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Executives

Lisa Mayr – SVP, IR

Paul Klaassen – Founder and CEO

Mark Ordan – Chief Administrative and Investment Officer

Tiffany Tomasso – COO

Rick Nadeau – CFO

Analysts

Frank Morgan – Jefferies & Company

Jerry Doctrow – Stifel Nicolaus

Derrick Dagnan – Avondale Partners

Ryan Daniels – William Blair & Company

Sunrise Senior Living, Inc. (SRZ) Q2 2008 Earnings Call Transcript August 1, 2008 9:00 AM ET

Lisa Mayr

Good morning, and welcome to Sunrise Senior Living’s investor conference call. This is Lisa Mayr, Senior Vice President of Investor Relations for Sunrise. Joining me today are Paul Klaassen, Sunrise's Founder and CEO; Tiffany Tomasso, our Chief Operating Officer; Mark Ordan, our Chief Investment and Administrative Officer; and Rick Nadeau, our Chief Financial Officer.

Before we begin, let me remind you that this call is being recorded and that the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995 apply to this conference call. During the course of this call, the company will make various remarks concerning management's expectations, predictions, plans, and prospects that constitute forward-looking statements. Actual results may differ materially from those anticipated by these forward-looking statements as a result of a variety of factors, including those identified in our 2007 Form 10-K that we filed with the SEC yesterday.

Any forward-looking statements reflect management's current view only, and the company undertakes no obligation to revise or update such statements in the future. For a further discussion on the company's forward-looking statements, we refer you to our 2007 Form 10-K. During this call, we will be discussing certain comparative preliminary financial data and operating metrics for the first two quarters of 2008 and 2007, including total revenue under management and revenues, average daily rate, expenses and occupancy for our same community portfolio, consolidated communities, and unconsolidated ventures.

While we believe these metrics are useful indicators of trends in our management business, they should not be considered indicative of the results of operations of the company for the six months ended June 30, 2008 and 2007. Also, please refer to our July 31 press release and related Form 8-K filing for additional information regarding these metrics and to our 2007 Form 10-K for significant developments that are expected to have a financial statement impact on the first two quarters of 2008. Any financial information discussed during this call regarding the first and second quarter of 2008 is preliminary and remains subject to audit. As such, this information is not final or complete and remains subject to change, possibly materially.

I would now like to turn the call over to Paul Klaassen.

Paul Klaassen

Thanks, Lisa. And good morning, everyone. Thank you for joining us today. In today's call, Mark Ordan and I will address some organizational and other updates that have recently been disclosed, then Tiffany will discuss our operating metrics for the second quarter, and then Rick will review the '07 10-K and give you an update on our progress towards becoming a current filer.

As you saw on our release last night, we filed our 2007 10-K. So we're pleased to have completed this major milestone towards becoming a current filer with the SEC. Since we still have to file our 10-Qs for the first two quarters of '08, we will only be discussing operating metrics for 2008.

Before we address some of our other updates, I want to say just a word about continued demand for Sunrise's senior living offerings, despite the current economic conditions. I’d like to make three points. First, while the economy and housing market do impact overall occupancy, Sunrise's portfolio is over 70% assisted living, and our product is generally need-driven. Therefore we expect to be less impacted than standalone independent living or entrance fee model, and our occupancy experience bears this out.

Second, the flexibility of the Sunrise model has a clear competitive advantage in today's market. A typical Sunrise community, we offer six or more different room sizes, with rates from less than $100 a day to over $200 a day, making our products and services affordable to a wide range of consumers. These options allow families that may feel some economic pressure to select a less expensive room and still benefit from Sunrise's high quality senior living environments and our service packages.

Third, we still believe there is significant demand for high quality senior living, especially in the top metro markets. As the Q1 '08 industry data from the National Investment Center for Senior Housing showed, assisted living supply under construction grew by only 2,000 units over the prior year. And Sunrise's newly opened communities are still experiencing strong demand. Although we are reducing our pipeline for 2008, due to the current credit market constraints, we remain focused overall on development as a key growth driver.

Now I'd like to review the organizational changes that we've recently announced. As indicated, I have made the decision after 27 years to transition from my role as Founder and CEO to become Chairman of the Board of Sunrise. And Mark Ordan, our current Chief Investment and Administrative Officer, will become CEO, effective at our next shareholders meeting, which we anticipate will occur in November.

I have known Mark for many years now. His business skills, his real estate expertise and understanding of customer service business models are very impressive and a perfect fit for Sunrise, but so is his genuine appreciation and passion for the special work that we do. Mark and I partner well together. And I am confident that together, with the support, experience, and talent of the entire management team, this transition will be quite smooth.

As I indicated, I have been CEO for over 27 years, and during that time I have enjoyed seeing Sunrise grow from a single community in 1981 to the senior living leader that it is today. And I believe now is the right time to begin making this transition. By the time this takes effect, we will have completed the restatement process and will have a good plan and the right team in place to lead Sunrise through the next stage in its journey.

The role of Chairman will allow me to focus more on the things where I hope I can uniquely add value. I plan to stay quite involved in the evolution and continuous innovation of Sunrise's design, which is an important part of distinguishing the Sunrise brand. It's also very integral to enhancing quality of life for those we serve. I'm also passionate about advocating for public policy that fights ageism and supports seniors’ choices and dignity. It's another area that I will focus.

And then finally, I will continue to promote the Sunrise mission and be out in the field more, spending time with seniors and team members as our Founder, dedicated to helping Mark and the entire Sunrise team build a strong future. I have dedicated my adult life to this cause and to this company, and to seeing that better senior living alternatives are developed. We have accomplished quite a bit, but I know there is still much to do.

