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Executives

Ross Rodman – SVP, IR

Bill Sheriff – CEO

Mark Ohlendorf – Co-President and CFO

Analysts

Ryan Daniels – William Blair

Frank Morgan – RBC Capital Markets

Sloan Bohlen – Goldman Sachs

Bryan Sekino – Barclays Capital

Jerry Doctrow – Stifel Nicolaus

Rob Mains – Morgan Keegan

Brookdale Senior Living, Inc. (BKD) Q2 2011 Earnings Call August 9, 2011 10:00 AM ET

Operator

Good morning. My name is Nicole and I will be your conference operator today. At this time, I would like to welcome everyone to the Brookdale Senior Living second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. I would now like to turn the conference over to Mr. Ross Rodman, Senior Vice President, Investor Relations. Sir, you may begin your conference.

Ross Rodman

Thank you, Nicole and good morning, everyone. I would like to welcome you all to the second quarter 2011 earnings call for Brookdale Senior Living. Joining us today are Bill Sheriff, our Chief Executive Officer and Mark Ohlendorf, our Co-President and Chief Financial Officer. Also present is Andy Smith, our Executive Vice President and General Counsel.

As Nicole mentioned, this call is being recorded. A replay will be available through August 16 and the details on how to access that replay are in the earnings release. This call will also be available via webcast on our website www.brookdaleliving.com for three months following the call.

I would also like to point that all statements today, which are not historical facts, may be deemed to be forward-looking statements within the meaning of the federal securities laws. Actual results may differ materially from the estimates or expectations expressed in those statements. Certain of the factors that could cause actual results to differ materially from Brookdale Senior Living’s expectations are detailed in the earnings release we issued yesterday and in the reports we filed with the SEC from time-to-time. I direct you to Brookdale Senior Living’s earnings release for the full Safe Harbor Statement.

And now, I’d like to turn the call over to Bill Sheriff. Bill?

Bill Sheriff

Good morning and welcome to our second quarter earnings call. We accomplished some very good things in the second quarter and at the same time had some outcomes which were not as good as we expected. First, I want to start by describing what we saw with regard to occupancy and rate for the entire quarter.

We began the year with expectations that we were nearing that tipping point where we would begin to produce the strong growth metrics that this industry will create given any – even a slow, but recovering economy. Our first quarter, while having the typical seasonal occupancy softness, was in line with our internal plans and we continued to focus on both rate and occupancy growth that began in 2010.

In the second quarter, we successfully drove rate growth, achieving a 3.7% same growth community growth for senior housing, the fifth consecutive quarter of rate growth improvement. All of our segments, retirement centers, assisted living and CCRCs have rate growth greater than the net industry average rate growth of 1.6%.

In terms of occupancy, April, other than having higher attrition than it’s customary, was not totally out of the norm, but as we went through May, we were not seeing the improvement we had expected. It became clear to us that the change in the economic drivers affecting our customers, was having an impact. It was at that time that we were in the process of undertaking a securities offering and we felt it necessary to update our guidance. More importantly, in response to what we were experiencing, we undertook to mitigate the more challenging environment.

We tweaked some of our pricing and use of incentives beginning in May to drive move-ins. With the use of measured incentives, we were able to re-establish occupancy growth and in June, we moved in 1800 residents and increased average occupancy by 30 basis points. We ended the quarter at a higher occupancy than we started the quarter. This carried on into July and we increased average occupancy by another 40 basis points. We expect to see continuous improvement, while staying within the boundaries of reasonable competitive pricing.

We were also impacted by the decrease in hospital discharges, which has been broadly recorded by the hospital industry, which resulted in a drop in our skilled nursing census, particularly rehab oriented Medicare. Of the 90 basis point sequential drop in our CCRC occupancy, over half of that was in skilled nursing, which also accounted for about 25% of the 60 basis point overall sequential occupancy decrease.

While skilled nursing census is a short duration and can be a little volatile, this was unusual. We believe this is a temporary situation and we saw an increase in July and expect further improvement through the third quarter.

The second quarter was also (inaudible) with entry fee sales. We were on track to have a good second quarter when it unraveled at the end of the quarter with (inaudible) and cancelled sales. We did increase the number of sales to 73 from last year’s 59 with gross proceeds increasing to 12.5 million from 9.4 million. The third quarter is off to a decent start, but we’ll have to see the effects of recent market moves and other events.

I want to take a minute to provide an update on our ancillary services business, which does not include skilled nursing. The second quarter was the first time that our ancillary services business growth leveled off a bit. Our revenue grew by 5% over the prior year, even with the impact of rate cuts in both outpatient therapy and home health, primarily from increased home health census volume.

Like most home health providers have reported, we were also not immune for the impact of CMS procedural changes such as the face-to-face requirement and home health re-assessment changes. We are making progress on mitigating the impact on our productivity with systems and process changes.

