Summary:

Due to a transaction that closed on January 1st 2020, Five Star Senior Living (“FVE”) is a $5.24 stock with ~$1.60/share in unrestricted net cash and $0.53/share in 2020 FCF that we anticipate to grow nicely over the coming years. It currently trades at 4.8x EV/EBITDA vs. peers at ~11x. While the company has been public for some time, this business transformed at year end from a ~$20mm mkt cap company with a run rate of ~$10mm of EBITDA losses/year and ~$900mm of capitalized operating leases to a ~$170mm company generating ~$25mm of EBITDA annually with ~$50mm of unrestricted net cash and investments.  This transaction changed the nature of the business from a levered operator in the senior living space to that of an undercapitalized, more asset light management business.  

Despite this immediate change in profitability, the stock is roughly in the same place as it was over the previous few months.  Why?  We believe, that the main reason is that on January 1st, 2020 over 50% of the shares outstanding were distributed to shareholders of a REIT that did not want/could not hold shares in an operating entity.  The anticipation of this event and ultimately the event itself triggered a massive increase in volume and a subsequent decline in price.  It is reasonable to ascribe this dislocation to the notion that 1) very few investors pay attention to $20mm mkt cap companies, 2) no one wants to buy ahead of a significant equity issuance and substantial spin related selling, 3) there has been limited financial disclosure and no analyst coverage and 4) FVE screens poorly on Bloomberg due to its ~$900mm of capitalized operating leases that no longer exist.  

We believe this investment is very timely because there is not currently an understanding of what this company is nor where it should be valued. Based on a broad set of peers, we believe FVE should be worth $7+ today and looking out 3 years, the upside is $10-$13. Moreover, unlike most of the public equity universe that has been negatively impacted by ASC 842 requiring operating leases to be recorded on the Balance Sheet, this transaction will remove this burden from FVE’s Balance Sheet and should underscore its significant net cash position. 

Business Overview:

FVE is one of the largest senior living operators in the US. As of their Q3’19 10Q filing, FVE owns/leases/manages ~30,000 senior living units across 31 states subdivided between:

• Independent Living (~11K units) – Facilities where residents are independent;

• Assisted Living (~13K units) – Facilities where residents have a basic level of support including but not limited to medication management, daily meals, housekeeping;

• Memory Care/Alzheimer’s (~3.5K units) – Specialized assisted living facilities for those requiring memory care

• Continued Care Retirement Community (~2.2K units) – A single use facility that can provide the whole life cycle of independent living, assisted living, nursing care, etc.

FVE oversees front office (tenant recruitment, marketing, retention, tenant support functions, etc.), back office (finance and accounting, expense management, employee recruitment, training, etc.) as well as facility upgrades and upkeep within the communities that they own or lease (leases are structured as triple net leases). Prior to the conversion of its master leases to management leases (more below), FVE leased 59% of its units, owned 7% and managed 34%. However, the conversion significantly reduces FVE’s operating leverage and shifts its pro forma management to 92% of its units while leased units are reduced to 1% and owned units stay at 7%. FVE’s overall reimbursement risk is manageable with ~90% of its community level revenue coming from private pay (Source: Q3’19 10Q & November 2019 Investor Presentation).

Although FVE has been positioned extremely well to take advantage of favorable long-term industry demographics (aging baby boomers), its profitability took a significant turn for the worse in 2016/2017 on the heels of significant macro and micro pressures. 

From a macro perspective, the senior living industry saw the perfect storm begin to originate in 2013/2014. First, rising expectations of aging baby boomers fueled demand for senior living units and drove a significant rise in construction (Source: NIC Data). By the time new units began to hit the market in 2015/2016, the overall growth of supply was outpacing demand by ~1.0-1.5% per year (see below – source: NIC Data). This supply under absorption was exacerbated by seniors deciding to stay longer in their dwellings vs. moving into senior living communities. This dynamic means that the average length of stay at senior living communities was shortened due to the increasing average age of new residents. Therefore, age induced turnover was increasing at the same time that industry pricing was coming under pressure. Second, labor shortage began plaguing the industry and the competitive labor market resulted in higher employee turnover and significant wage pressures. High employee turnover taints the overall quality of the offering and typically leads to market share loss and pricing pressures at the community level. Third, government reimbursement rates came under pressure. Although FVE’s current Medicare/Medicaid exposure is <10%, this exposure was more material 5 years ago.

