremental units to existing facilities, potentially expanding total owned capacity by 20%, at a cost of $125,000 per unit with unlevered returns of approximately 15%-20%. Management also intends to make acquisitions.

 

ALC’s current total enterprise value, adjusted to capitalize all leases, represents 8.2x pro forma EBITDAR. Comparable companies are valued at approximately 13x EBITDAR. Were ALC to achieve industry average private pay and occupancy levels and achieve a comparable valuation, its shares would be valued at $13-14 per share, or 60-70% above current levels.