And now I'd like to turn things over to Mark to discuss some of our other updates.

Mark Ordan

Thanks, Paul. As I said to many people over the past month, I came here because I was very excited to join the company that Paul, Terry, Tiffany, and many others have built over 27 years. I also saw the power of Sunrise's brand and its reputation for providing outstanding service to seniors. I'm very happy to be here.

So, I've been here for four months, and I've been able to see for myself the challenges that Sunrise is facing and the fundamental strengths of the business that give me confidence for the future. I have managed through challenges like this before and I have great confidence that our team will right the ship. I believe that Sunrise has great growth potential, as we look at the supply and demand demographics in our many target markets. At the core of our business is the care we provide for 50,000 residents in a growing market. Providing the very best in care will be the basis of all we do and how we move forward.

As we disclosed in our filings, and as Rick will elaborate, we incurred a significant amount of losses related to problem situations. Our number one priority is working through each of these areas to minimize future cash outflows related to these projects. In addition, for the foreseeable future, we are not making any acquisitions. We are not exploring new geographic markets. We are not providing any new products, and we are not providing guarantees that misalign risk and reward.

We need to right-size our overhead. As you saw in our announcement, we have implemented a voluntary separation program to reduce staff numbers, and we are analyzing our costs line-by-line to eliminate every expense that is not proven to be adding to our brand and to the care our residents receive. This effort applies equally to non-service expenses that are charged to our communities.

In addition to reorganizing our staffing, we will reduce spending on outside consultants, rationalize our vendor list, and take a more systematic approach to managing our spending. Existing policies and processes such as using purchase cards, corporate travel, spending on supplies have been challenged, and where we have found opportunities to reduce spending, we are making changes.

Overall, our projected reduction of overhead costs is approximately $15 million to $20 million on an annual basis, excluding any separation payments. And this impacts both the G&A line and development and venture expense. I should note that we do expect annual increases related to our base overhead cost for inflation and some additional investments in accounting and compliance. So, not all of the savings will flow through to the bottom line.

We will continue to use our capital in the most efficient manner, which includes adjustments to our development. As you know, there is limited availability for construction debt financing and terms have become more onerous. While we have a number of excellent locations identified, zoned, and ready to develop, we have to work within the constraints of the capital market and we will be pushing some of our construction starts into 2009.

I am extremely confident that there is long-term demand for our product pipeline, and development will continue to be the key driver of our future growth. We will be disciplined in our use of cash and trimming some starts that do not meet our return standards based on the current economic environment. We will develop sites based on hard analysis with our proven development team. And while we are fully dedicated to the development partnership model, over time we will be studying ways to own more of the enormous value we create.

While we don't have a specific plan to announce, this is something we will be talking about more in the future. In addition, we aim to become a current filer with the Securities and Exchange Commission this year, and we are well on our way. Rick Nadeau, Julie Pangelinan, and their team have done a phenomenal job at leading us through a grueling process. And we hope to be fully caught up in our filings over the next two months.

Before I turn the call over to Tiffany, let me just say again how excited I am and how flattered I am to be the next CEO of Sunrise and to work with Paul and such a wonderful group of colleagues. We are determined to meet our challenges directly and move forward.

Now Tiffany Tomasso will review our second quarter operating statistics.

Tiffany Tomasso

Thanks Mark. Good morning, everyone. In spite of the economic issues that we are all facing, this past quarter, the Sunrise team was successful at growing overall revenue by 5.6%, with daily rate growth of 5.4%, while we maintained occupancy at a solid 90%. Our growth in average daily rate resulted from both increases in base room rates as well as increases in extended care rates, and also increases in extended care utilizations.

Let me explain why I believe we have been successful at maintaining occupancy and growing our rate in spite of the current economic and housing market conditions. As Paul said, our core product is uniquely positioned to care for the most frail seniors and has been designed with a variety of suite types and floor plans, enabling us to flex rates based on market conditions in both good times and bad. We believe the combination of these two, our program offering and the flexibility of our room types, is serving us particularly well today because it allows us to tailor not only care and services, but also room accommodations to better meet both the financial and service needs of current and prospective residents.

I am often asked the question, do we discount? For all of Sunrise's 27 years, we have, like any smart operator in this business or any other, used price and other tools to build and grow revenue. And certainly in a tight economy, we may push this harder, but this is only a matter of degree. In our last call, I said that our biggest opportunity was to drive occupancy in our Assisted Living product line, particularly in the smaller-style units.

Over the past quarter, we have adjusted our rates, strengthened our companion living sales strategy, and as a result, seen a decrease in our AL vacancy, helping us to maintain our occupancy at 90% overall. We are, however, continuing to see pressure on our independent living portfolio, particularly in those markets most affected by the housing downturn.

Now turning to expenses. We saw expense growth in three primary areas. Labor expense increased largely due to the increase in utilization of extended care services, which requires additional labor hours, and while profitable, has a lower contribution margin. We saw minimal increases in wage rates and continued to see positive trends in overtime. Food and utility expense has been somewhat impacted by the recent economic trends, but our year-over-year increases were less than the broader market conditions and we continue to see benefits from our national purchasing contracts.

As we mentioned last quarter, we are closely tracking utility consumption and we have a number of energy purchase contracts in place. We also benefited from credit to our health and dental expense this quarter related to our favorable loss experience. Additionally, we have completed our insurance process for this year, and we are expecting a decline over prior year, also due to more favorable market conditions and operating trends.

In sum, our community and field operating teams have continued to stay focused on carrying out the mission of providing the highest quality of life to our residents, while also maintaining strong focus on our community's financial performance. Moving forward, we will continue to maintain our focus and be creative as we try to grow occupancy while maintaining price and enhance profitability.

