Description

Sunrise Assisted Living (SRZ) is a classic case of the baby being thrown out with the bath water. Over the last few years many assisted living companies have either gone out business or are on life-support with over-extended balance sheets and dismal prospects of attracting capital. Not surprisingly, the best player in the industry with exceptional management, a strong balance sheet and ever-increasing net income and cash flow has seen its share price languish well below liquidation value. The company is trading at well under 50% of its intrinsic value and can easily be a double within the next 1-2 years.

An Introduction to Sunrise

Paul and (his wife) Terry Klaassen started Sunrise over 20 years ago. They were the pioneers of the industry. At the time, there was no concept of senior assisted living. Paul is still very much engaged as CEO and is deeply in love with the business. Their focus on being the best and doing the very best for their residents clearly shows. They now have over 200 communities all over the US with a rapidly expanding network in Canada, UK and Germany. They have over 70 properties currently in development.

Some salient facts:

- Sunrise clusters its facilities in the top 20 largest metropolitan areas in the country with 6-25 properties per cluster. This makes it more efficient to manage, staff and grow the entire area. They have been selling or closing stray properties outside these clusters.

- Since 1998, development of new assisted living facilites has dropped off dramatically due to the poor health and over-extended financials of most players. During this period of pain for the industry, Sunrise has continued to grow at a steady clip. They expect to open 20 new homes this year and 25-30 homes in 2003.

- Assisted Living costs $60-150/day. 99+% is private pay – typically by a son or daughter living close by. This compares very favorably with home care which runs $60-400/day or nursing homes which run $100-400/day. The Sunrise facilities have three types of residents – Assisted Living, Higher Acuity Assisted Living and Alzheimer’s/Dementia Care. As residents move through these stages, the daily rate rises. Their typical homes can accommodate all three.

- Sunrise is probably the best in the industry in site selection. They carefully study income and age demographics and base home accordingly. As an example, the one facility near my house is 1 block from a strip mall anchored by a large grocery store and 24 hour pharmacy. Its next door to a 24-hour emergency care clinic and surrounded by high-income residents (able to afford SRZ type facilities for aging parents).

- Over the last 21 years, SRZ has perfected its typical model unit. They are quaint Victorian architecture with pleasing views and well-appointed rooms and common areas. Beautiful landscapes, nice porches and balconies adjoining the rooms etc. This is in stark contract to many AL providers with their high-rise non-descript structures.

Sunrise has two distinct recurring revenue streams:

1. The Sale-Long Term Manage Back Process of Mature Properties
2. The long-term management contracts at its Sunrise-branded homes and elsewhere.

1. Sale- Long Term Manage Back Economics

It costs about $11 Million to build a typical Sunrise facility. This is typically funded with $2.5 Million of equity and $8.5 Million of debt. It takes 12-18 months to stabilize a property and get it at the target 90+% occupancy level. Start-up losses and pre-development expenses are typically $700,000, for a total cost of $11.7 Million.

Typical sale price for this property is $16 Million, leading to a net pre-tax free cash flow of $4.3 Million or a 172% pretax return on the investment. Sunrise typically retains a 20% residual interest in the property upon its sale, so cash proceeds are about $12.8 Million, which releases about $4.3 Million in cash after each sale. So for every 2 properties sold, 3-4 new ones can be built from the cash generated.

Start-up losses and pre-development costs are expensed as ordinary expenses. Hence net income is artificially low as a result. As Sunrise slows down its building activity, net income will rise significantly. Since they build 20-30 homes a year and expect to sell a similar amount each year, income from sales-manage back contracts is expected to hover around $60 Million for the next few years or nearly $3/share.

The sales are recurring to the same buyers while always adding new ones. Buyers are very blue chip – Calpers, GE, Prudential etc. And they keep coming back to buy more homes. Good model.

