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Five Star Quality Care (NYSE:FVE) has garnered a lot of press over the years, for a small cap stock. This may be explained by the fact that it is one of a handful of companies in the stable at REIT management and research firm RMR Advisors, a company providing FVE with advisory services. RMR runs several real estate investment trusts including Senior Housing Properties Trust (NYSE:SNH), FVE’s principal source of long term lease financing for acquisitions.

FVE operates a bit of everything in caring for seniors, long term care pharmacies; inpatient rehab hospitals; skilled nursing; private pay senior living; and a home health agency. If you find this confusing, join the club. Many have struggled to categorize FVE but I’ll let you in on a little secret: despite its name and holdings, FVE is not really a healthcare company. FVE is a leading owner/operator of middle to high end independent and assisted living for seniors - that is what makes FVE so attractive.

For those unfamiliar with the dynamics of the senior living business, let me briefly recap the major themes. In the past three years several high profile bankruptcies and collapses of major public and private senior housing companies resulted in a dramatic curtailment of new development. Economic pressures, aggravated by depleted nest eggs, have limited seniors’ ability to fund the large deposits required by many retirement communities and delayed movement into supported living arrangements. This has led to historically low occupancy rates throughout the industry despite demographic trends showing a burgeoning elderly cohort.

Supported living is a need, not a want. How this need is fulfilled is one’s only choice. It can be done through family support; private duty aides; home health services; adult day care; and senior living options. Aided by dual wage earner social security checks, savings and family support, most seniors can afford independent or assisted living. Next to one’s own home, senior housing is the preferred choice offering social, spiritual and therapeutic benefits along with a maintenance free lifestyle. This is where FVE comes in – FVE offers the variety of living choices from middle class to luxury senior living rentals, and all without major entrance fees or deposits.

Operating as Five Star Senior Living, FVE’s independent and assisted living business (including continuing care retirement communities) generates over $850 million in annual revenues or 68% of its overall revenues. FVE has grown its profitable senior living business at a 16.6% CAGR since its first acquisition in 2002. As of today, FVE operates or manages 203 senior care communities with over 23,000 units. FVE’s strategy is to leverage its very efficient overhead model and large footprint by buying or leasing attractive properties with decent occupancy and then investing aggressively in these properties to drive rental rates at a 3%+ level.

FVE was recently pummeled along with concentrated skilled nursing operators because of reductions in Medicare reimbursement rates that went into effect on October 1, 2011. And while FVE does own and operate skilled nursing facilities (SNFs), Medicare revenues from this business make up just 15.4% of its senior living revenues and 13.1% of overall revenues. At the JMP Securities 2011 Healthcare Conference held on September 28, 2011, FVE’s CFO said the impact of the Medicare cut would be limited to $13 million to $17 million – compare this to expected revenue cuts at Sun Healthcare (NASDAQ:SUNH) of $40 - $50 million or Skilled Healthcare (NYSE:SKH) of $42 million and it’s easy to see the difference in business models of these similarly sized companies. FVE has already mitigated much of its Medicare rate reduction through growth in 2011.

In addition to being a growth stock, Five Star is also a value stock, sporting an EV/EBITDA multiple of 3.9 on a TTM basis and a price to tangible book percentage of 60%, providing investors an excellent margin of safety. It trades more cheaply than all of its peers; has high insider ownership; a solid management team; access to nearly unlimited financing; can grow its business aggressively achieving excellent returns; and has very high upside potential.

Despite all the turmoil in the senior housing industry over the past few years FVE has remained profitable by relying on margin expansion and acquisitions and is poised to grow earnings rapidly once occupancy rates rebound. Each 100 basis point increase in occupancies translates to $10 million of additional revenue, nearly all of which falls to the bottom line. The question is not if occupancies will rise, but when.

Source: Five Star Quality Care Poised To Profit