I’m now going to turn things over to Rick to review our financials.

Rick Nadeau

Thanks, Tiffany. As you saw last night, we filed our 2007 Form 10-K with the SEC. We are pleased to have met this major milestone. I want to thank and congratulate the entire Sunrise team for their tremendous efforts. As you saw in our press release, we plan to file our first quarter 2008 Form 10-Q on or before August 20, 2008 and our second quarter on or before September 10, 2008. We also will file our third quarter 2007 Form 10-Q shortly. We expect to be a current filer by September 2008. And as we have previously mentioned, it is our intention to hold an Investor Day later this year and, beginning in 2009, we plan to provide more disclosure on a quarterly basis.

In 2007, we had a net loss of $70.3 million as compared to net income of $15.3 million in 2006. Both periods included a number of large and unusual items that I would like to review with you. First, you will see an additional charge for our communities in Germany. Sunrise entered Germany in 2002 in a venture for the development and construction of assisted living communities, of which nine were built and opened. These nine communities are in five cities, and we have experienced lower than expected lease-up, particularly in the four communities in northern Germany.

In connection with the development of these communities, we’ve provided operating deficit guarantees to cover cash shortfalls. In 2006, we recorded a charge for $50 million, as we did not expect full repayment of the loans resulting from this funding. Since the filing of our 2006 Form 10-K, these communities have continued to fail to meet expectations, and in 2007, we took an additional charge of $16 million.

Through June 30, 2008, we have funded $37 million under these guarantees. We expect to fund an additional $62 million through 2012. Charges taken are less than cash paid, as we do expect to recover some amounts from the venture. The charges we’ve recorded are based on current lease-up and pricing forecast. While we believe our current assessment is based on our best knowledge available, we could incur additional charges if we do not achieve a stabilized level of occupancy, as we are obligated to fund under operating deficit guarantees.

Next is our construction guarantee related to our remaining condominium project. We began to develop senior living condominium projects in 2004. By the first quarter of 2008, we had discontinued or suspended the development of all but one of our condominium projects. In conjunction with the development agreement for this project, we agreed to be responsible for actual project cost in excess of budgeted project cost of more than $10 million.

Project overruns paid by us has been approximately $48 million. Based on our estimates today, we do not believe additional payments will be required related to the construction of the condo project. Of this amount, $10 million is recoverable as a loan from the venture. During 2007 and 2006, we recorded a loss of approximately $6 million and $17 million respectively due to this commitment.

The project is currently scheduled to open before year-end. You should note that we have a good location and a good product, but to the extent we do not hit our sales targets, we could have additional financial exposure. We will update you on this as we progress. For the four condominium projects that were discontinued in 2007, we recorded pretax charges totaling approximately $21 million in 2007 to write off capitalized development costs for these projects. In 2008, we discontinued development of four other projects and took an additional charge of $22 million, which will be reflected in our Q1 2008 financials. There are no anticipated future cash outlays for these projects.

Now I will discuss Trinity. In September 2006, we acquired Trinity for $75 million with the objective of entering the hospice care industry. As explained in our 10-K filing, Trinity is currently undergoing an OIG investigation related to the period prior to our acquisition. In 2006, we recorded a loss of $5 million for possible fines, penalties, and damages related to the Trinity OIG investigation.

In 2007, as a result of our periodic review of the goodwill and intangible assets related to Trinity, we recorded an impairment loss of $57 million in 2007. There are no cash charges related to this impairment. Sunrise has dedicated significant resources to turning this business around. We have recently hired a new President for Trinity, and we are investing and opening up de novo centers in areas where Sunrise has a strong cluster of communities. We are still dedicated to the hospice business, as we believe it is a good fit with the Sunrise mission, and we are focused on driving profitability for this business.

You will also see that in 2007 we expensed $52 million related to the accounting restatement. You will see additional expense of approximately $18 million in the first quarter of 2008 and $4 million in the second quarter of 2008. We do not expect significant additional expenses in this area. A new item that we did not discuss previously relates to our venture portfolio, Aston Gardens. In September 2006, a venture in which we owned 25% acquired six senior living communities with a capacity for 2,300 residents in Florida.

In late 2007 and into 2008, the operating results of the Aston Gardens communities have suffered due to the adverse economic conditions in Florida for independent living communities. Based on our assessment, we have determined that our investment is impaired, and as a result, we have recorded a pretax impairment charge and write-off of approximately $22 million in the fourth quarter of 2007. This item is recorded as a reduction to Sunrise's share of earnings and return on investment. There is no cash impact related to this impairment.

As you saw in our Form 10-K for 2007, we have received a notice from our capital partner alleging default under our management agreement. As with many of our management agreements, there are termination provisions in this contract subject to certain rights. There is an operating deficit guarantee we provided for this venture. We do not believe we will incur a loss related to this operating deficit guarantee. We are in active discussions with our capital partner, and we will update you if material information becomes available.

I won't go through all of the line items on our income statement, but I would like to speak to our general and administrative expenses. G&A was reported at $187 million in 2007 as compared to $131 million in 2006. Of this $56 million increase, only one $5.7 million [ph] was related to employees’ salaries, benefits and other expenses. And this increase in employees’ salaries was largely driven by the opening of 17 new communities.

A portion of the G&A increase is related to a special bonus pool for our United Kingdom venture. When this venture was formed in 2002, in conjunction with our 80% capital partner, we established a bonus pool for the benefit of employees responsible for the venture's success. At that time, we agreed with our equity partner to fund this bonus pool by each of the partners reducing their percentage interests in venture distributions. This venture has exceeded our expectations for it at the time of its formation.

