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Executives

Tim Bonang – Director, IR

Bruce Mackey – President, CEO and Secretary

Fran Murphy – Treasurer, CFO and Assistant Secretary

Analysts

Frank Morgan – Jefferies & Co.

Kevin Ellich – RBC Capital Markets

Derrick Dagnan – Avondale Partners

Jerry Doctrow – Stifel Nicolaus

Stefan Mykytiuk – Pike Place Capital

Donald Hooker – UBS

Michael Potter – Monarch Capital

George Walsh – Gilford Securities

Five Star Quality Care, Inc. (FVE) Q2 2008 Earnings Call Transcript August 6, 2008 5:00 PM ET

Operator

Good day, ladies and gentlemen. Welcome to the Five Star Quality Care second quarter 2008 financial results conference. As a reminder, today's call is being recorded.

Now for opening remarks and introductions, I would like to turn the conference over to the Director of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Tim Bonang

Thank you, Dalia. Good afternoon, everyone. Joining me on today's call are Mr. Bruce Mackey, Five Star's President and CEO and Fran Murphy, Five Star's CFO.

The agenda for today's call includes a presentation by management followed by a question-and-answer session. Before we begin today's call, I would like to state that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Federal Securities Laws.

These forward-looking statements are based on Five Star's present lease and expectations as of today, August 6, 2008. The Company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call, other than through filings with the Securities and Exchange Commission regarding missed reporting period.

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

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

Bruce Mackey

Thanks, Tim and thanks to everyone for joining us this afternoon.

Let me begin with a brief overview of Five Star Quality Care. Five Star is primarily a senior living services company that owns, leases and operates senior living communities with nearly 21,000 living it, located in 30 states.

The units in our 190-plus communities break down by product type as follows; 27% are independent living units, 43% are assisted living units and 30% are skilled nursing beds. In total, our senior living operations account for nearly 84% of our revenues. In addition, we operate six institutional pharmacies and two rehabilitation hospitals as complimentary ancillary businesses that together make up approximately 16% of Five Star's revenues.

Now let's move to our second quarter results as reported in our news release issued after market close today. Net income per diluted share from continuing operations for the second quarter of 2008 was $0.13, compared to $0.15 for the same period last year. After excluding unusual items, net income from continuing operations increased from $0.13 per diluted share to $0.16 per diluted share between the second quarters of 2007 and 2008.

The second quarter of 2008 had an unusual item related to a write-down of $1.1 million, plus $0.03 per diluted share as a result of our holdings in auction rate securities. The second quarter of 2007 had an unusual item related to a benefit of $934,000 or $0.02 per diluted share regarding a gain on extinguishment of debt. Excluding unusual items in both 2007 and 2008 six month periods, fully diluted earnings per share have increased from $0.21 per share last year to $0.37 per share this year.

I would now like to give an update on our auction rate securities. Our $70.5 million in auction rate securities remain triple A-rated and are backed by student loans that are 97% guaranteed by the federal government. Thus far, we have written down these securities by a total of $4.4 million using the valuation model. The decline in the fair value of these securities was less in the second quarter than the first. In fact, for the first two months of the quarter, we'd anticipated recognizing a benefit.

Looking to the third quarter, in July, we saw the values of these securities increase by over $700,000. While there have been additional developments that are encouraging for the long-term resolution to the illiquidity in the auction rate market, because of the Commonwealth of Kentucky redeeming some of the securities and President Bush signing into law a measure that grants the Department of Education the authority to purchase federal student loans, we are focused on what we can do to help Five Star.

Since we last spoke with you, we have continued discussions with UBS to establish a credit facility secured with these investments. I am pleased to report that in the last week, we reached an agreement in principal with UBS on a credit facility. The agreement is in documentation stage and we will make an announcement when it is completed. Of course, this agreement is not finalized and may or may not occur, depending upon the final agreement of the terms. While we have no immediate need for these funds, we believe their availability in the longer-term is important to the financial flexibility of Five Star.

Moving on to EBITDA, our EBITDA decreased from $8.9 million in second quarter year ago to $8.6 million in the second quarter of 2008. However, discounting the unusual items in 2007 and 2008, EBITDA actually increased 22% from $8.0 million to $9.7 million.

To reiterate from prior calls, Five Star's long-term business plan is very straightforward. On the highest level, we plan to take advantage of our proven abilities as an operator of senior living communities to meet the needs of the expanding senior population in the United States.

