Description

FVE represents an opportunity to purchase a senior living facility operator which is at a major operational inflection point (recently becoming free cash flow positive) at a 25-70% valuation discount to its peers. This company is well-positioned within an industry that enjoys extremely attractive fundamentals and that has just recently begun regaining investor interest.

A major supply / demand imbalance exists within this highly fragmented industry as a result of powerful (and accelerating) demographic trends on the demand side coupled with the relatively fixed supply of senior living facilities. This dynamic has recently begun to lead to increased pricing power among the larger existing players, driving opportunities for them to achieve substantial margin improvements. As the profitability gap widens between these larger players and the regional sub-scale players, many of the smaller operators are choosing to exit the market, creating a pipeline of accretive acquisition opportunities for the handful of remaining scale competitors (such as FVE).

As the smallest player in this top tier, FVE has thus far remained just under most investors’ radar and has garnered virtually no research coverage. In fact, the only analyst publishing on the company has still not updated his estimates to reflect the full accretive impact of the June 2005 Gordon Health acquisition and the related sale-leaseback transaction. Even just the anticipated upward revision of these estimates in the next few weeks (likely following the upcoming earnings release on August 11th) should be an important near-term catalyst for the stock price, as the company’s true earnings power will become more visible to the Street.

Furthermore, we expect FVE to generate significant incremental earnings (above expectations) in 2005 through increases in occupancy rates and rents on both its existing and recently acquired properties as well as through the continued growth of ancillary services. Management (most of whom are also significant shareholders) has a superb four year track record of continuous improvement in each of these metrics and believes that it will be successful in bringing its operational discipline to bear on the recently acquired properties (which are operating below the demonstrated potential of the FVE portfolio). As such, we believe that management will exceed their relatively modest targets for operational improvements.

Given the current depressed valuation, we believe that FVE presents an extremely attractive risk-reward tradeoff, with upside potential of more than 100%. On the basis of our 2005 forecast, which we believe is quite reasonably achieved, we see shares reaching $11-$12 within six months without significant multiple expansion and $16-$17 if the catalysts (further described below) drive multiple expansion just to the level of FVE’s publicly-traded peers. Furthermore, we believe that current levels represent somewhat of a floor valuation given FVE’s level of positive free cash flow generation and the fact that the current market valuation implies that the company’s financial performance during the last three quarters of 2005 will remain just on par with Q1 2005 (a seasonally slow quarter which contains no benefits from the Gordon Health acquisition or anticipated occupancy and rent increases). Consequently, we see minimal downside from current levels with the potential for major upside outperformance stemming from a variety of catalysts.


INVESTMENT THESIS

1) FVE is at an inflection point and valuation is cheap.

- FVE is the smallest of the “top tier” of public senior housing operators, and has so far escaped the attention of the broader investor community. Given the scant analyst coverage, the Street has not yet fully recognized that, even though FVE’s corporate life began when it inherited a portfolio of 52 distressed skilled nursing facilities from SNH (its erstwhile parent), it has since transitioned into being mainly (70%) an operator of the more attractive independent living and assisted living facilities (with significantly decreased Medicare/Medicaid exposure) that characterize the bulk of business for the company’s more widely-known public peers.

- Though FVE benefited from the run-up in senior living services over the last year as the sector came back into favor (SRZ, ACR, ESC, CSU gained an average of 88% over the last year, compared to FVE’s 58%), FVE has lagged the sector this year (down 10%, compared to the peer average gain of 11%). The stock’s recent underperformance can be traced to the lack of analyst coverage and investor community awareness, coupled with a secondary offering of 3.5MM shares in December 2004, which created dilution/overhang that has—to a great extent—resolved itself over the last six months.

- The company has recently swung to a free cash flow positive position, and continues to enjoy significant opportunities to drive incremental EBITDAR/cash flow by increasing occupancy rates and rents in recently acquired properties and across the rest of the asset portfolio. The LTA acquisition (47 communities with 2,636 independent and assisted living units across seven states) in September 2004 has been effectively integrated, with overall company occupancy rates and rents back up to the levels the company enjoyed prior to the acquisition (but there is still room for improvement in the LTA properties). The Gordon Health acquisition in June 2005 provides an opportunity to increase the occupancy rate in those six properties from current 85% to FVE’s average 90% occupancy, generating incremental EBITDAR of $1.5MM (even without accounting for the rent increases that would accompany the increase in occupancy). Management expects to complete the integration of these properties by the end of 2005. At the same time, the rest of the portfolio continues to see higher occupancy rates (the company aims to increase average company occupancy to 91% by the end of the year) and rents (management says it expects and is on track YTD to increase rents this year on the Sunrise-managed assets 4-5%, on self-managed assets 3-4%, on skilled nursing facilities 3% on the Medicare side and 1-2% on the Medicaid side, with a net increase across the portfolio of ~3-4%, driving incremental EBITDAR of $3-$4MM).