And in 2007, we recorded equity and earnings of approximately $75 million, primarily due to venture asset sales. Both the capital partner and Sunrise contributed to the funding of this bonus pool through reductions in our respective venture distributions after certain return thresholds were met. However, due to the structure of the bonus pool as a 100% subsidiary of Sunrise and due to the fact that the recipients of this bonus are Sunrise employees, Sunrise recognized 100% of the $28 million gain attributable to the bonus pool's interest in the venture, which is completely offset by the related bonus expense of $28 million, which is required to be reflected in our G&A.

Other items explained in our G&A disclosure include $9 million for our legal expenses related to the Trinity OIG investigation, our exploration of strategic alternatives, and the settlement of litigation. We also expensed $3 million for abandonment acquisitions and $9 million related to the outsourcing of payroll processing.

In sum, our G&A expense for 2007 included a number of large and unusual items. We are not satisfied with our current levels of G&A spending. As Mark told you, we are looking at a number of ways to reduce costs, and we hope to be able to report a more rational G&A number in 2009.

Let me clarify one matter in the Form 10-K in the MD&A section under the caption Gain on the Sale and Development of Real Estate and Equity Interests. This is also included in Note 7. As you can see, we recognized in 2007 $85.2 million of pretax gains related to the previous year transactions where sales accounting was not achieved, due to guarantees, et cetera.

I know this is confusing. What is happening is that some of our prior sales transactions that were deferred in the accounting restatement are recognized in future years, including 2006 and 2007. We have another $20 million or so of deferred gain remaining that will be recorded at some point in the future. And it will go through the line item entitled Return on Investment in Unconsolidated Communities, which goes through the Equity and Earnings section of our income statement. You should not expect this to be a large recurring item to us in the future.

Another item to note is that our results of operations do not reflect development fees for either Greystone properties or certain Sunrise-developed properties for which we did not achieve sales accounting. As you may recall, during the accounting restatement, it was determined that although Greystone has received development fees related to projects, these revenues are required to be deferred. These fees are largely recognized for accounting purposes when the contracts are completed.

In 2007, Sunrise deferred $26 million in Greystone development fees, but we did recognize the related expenses. For Sunrise-developed properties, the company did not recognize approximately $9 million of development fees that we received in cash, because we have touched the real estate and will need to report the transaction as a sale. You will note from our restatement that when real estate sales accounting applies, we record profit after the cash is received. And we record it as a gain on sales. Deferred gains on the sale of real estate on the balance sheet at December 31 were $74 million, of which $55 million relates to Greystone and will be recognized in future periods.

Finally, let me review our liquidity with you. On June 30, 2008, we had $230 million of cash and cash equivalents. Of this balance, approximately $75 million was unrestricted. We had $380 million in consolidated debt outstanding as of June 30, 2008. This consolidated debt balance includes borrowings that we made on the mortgage financing that we told you about previously in April of 2008.

At June 30, 2008, we have availability of $59 million under our line of credit. You should note that we are required to maintain a minimum liquidity of $50 million comprised of both unrestricted cash, which was $75 million at June 30, 2008, and availability under the line. As you saw, our banks waived compliance with our financial covenants through the third quarter of 2008.

Due to the fact that covenants are based on four-quarter rolling income statements and including all of the large and unusual items we discussed previously, we did not believe we would be in compliance with these covenants in the third quarter of 2008. Therefore, we sought and received a waiver for the third quarter of 2008. And we do project to be in compliance at year-end 2008. The capacity under the line is $160 million. We believe we have adequate liquidity through available cash and borrowing capacity on the Bank credit facility to meet our needs.

We have been asked what other potential items we see out there as far as future risks. We continue to provide operating deficit and construction guarantees on our core mansion developments. However, historically, payments under these guarantees have been small. Today, the major risks that we see are those we have outlined today, with the largest potential issue relating to Germany. I can assure you, the entire team is focused on managing these risks.

Now I will turn the call back over to Paul for some closing remarks.

Paul Klaassen

Thanks, Rick. We hope the message that we are delivering today demonstrates our commitment to becoming a current filer and our focus on our core business. We believe we have the right team in place to get us through this challenging economic period and to create value. Like I said, I am very excited about the next stage of Sunrise's growth and our new course.

Operator, we will now take any questions that might be out there.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And we’ll take our first question today from Frank Morgan at Jefferies & Company.

Frank Morgan – Jefferies & Company

A couple of questions here. First, could you comment a little bit about the discrepancy in the occupancy trends between the joint venture portfolio versus your consolidated? And then secondly, could you just elaborate a little bit more on the notion of rate discounting, like, what form will this discounting take? And a little more perspective on how that's worked historically. And I mean, it just seems like that could be a slippery slope to start down that process of discounting. And then finally, one for Mark here, just clearly putting a halt on virtually everything, it kind of seems like the short-term focus is on stabilizing, but we’re curious about what you see so far based -- for the longer-term based on the amount of time you've been there. Thanks.

Tiffany Tomasso

Okay. Frank, hi, it's Tiffany. On the JV and consolidated and the difference in the occupancy growth -- in the consolidated portfolio, we saw that our strategy to really look at the vacant inventory in assisted living and really look at both pricing and sales strategy targeted to companion living has helped to drive the occupancy in that portfolio. On the JV portfolio, there is the mixture of independent living and assisted living. We saw AL maintain. We did see some decline in the IL portfolio in select markets. So, what we're doing there to kind of drive that performance moving forward -- and again, it's not across the board; it is in select markets where we are seeing more of an impact with the economy, the housing market. We are really looking at what is the right price for the vacant inventory in certain units, what is the -- are there specific move-in incentives that we can offer, help residents move in, those sorts of things. But again, I just want to stress it's not across the board. It is very targeted, both by market, by community, and then by product type. In terms of the continental rate discounting, I mean, we're still commanding a very strong ADR in both the venture portfolio and the consolidated portfolio. We did see a daily rate increase of 5.4%. So while we are very -- we are targeting inventory management and trying to move vacant inventory. It's very selective and it's not across the board, either in a community or end markets.