We are primarily focused on increasing the private-pay portion of our core business, both organically and through acquisitions. We will achieve this growth while maintaining solid operating metrics. In addition, we are striving to improve the performance of our complimentary ancillary businesses.

Our main areas of focus in our core senior living business are to; one, improve occupancy, two, increase same-store average daily rate, three, control labor costs and, four, maintain low G&A.

I will now review our second quarter performance in each of these areas. Occupancy, which is currently our biggest challenge, is also the most difficult thing for us to control. We have much more control over the other three focus areas. Occupancy for the second quarter of 2008 was 88.6%, compared with 90.0% in the second quarter of 2007. On a same store basis, occupancy for the second quarter of 2008 was 88.7%, compared with 90.0%.

As a reminder, when we reported first quarter results on May 7, overall occupancy for that date was 89.0%. When we presented at the Jefferies conference on June 26, overall occupancy was 88.6%. That number decreased further into July, but has started to move back up. As of last Friday, overall occupancy was 88.1%. This includes the ten communities that we began to operate on July 1, 2008. Looking at the same 180 property count we used at Jefferies, our occupancy was 88.4% as of last Friday.

I would like to remind everyone that from this level, 100 basis point increase in occupancy translates to a $9 million increase to our top-line. Occupancy remains our number one priority. I want to speak in some detail on the initiatives we have put in place over the last quarter, not only to improve occupancy now, but to better position Five Star for growth in the longer-term.

These initiatives include corporate level oversight and programs, organizational changes and staffing additions at the regional level, a company-wide lead generating blitz and IT enhancements at both the community and corporate level.

Starting from the top down, we have filled two strategic positions at the corporate level. First, we hired a new Director of Sales and Marketing. This is a very important position for us as we address the current occupancy head winds and manage through occupancy challenges in the future.

Second, we created and filled a new position, Director of Sales Training. This is something that Rosemary Esposito, our Chief Operating Officer, has felt we have needed for some time and I agree with her. We have had clearly defined Five Star standards of care in our communities and standards of service associated with our dining program. Now we are taking this approach to our sales team by bringing a uniformity and consistency in how each of our communities markets itself and works through the sales process.

On the regional level, we are taking steps to revamp our structure to better manage what has become a denser geographic footprint. During the second quarter, we expanded from 12 regions to 15 regions. I am pleased to report that we have filled the majority of the open positions that we had on the regional level as a result of this expansion.

On the community level, we have instituted a month-long blitz that is Olympic-themed and timed to coincide with activities in China. As you know, we've had success with programs of this type in the past, however, the program lasted a few days and was focused on immediate occupancy increases. The difference with this program is its focus solely on building up a solid pipeline of qualified leads. The typical rule of thumb in this senior living industry, is a single movement is achieved after culling through ten qualified leads.

Our goal of this initiative is to add 300 residents to our present census level. In order to do that, we need to generate 3,000 new qualified leads. Successfully executing on this blitz should build up our pipeline for months to come.

Also on the community level, we are making use of two software programs, one on the resident care side and one on the sales and marketing side. The first program is called AL Wizard. AL Wizard will help us more accurately track levels of care for our residents. Our caregivers in the AL communities now have hand-held devices that enable them to easily log services provided to residents as those services are completed. Any type of change in a resident's condition will lead to a new assessment.

There are two clear benefits. The resident gets an improved level of care as they need more help with the activities of daily living and Five Star will be able to capture additional fees for those services quicker.

The second software program is called Reps. Reps is a system that tracks tours, leads, referrals, deposits, admissions, move-ins and waiting list additions. While we have tracked these items previously, the Reps system is very robust and allows for a level of analysis and efficiency that we believe will improve our sales and marketing system.

Reps will be a great tool as we roll out Olympics to lead-generating blitz and formalize our sales process. We will also dovetail Reps into the back-end of our new retail-focused Web site that is currently in development.

I would now like to move to another metric, average daily rate which is an area where we have some control. On a same-store basis, our average daily rate increased by nearly 6% from $136 to $144. This increase reflects our ability to continue to push the rates for our private-pay residents in spite of the general occupancy challenges we are seeing.

In addition, we received some excellent news last week regarding government-funded rates. CMS announced final SNF reimbursement rules much better than we expected. The increase is a 3.4% rate hike to the market basket and will mean an additional $4.5 million or $0.11 per share fully diluted annually to Five Star beginning on October 1, 2008.