We made four home health agency acquisitions this year, add four hospice location and pre-survey readiness and started personalized living, which is private duty private nursing services in 18 location so far this year. Those activities incurred approximately 700,000 of start-up losses in the second quarter.

With the intending acquisition of Horizon Bay, our ancillary services organization has been preparing to roll out our services as quickly as possible across this large portfolio and may view this as a significant opportunity. We have been working hard to develop and maintain our strategic advantage with ancillary services, expanding our footprint, building the most cost effective model as well as introducing new services. Even with the impact of home health and therapy rate reductions and home health procedural changes, because of our strategic cost structure advantage, the outpatient therapy and home health businesses still produce healthy margins.

These programs are a way to leverage our capital intensive business with non-capital intensive services that provide good incremental investment returns and important services to our residents. One doesn’t like to give up margin, but there is a positive side. We are already beginning to see home health agencies and CON states coming to the acquisition market at reduced prices. We believe there may be similar opportunities for us to acquire CON beds for skilled nursing, where we’ve been previously unable to acquire at reasonable prices and where we need to fill out a campus for network.

The $0.52 CFFO number was disappointing to us. If you remember when we discussed Q4, 2010 expenses, that everything went right, this was the polar opposite. Demands lacking as the economy faltered, skilled nursing Medicare census fell, entry fee cancellations and refunds spiked. Ancillary services hit a growth low and was incurring some higher cost dealing with the procedural changes, both occurring for significant growth or the Horizon Bay acquisition and then storm related expenses jumped. All items that should and will correct themselves.

This was not our strongest quarter, but we are looking ahead to many exciting things on the horizon. We are seeing the positive impact of actions we took several months ago in occupancy and operating cost. We have pushed out our debt maturities at the same time without encouraging the large rate reset that was feared might happen.

The form of debt also lost in attractive rates and increases flexibility as the future accessibility to value in our assets. And of course, we are very excited about the Horizon Bay acquisition, which I will talk about, but first, I want to turn the call over to Mark to provide more details on the quarter.

Mark Ohlendorf

Our reported CFFO was $0.51 per share. Excluding almost $1 million of acquisition and financing transaction cost, our CFFO was $0.52 a share. As Bill described, there were some areas that caused the shortfall to our expectations. We incurred $1.1 million of incremental storm-related costs, our home health and hospice start-ups incurred start-up costs of $700,000, our entry fee refunds were $1 million higher than historical trends. Our Smith occupancy averaged 50 less Medicare occupied beds than in the first quarter. And of course, occupancy was lower sequentially compared to the first quarter. Rates generally held up well.

Looking at the details of our operating performance for the quarter compared to Q2, 2010, same community revenue increased 3% with average revenue per unit up 4%, but occupancy down 90 basis points and expenses increased 4.4%. Breaking the same community data down further, our senior housing revenue grew by 2.7% with revenue per unit increasing by 3.7% and occupancy down by 90 basis points.

Senior housing expenses grew by 3.3%, consistent with the 3% to 3.5% range that we had projected. Our labor cost, our largest expense item, grew by 1.9%. Food and utilities were both up around 2.8%. Excluding the ancillary services business, same community senior housing facility operating income grew 1.5% in the second quarter.

General and administrative expenses, excluding non-cash stock-compensation expense was approximately $28.2 million, which was 4.7% as a percentage of total revenue under management.

Turning to the balance sheet, we continued to strengthen our financial position and improve our flexibility. During the second quarter, we completed the issuance of $316.3 million of convertible senior notes due in 2018 and an underwritten public offering. Simultaneously, we entered into convertible note hedge transactions as well as warrant transactions relating to the same number of shares of common stock.

The effect was to increase the effective convert strike price to $40.25 a share, which was 75% over the closing price of our common stock on the day of pricing. The net cash proceeds of all three transactions were 276.4 million, which was used to repay $274.9 million of mortgage debt. The interest rate of the converts is 2.75% and including the net cost of the hedges, the effective rate is 3.1%.

Last week, we announced that the company closed a seven-year $437.8 million first mortgage loan with Fannie Mae. 75% of the loan bears interest at a fixed rate of $4.25 and the remaining 25% of the loan bears interest at a variable rate of 30 day LIBOR plus a margin of 182 basis points for a blended current rate of 3.7%. The loan is based on a 55% loan-to-value ratio and we have the right to substitute properties, important for our Program Max initiative and also the ability to increase the capacity where the asset value grows.

We used the proceeds, along with cash on hand, to repay $445.2 million of mortgage debt, which was scheduled to mature in February and August of 2012. Both the convert and these mortgages were structured to mature at the same time, so that with the low leverage on the mortgage debt, there would be free asset borrowing capacity to refinance the convert maturity if needed in 2018.