2. Long-term Management Contracts

While historically the sale-leaseback gains have driven earnings, long-term Sunrise expects most earnings to come from management contracts. This segment's EPS is growing at over a 25% annual rate. The growth comes from:

1. Development of New Properties
2. “Reflagging” of existing properties to the Sunrise brand
3. The emerging “Sunrise At Home” care services
4. Management contracts on Third-party owned AL facilities
5. Annual price increases per resident.

The EPS history of the Management Division is as follows:

2000: $0.59
2001: $0.79
2002: $1.01 (expected)
2003: $1.29 (expected)

With an average resident stay of 2.5 years, an ever increasing senior population and the continual addition of new properties and customers, historical EPS of this division has grown at a 29.8% CAGR. It is expected to continue posting atleast a 20% annualized rate of growth for the next few years.

Valuation:

Here is the recent history of sale-manage back deals:

1. 9/30/02 – Sold for $196M; Book Value: $138M – 42% premium to book
2. 8/5/02 – Sold for $17.5M; Book Value $9.7M – 80% premium to book
3. 7/1/02 – Sold for $29.7; Book Value $18.3M – 62% premium to book
4. 5/25/02 - Sold for $197M; Book Value $137M – 43% premium to book
5. 8/31/01 - Sold for $86M; Book Value $67M – 28% premium to book
6. 12/28/00 - Sold for $131M; Book Value $77M – 70% premium to book

On average, per the company, the premium to book has been 53% pre-tax.

Sunrise has $772.4 Million is Property and Equipment on its books as of 6/30/02. Nearly all of this is related to their 200+ communities. Real book value is understated by $309 Million or $13.55/share. Sunrise’s tangible book value is $19.31. Real book value is $32.86

There may be some debate here on real book value as its unclear whether the most pristine properties have been sold with the dogs being on the balance sheet or whether properties sold are a mirror image of the portfolio. Since all the deals have been at significant premiums to book it seems to lend credence to the premium theory. Also, during the last call, sunrise dumped 2 non-strategic homes (one in Nebraska was the only one there, for example) and both netted about book value. The company considered these underperforming and non-strategic and also reaffirmed that the vast majority of its portfolio does not fit this description.

The Management Services division is basically a people business with very little in terms of assets. It can be valued simply on a multiple of earnings. 2003 EPS attributed to the management services division is $1.29. If one attaches a multiple of 15-20 to this it would be below growth rate with a PEG ratio below 1.

So the management services division is worth $19.35 - $25.80 per share. Adding in the $32.86 in book value yields a valuation of $52.21 - 58.66 or $1.2-1.4 Billion.

Stock Buyback

Sunrise Management is very frustrated with their stock price and has resorted to substantial buybacks. They just announced another $50 Million share buyback. If they retire another2 Million shares (as announced), intrinsic value jumps to a range $57.69-$66.20 per share

Cash Flow based Valuation:

Management has guided 2003 EPS of $2.57 to $2.65 per share. Historically, they’ve always beaten guidance. Depreciation will be $25-30 Million or $1.09-1.32 per share. The depreciation is artificial (as their properties are appreciating, not depreciating) and needs to be added back to get to real free cash flow. In addition, startup losses of $200K/unit also depress earnings by $4-5 Million or 0.20-0.25/share.

2003 FCF plus startup losses add back is expected to be $3.86 to $$4.22.

Sunrise is worth atleast 13x cash flow given its stable growth model – which yields a valuation of $50.18 to $54.86 which is pretty close to the $58-66/share based on the previous method (book value + management services). Hence it’s a pretty good bet that intrinsic value is somewhere between $50 to $66 per share – which is a nice discount from its present $22/share price.

Margin of Safety:

You’re buying for below real book value and get the management services business for free. Conservative Balance sheet. No high leverage here and very prudent shareholder oriented management. Plus the buyback. I cannot see a downside.

Catalyst

Value is its own catalyst. As the company continues to deliver quarter after quarter the street will learn to ascribe it an appropriate valuation. I do expect it to take 1-3 years, but even at three years, you’re looking at a very healthy annualized rate of return.