Sunrise Senior Living, Inc. SRZ
November 03, 2008 - 5:45pm EST by
upgrayedd11
2008 2009
Price: 3.52 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 180 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

Sign up for free guest access to view investment idea with a 45 days delay.

Description

Two certainties that I believe we can agree on are 1) the US population is aging, and 2) an aging population requires a significantly heightened amount of health care.  Sunrise Senior Living (SRZ) will, over the next 5-10 years, be one of the greatest beneficiaries of these trends making this the single best play on the baby boom generation.  SRZ is a provider of senior living services including owning, developing and managing senior living assets. 

 

SRZ operates in 5 core business segments:  

Segment Description
Consolidated Properties 65 communities with 8,940 units.  Approximately half are leased.  SRZ owns NOI.
JV properties 206 Properties with 23,027 units that are approximately 18% owned by SRZ (SRZ owns ~18% of NOI).  These are typically properties that SRZ developed with a healthcare reit partner.  SRZ has management contracts with all of these properties.
Management Business SRZ manages 174 properties that are not in JVs as well as all of the JV properties.  They receive approximately 6% of revenues under management as a fee and all direct costs are reinbursed.
Professional Fees Comprised of fees received for services provided prior to the opening of an unconsolidated community.  These fees are related to the building, design and construction oversight.
Construction in Progress Properties on balance sheet that have not begun lease-up.
 

SRZ’s communities are high-end facilities with a range of services at each facility averaging approximately 69% assisted living (26% of which is memory care), 7% skilled nursing and 24% independent living.  Assisted living and skilled nursing services are for high acuity residents and are the least discretionary offerings.  On the other hand, independent living caters to a younger healthier senior so is more discretionary, offers fewer services, and tends to be more economically sensitive. The JV communities tend to be higher quality than the owned communities as reflected in average daily rates of $170 and $146 respectively.   The average resident is 80-85 years old and has an expected stay (and life expectancy) of 12-24 months reflecting the severity of their health conditions. With 76% of residents qualifying for non-discretionary care, the demand base for SRZ’s business is highly stable.

 

The best way to value this business is through a sum-of-the-parts NAV.  To cut to the chase, a very conservative NAV analysis ignoring future growth opportunities, jacking up cap rates from recent transaction levels, and assuming current challenging operating conditions hold, suggests that SRZ is at a minimum a double from here and over the next 2-3 years may triple or better.