We’ve now eliminated all of the company’s 2012 debt maturities, except for normal scheduled principal amortization and of the portion of the company’s 2013 maturities. Since the beginning of the year, we’ve paid off $845.5 million of debt and obtained new financings of $782 million for a net reduction in funded debt of 63.4 million, while also un-encumbering assets that can be used to add borrowing capacity to our secured line of credit. Moreover, we’ve managed to reduce our interest cost by about 1.7 million per year in contrast to our original expectation that we would have a $20 million increase due to refinancing rate resets.

We ended the quarter with $40 million of unrestricted cash and no borrowings on the line. At the end of the quarter, we had cash and available borrowings under our line of almost 260 million. We will use roughly 50 million of this liquidity to close the Horizon Bay acquisition and the related transactions with HCP.

Looking at the CapEx, which we include in our CFFO calculation, our spending in Q2 for maintenance CapEx was $9.3 million. For the full year, we continue to expect to spend $35 million to $40 million on maintenance CapEx for our communities.

Next just a few comments on CMS’s 2012 skilled nursing rule. Our Medicare party skilled nursing revenues are approximately $165 million to $170 million per year, plus we have an additional $15 million or so of managed care skill nursing revenue, that is contracted based on Medicare of PPS – rates. The new rule reduces rates about 11% for us with our current case mix and eliminates the use of group therapy, which will initially increase cost.

Our preliminary analysis shows that we expect our CFFO for the year from October 1, 2011 to September 30, 2012 will be reduced by $20 million to $25 million before considering any mitigation measures. We’ll look to lower expenses to increase productivity and examination of our case mix, and believe that we can mitigate 10% to 15% of the rule change impact.

The bottom line of these changes for us is that, the rates end up about 3% to 4% higher than what we received in 2009, with somewhat higher operating expenses. Skilled nursing remains an integral part of our business strategy. As part of our strategy to have a range of products and services in a market, skilled nursing fulfills our customers desires to make only one decision to minimize moves and to build a lasting relationship with the trusted provider.

We do not operate freestanding skilled nursing and enjoyed both the cost structure advantage in a higher quality mix with a combination of private pay and Medicare beds part of our continuum. For us, skilled nursing remains a profitable product line even after these rate reductions.

Finally, we are excited about the Horizon Bay acquisition. We will be adding 90 communities with over 16,000 units, increasing our footprint by over 30%. 21 of these communities will be in a RIDEA joint venture with HCP. Brookdale will buy a 10% interest in the joint venture and assume the management of those communities. There is a base management fee based on gross revenues and an incentive fee based on exceeding EBITDAR targets.

We will retain all of the ancillary services cash flow and pay fair market rent for the space occupied. Second, Brookdale will triple in that least 12 communities from HCP. The primary lease term expires in 2024 and has two 20 year renewals. The lease has a predetermined rent scheduled for five years, then escalates 3% per year thereafter.

Those 33 communities in the RIDEA JV and the lease pool with nearly 7,000 units of capacity had 90.8% occupancy for the second quarter. The remaining 57 Horizon Bay communities are third-party managed. In total, we received significant management fees, all of the ancillary services cash flow, joint-venture ownership returns on some of the assets and the operational cash flow on the leased assets.

Our initial investment for both of the transactions will be approximately $47 million, including acquisition consideration capital contributions to the HCP joint-venture, integration costs, transaction expenses and capital expenditures related to the roll out of our ancillary services programs. We project our return on the invested capital of approximately $47 million for all of these transactions to be in the 35% to 40% range. Before transaction and integration costs, we expect CFFO accretion of $0.08 to $0.09 for the first year and to grow from there.

For 2011, that means a few pennies of accretion, which becomes more significant in 2012, a range of $0.09 to $0.11 and in 2013, a range of $0.15 to $0.17. This does not include opportunities for us to reduce costs across our total portfolio using procurement volume leverage, which we’re exploring with our vendors.

I’ll turn the call back over to Bill.

Bill Sheriff

Thanks, Mark. It remains to be seen what happens with the economy during the remainder of the year. But we are operating under the assumption that we will not see much improvement and have taken actions consistent with that assumption.

As I said, we are focused on occupancy with more aggressive, but measured pricing and looking to manage all our costs appropriately. For the remainder of 2011, we now expect that we will continue to have a consumer challenge by a stalled economy. That leads us to expect that for the full year 2010 the following.

Revenue will grow by 3% or so. We do expect full-year average level of occupancy to be at least that of 2010. And we expect rate growth in the 2.5% to 3% range including the effect of the $5 million hit in Q4 due to the CMS sniff rate reduction. Ancillary contribution growth, which slows seasonally in Q3 will then pick up in Q4, plus we will have growth as the roll out begins with the Horizon Bay acquisition.

Expense growth will be in the range of 2.5% to 3% with senior housing cost growing at 1.5 to 2.5%. Routine CapEx, maintenance CapEx will be in the range of 35 million to 40 million. We would expect approximately 13 million of net entry fee cash flow. And we should experience a small contribution from the Horizon Bay acquisition during the latter part of the year.

