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Five Star Quality Care Inc. (NYSE:FVE)

Q3 2009 Earnings Call

November 2, 2009 5:00 pm ET

Executives

Tim Bonang – Vice President of Investor Relations

Bruce Mackey - President and Chief Executive Officer

Francis Murphy- Chief Financial Officer

Analysts

Kevin Ellich – RBC Capital Markets

Jerry Doctrow - Stifel Nicolaus

Donald Hooker – UBS

George Walsh – Gilford Securities

Operator

Good day, and welcome to the Five Star Quality Care third quarter 2009 financial results conference call. This call is being recorded.

At this time, for opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Mr. Tim Bonang.

Tim Bonang

Thank you, and good afternoon everyone. Joining me on today’s call are Bruce Mackey, Five Star’s President and CEO, and Fran Murphy, Five Star’s CFO. The agenda for today’s call includes a presentation by management followed by a question-and-answer session.

Before we begin today’s call, I would like to state that today’s conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and federal securities laws. These forward-looking statements are based on Five Star’s present beliefs and expectations as of today, November 2, 2009. The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today’s conference call, other than through filings with the Securities and Exchange Commission regarding this reporting period. Actual results may differ materially from those projected in these forward-looking statements.

Additional information concerning factors that could cause those differences is contained in our filings with the SEC. Investors are cautioned not to place undue reliance on any forward-looking statements.

With that, I would like to turn the call over to Bruce Mackey.

Bruce Mackey

Thanks everyone for joining us this afternoon. For the three months ended September 30, 2009, net income from continuing operations was $0.13 per basic share and $0.12 per diluted share, compared to a net loss of $0.05 per basic and diluted respectively for the same period last year. However, the third quarter of both 2009 and 2008 included certain non-operating items.

The 2009 results include several items that in aggregate result in a positive impact of $4 million or $0.10 per diluted share. These items included a $3 million gain due to early extinguishment of debt, a $795,000 on the sale of certain marketable securities held by our captive insurance companies, a $455,000 unrealized gain on our UBS put right related to our auction rate securities—all offset by a $238,000 unrealized loss on our holdings of auction rate securities.

By comparison, the third quarter of 2008 included unrealized loss of $1.7 million as a result of our holdings in auction rate securities, a loss of $3 million due to recording a permanent impairment on some of our marketable securities—both offset by a $743,000 gain on early extinguishment of debt. Excluding these items, net income from continuing operations per diluted share was $0.01 in the third quarter of 2009 versus $0.08 in 2008.

While we realize this is a disappointing quarter, I’d like to point out some additional items that on a sequential basis negatively affected our earnings this quarter. We had additional energy costs of $1.7 million, and we incurred additional bad debt expense of $500,000. The additional energy costs related to air conditioning use to combat the heat in August and September. This should moderate in the fourth quarter, but will likely move up again in the first quarter winter months as heating needs arise. The additional bad debt expense was incurred as a result of our skilled nursing receivables aging out during the quarter.

We also incurred a $290,000 charge in the third quarter of 2009 because of a bankruptcy filing of a buyer of skilled nursing beds that we sold in Connecticut in 2008. I also want to remind people that in the second quarter of 2009, we got the benefit of an $800,000 payment to low-income patients related to our hospital operations. We believe that we are now accruing for those payments at the appropriate level on a go-forward basis and will not face any significant adjustments in future periods.

In total, these additional items account for $0.10 per fully diluted share. Finally, it is worth noting that while our health insurance did decrease $1.3 million in the third quarter from the previous quarter, it did not offset the large $3.3 million increase we experienced between Q1 and Q2, and as Fran will mention later, the decrease in health insurance claims was completely offset by a $1.3 million actuarial true-up for insurance reserves during the quarter.

For Five Star and those that operate in and follow our industry, the focus over the past few years has been occupancy. The good news is that Five Star’s overall occupancy increased sequentially for the first time in 8 quarters. Occupancy for the third quarter of 2009 was 86.1%, compared with 86.0% a quarter ago and 88.3% a year ago. Same-store occupancy for the third quarter 2009 was 86.6% compared with 88.2% a year ago. Occupancy as of this past Friday has actually increased by 30 basis points to 86.4%.