- Note, as an indication of management’s track record of extracting occupancy and rent increases from underperforming properties, that FVE has increased occupancy from 83% in 2000 to 90% in 2004 and EBITDAR from $10MM to $24MM in the 52 distressed skilled nursing facilities that it inherited from SNH in 2000 as its legacy assets. During this same time, by augmenting the legacy SNF assets with acquisitions of attractive independent and assisted living properties, the company has decreased its Medicare/Medicaid exposure from more than 80% of revenues to less than 37% and built a much more attractive company. In addition, on a same-store basis, company grew revenue by 5%, rents by 4% and occupancy by 1% in 2004. We believe that management ownership (~4%) in FVE is a key factor behind the team’s focus on making the necessary operational improvements to drive shareholder value.

- Additional upside comes from: the expansion of FVE’s institutional pharmacy business to additional company-owned facilities (saving cost) and to facilities owned by other companies (increasing revenues); expansion of onsite physical therapy/rehab services to 20 additional properties by the end of the year from the current 20 properties at which these services are currently offered, at $100K incremental revenue per property at 40% EBITDAR margins; and from additional acquisitions resulting from a robust pipeline (management has indicated that they intend to complete at least another “couple” of small acquisitions, and possibly a big one by the end of the year).

- Because FVE is at an inflection point in terms of its financial performance, its valuation—though perhaps not cheap based on depressed historical metrics—is extremely attractive based on conservative forward estimates. Our 2005 forecast is driven by a very realistic forecast of 1% improvement in occupancy (per management guidance) in the company’s existing facilities with a 2.5% increase in rents across the portfolio (below management guidance of 3%-4%)—management is extremely confident in its ability to meet these operational goals. Based on what we believe is an extremely achievable 2005 forecast, the stock is trading at a significant discount to its peers (a couple of which it is operationally outperforming) and is cheap by any absolute measure for a company at an inflection point in an industry with strong and growing fundamentals. Moreover, the only analyst covering the company has not yet updated his estimates to reflect the company’s June 2005 acquisition of Gordon Health, which is providing some of the upside in our forecast.


Peer Average FVE
2005 P/E 29.6x 8.9x
2005 EV/EBITDA 10.6x 5.5x
2005 Adj. EV/EBITDAR 10.2x 7.6x


$MM 2004A Q105A 2005E
Revenue $628.0 $182.5 $766.5
EBITDAR $90.4 $27.8 $119.7
EBITDA $7.0 $3.3 $21.4
EPS $0.38 $0.11 $0.91
FCF -$22.2 $1.4 $6.4


- Even without multiple expansion, FVE should move 50% from current levels to the $11-12 range (8.0x 2005E EBITDAR, 13.0x 2005E EPS) within six months as its quarterly results confirm the inflection story that is playing out in the company’s financial performance (one of the most promising signs of which is the FCF-positive Q1 2005). Multiple expansion to bring FVE in line with its peers would further propel the stock to the $16-17 range, or 2.1x current levels.

- Downside on FVE is minimal: an inexpensive 8.0x EBITDAR multiple/8.5x EBITDA multiple on annualized Q1 05 results yields a stock price in the mid-$7s (i.e., very near current levels), implying that investors are not currently giving the stock any credit for the inflection point in its trajectory. We believe the 50%-100% upside potential with minimal downside risk presents an extremely compelling risk-reward balance on an investment in FVE.


2) Strong (and accelerating) industry fundamentals.

- The macro trends driving the $50B senior living industry are compelling. The US population is aging (over-65 population of 36MM, estimated to grow ~1.5% annually to 2020), there is a significant Baby Boomer overhang, average life expectancy is growing, and the nuclear family setup creates the need for facilities where retirees can comfortably spend their twilight years with the requisite care and amenities. Moreover, the industry has currently penetrated only ~10% of the over-65 senior population, pointing to significant room for future growth.

- The senior living industry experienced a boom-and-bust in the 1990s, as too many companies went public, too much capital was deployed, and too much capacity was brought online. The result was price competition that eroded margins even as occupancy rates remained below profitable levels for most players. Aggressive off-balance sheet financing of start-up developments contributed to the round of bankruptcies and restructurings that began in 1999 and continued into 2003.

- However, the industry has stabilized in the last two years. A “top tier” of public companies has emerged: they are the survivors in this industry, with relatively clean balance sheets, strong operating positions, and the liquidity to make accretive acquisitions. This top tier of companies sits atop a largely fragmented base of numerous small operators lacking the necessary infrastructure to competitively manage a portfolio of senior living facilities. As these smaller players face restructurings and bankruptcies, their asset portfolios provide ample accretive acquisition opportunities for larger players to add high-margin incremental revenue.

- The newly stabilized industry benefits from the current mismatch between growing demand and relatively inelastic supply. As the demographic argument continues to increase demand for senior living services, tighter capital availability for new developments (higher equity requirements in light of the late 1990s fiasco) and regulatory requirements in some states for launching new facilities have slowed growth in the number of units available (number of units added annually since 2002 remains well below peak levels of 1999; in 2003, 28,696 units were added, representing a 56% decrease from 1999, and 32,184 units—a 49% decrease from 1999—were estimated for 2004). The mismatch between supply and demand trends has enabled the industry to drive rent increases of close to 5% annually since 2002 as move-in rates and occupancy rates have turned upwards from trough levels.