All of this will drive CFFO to be in the range of $2.10 and $2.20 per year. In rough terms breaking down the 15% –the $0.15 reduction in guidance is due to occupancy shortfall of roughly $0.10, rate shortfall of $0.08 including the additional four from CMS reductions in Q4, an entry fee reduction of several cents, the one-month delay in closing of the Horizon Bay transaction, which could be a reduction of approximately $0.01. Some of these would be offset by positive impacts of lower operating cost and interest costs.

The guidance does not include the impact of any future acquisitions we may make. It is unfortunate that the economy trying against this and has created the disappointing short-term results. We still are excited about the value that we are creating and will create over time. Putting aside the current economic environment, we are in a very good place. We have spent a lot of time, resources and efforts to build the platform that positions Brookdale to pursue the growth opportunities that we knew will inevitably emerge.

We have created relationships with partners, who’s interested in our line and who have significant low-cost financial wherewithal. We are seeing a period of time, where sellers are reappearing and for the most part with valuation perspectives that make attractive variations to our portfolio given our operating advantages.

Horizon Bay is a good example. We have exulted many benefits before, but as we go deeper into the integration process, which is well underway, we find that our assumptions of culture bid and strong people talents are being exceeded. We believe there will be other significant opportunities that would evolve out of this acquisition though it is premature to discuss that we have – after we close and are deeper into the integration process.

The pipeline is very active subject of course to market financial market conditions, we expect to make additional acquisitions before the end of the year. We have reduced leverage and executed the refinancing plan that eliminates debt maturities until 2013 and actually reduces interest cost in the phase of higher vendor spreads . We believe we are incredibly well positioned to capitalize on some significant opportunities to maximize shareholder value and incredibly that investors should not become the periods of time on the table set for good things to happen despite a challenging environment.

We will now turn the call back to the operator to begin the question-and-answer session. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Ryan Daniels with William Blair.

Ryan Daniels – William Blair

Yeah, good morning guys. I want to dive into a little bit more on the incentives that you’re using through drive up the occupancy, obviously that they’re working fairly nicely of late. Can you give a little bit more color on kind of what form those are taken on your lowering street rents? Is it just additional months for free? And I’m also curious, if you knew inventory management system has allowed you to have a little bit more flexibility there, and it’s kind of driving that occupancy growth?

Bill Sheriff

These systems which we rolled out are certainly providing us much better tools and play a real-time information. The incentives are not lot different than what we have used and had in our tool boxes before. Though we’ve loosened up, where we had tighten up a fair amount in the first quarter and even into the early part of the second quarter. But it’s a lot of the same tools, that’s not aggressive price reductions, it is more in the form of incentives that we burn off, and are not long-lasting as far as totally decreasing your rate base. So it is a lot of the tools that we’ve known it, times in the past used and times in the past that have been affected. And it – gets varies a little bit market by market depending on what those market conditions and the competitive environment is.

Ryan Daniels – William Blair

Okay, fair enough, that’s helpful. And then, just looking at a nuance maybe a question for Mark. Entrance fee refunds even netting out the MyChoice refunds look a lot higher than we’ve seen in the past. And I think you’ve called that out is being maybe a million or million two above your expectations. Was there anything unique there, that drove kind of that average refund per unit up during the period or was that just an anomaly?

Bill Sheriff

This is Bill. I’ll – Mark will expand on it, but it is a look more of an anomaly. You had more of the non amortizing set that refunded during that quarter than the amortizing. And it was one of the higher peaks that we’ve seen in that particular mix, and you would expect that to balance. And as you see in the data, the trend has been over the last couple of years, that marketing more non-refundable than refundable. So once it don’t amortize as much as actually decline, but that in the refund side of that, that peak during the quarter.

Ryan Daniels – William Blair

Okay, that’s enough color, that’s helpful. And then two more and I’ll hop off. Just on program MAX, I’m curious if given some of the recent change as you guys have revisited that at all, you’re thinking about the macro environment and growth opportunities there may be more specific to sniff that, are you kind of revisiting the potential to change maybe more Dementia beds or other categories given the recent rate reductions?

Bill Sheriff

First of all, we had a good healthy mix of the Alzheimer and Dementia beds in our Program Max. We are still getting extraordinary high returns out of those where we’re adding the skill nursing components. And even after rate reductions and other effects of cost again due to our cost structure in skill nursing, that is still a very attractive components again. We’re quite different than the respending and nursing in terms of our cost structures and the quality of the paying extra beds here, but we still get very good returns on that. But we are – returns – with all that and in terms of all the detail, we are getting very strong, healthy returns out of that and probably is even more effective to the adverse conditions or not. But we will certainly be evaluating and looking at every aspect of our capital deployments in light of the last few days market changes.

Ryan Daniels – William Blair

Okay. And then my final question, I’ll get off. Just thinking about the pending Horizon deal, I’m curious if you engage more with Chartwell, but the potential actually buy some of those real estate assets. I think they’ve become more vocal lately given some of the Tazewell changes about their desire to invest in some of the U. S. real estates. So any color there about that would be helpful as well? Thanks, guys.