This data provides additional support to our belief, shared by others in the industry, that senior living occupancy appears to be stabilizing. For us, the overall occupancy by product type and geographic location hasn’t changed much since last quarter’s call. I think we’re doing fairly on the assisted living and Alzheimer’s front while facing challenges with independent living and more recently in our skilled nursing, primarily with Medicare.

Geographically, the mid-Atlantic region has been an area of strength for us, while Florida still faces challenges. Last quarter, we told you that in many markets where we operate, other operators are significantly slashing prices. Despite this, I think we did a good job of pushing rate where possible. Our average daily rate increased 2.2% year over year overall, and more importantly 3.6% on a same-store basis. On average, Five Star increased its same store average daily rate by over 3% in each of the last seven quarters.

Moving on to other metrics, wages and benefits as a percent of senior living revenues were 51.3% in the third quarter, up from 49.9% a year ago and even with last quarter. This year over year increase is primarily related to significant increases in our healthcare insurance costs, which Fran will describe in more detail in a few moments.

G&A as a percent of revenues was 4.5%, as we still maintain the leanest operations in the industry. We expect this percentage to be in a similar range throughout 2009 and into 2010. Our core senior living business continues to be profitable but is down from the second quarter of 2009. More than 85% of our total company revenues come from this business. Almost 70% of our senior living revenues are coming from private pay sources.

In the third quarter of 2009, Five Star Senior Living produced $18.6 million of EBITDARM, compared to $21.3 million for the second quarter. Two thirds of the drop in senior living EBITDARM on a sequential quarter basis is a result of the increases in costs that I spoke about earlier.

Our ancillary businesses, which make up only 15% of our revenues, showed improvement in the third quarter. The rehabilitation hospitals, which account for 8% of our total revenues, lost $284,000 of EBITDARM during the third quarter. Taking into account the $800,000 adjustment I mentioned earlier, this was actually an improvement of approximately $200,000 in EBITDARM on a sequential basis. Our hospitals also generated about $800,000 more in EBITDARM in the third quarter of 2009 compared to the third quarter of 2008.

Our renovations continue to progress. We opened our second wing at New England Rehabilitation Hospital recently and are due to complete our second wing at the Braintree Hospital in the fourth quarter. The pharmacy operations, which make up 6% of our total revenues, made $572,000 on an EBITDARM basis during the third quarter. This was an improvement of approximately $575,000 in EBITDARM on a sequential basis. Our pharmacies also generated about $1.1 million more in EBITDARM in the third quarter of 2009 compared to the third quarter of 2008. As of the end of September, we were currently servicing approximately 12,200 customers and have expectations to add almost 1150 customers during the next several quarters. The majority of those customer additions will be third party customers.

I would now like to update you on our recent acquisition activities. On October 1, 2009, we leased a 259-unit community called Brandon Woods at Alvamar from Senior Housing. Brandon Woods is a premier continuing care retirement community located in Lawrence, Kansas, right near the University of Kansas. We also agreed to manage the townhouse association that is affiliated with this community. Also in October, we agreed to lease an additional 10 assisted living communities with a total of 611 units from senior housing.

These 10 communities are located in North Carolina, South Carolina, Georgia, and Texas. We expect to close on this lease transaction by the end of the fourth quarter of 2009. The combined occupancy of these communities is just over 90%. In addition, several of these communities fall within our pharmacy’s area of operations.

Subsequent to the end of the third quarter, we sold two skilled nursing facilities that we leased from Senior Housing. One of the facilities was located in Iowa and one was located in Missouri. By selling these two facilities, we have eliminated an annual cash loss of approximately $230,000 and reduced our annual rent to Senior Housing by approximately $170,000.