Paul Klaassen

Frankly, just from the -- this is Paul. From a 27 years perspective, this is nothing different than we've done in any of the previous 20 years. We have always worked very hard at maintaining a wide spread of rates. In any given Sunrise community, we have a wide range of rooms. We try to maintain a wide spread. So, we get more questions on it now, but obviously a company that reports 5.4% increases year-over-year isn't discounting. It's actually for a real estate-oriented product has to be overall quite a success story.

Mark Ordan

And Frank, it's Mark. To answer the last part of your question, I'd say it's a couple of things. One, I think our job right now is to get our arms around the issues that we face and make sure that we hit them squarely and reduce spending, make sure that our risks and opportunities are well aligned. And that has to be an enormous focus. We want to protect our balance sheet and make sure that we're prudent. Having said that, we manage a large company and I think we do it very well. We take care of 50,000 seniors. We have a fabulous brand and we intend to build on that. People turn to us because they care deeply about the lives of their parents. And that's an enormous competitive advantage. So, we want this to continue to be a growing company. We also think we have a very strong distinctive confidence in developing. We have very strong analytical tool that we use. And as we move out of these capital market constraints, which we look forward to one of these days, we intend to continue to be a strong developer and manager of properties. So, I'm very excited about the future. I think that I am going to be the CEO of a growing company that's gone through a difficult period. And we will manage our way out of this period and grow carefully.

Frank Morgan – Jefferies & Company

I guess one final question here for Paul. In terms of your perspective over the past 27 years, we've been through periods where supply was an issue, but do you have any perspective you could share with us on kind of what -- the issue that's out there today that's causing the demand issue, just in terms of this impact on the economy? Do you have really seen this at any other period of time? Thanks.

Paul Klaassen

Well, if you've been in business for 30 years, you've been through a few recessions. We've seen these before and we will undoubtedly see them again. This is probably as bad a housing market as I've seen in my business career. So I'm not surprised that it's making everybody cautious. And anybody who reads the Financial Times or Wall Street Journal every morning, you get a little bit depressed. So I think that's having an effect out there. As Tiffany mentioned, particularly in some markets, particularly for the more choice-driven or less need-driven part of the market, we have only 24% of our product in independent living. So we will fare pretty well. And in past recessions, we saw the same thing that there was more impact on independent living. Seniors could put off that decision for a year. At some point, even independent living though in most markets, for Sunrise and others, has a need-driven part to it. So I do believe that families, when they're looking at choices, will quickly get to the point where they are looking at how to meet the needs of a senior. And then frankly, senior living choices by Sunrise and others are a very efficient way to deliver services, often more efficient than, say, private duty home health care.

Tiffany Tomasso

Right. And Frank, just one thing I'd like to add in terms of the demand. One of the things we are kind of coming through and trying to regain and recapture occupancy is just the seasonality that we experienced in Q1 and even through April. So we did see a greater number of move-outs through the first four months of this year over Q4 of last year and the quarter a year ago. But our move-in trends on the demand issue, we've seen Q2 '08 over Q1 of '08 has grown 13%. And quarter-over-quarter, year-over-year on a same-store portfolio, we are up almost 8% in terms of move-in. So, in terms of the demand, I think it really does speak to -- it is more of a need-driven product. Really the strength of our position in the market and -- but recognizing that we're in a difficult economy, we've just got to be able to adapt to that. And I think we've got a product offering, both from an environment perspective as well as a care perspective, that’s going to enable us to do that and do that effectively.

Frank Morgan – Jefferies & Company

Just to clarify, you said the same-store, was it -- on the 8%, that was same-store year-over-year move-in?

Tiffany Tomasso

Yes. Quarter-over-quarter, year-over-year. Yes, so Q2 '08 over Q2 '07. But it was also up Q2 '08 versus Q1 of '08 by 13%. So, a lot of the things we mentioned that we were doing, both on -- from a calibrating pricing but also lead generation, external business development, I mean, there's a number of tools we are deploying to get the message and the word out. But essentially, I think what we saw in the first part of this year was really an increase in the number of move-outs. Sales and marketing machine had not -- we had not yet geared up to be able to overcome that. And we are seeing that trend move nicely in Q2.

Frank Morgan – Jefferies & Company

Are you seeing that carryover into the third quarter? And has the move-out activity slowed?

Tiffany Tomasso

Move-out activity continues to slow and moderate as we've seen in every other year, and we're continuing to see positive move-in momentum. Again, more on the need-driven product, which again, as Paul said, is 70% of our product offerings, it's a little softer in the independent living.

Paul Klaassen

Our third quarter is consistently our lowest move-out quarter, historically.

Tiffany Tomasso

Yes.

Frank Morgan – Jefferies & Company

Okay, thanks.

Operator

And we’ll take our next question from Jerry Doctrow with Stifel Nicolaus.

Jerry Doctrow – Stifel Nicolaus

Thanks. Maybe just a follow-up on that, we were looking at 1Q -- or 2Q over 1Q, which is not sort of an apples-to-apples analysis. I know because some properties have moved around. But it looked like occupancy there had slipped more, the rates were about flat. Margins were higher. I was trying to get a sense of sort of quarterly trends. It sounds like what you were just saying that you would expect occupancy improvements in third quarter, I'm not sure that we will see much in terms of rates, because you're doing more with companions and that sort of thing. How about just -- any more color, I guess, on the quarterly kind of trend lines on the things you talked about and also maybe on the expense side?