Sunrise Senior Living - Net Asset Valuation (NAV)   
(In thousands except per share data)
Consolidated Properties
Resident capacity (owned and leased) 8,940
Occupancy rate (Q2 same community) 90.7%
Average daily rate (Q2 same community)(1) $146.38
Days 365
Revenue $433,231
Facility Operating Margin (excl mgmt fee) 25.1%
Management Fees Paid @ 6%                                 -  
Maintenance Cap Ex                          (13,410)
Estimated Cash Flow $95,299
Capitalization Rate   8.0%
Pre-Capex and Management Fee Capitalization Rate   9.1%
GAV/ Share   $23.37
Estimated Value Per Unit of Resident Capacity $133,249
Stabilized JVs 
Resident capacity (owned and leased)                           15,763
Occupancy rate (Q2 same community) 89.6%
Average daily rate (Q2 same community)(1) $170.35
Days 365
Revenue $878,177
Facility Operating Margin (excl mgmt fee) 33.8%
less G&A allocation
Management Fees Paid @ 6%                           52,691
Maintenance Cap Ex                          (15,763)
Estimated Cash Flow $228,639
Capitalization Rate 7.0%
Pre-Capex and Management Fee Capitalization Rate 9.1%
Total JV value $3,266,274
Estimated Value Per Unit of Resident Capacity $207,211
SRZ Ownership 18.0%
SRZ share of JV Value $587,929
JVs in Lease-Up
Resident capacity (owned and leased)                            7,264
Occupancy rate (Q2 same community) 89.6%
Average daily rate (Q2 same community)(1) $170.35
Days 365
Revenue $404,687
Facility Operating Margin (excl mgmt fee) 33.8%
less G&A allocation
Management Fees Paid @ 6%                           24,281
Maintenance Cap Ex                                 -  
Estimated Cash Flow $112,627
Capitalization Rate 9.0%
Pre-Capex and Management Fee Capitalization Rate 10.9%
Total JV value $1,251,410
Estimated Value Per Unit of Resident Capacity $172,276
SRZ Ownership 18.0%
SRZ share of JV Value $225,254
Ownership Interest in Joint Ventures
Equity value in joint ventures   $813,183
GAV/ Share   $15.95
Operating Management Business
Revenue under Management
JVs (Q2) 288,800
Managed Only (Q2 annualized) 225,800
Total 514,600
Management Fee % 6.0%
Management fees 123,504
Operating Margin on management fees 43%
Management operating Income 53,107
Multiple on Operating Income 12.0x
Equity Value   637,281
GAV/ Share   $12.50
Construction in progress(2)
Balance Sheet Value $198,007
Assumed Value   100.0%
GAV/ Share   $3.88
Estimated Value Per Unit of Resident Capacity $183,340
Gross Asset Value of Portfolio/ Share   $55.7
Liabilities
Cash + IRS settlement (140,578)
Funded Debt 302,299
Other Liabilities 60,300
MI 14,850
Total Balance Sheet Debt 236,871
Lease Valuation
Owned communities
Lease Expense (annualized) and grown 60,876.8
Cap Rate 7.5%
811,691
Off Balance sheet debt
Total JV debt 4,075,993
Share of JV debt 18.0%
733,679
Total Net Debt 1,782,240
Debt/ Share   $35.0
G&A 50,000
Cap Rate 8.0%
Capitalized G&A 625,000.0
G&A/ Share   $12.26
Total liabilities/ Share   $47.23
False
NAV (pre G&A)   $20.75
NAV (post G&A)   $8.48
Note: Analysis is modified from Stifel Nicolaus analyst, Jerry Doctrow, SRZ model.
(1) Equivalent of daily rent + ancillary fees such as extended care.
(2) Assumes an additional $30 million of write-downs for abandoned development projects.
 

Valuation Explanation – Choosing Cap Rates

  • Recent Deals
    • The value of SRZ’s real estate ownership interest as well as the premium SRZ-managed assets earn in the market is evident in a variety of deals that have closed in recent years, including a deal that was recently terminated but still provides a relevant data point.  Today’s capital markets have changed dramatically and suggest cap rates have moved upwards from the lows seen in 2007.  How much they should move is a function of borrowing costs, availability of debt and equity capital, and fundamentals at the property level.  The good news for Sunrise is that debt capital for senior housing remains available from FNM and FRE, health care REITs continue to demonstrate an appetite for senior housing assets and their cost of equity as measured by stock prices has remained firm, and this needs-based business has performed well despite a challenging economy.  While cap rates are undoubtedly moving up, the magnitude of the move for senior housing assets will be mitigated by the defensive nature of the cash flows, and the relatively steady availability of debt and equity capital.
    • Recently deals involving SRZ assets likely represented high points for market pricing, but they provide good benchmarks against which any estimate of the warranted change in cap rates should be measured.  Furthermore, the cap rates employed in our analysis are significantly higher and are applied to NOI after applying a reserve for capital expenditures, and management fees where relevant, to err on the conservative side.
Arguably the low cap rates for the property type in recent years have been partly driven by the pricing power evident in the business, which despite deceleration has remained at above- inflation levels and will re-accelerate along with an economic recovery.  An appropriate cap rate should reflect forward looking NOI expectations beyond the next twelve months.
 