2003 Capacity Estimates (source: American Seniors Housing Association)

Independent Living (incl. Senior Apartments) = 1,500,910 units (36%)
Assisted Living = 633,956 beds (15%)
Skilled Nursing Facilities = 1,956,134 beds (48%)
Total = 4,091,000

- The difficulty of financing and gaining approval for new developments has led top tier players (and providers of capital) to focus on the acquisition of existing facilities, and turning those around by increasing occupancy rates and rents. The rising interest rate environment has put increasing pressure on struggling operators unable to meet their now-higher interest payments (most of the sector’s initial development was financed through variable rate financing), triggering a continuing wave of sales and foreclosures from which larger players can opportunistically pick off attractive assets. At the same time, the rising interest rate environment positively impacts industry fundamentals by enriching the senior citizen customer base (which derives a great portion of its income from fixed income investments).

- The different segments of the senior living industry vary widely in terms of their economic attractiveness. Since its spin-off from SNH, FVE has dramatically reduced its exposure to the relatively unattractive skilled nursing segment (<30% of units) and grown its portfolio more towards independent living and assisted living facilities (>70% of units). While skilled nursing facilities are mainly paid for by government sources, independent living and assisted living facilities derive the majority of their revenues from private payors and hence command higher margins (even though skilled nursing facilities command higher absolute rates due to the level of service required). In addition, skilled nursing facilities are exposed to changes in government reimbursement levels and policies, which creates significant uncertainty as to future revenues and generally poses more downside than upside as the government tightens its budget.

- While FVE’s peers tend to own the majority of their properties, the majority of FVE’s are leased/managed, not owned, so the company captures the spread between its own lease payments and on the rents that it collects from residents. We believe that this is a net positive: the sale-leaseback arrangements have resulted in a healthier balance sheet than any of its peers (with the exception of SRZ), and the majority of leases—while long-term—require FVE to pay a percent of the increase in rental revenues over a “base year” (“base year” defined as 2005 for most properties, with the bonus percent-of-increase payments due to begin in 2006), an arrangement that we view as a good way to mitigate the risk of declining rental rates.


RISKS/ISSUES

- Medicare/Medicaid exposure. 37% (and decreasing) of FVE’s revenues are exposed to Medicare/Medicaid reimbursement. The next round of Medicare revisions will not occur until the summer of 2006; in the meantime, the most recent round of revisions has resulted in a net 3% increase in reimbursement rates for the company this year. Medicaid changes vary from state to state, and management has told us that they expect a negative impact in some states offset by positive changes in other states, with a net 1-2% increase in reimbursement rates for the year.

- Related-party transactions (synergistic benefits notwithstanding). FVE was spun out of Senior Housing to manage a portfolio of distressed properties. The two companies have overlapping boards, with representation from RMR, the holding entity that also controls Senior Housing. RMR related-party transactions include: right of first refusal on financing FVE’s real estate acquisitions, fund capital improvements etc. through increases in lease rates; workers comp insurance done through a RMR subsidiary, which was subsequently brought in-house at cost; CEO and CFO are also employees of RMR and divide their time b/w the two; Managing Directors of FVE are also owners of RMR; RMR allowed to act on behalf of Senior Housing in case of conflict of interest b/w Senior Housing & FVE; and RMR receives 0.6% of revenues as fee for mgmt & admin services. However, note that all transactions b/w RMR and FVE require approval of independent directors; we also believe that FVE’s relationships with RMR and SNH provide synergistic benefits, not least of which is access to a ready source of financing for acquisitions.

- Exposure to a potential housing bubble. Senior citizens obtain a great portion of their funds from equity recovered through the sale of their homes. In the event that housing prices decline, that would affect the target customer base’s ability to afford senior living facilities and might encourage senior citizens to hold on to their homes for a longer period of time and therefore delay relocation into senior living facilities (impacting both occupancy rates and rents).

- Properties could be more geographically concentrated. FVE has not been as effective as some competitors (e.g., SRZ) in clustering its facilities. Clustering makes it easier to retain customers by upselling and serving senior citizens throughout the customer lifecycle (e.g., when a senior citizen graduates from independent living to assisted living, FVE can lose those customers because it doesn’t always have independent and assisted living facilities in the same locales).

Catalyst

- Upward revision of earnings estimates from the only analyst following the company, to reflect full accretive impact of June 2005 acquisition.

- Additional analyst coverage/investor community awareness (company has been aggressively courting analysts, in particular Jefferies, and getting its story out there).

- Strong near-term earnings announcements, demonstrating continued ability to increase occupancy in acquired properties and drive rent increases across the board.

- Additional acquisitions (company plans to do at least another couple of small acquisitions this year and possibly one large one).

- Acquisition by a larger player.

- Achieving visible levels of contribution from pharmacy/rehab businesses.