While it’s clear that the macro played a significant role in deteriorating fundamentals for all industry players (i.e. BKD), FVE fell victim to having an outsized book of leases at above market rents. Prior to its restructuring, FVE’s operating leases were substantial as they were capitalized to the tune of ~$900mm. This size of operating leverage put FVE into a precarious situation. The deteriorating macro backdrop meant that operators had to focus on differentiating their community offering in an effort to drive new customer growth. However, not only was FVE already burdened with above market lease rates, but a clause in their master lease agreement forced them to pay an 8% rent increase on the capital they deploy in their leased properties. Given FVE’s inability to support a step up in rent, they continued to underinvest in their properties which culminated in further deterioration in community quality. Ultimately, the confluence of macro and micro factors led to FVE generate negative EBITDA of $40mm in 2018 and forced the company to evaluate alternatives to remain a going concern. 

Transaction with DHC Overview:

In conjunction with FVE’s Q3’18 results, FVE issued a going concern notice due to the aforementioned challenges plaguing the company and the broader senior living industry. While this was clearly a cause for concern for FVE and its shareholders, this was as much of an issue for Senior Housing Properties Trust (later renamed to Diversified Healthcare Trust, DHC). At the end of 2018, FVE owned/leased/managed 284 communities (Source: 2018 10K). Of those, 188 were leased and nearly all (184) were leased from DHC. The precarious situation at FVE left DHC with a handful of options; a) find a new operator and hope they can run the communities better, b) sell the underlying communities to another REIT and let them worry about the operator, c) run the communities themselves, d) let FVE go bankrupt, e) restructure the leases to enable FVE to remain profitable. Ultimately, we believe DHC decided that a lease restructuring was its only viable option:

• Finding a new operator would be messy as the inherent employee turnover would impact community morale and worsen community level turnover. Moreover, FVE’s issues were much more macro driven and they are/were considered above average operators 

• No REIT would be interested in buying distressed assets that ultimately would have to see a significant cut in rent. Furthermore, the increase in the level of supply has made REITs reticent to deploy incremental capital in the space

• DHC is not an operator so running the communities is a non-starter

• Bankruptcy is messy and would impact the underlying asset quality and tenant experience 

On April 2nd, 2019 FVE and DHC published an 8K to announce a comprehensive restructuring. At the onset, DHC agreed to reduce FVE’s rent by $6.4mm/mo starting February 2019 until December 2019. Starting January 1st 2020, DHC agreed to convert all of FVE’s leased communities under a master lease to managed leases. By doing so, DHC will transition the P&L of each community unto its Balance Sheet and FVE will earn a management fee/incentive fee for managing the properties. The underlying management agreement will be a 15-year agreement with two 5-year extensions at FVE’s discretion. FVE will be compensated with a base management fee of 5% of gross revenue and an incentive fee of 15% of EBITDA that exceeds a specified performance target (up to 1.5% of gross annual revenue). As part of the conversion/restructuring, DHC is being issued ~10.3mm FVE shares and DHC shareholders are being issued ~16.1mm FVE shares (REIT rules prevent DHC from owning more than 33% of FVE shares). Additionally, DHC is paying or assuming $75mm of FVE’s working capital liabilities and will be on the hook for FVE’s community level capex going forward. 

While the transaction was clearly a significant transfer of value from DHC to FVE (led to a 60% dividend cut announcement at DHC the same day), we believe that the transaction was consummated at DHC for the following reasons: 

• Ultimately, FVE was overpaying and rents would have to come down. Therefore, the ~$30mm EBITDA loss at DHC would have been partially inevitable;  

• DHC is now the owner of the underlying communities and can decide where/how to best invest. FVE leased communities were grossly undercapitalized. FVE was spending $1,000-$1,300/bed in recurring capex from 2014-2018 vs. DHC expected to spend $1,500/bed (Source: November 2019 Presentation). By investing in the properties, DHC could improve the overall user experience which should attract new customers to its communities; 

• DHC is now directly exposed to the underlying senior living market which could be reaching an inflection point as senior housing demand is expected to outstrip supply going forward; 

• By enabling FVE to remain profitable, DHC can purchase more properties and insert FVE as the manager. Additionally, DHC can partner with third parties who are more willing to consider a healthy FVE as their operator 

New FVE and Valuation Framework:

The restructuring takes a company that was cash flow burning burdened with ~$900mm of capitalized operating leases and transforms them into an asset light management company with approximately $1.60 of unrestricted cash and investments on the balance sheet. Based on management latest guidance of $20-$30mm of 2020 EBITDA (Source: November 2019 Presentation), which we provided a bridge for below, we expect FVE to generate $0.53 of FCF in 2020. Assuming an 7-10% FCF yield the shares could be worth $7.47-$9.16 or 43% to 75% upside from current levels. Of note, the implied EV/EBITDA using a 7-9% FCF yield is ~5.6x to 7.8x which still puts FVE at a significant discount to the two publicly traded senior living peers (BKD, CSU) which trade at ~11x. 