Buyer Seller Total Deal Price Properties Units Price per unit 12-month forward Cap Rate (1) Anncd
HCP (2) CNL 5,200,000 107 12,000 182,000 6.8% May-06
Ventas (VTR) Sunrise REIT 2,100,000 74 6,000 350,000 6.0% Jan-07
Health Care REIT (HCN) (3) Arcapita 715,000 29 2,000 343,000 6.7% Sep-08
SRZ NAV Cap Rate Employed 
Wholly Owned         133,249 9.1%
Stabalized JV        207,211 9.1%
Lease-up                172,276 10.9%
(1) Cap rates are based on NOI estimates excluding a reserve for capital expenditure and prior to management fee payments.
(2) HCP/CNL deal included various non-sunrise operated senior housing assets and a portfolio of medical office buildings. 
For senior housing, price per unit allocation provided by HCP management.
(3) Deal terminated on October 31 due to "market conditions".
 

 

  • The valuation analysis above ignores upside from the following:
    • Professional fees collected through new community development
      • 2007 professional fees were $39 million and at a conservative 20% margin and 10x multiple should represent up to another $1-$2 in per share value.
    • Value of having a system in place to develop top tier retirement communities as the population ages and assisted living becomes more acceptable (% of senior users to increase)
      • SRZ is the only major developer-operator in the market, a skill set that will warrant a premium when the market improves.
    • Implicit in a current period NAV is that the business will never move forward from its current state as you apply cap rates to current NOI however:
      • Opportunity over the long term exists to raise price exists as the credit crunch has halted supply which means an imbalance will be in the cards when demand growth returns.  Moreover, occupancy upside exists, primarily from leasing up independent living units that have been more adversely affected by the slowing economy.
    • The company has further opportunity to lower G&A beyond the $120 million guidance it has given the street.  As the company slows down additional development and deals with non-core assets, further G&A savings are possible.
    • THIS ANALYSIS IS A WORST CASE SCENARIO.  UPSIDE COULD COME FROM BETTER NOI THAN I AM ESTIMATING THROUGH BETTER OCCUPANCY OR RATE GROWTH, OR FROM LOWER CAP RATES THAN I ESTIMATE.  IF CAP RATES SETTLE AT A MIDPOINT BETWEEN RECENT TRANSACTION COMPS AND THE HIGHER LEVELS ASSUMED IN MY NAV ESTIMATE, SRZ'S NAV IS ROUGHLY $15 PER SHARE.  THE RELATIVE STABILITY IN THE CAPITAL MARKET FOR SENIOR HOUSING DUE TO THE CONTINUED ROLE OF FNM AND FRE ON THE DEBT SIDE AND THE PUBLIC REITS ON THE EQUITY SIDE SUGGESTS THIS BULL CASE CAN BE ASSIGNED A HIGH PROBABILITY.  LOOKING OUT 24-36 MONTH, FAIR VALUE COULD EASILY GROW TO OVER $20 PER SHARE SHARE WHEN DEMAND EXCEEDS SUPPLY PROVIDING A BOOST TO PRICING POWER AND OCCUPANCY.

Why this company is misunderstood

  • These stocks are often compared to home builders (most notably by Jim Cramer which I feels proves my point by itself) but I will try to defend further:
    • Investors do not understand the extent to which these services are non-discretionary.  Assisted living residents do not have the luxury of choosing whether they need specialized care; many of them are near blind, suffer from dementia, or can not use the bathroom unassisted.  They require skilled care to complete routine activities safely.  SRZ has the highest level of acuity care of any of the national players and while their residents do have a choice, it’s note whether they need care, but who provides it, and they basically have two other legitimate alternatives.  They can move in with a family member, who will have to forego work to provide assistance, and may not have the space, patience, skill, or emotional fortitude to care for their frail loved one.  Or they can hire a private nurse; a low end caretaker who works 8-hour days for 7 days a week will cost nearly $4,000 per month.  The cost of an at home nurse is similar to the cost of an assisted living facility which includes virtually all living expenses, includes 24-hour surveillance, and provides care in a purpose built facility.  Which option makes the most sense?
    • Providing care is not a commodity.  Facility management is labor intensive, requires a culture of care, and determines the success in resident care and attracting referrals.  SRZ has a fantastic reputation in the industry at managing facilities and that is why they are the major national source of these services.  A change in a facility manager can mean the difference between 85% and 95% occupancy.  In this environment, I want to own the best in class manager of facilities.
  • It is a fallacy that this age group is as economically sensitive as the rest of the population.  These seniors typically have no mortgage debt, or rent already, and hold conservative portfolios of financial assets with low equity exposure.  While seniors in weak housing markets might have trouble selling their home immediately, these seniors often can not live in their home alone, and whether they are making a good economic decision to sell is irrelevant when life expectancy is measured in months.
  • The concerns over a potential bankruptcy are wholly unfounded.  I discuss this in more detail below under “risks”.
  • The story is not simple and clean.  There is no 1-pager to explain all that is going on with this company (although I tried through the NAV on page 2).  The financials are not investor friendly, do not capture the true economics of their assets held in joint ventures, and the income statement according to GAAP is basically useless in assessing value.  Recent restatements have not helped confidence.  I consider all of this opportunity leading to a massively misunderstood company.