Bill Sheriff

Probably we’ve had discussions and certainly there is disruptions in their agreements and things that were there and do contemplate a number of different possible outcomes. But until all of that is finalizing and closed, we agree with them not to fill into discussion of the total range of different options that will be available there.

Ryan Daniels – William Blair

Okay. That’s fair enough. I understand. Thanks, guys.

Operator

Your next question comes from the line of Frank Morgan with RBC Capital Markets.

Frank Morgan – RBC Capital Markets

Thank you. Actually, I have a couple here. First, could you give us a little more color and commentary on the actual timing the rollout of ancillary expansion with the horizon acquisition in the end? I know you mentioned and talked about your interest in acquisitions. Do you – is there any way make you rethink your – the development expansion part of your story? And then the last one is on the incentive programs that you’ve talked about any kind of ideas or thoughts on how long you might be willing to run those programs? Thanks.

Bill Sheriff

Well, on the first point that Horizon Bay ancillary services rollout, Frank, I mean our own numbers that we’re providing you from accretion standpoint, we are assuming the full rollout is four, five, six quarters, somewhere in that range. We’re obviously trying to go quicker than that, but from the standpoint of providing some accretion guidance, that’s the assumption that we’re making.

Bill Sheriff

There’s about 70 some odd percent of all those units are within areas where we have licenser and have operating capability. But you have existing other third-party vendors are leasing spaces and other things, all of which have to be worked through that affect the timing of that rollout that we will be going at it pretty aggressively and as we get into it, of course, we can give a better outlook in terms of what the final timing of that rollout will be.

Mark Ohlendorf

What was your second question? The expansions as it relates to Horizon Bay or the environment in general?

Frank Morgan – RBC Capital Markets

Just the environment in general, you talked about just making acquisitions, but does anything that’s happened recently, particularly on the occupancy side that make you rethink the need for the expansions?

Mark Ohlendorf

I mean the expansion program is a very long-term program. We discussed earlier this year building the construction and progress pipeline there and the project in progress pipeline over the year this year, many of those projects take a number of years. And I think it’s clear to all of us what the demand situation looks like once you get out two, three, four years. Now it could theoretically impact pacing at some point, but quite frankly, the pacing is probably more impacted by our acquisition opportunities.

Bill Sheriff

But the expansion where we are opening those repositioning and the expansions – we’re even as a buyer, because those are some of our strongest performers that are taken on. And again typically, we’re filling in a missing level of need where we have internal feet, direct feed factors. So those would probably stay in a priority position with regard to the capital allocation.

Mark Ohlendorf

I think your last question was on the use of the incentive programs. You’re really not seeing a C change in incentive programs here. I’d say what you see now are sort of redeployment of the same kind of programs we would have used in the middle of 2010.

Bill Sheriff

And by the relative guidance that we’ve given you here for the balance of the year, we – it will moderate what we otherwise expected in terms of the rate increase, but we’ll still be still effecting rate growth in rates.

Frank Morgan – RBC Capital Markets

Okay. Just one final one, on the cost side, under that environment, are there really any cost levers left that you can pull or is it pretty much just a matter of getting incentives in place and just driving occupancy growth and I’ll hop off? Thanks.

Bill Sheriff

Well, we’ll be working hard on the cost side of the equation. We have a lot of the systems rollout and all we have. We have a very, very robust cost control system capability that helps us tweak those areas and in this environment to – you expect to tackle (inaudible). We expect it will be effective in holding the cost and cost increase in line and also the Horizon Bay growth, that’s about a 30% increase in our spend developments and we are absolutely saying that with our vendors and staff, we’re being able to leverage that for lower cost within the base of Brookdale. So we will be tenaciously looking at all the cost elements.

Frank Morgan – RBC Capital Markets

Okay, thanks.

Operator

Your next question comes from the line of Sloan Bohlen with Goldman Sachs.

Sloan Bohlen – Goldman Sachs

Hi. Good morning, guys. Just wanted to start with a question on kind of your view of the CMS’s philosophy on rate cuts and whether this year was just a matter of getting back to where we were before last year or whether going forward, kind of the idea of government austerity or future cuts, just how you think about that risk going forward?

Bill Sheriff

That’s a very good question. And the tone of CMS or IG was pretty harsh and I think they feel quite bitten by the aspect of the over calculations or whatever else in the clawback, which was expected I think the – we’re far more aggressive than that – than what people expected. So that it’s the combination of issues up here and the struggles between the Medicare and then the Medicaid basis, I think that there will still be some pressure there and that’s where our focus is on having the highest quality mix in the field and very different than skilled nursing, freestanding operators and having a cost structure advantage will be critically important to us.