Before I turn the call over to Fran, I’d like to highlight the strength of our financial position. Five Star ended the quarter with $26.4 million of cash. Five Star had an untapped line of credit with Wells Fargo for $40 million. Five Star has a put right to sell $75 million of auction rate securities to UBS in June 2010 from which we will net $35 million of additional cash after paying off the credit facility we have with UBS. Five Star has near term debt maturities for our senior notes or mortgages. The closest maturity we face is in October 2013, when our senior notes can be put to us. I would like to note that during the third quarter we repurchased $15.6 million of convertible senior notes for $12.1 million. After the quarter closed, we purchased another $800,000 of convertible senior notes for $638,000. We have $50.8 million of convertible senior notes currently left that can be put to us in October 2013. During the past year, we have purchased and retired $75.7 million par value of our outstanding convertible senior notes for $39.1 million plus accrued interest.

And last we own 25 communities that we operate. Twenty-two of these communities are unencumbered and have a net book value of $126 million.

Looking to the fourth quarter, I’ll remind everyone that for the first time we will get the full effect of the revenue reduction from senior housing which is $500,000 per quarter. Our four keys to success remain the same—increase occupancy and average daily rate while holding labor and G&A costs in check. Throughout the past year, we have performed consistently on the last three. Occupancy improvement is the most important key to improving our bottomline and smoothing out the recent volatility in our financial results.

At this point, I’d like to turn the time over to Fran Murphy, our Chief Financial Officer.

Fran Murphy

Good afternoon, everyone. For the third quarter, our senior living revenues increased $13.8 million or 6% to $253.7 million compared with the third quarter of 2008. Revenues from communities acquired or leased after July 1, 2008, our new communities, accounted for most of this change or a total of $9.4 million. A 1.9% increase in same-store senior living revenues accounted for the rest of the increase, rising on a 3.6% increase in average daily rate offset by a 150 basis point decline in occupancy.

Senior living operating expenses increased $12.6 million or 7% to $193.2 million compared with last year. Again, most of this increase or $7.4 million was from our new communities. Higher same-store operating expense, especially health insurance costs, explains the remaining increase rising 2.9% from prior year levels to $184.7 million.

As Bruce just mentioned, our third quarter results were dragged down by insurance adjustments that were identified in early October. As an overview to our insurance reserve process, we engaged Towers Perrin, top actuarial firm, to conduct a complete review of our health, professional liability, and our workers’ compensation programs three times each year. The review conducted during the past quarter indicated the need for $1.3 million adjustment which we recorded. $950,000 of this amount was related to adverse trending of prior year workers’ comp and professional liability claims. The remaining $350,000 was for increased health insurance reserves.

To give you just a little color on our health insurance, our consolidated third quarter health insurance expense rose $2.6 million compared with the third quarter of 2008. We understand that we’re not alone in facing this problem, which appears related to employee concerns about the economy and job security, but in order to help control insurance expense, we switched insurance carriers on October 1, 2009, in a move that will reduce our health administration costs by $2.5 million annually and provide us with better claims management.

For the third quarter of 2009, our same-store operating margins before rent or EBITDARM as a percentage of revenues declined to 23.8% from 24.6% in 2008. EBITDARM at our new communities was $2.8 million or 24.8% of related revenues.

Turning to our ancillary businesses, as Bruce stated, our rehabilitation hospitals operated at a slight loss during the quarter. Hospital revenues were up $700,000 or 2.9% compared to last year due mainly to increased Medicare reimbursement from higher acuity patients and improved patient length of stay, offset by a decrease in occupancy.

Hospital expenses increased only 10 basis points during the quarter due to our strong cost management, and rent was down 4.8% as a result of the $2 million annual rent reduction from the lease realignment executed on August 4, 2009.

Our pharmacy operations had a 3% EBITDARM margin in the quarter. Pharmacy revenues were up 12% compared with last year due to the impact of adding new customers, partially offset by lower average revenues per prescription due to higher sales of generic drugs. Pharmacy expenses increased 5.3% from the prior year because of higher costs associated with our rising customer base.

During the third quarter, general and administrative expenses increased 13% or $1.5 million from last year due to higher corporate and regional support costs associated with our new communities. Our G&A costs as a percentage of revenues are up slightly from last year at 4.5%, but still within our range of expectations.

