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:  

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.

• 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 7^th, 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

Catalyst