Source: Model Estimates, FVE public disclosure 

In addition to FVE’s 5% management fee and 15% incentive fee, FVE gets paid 3% of the incremental capital that DHC deploys in its properties. Assuming relatively modest organic growth at the property level in combination with incremental management fess from DHC’s deployed capital, we believe that FVE could be earning $0.66 of FCF in 2023. Based on FVE’s 2022 fiscal end Balance Sheet, and using a similar range of FCF multiples, the shares should be worth $10.40-$12.48 or an upside of ~100% to ~140% from current levels. 

Source: Model Estimates 

In evaluating the right multiple, we looked at a myriad of comps. Post the restructuring, we believe about ~50% of the EBITDA will emanate from managed assets and ~50% will be from owned and operated assets. From a peer perspective, there are only 2 public peers (BKD and CSU). However, both companies have significant financial leverage as well as operating leverage (given their exposure to leased assets). Nonetheless, both companies are not expected to be FCF positive in 2020 and yet still trade at ~11.3x vs. FVE’s current valuation of ~4.8x (Source: Bloomberg). Some can argue that FVE’s managed business deserves a higher multiple. While there are no pure play public management company peers, one can also look at the valuations afforded to commercial real estate brokers with property management exposure, single family/multifamily REITS with property management exposure and asset-light hotels franchisers/management companies. 

                    Source: Bloomberg

Either way you cut, our underlying valuation assumptions of 7-9% FCF yield or implied 6-8x EV/EBITDA on 2020 figures is conservative relative to peer valuations. Our assumptions also do not reflect a) FCF upside from incremental properties that DHC develops/partners where FVE will be the manager, b) ability to unlock value from the restricted cash/investments on the balance sheet ($1.35/share), c) $112mm of unrestricted net cash/investments (>$3.50/share) vs. our estimate of $50mm as we assume ~$62mm of working capital outflow.  

Risks 

• Supply/demand of the broader senior living industry has been improving, but there could always be additional announcements of supply. 

• RMR and related entities owns significant stock in FVE and DHC and gets paid 60bps of FVE’s revenue as a management fee. RMR has a horrible reputation amongst minority shareholders as they are known to force their managed REITs to grow by any means possible that ultimately lead to higher fees that accrue to RMR. In this case, in typical RMR fashion, FVE could decide to deploy capital to buy management contracts regardless of the multiple in an effort to grow the management fee.

• FVE may not benefit from the $75mm of cash investment as it will be fully absorbed by a working capital outflow.  We are trying to better understand whether the company should receive the full value of the cash and do note this as a risk.

• Opt out clause in the management contract: “The New Management Agreements also provide DHC with the right to terminate the New Management Agreement for any community that does not earn 90% of the target EBITDA for such community for two consecutive calendar years or in any two of three consecutive calendar years, with the measurement period commencing January 1, 2021 (and the first termination not possible until the beginning of calendar year 2023), provided DHC may not in any calendar year terminate communities representing more than 20% of the combined revenues for all communities for the calendar year prior to such termination. Pursuant to a guaranty agreement dated as of January 1, 2020, or the Guaranty, made by us in favor of DHC’s applicable subsidiaries, the Company has guaranteed the payment and performance of each of our applicable subsidiary’s obligations under the applicable New Management Agreements.”

Disclosure: At the time of publication, the author of this article holds a position in FVE.  This article expresses the opinions of the author. The author has no business relationship with any company whose stock is mentioned in this article.

The author of this article, has a long position in the company covered herein and stands to realize gains in the event that the price of the stock increases. Following publication, the author may transact in the securities of the company, and may be long, short or neutral at any time.  The author of this report has obtained all information contained herein from sources believed to be accurate and reliable.  The author of this report makes no representation, express or implied, as to the accuracy, timeliness or completeness of any such information or with regard to the results to be obtained from its use.  All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this article or any of the information contained herein.  This is not an offer to sell or a solicitation of an offer to buy any security.