On the Medicaid front, most states have finalized their upcoming rates. We seem to be in line with the situation from prior year of some states being up, some states being down. And the net result is a 2% rate increase like we've received in prior years. This is particularly positive given the shape of most state's budgets.

Moving on to wages and benefits, wages and benefits as a percent of senior revenues were 48.9% in the second quarter of 2008, compared to 51.8% a year ago. In addition, this is a sequential improvement from the 50.3% we reported last quarter. This is an area that we can control and watch very closely. While we have performed well on this metric, we are not resting on our laurels, particularly given the occupancy challenges that our industry faces.

Recently, we instituted a labor initiative, based on a mid-year budget assessment to right-size our organization to present occupancy levels. We targeted the 30 communities in our portfolio with the lowest census. We removed a number of full-time equivalents. There were no employees removed from the direct care. The cuts came in areas like dietary and housekeeping. This labor initiative should bring $2 million in gross wage annualized savings.

Another area that we can control very well is G&A. Our G&A as a percent of revenues was 4.3% in the second quarter of 2008 which is down from the 4.5% we reported in the same quarter a year ago. We expect our G&A to remain in the 4.5% range going forward. This compares very favorably with the rest of our pair group of publicly-traded senior living operators.

Even with our occupancy challenges and rising costs, as Fran will outline in a moment, we were still able to increase margins. On a same-store basis while quarter-over-quarter expenses increased by 2%, our revenues increased by nearly 4%.

Moving on to our ancillary businesses, I would like to start off with our rehabilitation hospitals. We continue to strive for profitability on a number of fronts. One thing that's been working against us in the Boston area is that occupancies and referring hospitals were low in the second quarter. While we still get our fair share of hospital discharges, it was just lower than in quarters past.

Our interior renovations continue, however. In Woburn the first wing should be complete by the end of November. In Braintree, it will likely be January before we've completed the first wing.

On a year-over-year basis, we have trimmed expenses. We did this by closing three outpatient clinics that were not profitable. We are also looking to reduce third-party staffing costs in the third quarter. To give you an idea of the magnitude of savings third-party cost reductions can have, I would not be surprised if we saw a $250,000 savings per quarter related to the third-party staffing costs. This past weekend, we had a job fare for the Woburn hospital which was very well attended.

Moving over to our pharmacy business, revenues increased 28% to $18.3 million in the second quarter, compared to $14.3 million in the same period last year. Our EBITDA margin in this business was 5.1% for the second quarter. Excluding the pharmacy we sold, we have approximately 11,400 customers. Since our last call, we have added approximately 250 customers. We still expect to add over 1,200 Five Star customers over the next few quarters. We also look to add third-party business where possible.

I just want to reemphasize our reasons for getting into the pharmacy business. For our communities, pharmacy expenses are among the larger of our outside costs. It also has the biggest impact on how nurses and caregivers do their job. We got into the business first to improve our residents' experience and second, to make money.

In the last several months, we have been working on adding some satellite pharmacies. The first one opened in western Wisconsin last month, and the second in Delaware will open by the end of September. Utilizing these satellites, we expect to save on shipping costs and provide better coverage for our residents. This should also help to speed up the process of adding our own communities to our pharmacy platform.

Looking to the future, we are renegotiating our wholesale agreement that could lower our costs. We are also in the process of reducing our dispensing systems and we've begun implementation of a system that will facilitate web-based communications within the pharmacy and between the pharmacy and its customers. The system lets nurses and caregivers track where medications are in the delivery process and allow pharmacists to focus on filling prescriptions.

One of the other initiatives we are working on is consolidating some of our business office functions into one pharmacy location. We are pleased with our pharmacy margins and believe the 5% to 6% range is sustainable going forward.

Moving back to our senior living communities, in terms of development, we are currently working on adding 80 units in communities in Tennessee, South Carolina, Georgia and Maryland. We are also in the process of converting 50 independent living units to assisted living units in communities in Florida and Maryland. Lastly, we are working on the conversions of 100 assisted living units to Alzheimer's units in five communities. We will continue to look for opportunities in the marketplace and will be nimble in our approach.

After the end of the quarter, we announced a significant transaction. We successfully negotiated with New Seasons assisted living communities to assume their lease obligations on ten assisted living communities with 873 units in suburban Philadelphia. These communities were owned by Senior Housing Properties Trust. The average occupancy on these communities at the time of the acquisition was 82%.

