Diversified Healthcare Trust / Five Star Senior Living Spin-off Quick Summary – January 17, 2020
Resources from Diversified Healthcare Trust
Note: DHC renamed themselves as Diversified Healthcare Trust from Senior Housing Properties Trust on December 30, 2019. Certain sections throughout this report will refer to DHC as Senior Housing Properties, and the two can be thought of as the same business.
Investor Relations Contact Information:
- General IR Contact:
- Phone: (617) 796-8234
- Email: ir@DHCreit.com
Resources from Five Star Senior Living
Investor Relations Contact Information:
- General IR Contact:
- Phone: (617) 796-8245
- Email: email@example.com
In a slightly different transaction than usually analyzed here, Five Star Senior Living was not necessarily spun out of a specific business, but rather restructured through what was essentially an pre-packaged bankruptcy reorganization in which its largest creditor, Diversified Healthcare Trust, restructured its lease agreement with FVE such that FVE effectively became an asset-lite operator of their senior housing facilities, acting as a manager of these properties. As a result, the triple net leases that FVE had with DHC would effectively be cancelled and capital requirements would instead fall to DHC. In exchange, DHC received 85% of FVE equity and also benefits from a stable outlook for FVE (FVE’s share price weakness had been weighing on DHC). After the restructuring was completed, DHC distributed ~51% of FVE equity to their existing shareholders and kept the rest of the shares on their balance sheet. This plan was announced on April 1, 2019, with the S-1 being filed on December 16, 2019.
Why the Spin-off?
This transaction occurred based on a confluence of factors, both from an operations and industry perspective. To sum it up, FVE’s business was suffering greatly, and the company was threatening to default on its lease obligations to DHC. This restructuring greatly improved FVE’s business model and improved DHC’s outlook by removing a large overhang related to the financial stability of a major counterparty. The restructuring avoided a bankruptcy and appears beneficial to both DHC and FVE shareholders.
The new management structure for FVE/DHC will be 15 years in length with two, five-year extension options at Five Star’s discretion. FVE will receive a base management fee of 5% of gross revenues at the community level, and they can also receive up to 1.5% of gross revenue based on operational performance. This structure works considerably better from an economic perspective for FVE, removing their capital spending obligations and allowing them to focus more on the pure operational side versus their initial triple net lease obligations with DHC.
Five Star Senior Living used to own and operate senior living communities – now it will manage these properties. The Company offers memory and respite care, independent and assisted living, short term stays, and rehabilitation and wellness services throughout the United States. They operate across the spectrum of senior living, including independent living, assisted living, Alzheimer’s and Memory Care, and Continued Care Retirement Communities across 31 states, managing 29,852 units as of September 2019.
The Company has grown top line relatively modestly, with low single digits growth over the past decade. EBITDA margins have remained relatively consistent in the low single digits, save for the last year or two in which operational challenges have compressed margins.
While a difficult operating environment led to tough financial results for FVE last year, management is guiding to ~$20-30mm in EBITDA this year, which would get them back to the midline of usual EBITDA numbers for the business. This is primarily due to the restructuring of their management agreement with DHC, as previously noted.
Although it may seem a bit counterintuitive due to the demographic shift in America of an aging population and an increased number of baby boomers retiring and aging into these facilities, the assisted living real estate sector has seen a fair bit of trouble in recent years. To quote Clark Street Value, “Developers got excited, overbuilt in recent years into this well telegraphed demographic trend and senior housing operators have struggled due to the oversupply of rooms”. Essentially, baby boomers haven’t aged quite fast enough to support the growth in supply, and operators have been stuck with lower occupancy rates.
However, there has been a marked shift since 2016 in the industry, with new construction projects slowing as developers and operators have gotten burned in the past. Additionally, there are pretty compelling prospects as a slowdown in new construction combined with a continually aging population should provide higher, more stable occupancy rates in these facilities in coming years. The population of American citizens aged 85 and over is projected to grow significantly over the next couple of decades.
The industry as a whole is rather fragmented, but FVE does have a very high degree of scale, enabling them to operate as one of the more active players in the space. Brookdale Senior Living (BKD) and Capital Senior Living (CSU) are the two other publicly traded comps within the U.S., both operating under similar low-margin, stagnant revenue profiles.
Operators differentiate themselves to consumers primarily through quality of service. Elderly people, and potentially their families, will pick one operator over a competitor primarily due to the level of service that they receive in the facility.
Quality of Business
Historically, FVE’s business quality has been quite low due to low margins and relatively high capital intensity. In 2018, FVE spent $31.0MM on capex representing 2.3% of sales. 2.3% of sales may seem relatively low for a typical business, but it is quite sizable for FVE given the business generated negative $78MM in operating profit in 2018.
As a result of the restructuring, FVE’s net PPE declined and its profitability improved on a pro forma basis. Nonetheless, the ROIC of 9.9% does not seem too inspiring.
However, the ROIC could improve over time. First, net working capital (NWC) was negative for FVE in 2018, 2017, and 2016. If NWC is negative on a normalized basis, returns will improve. Also, FVE still has ~$165MM of net Net Property, Plant and Equipment. As it is switching its business model to focus on management of real estate properties (instead of ownership or leasing of them), it should be able to sell additional real estate which would further improve returns.
Following the transaction, FVE’s capital structure changed significantly. With the cancellation of over $778MM in lease obligations that should be viewed as equivalent to debt, the Company’s leverage profile improves considerably.
Management of the spin-off will be the same management that is currently leading First Star, with Katie Potter as the CEO and Jeffrey Leer serving in the CFO role.
Potential for Indiscriminate Selling
We saw significant selling pressure when DHC distributed shares in FVE to its shareholders. DHC distributed .07 shares of FVE per share of DHC owned. As such, it resulted in a very small distribution and heavy selling pressure from REIT index funds and individual investors. Shares jumped significantly higher following this tweet and this write up.
I would expect shares to remain volatile for the next several months.
On an annualized basis, FVE generated $0.53 in the 12 months ending September 2019. If we assume earnings stay stable at $0.53, FVE is trading at 10.4x earnings. Management guided to $25MM (at the midpoint) in EBITDA for 2020. As such, FVE is trading at 6.6x EBITDA.
In terms of comparable companies, there are two: Brookdale Senior Living (BKD) and Capital Senior Living (CSU). BKD trades at 10.8x 2020 EBITDA while CSU trades at 13.9x 2020 EBITDA. Neither BKD or CSU generate positive EPS.
Versus its competitors, FVE looks cheap. However, there are a few things to be aware of.
- The senior living industry has been challenged due to oversupply. Check out the longterm charts of BKD and CSU.
- Adam Portnow has a poor reputation with investors due to self dealing. He owns 13% of FVE and also owns 50% of RMR Group. FVE pays RMR 0.6% of revenue and there is the risk that FVE’s relationship/agreement with RMR shifts economics to RMR.
- Is EBITDA guidance of $20MM to $30MM reasonable? The company looks cheap based on guidance, but I’ve been burned by relying on guidance. I will work to independently verify the company’s earnings power.
This is a very interesting situation that I’m going to continue to work on. It’s a little outside my circle of competence given my lack of familiarity with the senior living space, and so I’m proceeding with caution.
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