Rent expense increased $2.8 million or 7% compared to last year. Most of this increase was due to rent at our new communities, offset by the $333,000 decrease in the third quarter related to the lease realignment agreement. Taxes were $565,000 in the third quarter, and absent any unusual gain or losses next quarter, we expect taxes to be $300,000 in the fourth quarter.

Before concluding today, let me review our liquidity, cash flows, and selected balance sheet items. At September 30th, we had unrestricted cash and cash equivalents of $26 million and total current unrestricted cash and investments including our UBS put right and auction rate securities of $110 million.

At September 30th, and as of today, we had nothing drawn on our $40 million revolving line of credit with Wells Fargo, and $40 million drawn on our line with UBS. Consolidated EBITDA, excluding certain items noted in our press release, was $5.4 million during the quarter compared with $6.6 million last year. Operating cash flow for the third quarter was $8.1 million. We made $16.6 million of capital investments during the period and sold $6.1 million of CapEx to Senior Housing. We anticipate recovering another $5.3 million in future sales of CapEx to Senior Housing for expenditures made by Five Star through September 30th.

Our accounts receivable management remains strong as the number of days sales outstanding for our consolidated operations was an exceptional 21 days at September 30th. At the end of the third quarter, we had $187 million of net property and equipment which included 25 properties that are directly owned by Five Star, 22 of which are unencumbered by debt. In addition to the lines of credit mentioned previously, we had $52 million of convertible senior notes and $12 million of HUD mortgages outstanding. We believe we are in compliance with all material terms of our credit note and mortgage agreement.

Wrapping up today, we again want to express our disappointment with our third quarter operating results. While we have been able to take advantage of favorable market conditions to redeem a large portion of our outstanding debt at an average discount to par of 44% and we also entered into a very favorable realignment agreement with Senior Housing, we are in the end measured on our ability to perform as a senior living operator. As Bruce mentioned earlier, we’re focused on attracting residents to our communities and have made great strides in the last year, developing the tools, the people, and the strategies to make this happen. We are encouraged by present signs of occupancy stabilization and will continue to cut overhead when we can do so without diminishing the satisfaction of our residents.

That concludes our prepared remarks. We'll now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Kevin Ellich – RBC Capital Markets.

Kevin Ellich – RBC Capital Markets

Fran, maybe I can start with you. Looking at the cash flow and the CapEx and what you expect to recover, would it be safe to net that out and say that free cash flow for the quarter was about $2.9 million?

Fran Murphy

Our net CapEx for the quarter was about $10 million. That $5 million represents kind of a balance that rolls forward, and it does have an impact on the quarter, but it’s not a direct reduction from that net $10 million.

Bruce Mackey

It’s more of a question of timing of when the project is completed.

Kevin Ellich – RBC Capital Markets

Do you have any expectation for the timing of when you expect to get that $5.3 million?

Bruce Mackey

The majority will come in the fourth quarter, and then it will tail off a little bit after that. That’s usually the way it’s worked in the past.

Kevin Ellich – RBC Capital Markets

I was wondering if you guys could talk about what you’re seeing on the health insurance reserves. Who did you guys switch to on October 1st? I think Fran said the savings was going to be $2.5 million annually. That’s pretty significant, and what’s driving up the higher insurance reserves? Are people using healthcare services more?

Bruce Mackey

I’ll start Kevin, and maybe switch over to Fran if he’s got any thoughts. We switched from Blue Cross Blue Shield to United, and it was a pretty big switch for us. We’ve been with Blue Cross Blue Shield since 2002, I believe, so it’s been quite sometime, and United really came through with a very favorable contract for us as well as the claims management piece which we think we need to do a better job with that third party. What we’re seeing is an increased utilization in the claims. Last quarter, we talked a little bit about the percentages, but they’re still the same this year when you look at a year over year basis. Our claims percentage is up significantly, and we really haven’t increased the headcount that much, so we’re just seeing a vast increase in the claims count, and working with our benefits consultant, Mercer, which part of the MMC Group to help us manage those costs, and they helped us out with our United contract renewal. They do point a little bit to the economy and the fact that if people have health insurance and they have a job, they can make the co-pays, etc. They will utilize those benefits because they’re at a little bit of a fear of losing those benefits, so we’ve seen some data from other companies as well, not necessarily fully in this industry, although I think one other company in the senior living industry did say the same thing last quarter, but you see it in other industries as well.