We think we’ll actually end up with some benefits out of this and certainly all the work that we’re doing with the different initiatives in terms of ACO related to their preliminary runners and working with different health systems and stuff and proving what we can do in transitions of care and those things, there is still the piece that hasn’t totally dropped away in terms of pay performance settlement that come with it, we think we’re in very good position and working very hard to maximize our position with respect to those. But it’s a crystal ball that’s pretty clouded right now.

Sloan Bohlen – Goldman Sachs

Okay. And then just a question on margins, to what degree, you guys have done a lot of cost cutting back in kind of the previous downturn. To what degree do you feel like you have got flexibility on managing those expense, growth rates going forward?

Mark Ohlendorf

Yeah. There is some flexibility there. I think we do have some flexibility in our benefit programs for example we’ve learned that we need to make those benefit programs sensitive to our results in some cases. So some of that is self-correcting. Clearly you see was pressure on wage cost now then I think we would have feared you let’s see if you asked us that question a year ago. So in spite of the fact that the great growth for the industry is 1.5% or 2% and for us is 3%, 3.5%. That you’d feel like you can grow cash flow in that environment because of lack of pressure on the cost side.

Bill Sheriff

Any other questions?

Operator

Your next question comes from the line of Bryan Sekino with Barclays Capital.

Bryan Sekino – Barclays Capital

Hi, good morning, guys. On the procedural requirements in the home health you mentioned, I guess just wanted to see what happened I guess in the second quarter versus Q1 on the cost associated with that?

Bill Sheriff

It’s simply as you get deeper and to that, and as you dug more into the face to face and volume basis there, as well as the other impact from administrative back support elements to all of the procedural changes and I think you can see it in the other home health, public home health folks that the impact came to impact more in the second quarter, it started showing up more than world had anticipated. We at the same time working through that and it takes some process, you got the doctor corporation, the doctor’s amendment which the process and systems and support that you do with that in terms of being efficient, effective in that place to place, is our link I mean you pay it for an episode, but we didn’t see it as you work through all that. But an increase in the length of stay, which is more time more expense but the same dollar revenue of element.

And to the process improvements and this month procedure, training and everything else we start getting some of that back. But it was more than just the rate reduction that procedural aspect had an impact as well.

Bryan Sekino – Barclays Capital

Okay. Should I guess, as you work through that we should see the impact on the cost kind of abate throughout the year?

Bill Sheriff

We expect some mitigation, yes.

Bryan Sekino – Barclays Capital

Okay. And then, on the occupancy growth in independent versus assisted, I know assisted you started the largest decline in the quarter. Just curious in terms of how I would have thought I would have underperformed AL and curious to get your thoughts in that dynamic?

Bill Sheriff

First we’ve been working very hard diligently on our IL and also the supportive service elements and everything else that have been going into support that, or having effect, the pricing element and as we’ve said we in retrospect feel that may be we were a little bit more aggressive on the pricing and good and adjust the bigger part of that hit the assisted living is the first, we shouldn’t do all of that at the first of the year. The fact while as the other rates increases across the other lines of business spread through the year more. And certainly there are some element of effect there.

I think the issue of how more challenged our IL is we have 8% or 9% of our total capacity as the entry fee IL which you can put aside from one standpoint and it has not varied over 200 basis points over the last two years, it has seen found with the rental part of IL and the CRCs has always been much stronger than the other rental of just great IL and that we’ve been working hard on all of those components. And just with the assisted living, certainly expect some direction on that and I’ve certainly seen that in June and July. And that some of that was probably from the strength of what really work, pushing on the right side.

Bryan Sekino – Barclays Capital

Okay, thanks. And then just one last from me, on the acquisition pipeline, can you give us some color on the types of acquisitions you’ve seen, are they more on the management side similar to Horizon Bay and then also are you seeing in terms of the size, are they basically one-off or are there some portfolios out there of multiple facilities that are in your pipeline right now?

Bill Sheriff

We’re seeing a number of certainly a number of singles and twos but we’re also seeing a number of portfolios of varying sizes and across the whole product spectrum.

Bryan Sekino – Barclays Capital

Okay, so I guess acquisitions with the real estate component as well?

Bill Sheriff

Yes, that’s more elaborate not acquisitions of management entities.

Bryan Sekino – Barclays Capital

Okay, great. Thanks a lot.

Operator

Your next question comes on the line of Jerry Doctrow with Stifel Nicolaus.

Jerry Doctrow – Stifel Nicolaus

Hi, thanks. Just few things, Bill back your guidance and I appreciate you breaking in out the way you did, in terms of those things the occupancy shortfall rates entrance fee, I was curious between the guidance June 1 and now, sort of what’s may be changed or may be changed the most?

Bill Sheriff

Well, we made up less ground than we had anticipated, which – the base of which we went, even though, we gained 30 basis points in June. We had expected to gain some in May that didn’t quite fully materialize and which set us at a slightly lower base and it’s that lower base that you work through from there on out that really is the difference. The skilled nursing shortfall that was emphasized back in the second quarter, the month – the latter part of May and the full month of June was particularly disappointing in that regard.