Tiffany Tomasso

I believe that the move-out pace really in Q2, kind of we saw the decrease start in May and that has now continued. So that's moderating. If we could continue to get the lead generation, the consistent solid closing experience that we've had, and we haven't seen a slip in that. I'm hopeful -- I'm going to say hopeful that we will be able to see some continued occupancy growth in our AL and memory care portfolio. I just want to be cautious on the independent living portfolio, which again, while we have independent living memory care on those campuses, the independent living component is still very much more of a choice lifestyle decision. So, cautiously optimistic on the assisted living based on the things that we're seeing in May, June and July. And I just want to moderate expectations relative to independent living.

Jerry Doctrow – Stifel Nicolaus

Okay. And how about on the expense side? Expenses could have been rising faster than the rates. Is that sort of the trend line we would expect to continue to see through the rest of the year or does some of that moderate as well?

Tiffany Tomasso

Well, I think we're seeing -- we've reported for, I think, the last -- just probably the fourth quarter now, some of the expense lines we've seen some real positive expense moderation in downturn; repair maintenance, health insurance, those sorts of things. So we expect that to continue. The labor increases, they're being driven because of an increased level of extended care utilization. We have more folks today that are on extended care services and on a higher level of service. So there is a direct correlation to that and then the number of hours. And those hours are priced; those additional services are priced at a positive contribution margin. So we're making money on it; but less money at, say, the third of fourth level than we would at the first level. So, the hours have a direct correlation to acuity. I'm hoping as we continue to grow the occupancy, we will see maybe a greater number of residents on our lower levels as we can [ph] see more moderation there. The real positive though with the labor story is over time it's being very well managed. Our wage rates have essentially been flat in terms of experience. So the team is doing a very, very good job managing the day-to-day both labor hours as well as labor rates. So -- and then in terms of food and utilities, we have seen the last three quarters very good experience on food. It did trend higher than it has in the previous two quarters, but it's below inflation. So we're staying focused on it. We are looking at our purchasing contracts and compliance against those. And then the last area we are seeing a spike that I'm not going to prophesize on that is really utilities. So I just -- I think that that's going. It's an area we have contracts in place. We’ve put an energy-efficient lighting program over a year ago. I think it's helping us to moderate the increases, but there are increases.

Jerry Doctrow – Stifel Nicolaus

Okay. All right, that's helpful. And then Mark, maybe if I just shift gears, it seems to me that with the big focus that I think you had touched on, I just want to try and get a little more color on the sort of cash needs versus cash generation. You've talked about this some. You and I guess Rick touched on it as well. But could we just get sort of a sense maybe in terms of cash needs? I guess one of the big variables is potential future guarantees for properties and lease-up. I was wondering if you could talk a little bit about CapEx. But as we go forward the next couple of quarters, do you expect to actually be increasing debt or do you really expect to be generating enough cash from operations now with the scale back in the development pace that you'll be positive cash flow here, maybe through the rest of the year?

Mark Ordan

It's Mark. I'll lead off and then turn it to Rick. What I was trying to convey and it seemed very important to convey is simply that we are going to be extremely prudent in how we use cash and how we create our balance sheet. So it's no more than that. It's saying that we've gone through a difficult period. And after a period like that, with maybe a fresh set of eyes, you say, how can we dramatically increase the efficiency of the organization. So that's the kind of operating mantra around here. And so, that was the point that I was trying to make. And I'll ask Rick to elaborate on that specific question.

Rick Nadeau

Yes. We do think that the cash flow from operations will be sufficient to satisfy our cash needs in the future. We will be judicious in how we go forward with development. And we're going to continue to develop as we have indicated, but we're not going to get speculative. We will do our developments with JV partners and with construction debt. And we are not going to allow ourselves to get longed on the construction side without having the financing adequately taken care of. So I think that in these uncertain times, we're going to be careful with how we do it, but we are going to continue to build in our core products.

Jerry Doctrow – Stifel Nicolaus

Okay. And how about just CapEx? Because that's been running at a fairly high level sort of per unit. I'm thinking more the maintenance and stuff, where do you see that sort of trending? I think you've been investing certainly in sort of the core portfolio products. Any sense of where that trends out?

Rick Nadeau

Well, one of the things you will see in our cash flow statement for 2007 is a pretty good size CapEx number. But what you have in there is condominium projects. And also the fact that we did for awhile during 2007 build somewhat for our balance sheet. And so I do think you will see that number begin to come down with -- as we go forward. As I said, we are going to build with JV partners and we will have the CapEx, but we will have the construction debt and the JV financing established. And as we have more of a trend line visibility, we will share that with you. But Jerry, right now, there's no other visibility to a change in trends.

Jerry Doctrow – Stifel Nicolaus

Okay, all right. Thanks.

Operator

And we will take our next question from Derrick Dagnan with Avondale Partners.

Derrick Dagnan – Avondale Partners

Good morning. Thanks for taking my question. I would like a little more color on the development delay and some of the decision variables behind that. Is it mainly credit market issues? Or when you look at proceeding with one property versus not proceeding with another project, is it the type of product or the region? Or what are some of the factors behind that?