Kevin Ellich – RBC Capital Markets

Do you guys self-insure or is United underwriting the insurance?

Bruce Mackey

We do self insure.

Kevin Ellich – RBC Capital Markets

Going through the expenses, G&A ticked up a little. I know it’s still industry low at 5.3%, but should we still expect it to be right around that 5.3%? Was there anything unusual in this quarter?

Bruce Mackey

I think you got the number wrong. It was actually 4.5%, and not 5.3%. There’s nothing significant or unusual. There may be one or two items that may roll off in the fourth quarter, but within $100,000 here and there, so I don’t think it’s going to make any significant difference. We try to point people that we’ll be within the 4.4% to 4.6% range. As we take on acquisitions, that will tick down a little bit as well.

Kevin Ellich – RBC Capital Markets

The other operating expense, did you say there was some unusual items in that this quarter?

Fran Murphy

If you’re looking on a sequential basis, we talked a little bit about just how seasonality of utilities affected us.

Bruce Mackey

That was $1.7 million, Kevin.

Fran Murphy

Also in the third quarter, we had to take almost a $300,000 charge for a receivable related to the sale of SNF beds in Connecticut. The sale was made to a company that’s now bankrupt, and we’ve had to disgorge those funds. The health insurance is really the big thing on a year to year basis. We saw a $2.6 million increase from the same quarter last year. Now we had a little bit of a benefit. We had a $1.3 million benefit going from Q2 to Q3 of this year for health insurance because those costs had spiked up so much in Q2, but it was all taken away by the actuarial adjustments that were made.

Kevin Ellich – RBC Capital Markets

Bruce, did you say Q4 will be the first full quarter with the rent reduction from S&H and is that $500,000 a quarter?

Bruce Mackey

Yes.

Kevin Ellich – RBC Capital Markets

Maybe a little bit more color on the acquisitions, the 10 additional facilities in North Carolina, South Carolina, and Texas. It sounds like pretty good properties if they are 90% occupied.

Bruce Mackey

Yes, they are good properties. Average age of the properties is less than 10 years. There was a guy that developed them and was looking to cash out. They think the CAP rate is attractive at over 9%, and both that and the community that we’ve already closed on should help drive earnings in 2010, and so good acquisitions, good properties, very glad to have them on board.

Kevin Ellich – RBC Capital Markets

So those ten properties will come into the count in Q4?

Bruce Mackey

Correct. One we closed on already, so there will be eleven in total that we’ll take on in 2009. One was Brandon Woods that closed out October 1st, and then we should close another 10 hopefully in the next two to three weeks and then another one early December.

Operator

(Operator Instructions). The next question comes from the line of Jerry Doctrow with Stifel Nicolaus.

Jerry Doctrow – Stifel Nicolaus

We actually had your unit count, I guess, 118 units below what we had in our model, and I was trying to figure out did the SNF units get taken out because they were being sold or were you taking some units off line?

Bruce Mackey

We did take SNF units out and that’s when we were going to discontinue. We pulled them out.

Jerry Doctrow – Stifel Nicolaus

Okay, they’re in discontinued option and that’s basically that number?

Bruce Mackey

I would assume that’s the bulk of it.

Fran Murphy

We haven’t taken any out of service, other than the discontinued operations.

Jerry Doctrow – Stifel Nicolaus

There were a lot of numbers going back and forth on rate change and all of that stuff, so I was trying to do the comparable community quarter over quarter, if you’ve got that, I was trying to understand the rate growth and occupancy change on those.

Fran Murphy

Sequentially you mean?

Jerry Doctrow – Stifel Nicolaus

Yes, sequentially.

Fran Murphy

I’m showing on a quarter-quarter change, it’s actually down about 70 basis points, and the reason for that is really related to the number of days in the period. That’s one of the big things.

Bruce Mackey

I think also Jerry that’s impacting that, and I mentioned this in my script, is we had this Medicare fall off on us a little bit in our skilled nursing units. They were down about 70 basis points quarter over quarter sequentially in terms of our revenues coming from Medicare.

