M&A Market Update for assisted living, independent living, memory care, skilled nursing facilities and continuing care retirement communities:
Originally Published in the February 2017 Issue of The SeniorCare Investor
Three years ago this month, Brookdale Senior Living (NYSE: BKD) announced its acquisition of Emeritus Assisted Living (NYSE: ESC). At the time of the announcement, Brookdale’s shares traded around $27.00, and trended up another 50% over the next 14 months with all the excitement of unrealized real estate value. The shares are now closer to $15.00. Recently, Goldman Sachs, Brookdale’s advisor, leaked that Brookdale is in talks to be bought, and some potential buyer names, like The Blackstone Group, KKR (NYSE: KKR), and private equity firm TPG Capital have popped up. In this article, we will discuss the possibilities and implications regarding Brookdale being purchased and going private.
Just three years ago this month, Brookdale Senior Living (NYSE: BKD) made its most significant, and fateful, decision when it announced the acquisition of Emeritus Assisted Living. Not only was the impact significant on Brookdale, but it also became very important for the seniors housing industry, the healthcare REITs, and other publicly traded companies. It shifted the focus away from operations to the value of the real estate held in various company portfolios. At the time of the announcement, Brookdale’s shares traded around $27.00, and trended up another 50% over the next 14 months with all the excitement of unrealized real estate value. The shares are now closer to $15.00, and “smart” investors lost tens of millions of dollars, each, along the way.
The talk was the real estate value of the owned properties of the combined companies and monetizing that value, plus the value of the purchase options embedded in certain leases that Emeritus had, not to mention the potential for a billion dollars of ancillary revenues. But along the way, someone, and perhaps everyone, forgot that it was really an operating business, and now the largest operating business the seniors housing world had ever seen. It was a multi-cultural platform, because it was really a combination of several disparate acquisitions over several years by both companies. And this is something that every potential buyer (perhaps three of them) should take into account and factor into the formulaic value of the cash flows of the owned real estate as well as the leased properties, the management business and the ancillary services. In other words, this is not your garden variety real estate play, nor should it be.
We bring all this up, as you know, because in early January someone leaked it to the press that Brookdale was in discussions with a few potential buyers, among them Blackstone Group (NYSE: BX), to either sell a big chunk of its real estate, or perhaps sell the entire company. That sent the shares up 20%, half of which has already been lost. The assumption is that Goldman Sachs, Brookdale’s advisor, leaked the story, perhaps to gain some traction with a buyer or two, or to pit one buyer against another, or to shake the tree and see how high a price the buyers were really going to get to. Perhaps to “ensure” that the price paid for the company was going to be worth it to the activist shareholders, as well as the Board. One of the problems is that many of the activists of 18 months ago have already dumped or reduced their positions, and many of the new activists came in after the stock dropped to a low of $10.65 per share after third quarter earnings were released. These latter investors will probably be happy with any premium paid.
Speaking of earnings, in each of the past four years and possibly longer, Brookdale has announced its fourth quarter earnings results between February 2 and February 8. A week prior to those dates it announces when that date will be. The press release inbox has been silent. Our guess, and it is only a guess, is that management would like to announce a deal before it reports the fourth quarter’s results, and in that case, it wouldn’t matter anymore. Why is this important? Because the theory is that the fourth quarter was not too good, given NIC’s already reported numbers for the quarter, and even though BKD has been slashing expenses, including midlevel management and advertising, presumably to bolster cash flow, we are not sure that will fool anyone. Actually, we kind of miss those Brookdale TV ads featuring real employees every morning during breakfast, which were really well done. Successful in increasing awareness and census? Hard to tell, but not yet. So much for the national branding campaign. But we digress.
There have been two potential buyers most talked about. First is Blackstone, which already announced a major acquisition of Brookdale properties last year, so it would appear to be farther along on the due diligence path than any other buyer. The second one is KKR (NYSE: KKR), which has wanted to have a seniors housing platform to grow and has very strong ties to Brookdale’s Executive Chairman, Dan Decker. Remember that KKR and its partners looking at seniors housing, one of which was Decker’s company, negotiated a deal to acquire the Sunrise Senior Living management company from HealthCare REIT, now Welltower (NYSE: HCN), for what appeared to be a relatively low price, and then sold it less than a year later for a price that was 4x to 5x its original cost.