For assuming their position, New Seasons paid us $10 million as well as transferred title of certain personal property they owned. We then negotiated to purchase three of these ten assisted living communities from senior housing for $21.4 million. These three communities have 259 living units, occupancies range from 50% to 80%.

One of these communities, located in Devon, Pennsylvania, one of the most affluent areas in Pennsylvania, had been operating for over a year with a ban on admissions. The day Five Star took over, the ban was lifted. When factoring in the money we received from New Seasons, we effectively purchased three high-quality properties in suburban Philadelphia at a cost of less than $45,000 per unit.

Last Friday, we leased two more communities from senior housing located in Birmingham, Alabama. These two communities are stabilized and have 112 assisted living units. Our rent payable to senior housing is approximately $1.1 million.

At the end of 2007, we told you that we expected to add 30 communities to our portfolio in 2008 and thus far we have added 31 communities. We also have several other deals we are looking at. These deals are in various stages of diligence and we may or may not close on them.

At the end of the second quarter, we also amended our three combination leases with senior housing. These were changed to four combination leases. The most notable change from our perspective was that we received an adjustment to the rate charged by senior housing for capital improvement costs. A quick back of the envelope calculation using 2007 numbers and on a fully diluted basis, showed a savings to us of more than $0.02 per share annually.

At this point, I would like to turn it over to Fran Murphy, our Chief Financial Officer.

Fran Murphy

Thanks, Bruce and good afternoon, everyone. I would like to begin by reviewing our senior living operations and touch upon some high-level financial metrics. Senior living revenues were $228 million in the second quarter of 2008, an increase of 14% compared with the same period a year ago. About 9% of this increase was due to additional revenue generated by communities we began to operate in 2008. Higher rates, partially offset by a decrease in occupancy at our existing communities, explains the rest of this increase.

Including our most recent acquisitions, we've added $121 million of additional revenue on an annualized basis in 2008. Operating expenses at our communities were $170 million in the second quarter, an increase of 12% when compared with 2007. This increase was due primarily to the addition of new communities in 2008.

On a same-store or comparable basis, senior living revenues in the second quarter increased by 4% to $208 million compared with the same period a year ago. This increase was due to a 5.8% improvement in rates, offset by 130 basis point decline in occupancy.

Same-store senior living expenses in the second quarter increased 2% to $155 million when compared with 2007. This increase was primarily due to wage and benefit increases. On a same-store basis, while quarter-over-quarter expenses, including labor, food and energy increased by just 2%, our revenues increased by 4%, underscoring our continued margin expansion.

Our hospital revenues were down 3% in the second quarter as compared with 2007, and down 1% on a sequential basis versus Q1. EBITDA margins for the hospitals were at 7.4% during the second quarter of 2008 versus 7.3% in the prior year period.

As Bruce mentioned earlier, pharmacy sales increased by 28% in Q2 versus the same period a year ago. On a sequential basis, pharmacy sales increased by 6% as compared with the first quarter of 2008. Our corporate and regional overhead or G&A, necessary for supporting operations, increased by 8% to $11.7 million in the second quarter from the same period a year ago. This increase was primarily due to additional regional support necessitated by the communities that we began to operate in 2008.

As Bruce noted earlier, our G&A expenses were just 4.3% of total revenues in the second quarter, consistent with our results in the first quarter. These expense levels remain the lowest in the industry. Going forward, we expect this percentage to trend towards 4.5% as we continue to staff for acquisition growth.

Rent expense during the second quarter increased by 23% to $39 million from the second quarter of 2007, due to the communities we began to lease in 2008 and additional rent for capital improvements purchased by senior housing since July 2007. Including our most recent acquisitions, our annualized rent expense is approximately $166 million.

Income taxes were $444,000 in the second quarter and we estimate that our effective tax rate will be 9% for the remainder of 2008.

Looking now at cash flows, consolidated EBITDA after adjusting for the unusual items noted in our press release, increased by 22% between the second quarters of 2007 and 2008. Cash provided from continuing operations was $540,000 in the second quarter, after factoring in changes in our working capital assets and liabilities, primarily, the paydown of nearly $12 million of accounts payable and accrued expenses, this number rises to $8.2 million.