Jerry Doctrow – Stifel Nicolaus

So that 70 basis points is change in rate rather than the change in occupancy?

Bruce Mackey

Change in rate.

Jerry Doctrow – Stifel Nicolaus

How about change in occupancy?

Fran Murphy

Sequentially almost 1%.

Jerry Doctrow – Stifel Nicolaus

It’s almost 1% sequentially on occupancy, down about 70 basis points on rate?

Fran Murphy

Another way to look at it is we went from 86% to 86.1%.

Bruce Mackey

So tenth of a percent.

Jerry Doctrow – Stifel Nicolaus

Okay, 86% to 86.1%, this is quarter over quarter comparable, and then the rate was down 70 basis points, and mostly that’s on the Medicare side rather than on private pay?

Bruce Mackey

Correct.

Jerry Doctrow – Stifel Nicolaus

I think I just missed this. You said there’s something about an $800,000 adjustment for low-income patients. Was that the rehab hospitals? I just want to clarify.

Bruce Mackey

It was. If you remember in Q2, we had a pretty big spike in the revenue. We did point that out in our Q2 call that that was a one time thing that did come to fruition. It wasn’t in Q3 as well.

Jerry Doctrow – Stifel Nicolaus

So it wasn’t so much. That’s basically a one-time change. It came down from Q2. There wasn’t a specific charge in this quarter that we need to back out?

Bruce Mackey

No. That’s exactly right. What we’re trying to do is just try to get people from Q2 to Q3 in terms of what were the big drivers.

Jerry Doctrow – Stifel Nicolaus

And Q3 is relatively then reasonable run rate depending on what happens there just in terms of the fundamentals?

Bruce Mackey

In the hospitals, yes.

Jerry Doctrow – Stifel Nicolaus

Overall, it looks like your public pay portion went up, and I was trying to sort of understand that because you were talking about Medicare dropping and Medicare rates dropping, but it looked overall the mix of the public pay was up a little bit. Am I reading that the right way? I’m just trying to understand whether you’re taking Medicaid into AL or what’s going on there.

Bruce Mackey

I think it’s more of a function of the drop in the Medicare because of a shift to the private to the pay. Like I said, we have done particularly well in the AL, ALD. I can tell you we’re not taking Medicaid to any greater extent in our private pay business than we have been already. Most of our Medicaid in the private pay businesses has come from acquisitions, and we try and wean off that to the extent that we can, and some states, it’s kind of mandated by the state. Wisconsin is a good example where a lot of our buildings in that area have community programs that are set up, and they actually work out okay, so we’re content to have Medicaid in those buildings.

Jerry Doctrow – Stifel Nicolaus

I think there’s a lot of talk back and forth about the health insurance. There was this add and subtract, but the run rate basically for that, that’s in the wages and benefits, so the run rate on that basically is the same? We’re not going to see much of a move as we go from third to fourth quarter in terms of the third quarter run rate?

Fran Murphy

It’s hard to predict that. We do expect the administration component of that cost to go down. That’s $2.5 million a year.

Bruce Mackey

And we did see those costs, Jerry, come down $1.3 million from Q2 to Q3. The insurance reserve true-up should go away, and then hopefully you’ll continue to see those claims ameliorate a little bit as well. Like Fran said, it’s pretty tough to predict. Hopefully, employees are getting comfortable with the fact that recession might be ending and maybe Five Star is going to be sticking around.

Fran Murphy

As we move into the fourth quarter, we would expect to see utilities come down $1 million or $1.5 million.

Bruce Mackey

The bad debt expenses should come down as well, and that charge that we took for the bankruptcy filing of the skilled nursing beds.

Jerry Doctrow – Stifel Nicolaus

Just to come back to the health insurance just for a second, if the claims rate stayed identical because you reduced your cost of administration, what is that delta as we go from third quarter to fourth quarter? Was that a quarterly number?

Bruce Mackey

We gave an annual number of $2.5 million to with the change in administrator, but then you also got that $1.3 million reserve true-up that should go away.

