Description

Senior Housing Properties Trust (SNH)

There are two significant corporate events pending with this elderly care properties REIT currently (a major acquisition and a spinoff). As a result, I believe it is inefficiently priced right now, offering about 27% upside. This value discrepancy should be cleared up over the next couple of months upon completion of pending transactions. There is very little deal risk involved.

The 27% gain I expect is a near-term target of $15.50 on the stock (8.5% yield based on 2002E dividend of $1.32), plus a spinoff on 12/31 worth at least $1 per share, plus a 30 cent regular dividend in January ($16.80/13.20 = +27%).

Vital Signs (pro forma for pending transactions where applicable)

Price 13.20 Pro forma debt 492.4mm
Shares 43.4 Pro forma assets 1,116 mm
Mkt Cap 566mm pro forma book 581.5 mm

Pro forma LTM Rev 123.8 mm
Pro forma LTM EBIDA 116.1 mm
2001e FFO $1.47
Pro forma 2001e FFO $1.61
2002e FFO $1.80 [7.3x]
Current dividend $1.20 [9.1% yield]
Pro forma 2002e div $1.32 [10.0% yield]

Background

SNH is a REIT that owns 86 assisted living facilities. It was spun out of HRPT Properties (HRP) in 1999 and HRP retains a 30% interest in SNH. Most of the properties are moderate care assisted living – a few are nursing homes. About 80% of patients are covered by Medicare/Medicaid. The balance are private payors.

In August 2001, SNH announced the acquisition of 31 senior housing facilities managed by Mariott from Crestline (CLJ). This acquisition will significantly change SNH’s portfolio. Senior living facilities attract predominantly private-pay tenants. The pro forma payor mix is 79% private, 21% Medicare/Medicaid on 117 properties.

The acquisition price is $600 million representing 8.4x 2001E Ebida for properties with double digit LTM Ebida growth. It is being funded by a 14mm share SNH secondary offering completed in October at 12.90 per share (led by UBS Warburg) and a 200mm 8 5/8% senior notes offering completed in December (UBS Warburg again). The CLJ shareholder vote occurred on 12/13 and the deal is scheduled to close in late January (although SNH is urging them to close ASAP because of the negative arbitrage on the financings.]


SNH + Crestline properties

As noted above, the acquisition of the Crestline properties diversifies and improves SNH. The stock moves from small-cap to a solid mid-cap and should get some more sell-side coverage (eg, we haven’t heard from UBS Warburg lately). SNH also goes to a more optimal leverage ratio (43% debt-to-capital) which will offer more operating leverage yet not preclude future acquisitions.

The acquisition is smartly accretive with 2002e FFO jumping to $1.80 from $1.47 in 2001 (22% growth). Obviously, this will translate into a higher indicated dividend than the current $1.20 per annum. This will be addressed in early Q2, the January 2002 dividend will be 30 cents. I figure that at least half of the FFO gain will be added to the yield, indicating $1.32 (33 cents/quarter). This industry-low 70% payout suggests a safe dividend and ample leftover investment capital.

SNH will stack up well against its comparables. A universe of heath-care and senior property REITS [VTR, NHP, NHR, HCP, HR, HCN] for yield-seeking investors pays an 8.4% yield and trades at 9.6x 2002e FFO, with average FFO growth of 7% from 2001 to 2002.

SNH Positives: SNH has pro forma 2001-2002 FFO growth of 12% well the above-market. Plus we can count on a hike of the dividend and increased analyst coverage in the near term.

SNH Negatives: Some potential investment concerns might be 1) the HRP ownership overhang; 2) externally-managed structure with high exposure to Marriot; 3) perennial Medicare reimbursement issues that always dog assisted living.

On balance, I think SNH can easily trade to a 8.5% yield, suggesting $15.50 per share. This is well below the group FFO multiple [8.6x vs. 9.6x].

PLUS, YOU GET A SPINOFF FOR NUTHIN! . . .

Spinoff of FVE.

On December 31, 2001, SNH will spin off Five Star Quality Care (FVE) in a 1 for 10 distribution. FVE operates certain of SNH’s properties and will serve as the “tenant” on SNH properties externally-managed. This spinoff is necessitated by the REIT rules and ostensibly to cure some conflicts of interest. The spin is not purely tax-free, but a fair tax basis will be allocated to FVE shares, making it at least partially a return of capital.

FVE is capitalized with $50 million of book value (including $31.9 of cash) and no funded debt. Along with 4.34 mm basic shares, 250,000 shares have been awarded to the managers, Barry Portnoy and Gerard Martin. So on 4.6mm shares, you have $10.86 of tangible book and $6.93 of net cash. You also have at least $1mm of projected net income on $482mm of pro forma revenues.

This write-up concerns SNH, and FVE only by extension. I invite someone else to write up FVE in more detail but will offer my investment positives and negatives to support the case that FVE is at least $1 worth of “dividend” on SNH.

FVE Positives: $10.86 per share (over $1 per SNH share) initial capitalization. About 8mm of SNH pro forma EBITDA was deemed transferred to FVE in the SNH pro formas, suggesting that one day soon FVE can earn more than its pro formas suggest. Opportunity to benefit from the continued improvement of certain properties recovered by SNH upon tenant’s bankruptcies (Integrated, Mariner, Genesis) managed by FVE. Opportunity to benefit from greater tenant reveues generated on the externally managed properties. Opportunity use excess cash and borrow against considerable receivables to take on management of other properties. Seasoned management with 5%+ of stock.

FVE Negatives: Very small cap. Very poorly distributed (not only will SNH holders get 1 for 10, but HRP will distribute its shares in a 1 for 100 distribution!). Conflicts of interest still exist (principals will still own a private management company which gets well paid as an external advisors to SNH and FVE).

FVE could of course trade well under book value, in which case, I would hold on to this “dividend” and see what kind of operating plan develops.

Conclusion

SNH looks like a classic mis-priced “event stock” right now. Yield seeking investors stay on the sidelines while the acquisition is pending, creating an opportunity. The market assigns no value to the spinoff of FVE. There is an arbitrage here that should trade for a smidgen of return in an efficient market given the low deal risk. Instead, it offers a very fat potential return over a short timeframe.

Catalyst

Closing of Crestline acquisition; spinoff of FVE; raising dividend; more analyst coverage