 

Management

  • Mark S. Ordan was appointed CEO of SRZ on November 2, 2008 after starting with the company as Chief Investment and Administrative Officer at the end of March 2008.  Prior to joining SRZ, Mark was the CEO of The Mills Corporation, where he oversaw the eventual sale of the company to Simon Property Group and Farallon in May 2007.  Previously, he founded and was CEO of Fresh Fields Markets, which was later sold to Whole Foods Markets.  Mark’s deep real estate and operational knowledge are a fantastic fit with SRZ.  Coincidentally his compensation is likely to include at health dose of stock options which should be struck before or around the Q3 earnings call on November 7th, 2008, providing a strong incentive to start making progress.
  • SRZs former CEO is Paul Klaassen, who founded the company.  Paul is billed as a visionary in the industry, but his expansionary tendencies led to poorly performing acquisitions, expansion into non-core businesses, and out-of-control G&A spending all of which are expected to be reigned in under the current regime.
  • The change in management is a key catalyst that paves the way for my thesis to play out.

 

Risks

  • There is a near term risk that occupancy declines precipitously in the next twelve months due to current economic conditions.  I believe that SRZ is more than priced for this move as occupancy would need to decline OVER 10% to justify current valuation using my already highly conservative assumptions (only change from page 2 of analysis is to drop occupancy to apx 80% from current levels).  If you think senior finances are going to get that bad, your situation will be even worse and you should consider moving out of equities entirely and potentially moving out of the United States.  This scenario is highly unlikely, is indicative of how low expectations have fallen, and suggests that a fair amount of bad news is priced into the stock.
  • There is evidence of promotions in the channel that have lowered the average daily rate growth.  Average daily rate growth has dropped steadily from 8.0% in Q3 07 to 5.4% for Q2 08 in consolidated communities and from 6.8% to 5.5% for JV communities.  These promotions are real but our channel checks indicate that they are generally on the margin and industry veterans continue to support the thesis that rate growth will continue.
  • A lot has been made of liquidity concerns around SRZ’s line of credit.  I’d like to address that directly here:
    • Given the degree of uncertainty in the capital market, a primary concern is how the company will handle line of credit negotiations with its lead lender, Bank of America.  Sunrise is currently in violation of debt covenants based on a variety of impairments and other charges that have been or will be taken as the company restructures operationally and right sizes the development pipeline and personnel.  The bank line doesn’t mature until December 2009 but Sunrise will likely remain out of compliance beyond the period contemplated by their recent waiver received in July that relieves the company from compliance through September.  Notably, the line of credit was established in December 2005 so the lender has patiently worked with Sunrise throughout the company’s two year saga of restating financials, and through the recent spate of financial charges in exchange for modifying various terms and charging various fees.  It is fair to assume they will remain accommodative at least until the final maturity date at the end of 2009 when SRZ, under the helm of a new executive management with a leaner cost structure, smaller development exposure, and more defined focus, will be a much different company. It’s important to remember that the company is current on its obligations, has no bondholders, the amount outstanding on the line is modest relative to the enterprise value of the company, and the charges being taken, especially non-cash charges due to abandoned development costs, will be accompanied by lower expenditures and improved retained cash flow on a look forward basis.
    • In terms of liquidity, a variety of options are available to the company, and they will likely address these on the next call to be held on Friday, November 7.  In addition to land parcels and interests in operating real estate that can be monetized, the company is owed a cash settlement from the IRS of $63 million, a portion of which is expected to be recognized before year end.
    • Moreover, the best way for Bank of America to recover their $100 million as soon as possible, assuming they want to closeout this relationship, is not bankruptcy.  In a bankruptcy scenario, maintaining occupancy and keeping facilities staffed becomes more challenging and potentially impairs an otherwise sound core business.  A more likely scenario if Bank of America decides to terminate the bank line is to restrict uses of cash such that every available dollar gets funneled toward repaying the line until the liability is paid off which is probably an acceptable, albeit less than optimal, outcome for shareholders. 