That does start and that will correct itself quick and we did see that in the latter part of July and continuing into August. But it is that ace factor where you’re starting – base level factor that you’re starting from that has the effect. And then you do effect a little bit and certainly what’s happened through that period of time as well as particularly what’s happening in the rolling environment and all is what tells us also to moderate the rate factor in that a bit. So

Jerry Doctrow – Stifel Nicolaus

And was the entrance fee also just a surprise kind of the cancellation?

Bill Sheriff

We’ve had – it’s continued to be a challenging area and where you have build up both bad news that drove up that wall of worry and concern and apprehension of making decisions, that builds up strongly. We were having quite frankly looking to be one of our better quarters and have a better lock on those things and we’re trying to make sure that we were anticipating levels of fall-outs than we had, we would have to admit at the same time that as that totally (inaudible) until the end of the quarter and what all had built up there, the cancellation decision and delays putting off closings were definitely more than we had anticipated.

We thought we have factored that fairly well into the base results we’re seeing that we’re off to another – July was a very good month against some of that was from those things and all, but yet, we’ve got to still see with what all the economic environment news here lately. We definitely were seeing the fact that people were beginning to be able to sell their homes, although a bit better, we were seeing some definite little ticks that was very helpful. Again, what will happen in this environment is a little unknown, but we’re still getting good activity and but it’s – that will be a battle on those units, again that’s about 8% or 9% of our total capacity.

Jerry Doctrow – Stifel Nicolaus

Marks up to a couple of percent, so hopefully we can hope for the best. Also I just wondered on guidance to directionally 3Q, there is obviously sort of a lot going because you’re about to close on Horizon Bay, and you’ve got kind of this drag from gearing up on the home health side and that sort of thing. So – and you’re doing this and you got occupancy going up, so directionally, should I be thinking CFFO up, CFFO down, CFFO level for third quarter, I’m just trying to understand sort of some of the moving parts.

Mark Ohlendorf

Yeah. It should move up as we go through the year and that’s our forecast. Again, we’re coming out of the second quarter with much stronger occupancy than you would have averaged in the quarter. We’ll also see entry fees building as we go through the year, that’s the typical seasonal pattern. And we do have some entry fee sales that have effectively rolled out of the second quarter into the second half of the year. So our expectation is we’ll see those numbers move up in the second half.

Jerry Doctrow – Stifel Nicolaus

Okay. And then on AL, I think someone asked about this, but it looked like you had like 150 units less on the AL, the number of properties was the same, so are you taking units out of service for Program Max or was that a factor in the occupancy, just trying to understand that a little bit.

Mark Ohlendorf

I think the number of properties would have changed. We have had a couple of dispositions as we’ve gone through the last year.

Jerry Doctrow – Stifel Nicolaus

Okay.

Bill Sheriff

We have about 100, 150 units out of inventory at this time in total. But that’s more IL than anything, because it’s more IL conversions to AL and memory care and things that’s in that right now. But there was a little bit of doubt in the quarter, but we have – I’m not trying to keeping it, but introduce so much noise in the thing that it’s hard to work through that, so we’ve chosen not to call out or breakout – break those out.

Jerry Doctrow – Stifel Nicolaus

Okay. And do you – can you quantify how much the gearing up for Horizon Bay really dragged on the quarter. And – was that a particularly big issue on the ancillary stuff?

Mark Ohlendorf

There is a little bit there, but it’s not – I wouldn’t say it’s huge. But it’s several hundred thousand dollars in just an ISC.

Jerry Doctrow – Stifel Nicolaus

Okay.

Mark Ohlendorf

You’ll begin to see those numbers ramp up in the third quarter, where we’re doing a lot of underground integration work.

Jerry Doctrow – Stifel Nicolaus

Okay. Okay. And then just last one for me and Mark, you had sort of mentioned that you’re very optimistic about sort of growth sort of three, four years out and I mean when I look at the numbers and we tend to focus on the 85 plus population, I see that growth rate of that group just continuing to drop off as we kind of move through the last, what we call the (inaudible) maybe, so when I look at growth three, four years out, I see much lower organic growth in that old senior population. So what makes you sort of bullish to things you’re going to be?

Mark Ohlendorf

Well, you’re correct. You really have a couple of things. I think if you dug into those numbers and looked at it more on an asset and income basis, you’d see that there is some growth there. The second piece is there is clearly some pent-up demand in the market. We’ve seen a lot of volatility in the economic situation. Unemployment is currently very high. So either deferral of the decision or some other substitute form of care is clearly much more active in the market today than you would see in a more normal environment.

Bill Sheriff

Considering what’s happening in the aging, how much longer the living beyond the 85 point, but multiple chronic conditions as a bigger percentage of those, look, we’ll have more demand factor for services and if you just isolate on just the instance of Alzheimer’s and the growth of the Alzheimer’s component within that, which relates more to driven the man factor, there is all those factors that would strongly suggest you’re not only still seeing some growth in the modeling part and predicting the income as it qualified, but also in the three demand drivers of that that would also suggest the penetration improvement. And on the supply side of the equation, it’s very, very muted.