Jerry Doctrow – Stifel Nicolaus

So we’ve got a $1.3 million potential drop and plus a quarter of that $2.5 million potentially.

Bruce Mackey

Correct.

Jerry Doctrow – Stifel Nicolaus

I just wanted to see if we can get a little more color on the properties being added because they are significant enough to matter. So 90% occupancy, you are acquiring basically at 9 CAP rate. Is that the lease rate, I was just trying to get a sense as to whether they’ll move your margins and stuff. I was just wondering if you can give me a little more color on how to think that through.

Bruce Mackey

It’s better than 9. I said 9, 9 plus range. Revenue ballpark will be about between $40 and $45 million. It will move the needle a little bit in terms of Five Star. Our lease rate is sub 9, so I think there is potential to add $1 million plus in earnings, maybe a little bit more in 2010. I’m trying to be a little conservative on that.

Operator

The next question comes from the line of Donald Hooker with UBS.

Donald Hooker – UBS

Just looking at the pharmacy business, it looked like it improved nicely in the quarter. If I recall and correct me if I’m wrong, I think you have five pharmacies. Is there like one or two that are really bad and the rest are really good? What’s the dispersion of performance there?

Bruce Mackey

Yes. I talked about this I think a little bit on the last call. There are a few that are doing quite well. We’ve got great operations in the Nebraska area, the Wisconsin area. We’re struggling a little bit with our newer pharmacies especially in Virginia and Delaware. That’s what’s pulling us down a little, but you’re right, The quarter is a pleasant quarter what we have seen in the past, and hopefully we’ll continue that progress, but it’s mostly a volume story in that Virginia-Delaware pharmacy. We need to get volume up a little bit more. It’s probably going to take a little bit to do that. Other than that, we’ve got one in the South Carolina/North Carolina that is doing okay. It’s not doing as good as the other ones, but it is a positive as well. So we’ve got one that’s a negative; the rest are all positive.

Donald Hooker – UBS

Virginia and Delaware were the negatives?

Bruce Mackey

Yes.

Donald Hooker – UBS

Is there any breakout you can provide there? I was trying to figure out how much that was pulling you down? Are you just barely negative or are they really pulling?

Bruce Mackey

This is a ballpark number, but they probably lost about $100,000 of EBITDARM, between $100,000 to $200,000 of EBITDARM in the third quarter. Again, I don’t have the figures with me, but I’d say that’s in a range of reasonable probability.

Donald Hooker – UBS

You’re buzzing off some numbers in the beginning, Bruce. The $290,000 or some bankruptcy there, was that some cost that came back to you?

Bruce Mackey

It was. We sold some skilled nursing beds, some licenses that we actually got a long time ago in our spin-off in 2001. We sold them in 2008 to a skilled nursing operator that unfortunately just recently filed for bankruptcy, so because of bankruptcy laws, we actually had to give those payments back that we received.

Donald Hooker – UBS

Looking at the hospitals, you mentioned some progress with the renovation which is nice to hear. Any updates in terms of thinking about when those facilities might become profitable?

Bruce Mackey

I think we’re pretty close. We lost a little bit in Q4, $300,000 ballpark or a little less than that. You’ve got the Medicare rate increase kicking in 10/01, and one of the things I mentioned in the last quarter call that will really help drive profitability at the hospitals is our ability to push those licenses out from the main campuses to third party host hospitals. We had some good progress on one of those deals really in the last two to three weeks, hopefully we’re close on that. We don’t have any deal documents lined up, but we’re very close on the negotiations. It will take sometime, still have to clear state hurdles, but if it’s possible we can get things signed up in the next several weeks, that could be operational by end of 2010. That would really help us out on that end.

Donald Hooker – UBS

Renovations you mentioned will be done by the end of the year?

Bruce Mackey

We’re about halfway down. Don’t forgot each of these hospitals have wings, so we’re completing the second wings right now at each of the hospitals, so you’ll see some more of that come through in 2010, but it’s going much quicker now compared to if you look at how long our first wings took to get through this state, and now we’re with the second wings, we’re down to about a 6-month cycle as opposed to a 2-year cycle.