 

 

Industry Dynamics

  • The senior living industry is highly fragmented and characterized by numerous local and regional operators.  There are only a few national players.
  • The primary market for senior living services is individuals age 70 and older
    • With a higher than average acuity resident, SRZ specializes in the older end, typically 80-85.
    • The population 85+ in the US is growing 3x faster than total US population (4.2M in 2000 to expected 6.1M in 2010).
  • A 10% increase in the number of seniors would equal more than the entire supply of senior housing.
  • In 31 largest MSAs 9.6% of the senior population lives in senior housing properties.
  • Much of existing supply is old, institutional and poor quality.
  • There is a 5-year lead time from site selection to stabilized development.
    • Current development has crawled to a standstill.  As the population ages there will be a massive undersupply of senior housing.

 


 

Comparison to 1999 Industry Explosion

Some may remember that in 1999 there was a major shake-out in the senior housing industry.  This occurred as a result of dramatic overbuilding, and had an adverse effect on occupancy rates and the resident fees of certain senior living providers resulting in widespread financial trouble for the sector.
 
Long Term Construction Trends (000 of units)
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Units 46 51 66 35 29 21 29 32 32 32
 

 

  • Supply has been much more restrained this time around for a variety of reasons:
    • Construction costs have skyrocketed due to the commodity boom.
    • Land prices soared in recent years particularly in the high barrier markets  that SRZ targets.
    • More recently the credit crunch has brought new construction to a standstill and given the long lead time, the industry will likely be characterized by undersupply for the next 3-5 years.
    • Based on data provided by Stifel Nicolaus, new unit deliveries in senior housing in August and September of 2008 was roughly 2,500 units per month.  By this time next year, unit deliveries are expected to average between 500 and 1,000 units per month, a steep drop.  So long as financing remains challenging, the supply dynamic will remain favorable.

 


Non-Core Businesses and International

  • Sunrise has a number of businesses I deem non-core relative to their expertise as an owner, operator and developer of senior housing.  Non-core subsidiaries include Trinity, Greystone and German operations.
    • Trinity is a provider of hospice services.  While hospice can be a profitable service, the company has yet to make a positive contribution to Sunrise’s results.  Our model attributes no value to this business. 
    • Greystone is a third party developer and manager of Continuing Care Retirement Communities (CCRCs) on behalf of non-profit organizations (Greystone does NOT own real estate).  Greystone’s contribution to the bottom line is understated due to GAAP accounting treatment of projects under development, however measuring the profitability of the company is challenging using current disclosure and I attribute no value to the business. 
    • Germany has been a sore spot for the company with its nine projects having underperformed expectations.  The development agreement with their partner requires Sunrise to fund shortfalls relative to underwritten expectations which has been a costly arrangement.  The company has funded $37 million through June 30 and expects to fund an additional $62 million through 2012 and has a liability on balance sheet to reflect this estimate.  In September, the company paid $4.4 million to their partner for the option to buy them out.  They expect to complete that buyout in early 2009 and will subsequently have greater flexibility to restructure the debt associated with the assets and extricate themselves from the current arrangement.  Our valuation reflects the liability as estimated by the company, though I expect that a restructuring will result in a more favorable outcome for shareholders.

Catalyst

SRZ reports earnings November 7 at which time they will likely demonstrate their liquidity and core business strength.
    show   sort by    
      Back to top