As far as a third buyer, private equity firm TPG has been mentioned, but heavily discounted, and the REITs have always been talked about, including Ventas (NYSE: VTR) recently, but we don’t see how that would make sense in the current environment. We will get to this later, but Brookdale should be taken private, and the best vehicle for that is with a large private equity firm. Now, if we were representing one of the PE firms, our first piece of advice last month would have been to throw out a decent price, maybe $18 to $20 per share, and then drag discussions on until the fourth quarter earnings release. If the quarter is bad, and any due diligence should have picked up on that, at best the shares would tumble to $11 to $12, depending on how bad the news is and where it is concentrated. If the quarter is worse than people think, then you could be looking at a single-digit price, especially if the announcement comes with no progress on the sales front. This is all speculation, and we realize that it runs counter to all the talk about the real estate value alone being worth up to $21 per share. But remember, these companies don’t trade on their real estate value. Otherwise, Capital Senior Living (NYSE: CSU) and Five Star Quality Care (NYSE: FVE) would be trading at 50% to 100% premiums to current levels.
Now, let’s get to why everyone but the public investors in the shares are valuing the company at anywhere from $18 to $26 per share, admittedly a wide range. In every analysis we have seen, the vast majority of the value is from the real estate, of course, and the main thing that impacts that value is obviously the cap rate applied to the cash flow, as simplistic as that may sound. Most people seem to be coming in around 6.0% to 6.5% for a cap rate on an owned portfolio that was 33,949 units at the end of the third quarter. For the third quarter, the owned portfolio posted revenues of $403.65 million and EBITDA of $132.0 million, but we believe this is before an allocated management fee. These numbers also include 1,257 units that were disposed of during the quarter, but we have to assume these were not performing well. Average occupancy was 85.4% in the third quarter, and the operating margin (before management fee) was 32.7%, the lowest level of the past seven quarters. The leased portfolios were performing better on an occupancy and margin basis.
Activists have been coming up with this cap rate because they think the best comparable is the recent sale by HCP, Inc. (NYSE: HCP) of 64 Brookdale leased properties with 5,967 units for $1.125 billion, or $188,500 per unit, to Blackstone, a deal that hasn’t closed yet. On a trailing 12-month basis, this portfolio had a lease coverage ratio of 0.81x. According to HCP, the sale was done at an 8.0% lease yield, which should mean the lease income it was receiving divided by the sales price was 8.0%, which implies rental income of $90 million. With the 0.81x coverage, EBITDAR was about $73 million (once again, this may be before a management fee). Occupancy for this smaller portfolio was 85.2%, just 20 basis points lower than the larger owned portfolio. So using that $73 million, the market derived a cap rate of 6.5%. If that is before a management fee, then the cap rate drops to 5.3%, but no one is going there. So, after applying a 5% management fee to Brookdale’s owned portfolio, and a 6.5% cap rate to the resulting EBITDA, one derives a value for this real estate of approximately $6.9 billion, or $203,000 per unit, which is close to the smaller HCP/ Brookdale transaction. It is also very close to the $206,700 average price per unit in 2016 for the combined assisted living and independent living market, as well as the $193,650 per unit for assisted living (see lead story on page 1). After subtracting out liabilities, one derives a per-share value of close to $20.50 for the real estate alone. Sounds very reasonable, right?
It does, except for a few variables. First, this is a huge portfolio, and because it is so diverse and presumably cumbersome to manage, we believe there should not be a portfolio premium or a cap rate discount. Second, thirdparty industry players we have talked with almost uniformly would call this a “B” portfolio, with a lot of older properties and certainly a lot of properties that need significant capex to compete with all the new product opening up. Cap rates in the 6.5% area are usually reserved for higher quality real estate, and while we do not know the quality of the 64 properties Blackstone is buying, we have to assume they are not too different. Third, if Brookdale is taken private, who is going to run the company? If the current management has not been able to turn things around, what would give a buyer confidence that they could do so as a private company? Wouldn’t there have to be some sort of a risk discount to take this into account? The reality is that a 5,000-unit portfolio is not the same as a 33,000-unit portfolio, and then there are all the other properties under leases and management agreements to worry about with multiple landlords.