Mark Ordan

Derrick, it's Mark. Why don't I talk about exactly what we're doing? Number one, the capital markets. You just have to go to page one of the paper. They are enormously challenging, and construction financing is probably the most difficult aspect of the credit crunch. So that is the direct contributor to our decision to curtail our pipeline. So I mean, in a way, I could just stop and then say that's the answer to your question. I'll go a little bit further. We are a rigorous developer. We want to make sure that we are developing great properties. And we are using very strong analytical standards. And at a time like this, when the overall economy is weaker, people are looking for larger spreads. So you just want to go back and make sure that every development that you're thinking of building is going to have robust returns. The third thing I'd say is -- nobody asked for an economy like this, but at a time like this when you have the initiatives that we've described, when we really want to focus, as Paul mentioned and I've said, and Rick and Tiffany have said, you want to focus on your core portfolio. It comes at a handy time. We want to really strengthen the company, strengthen our balance sheet. And we look forward to the capital markets becoming more hospitable, and then we will look forward to resuming a more robust growth pace. There is nothing about our product type that has caused us to reduce our pipeline. And I'd also like to say that when people talk about national demand, we are a national developer. Well, we are a national developer. We are a national developer that develops zip code by zip code. So you don't just say what's demand nationally and how many can you open. It's in particular zip codes, what is the demand, what are the competitive – what’s the competitive landscape look like? So those are the things that drive our thinking. But broadly what has changed over the last many weeks, as we all know, is the worsening of the credit markets. And that's driven what we are doing now.

Paul Klaassen

I'd just like [ph] to underscore that, because I think we would otherwise be attempting to say -- Sunrise reports a loss in 2007 and then trying to make that a connection to the reduction in development starts. And nothing could be further from the truth. That is not why we are taking a look at development. It is overwhelmingly the credit markets. Frankly, in our approach, we have great sites that are zoned. We have some really excellent joint venture partners. The availability of construction debt at attractive terms is tougher to get. But in general, we know the credit markets will come back and we will be ready with a good pipeline of great properties. And under our joint venture approach, a $25 million project with 30% equity being required and us taking 20% of the 30%, we're in the $1.5 million to $2 million of Sunrise's portion. It's not a significant capital requirement for us to start a project there. So, we like that approach even while we look at other approaches, and believe that the credit markets will turn and we'll be out there to fund good projects, of which we have a good pipeline.

Derrick Dagnan – Avondale Partners

Okay. Thank you. That's a very clear answer. Also, Paul, I want to ask you another question. In your prepared remarks, you talked -- and in the Q&A, you've also discussed kind of this range of product, at least on your pricing from the low end to the high end. And I guess when we think about back a couple of years ago, one of the main drivers of sort of the Sunrise story was the fact that you are focused in on this high net worth private pay business model. And I guess, should we look at your comments talking about the low end that maybe there is maybe a trade-down going on in the industry at all from the product side? Like, if the potential residents are not willing to go to the high end, so it's important to have some of the lower end product available?

Paul Klaassen

Well, actually, if you listen to me for 20 years, I really don't force or wish on anybody. But this has been a hallmark of our strategy since the very, very beginning. We've always had more of our pricing guidelines to make sure that we have a 100% range in our rates. This goes back to the 1980s. It has been remarked upon by a few observers that Sunrise does enjoy a price premium and yet has the highest percentage of shared occupancy units in senior living. And we do this on purpose. We were very proud of the fact we build buildings that are clearly very attractive. And we don't mind charging for the lobster special, if you will. We have a joke sometimes around here that we also want to make sure there's always chicken on the menu. Thus we want to be able to provide an option to the retired schoolteacher who doesn't have a big income or a huge net worth. And I think it's true that you can move into any Sunrise for under $100 a day and you can also probably spend over $200 a day. By the way, good retailers do this in every market, from Mercedes Benz to -- I dare say, Mark had it at Fresh Fields as a grocer a few years ago. It is important to have a wide range of rates because people come to us with maybe similar needs, but with a wide range of economic backgrounds and capacities. This has been a -- in fact, I would say what happens -- tends to happen in good times is that sometimes our rates start creeping up and we forget how important it is to maintain that 100% spread. Interestingly enough, we notice our -- in this economic downturn that we had more vacancies in our smaller units. It wasn't in our larger units. Just by maintaining and making sure that our sales team continues to communicate to our referral base, people shouldn't think of us as only there for the high end consumer.

Derrick Dagnan – Avondale Partners

All right. Thanks a lot. I'll hop back in the queue.

Operator

(Operator instructions) We’ll take our next question from Ryan Daniels with William Blair.

Ryan Daniels – William Blair & Company

Yes, good morning, everyone. I just want to go back to some of the earlier comments on the occupancy and move-in/move-out trends. It sounds like the leads in the conversions are pretty stable, but move-outs were a little bit higher. And I'm just curious, given that you guys track that, if you think it was just typical seasonality maybe a little bit worse with the flu season, or if you're hearing more about people actually moving out to help with other family members, we've heard of some seniors moving back in with families. So, any color there on what may be going on?

Tiffany Tomasso

Hi, Ryan, it's Tiffany. We saw, as I reported, I think the last quarter, we just saw it was a spike in move-outs. We saw a greater number of deaths that continued through April. So we had – if you typically have like a three-month season for move-outs, and it can be any three months and, say, the first four months of the year, what we saw this year was, it was four months and it was driven by an increase in the number of deaths.

Ryan Daniels – William Blair & Company

Okay. So, definitely not the economy there. And then, Paul, you mentioned just a second ago in responding to a question that Sunrise will typically invest 30% equity. I know a couple of quarters ago, it was 25% and I think last quarter 27.5%. Is 30% a good number to be thinking about now? Or were you just using that to make the math easy?