Mark Ohlendorf

And it’s somewhat early to see what the changes in public policy that we are witnessing are going to have, but clearly if there is going to be pressure on freestanding skilled nursing rights, you may well see some contraction in capacity there. Clearly if you’re going to see pressure on home health rates, you’re going to see that market rationalize and because we have a meaningful cost advantage in both of those business lines, we should receive better share than we do today.

Jerry Doctrow – Stifel Nicolaus

And last one for me, that was helpful, thanks. Just would you anticipate financing acquisitions on balance sheet or would you use refinancing just as you think about the stuff in the pipeline?

Mark Ohlendorf

I think it is very transaction dependent. There is a range of opportunities. We’ve got equity available on the balance sheet with our line, we’re generating internal capital. At the same time, the REITs clearly have access to low-cost capital now. I think it would be more likely that we would look at RIDEA structures than additional triple net leases, but even that could be very transaction specific. Our investment level in this initial RIDEA joint venture is relatively low, in 10%. I think our objective would be to have a higher ownership level than that in any future deals we might do.

Jerry Doctrow – Stifel Nicolaus

Thanks. That’s helpful.

Operator

Your next questions comes from the line of Rob Mains with Morgan Keegan.

Rob Mains – Morgan Keegan

Thanks. Good morning. Follow-up on one of Jerry’s questions, Bill, in the past, you talked about, I think you may have been when the European debt crisis kind of first became primary issue. So how you’ve seen in your experience exogenous issues that all of a sudden kind of put people in suspended animation when it comes to making these sorts of decisions and I know that it’s a pretty tough to kind of take a crystal ball and figure out what the last few days are going to do to your business, but when you are contemplating the guidance for the remainder of the year, we eagerly wait for the idea that, all the turmoil in the last couple of weeks could have a negative impact on some of the measured improvements in move-ins that you’ve seen?

Bill Sheriff

Yes, we did. The whole picture here is still evolving, but definitely we saw that and view that that was going to steepen the incline just a little bit. And we – as we’ve seen – as we’ve had those shocks from a year ago in the second quarter, we’re slipped in Greece and the European thing and what all built up, it had some quick reactions, consumers then adjusted a little bit and moved on. And we’ve seen the same thing happen again here in the second quarter and now we’re having in our third quarter, a thing that’s quite concerning. We certainly did take – it did influence a bit of our tampering some learning and being slightly more cautious in our guidance and – but we’ll still be needing to assess for all those that settled out at.

Rob Mains – Morgan Keegan

Right. And then I hate to get into the Medicare membership, when you talked about the guidance for your sniff units, did you have same cool that potential negative impact of the new assessment roles?

Bill Sheriff

Yes.

Rob Mains – Morgan Keegan

Okay. And I appreciate the breakdown of what you get directly from Medicare and what you get from managed care payers who pay like Medicare, I assume you also have revenues in the sniff for managed care payers who pay like I don’t like rational humans, is that the fact as well?

Bill Sheriff

We do have some of that –

Rob Mains – Morgan Keegan

Okay.

Bill Sheriff

– and we continue to work on improving that and as we’re working with some of the systems and some of the markets, where we’re proving that we can have significant positive impacts from hospital re-admissions and work on basic disease management protocols and things, we’re getting good attention there and we expect that’s an area that we expect maximum improvement with them and we’ll focus even more on, as a matter of having to deal with this new order.

Rob Mains – Morgan Keegan

Right. And I assume that those payers that are more kind of outcomes focused than they are cost focused kind of turn to blind eye to what’s going on with Medicare rates

in terms of their rate setting discussions with you?

Bill Sheriff

I’d have to get inside their mind a lot deeper than what I might be able to hear to speculate much on – probably their thought processes are right now.

Rob Mains – Morgan Keegan

Okay. Lastly, if we go to managed care payer who is not paying you on the Medicare fee schedule, you don’t expect to get rate pressure from them just because of what CMS did?

Bill Sheriff

We don’t think so.

Rob Mains – Morgan Keegan

Right. Okay. And then just simple guidance question. Mark, I assume that guidance does not include any transaction costs you might incur in the second half of the year?

Mark Ohlendorf

That’s correct. No transaction costs or integration costs related particularly to Horizon Bay. Towards the third and fourth quarter, we’ll call those out separately.

Rob Mains – Morgan Keegan

Very good. That’s all I have. Thanks a lot.

Operator

There are no further questions at this time. Mr. Rodman, are there any closing remarks.

Ross Rodman

Just want to thank everyone for their participation and say that management will be around today. If you have any follow-up questions, give us a call. With that, thank you very much.

Operator

Thank you for participating in today’s conference call. You may now disconnect.

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