Donald Hooker – UBS

Is there any ballpark when the whole project will be complete?

Bruce Mackey

I would expect we’re talking substantial completion probably by the end of 2010, very early 2011.

Operator

The next question comes from the line of George Walsh with Gilford Securities.

George Walsh – Gilford Securities

Bruce, you earlier going into the fourth quarter said health insurance adjustment if not repeated in the fourth quarter and also does energy cost spike come down from the adjustment, you get about $2.5 to $2.8 million there and that gets you back to an operating income lying closer to about $4 million, and that doesn’t include any rent benefit that you might have. Does that sound more in line with something that’s reasonable for the fourth quarter?

Bruce Mackey

Doing the math you just did, yes.

George Walsh – Gilford Securities

What’s different quarter is, for the first time, you really faced the trends of having to deal with in general lower occupancy levels and not as much pricing power as you have been able to have previously versus an increase in cost. Is this a trend? Do you think it’s something that you’re going to be having to dealing with more severely on the cost side going forward or is the only answer to these really going forward that these occupancy levels and average daily rates better pricing power going forward?

Bruce Mackey

I’d like to think we’re at a low point, George, but time will tell on that. I think there are a few things. On the pricing side, we’re still going to forecast price increases into 2010. We actually met with my regional operators about two weeks ago, and while the color I gave earlier with people asking about 2010 rates, and no one has asked on this call what we’re looking at, but I’ll just give you a little bit of flavor. We’re still projecting decent rate increases, especially in the assisted living and Alzheimer’s side where we’re doing quite well across the country. We’ll be pushing rates again on the IL side, not so much. We do have a little bit of a rate give back on the Medicare side, but we’re mostly getting that back on the hospital side because they’re getting a Medicare bump, so I expect we’ll be able to push pricing a little bit. In terms of where we are occupancy wise, things do appear to be stabilizing. I think it’s too early to say that we’re out of the woods yet, but this is the first quarter in eight quarters where we saw a little bit of an uptick. I realize it’s only 10 basis points, but as opposed to the 50 basis point drops we’ve had quarter over quarter for 8 quarters in a row, again, I’ll take it, and hopefully it’s something that we can build upon. There are a lot of favorable signs in the industry in terms of the demographics, both supply and demand. Supply is pretty much shut down and will take years to restart, so I think that’s going to be a big positive for us as well. If all that fails to come to fruition, we do have opportunities on the cost side as well. We’ve made some big changes on the healthcare plan really as a result of what we’ve been seeing, and there are probably other areas that we can tackle drastically if we have do. I don’t think we need to do that yet, but it’s always a possibility to take another look at it.

George Walsh – Gilford Securities

Any trends in the claim utilization, has that abated at all, and how did this plan going forward of the new insurance consortium you were putting together with other companies, how will that benefit this situation with the health insurance?

Bruce Mackey

To the second question, it won’t benefit at all. That we’ll probably primarily set up with property insurance, and then Workers’ Comp, and maybe professional and general liability insurance. We expect to see the benefits of that kicking in 2010, first with property. To the first part of the question, I know I spoke to this I think when I was talking to Kevin. Utilization has abated a little bit, and we did see claims drop $1.3 million from Q2 to Q3, and hopefully, we’ll see that trend continue. It’s too early to say. Our utilization is still up though year over year. It’s something that we need to work on, and we’ve got a lot of program that we’ve put in place over the last year to help drive down utilization. It’s more of a cost shifting, consumer-driven health plans where we’re really increasing deductibles, at the same time lowering some of the out-of-pocket, so really making employees take a conscious decision before they go to the ER on what could be a simple matter that could be handled by their primary care physician. Those are just some examples, but they’re mostly called wellness programs, and they usually take quite a number of years before you really get a good payback from those benefits, but there are things that we have implemented.

Operator

That’s all the questions that we do have. I’d like to turn the call back over to Mr. Bruce Mackey for any additional or closing remarks.

Bruce Mackey

Thank you all for joining us on today’s call. We look forward to updating you on our progress in the future.

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Source: Five Star Quality Care Inc. Q3 2009 Earnings Call Transcript
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