One could try the argument that a low cap rate (6.5%) is not too aggressive because of the upside in occupancy. The owned portfolio at 85.4% is a few hundred basis points below the leased portfolios, and certainly below the national average. Bringing those 375 properties to 90% would add $84 million in revenues and, assuming the operating margin on these additional residents would be at least 60%, another $50 million to EBITDA. Using the activists’ 6.5% cap rate, that would generate an additional $750 million in value. So the “stabilized” cap rate goes to 7.1%. If only it were so easy.
There is another side to the argument in favor of a low cap rate for a PE buyer, and that is cost of capital. We have to assume that Blackstone, and the others, has a large warehouse line that is LIBOR based. Banks love the PE business, so the spread could be anywhere from 150 to 250 basis points over the LIBOR rate. Even though LIBOR has doubled since the end of 2015, this would put a PE firm’s debt cost close to 3.00%. Assuming a 60/40 capital structure, the interest cost would be just $72 million on $2.4 billion of debt, with about $370 million available to service Brookdale’s existing debt and provide a cash return on the $1.4 billion of equity to be invested. Presumably, they would start to refinance any expensive BKD debt. It is all about expected return on their invested capital, and they can manipulate that to a degree by how much is borrowed for the acquisition. So, with a 300 basis point or more spread between a PE firm’s cost of debt and an “aggressive” 6.0% or 6.5% cap rate for the real estate, one can quickly see why the activists shareholders are eager to see a significant premium paid to Brookdale’s current price. The problem is, just because they can do it doesn’t mean they should.
The alternative to a sale of the company that activists, such as Jonathan Litt’s Land and Buildings, favor is for BKD to sell the real estate and distribute the proceeds to shareholders. So, shareholders of a stock that is trading at $15 per share would receive, under this scenario, anywhere from $15 to $20 per share in a dividend, depending on the percentage that would be distributed. Wonderful, and then what are you left with? A management company only with not too many people happy with how it as been managed. And while not many people would like CEO Andy Smith’s job right now, even fewer would want it with all the real estate sold, which would then be operated under management contracts or leases, depending on who the buyers are. And, since this is an operating business after all, no one would pay a top price without knowing who the management was going to be and the likelihood of them turning operations around. Another recommendation from some activists is to convert existing leases to management contracts and become an asset-light seniors housing company. Oh yes, the REITs will just roll over on that one. And let’s not forget, there would be a price to pay to get out of the leases. Again, the simplistic solutions by the likes of Jonathan Litt and others take no account of how these things would happen, nor the cost, and certainly not the aftermath. And why? Because they simply don’t care.
This is not an easy time for Brookdale and its management team. But we do believe it is the right time to go private. All they need is the right buyer, and the right price. Despite the value calculations which show, at least mathematically, why the company should sell for something between $21 and $26 per share, we don’t believe a PE firm will pay that. Where would the upside be? Embedded in that share price is a price for the real estate at full value (plus some), so if they start to sell it off, it is like treading water. Plus, on top of any purchase price will be the cost of the capital improvements over time, plus the operational uncertainty. As you know, three years ago we were quite vocal about how bad the Emeritus acquisition would be for all concerned, except Emeritus shareholders. If a buyer were to come in at any price above $20 per share, it would be great for shareholders (like it was for Emeritus shareholders), but we believe we would be doing a little “I told you so” story in a few years, just like we have done with Brookdale. The difference is we really won’t know what’s going on if it becomes private. As far as we are concerned, the only way this really works out is for the stock to sell off on fourth quarter earnings, and then a reasonable price could be paid to take the company private (where it should be), perhaps $15 to $17 per share. Brookdale is a very complicated company right now, and that can’t be underestimated, but should be embedded in any valuation. The activists don’t do that because they don’t have to. They won’t be the ones running a company the size of which this industry has never seen. There is a reason why no deal has been struck to sell off assets or the entire company, and we believe it has to be one of valuation. Our only advice is to proceed with caution, and discount the mathematical valuation that is derived. Pencils down, anyone?