Paul Klaassen

It’s mostly the math, but clearly we have seen a slight increase. We are right now modeling 72.5%. So, whatever that is, 27.5% equity in our JVs, of which Sunrise, by the way, is about 20% of the 27.5%. I'll let you MBA's figure that out. For me, it was easier to say 20% of 30%.

Ryan Daniels – William Blair & Company

Sure. Okay.

Rick Nadeau

That is a number that's in some state of flux, so, that we were trying to make as an example of the leverage.

Ryan Daniels – William Blair & Company

Sure. Sure.

Paul Klaassen

In either event, let's call it 30% equity on a $30 million project, one of the reasons we're not seeing a lot of new construction in the United States right now is that on these kind of credit markets, only the best-conceived, well-financed projects with deep-pocketed investors are getting done. And that's probably okay. It's healthy for the sector. It means there's less going to be coming out of the ground two years from now, which is overall a positive deal. We still have three dozen projects under construction right now. I look forward to the fact that in 2010, 2011, there's probably going to be less new senior living construction opening.

Ryan Daniels – William Blair & Company

Right.

Rick Nadeau

What you'll find and we do find there is debt available out there right now. It's a matter of how much is available and what the terms are. The lenders are driving harder terms. So we have to be careful what we do with that.

Ryan Daniels – William Blair & Company

Sure. No, that makes sense. And then if we think about kind of the pullback in the development pipeline this year, I know it looks like in the Q, you guys have about 86 contracts and $400 million potential land value. I know most of that can be pretty easily terminated and it won't cost you guys much to do so. But have you thought about those contracts? Are you going to keep them in place and try to keep them in the pipeline? Or is that something that you might see trimming down over the next few quarters?

Rick Nadeau

You're correct in your assumption that most of those we only need to go forward with. If we actually do the project, we can get out of the -- most of them are really options, if you will. But yes, I mean, we're going to look at them very carefully. And fortunately, the vast majority of them are very good sites, and we would like to keep them and develop them at the right time. But we're obviously going to have to be talking to the other side of the transaction to make sure that we can hold them. And yes, in some cases, we may need to let the site go.

Paul Klaassen

If history is any guideline, though, here, the current credit constraints that we have, these are some [ph] things do tend to -- and we can't predict if it's one or two quarters or if it's going to take a year or 18 months, but these are really great sites. We've worked on most of them from anywhere from one to five years. And we would like to build them. That's why we invested in them and why we've worked on them. A lot depends on what happens in the credit markets and whether or not this is something that recovers soon or like many predictors have -- a lot of people have been wrong so far. So we're not going to try to predict whether or not -- when these credit markets return to some kind of normalcy. But in many of these cases, we have the ability to also delay the takedown. And I think there will come a time when we're happy that we have a full pipeline, but we aren't going to do anything rash. We're going to build them when we get good terms and when we know we can create good value for our partners and for our shareholders.

Ryan Daniels – William Blair & Company

Okay. And then two more quick ones. The first, this is just an accounting one. I know the Aston Gardens, you got the kind of bank notice on the covenant in July. I'm curious just from an accounting basis, why that charge is going into the fourth quarter '07 versus something that we'd see mid-year '08 or even in the September '08 quarter?

Rick Nadeau

That's challenging. I've been an accountant for a number of years, and the area of accounting that we accountants find the most confusing is exactly what period to put the charge in. I think that with an impairment, I think the critical question is what did you know and when did you know it. One of the unfortunate things you have being in a restatement mode that we were previously in and then being behind with respect to the 2007 financial statements, is that you have a long subsequent event period to look at. If we were a current filer, we’d have filed our 10-K on February 28. And I don't know if that charge would have been in there. But on the whole, when you go and you look at it, impairment is an economic analysis. And we determined that we did not think we were going to have a full recovery of the amount that we had on the balance sheet. And so we look at -- in 2007, we obviously had very extensive discussions with the Audit Committee of our Board of Directors and with our auditor about what the right period was. But we felt that it was an economic impairment. And we thought the right answer was to record it in 2007. And as I said, the auditor and the Audit Committee agreed.

Ryan Daniels – William Blair & Company

Okay. That's helpful and that makes sense. And then the last one, and this is something, Mark, you mentioned. I don't know if you're going to want to provide much color, which is fine if you don't. But you talked a little bit in, I believe, your prepared comments about moving forward to try to capture more of the value that Sunrise is creating in their developments. And I’m curious if that means trying to keep more consolidated communities, if it's a thought process of maybe more equity ownership in those communities? And again, I know it's probably early in the thought process there, but perhaps any color you could share for us would be helpful in that regard. Thanks.

Mark Ordan

Well, it's sort of early -- it is early in the thought process. The only thing I'd say is I think we all know that there are many companies that have done very well in the real estate business because they are very good at building real estate value. And I think a lot of those companies, including during a time like this, fare very well. So I think that since we do have that distinctive competency, we are very good at finding sites, building sites, leasing them up, and then managing them. And that adds a lot of value in the real estate business. That is an attractive thought when you look at how different companies capitalize to say that there are other things that we could think about over time. It's very important on this call that people understand that we are fully aware of the issues we face, but we're also fully aware of the opportunities that we have. So we take our strength into account, and not just look at what we're doing today, but how we could really build value over time. So that's the amount of color I can provide.

Ryan Daniels – William Blair & Company

Great. That's helpful. Thanks, everyone.

Paul Klaassen

Okay. We'd like to thank everybody for joining us And we look forward to updating everyone over the next few months as we complete our financial filings. Till later.

Operator

And that does conclude today's conference. We thank you for your participation. You may disconnect at this time.

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Source: Sunrise Senior Living, Inc. Q2 2008 Earnings Call Transcript
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