As we said last quarter, our cash flow provided from operations was unusually high in the first quarter of 2008 and would reverse itself. This was primarily because accounts payable was very high March 31, due to timing differences of cash disbursements. Accounts payable is now $2 million less than it was at December 31, despite the addition of 19 communities in the first six months of 2008.

In the second quarter, we had $19 million of capital expenditures, anticipate recovering a total of $29 million of CapEx already expended by Five Star through sales to senior housing. We anticipate the bulk of those sales to be made by the end of 2008.

Turning now to the balance sheet and some more items of note. Cash and cash equivalents were $46 million at June 30, 2008. This was a $6 million reduction from our cash position at March 31. As I just noted, the primary reason for that decrease is that while we generated positive operating cash, our funds were reduced by $12 million as a result of timing difference of cash payments related to the reduction of accounts payable and accrued expenses. Many of these payments were related to construction and tax – property taxes.

Accounts receivable at the end of the second quarter was $61 million. Our days sales outstanding, including the rehabilitation hospitals and pharmacy operations, is an industry leading 20.3 days.

At the end of the second quarter, we had $132 million of net property and equipment. This included 15 properties comprised of 1,061 independent and assisted living units and 271 skilled nursing beds that were directly owned by Five Star. 11 of these 15 properties are unencumbered by debt. Since the end of the quarter, we have added three more unencumbered communities with 259 units and a fair market value of $21.4 million.

Our long-term liabilities at June 30 include $127 million of convertible notes and $16 million of HUD mortgages. We had no amounts outstanding on our $40 million revolving credit facility. We believe that we are currently in compliance with all material terms of our mortgages, convertible notes and revolving credit facility.

Looking forward to the third quarter, our goal is to increase occupancy levels through the various activities and initiatives on the corporate and community levels that Bruce outlined in detail earlier. We will also work to increase private pay rates to offset our increased costs of labor, food and energy. The favorable news on the Medicare and Medicaid rate fronts will greatly assist us in our efforts to drive rates into 2009.

In conclusion, our performance in the near-term will be greatly influenced by the future occupancy levels we are able to attain. These results will largely determine our ability to meet or exceed our bottom-line performance of the last few quarters.

We believe and hope that we have demonstrated this today, that our management team has the ability to drive revenue and control costs in even the toughest market conditions. Our operating leverage leaves us well-positioned to significantly expand operating earnings once macroeconomic conditions return to normal levels.

That concludes our prepared remarks. Dalia, we're ready to take some questions.

Question-and-Answer Session

Operator

Thank you, gentlemen. (Operator instructions) Our first question comes from Frank Morgan with Jefferies.

Frank Morgan – Jefferies & Co.

Thank you. I was hoping to get a little more detail to go back to those – those occupancy numbers over – I know you commented where they were at the time of our conference back on June 24, but at 88.6%. But I was wondering if you could maybe tell us what the end period occupancies were across that period? And maybe what's happened so far at the end of period for July? And if you have any data points so far for just first week of August?

Bruce Mackey

Sure, Frank. I would say they were in that range. I did a conference and again, we're talking about that 180 property count to be consistent. At your conference, we said they were 88.6%. We probably trailed down a little bit over the next few days to the end of July. I really don't have the end of July number handy, but I'm guessing it was 88.4%, somewhere around there. Like I said, that did trend down to a low – probably around 88.1%, 88.0%. And that's now trended back up as of last Friday to 88.4%. Now, between your conference and today, we've taken on those ten properties from New Seasons at an average occupancy of about 82%. That is bringing our overall down to 81%. I think we were trying to break out a little bit and give investors a feeling of – where on kind of a same store, even though that wasn't a same store occupancy at your conference, but as more of a point of reference.

Frank Morgan – Jefferies & Co.

Right. And I guess the improvement that you've seen off of that low back up to the 88.4%, presumably, this is before all these new initiatives you've started putting in place? Or do you think that might have been reflected in part of this?

Bruce Mackey

No, I would say it's before these initiatives that we put into place. Most of these initiatives are in the process of getting put into place right now.

Frank Morgan – Jefferies & Co.

Do you have any anecdotal evidence in terms of what – any particular thing that may have happened to start to see that number turn back up before the effect of all of this marketing initiative?

Bruce Mackey

It's something we have been working on now for several quarters. Occupancy has been the number one goal to drive that back up to where it was. I would like to say some of those efforts are starting to pay off. A lot of our regions and divisions are doing different initiatives really on an ongoing basis. I think some of them are starting to pay off. We're still seeing a lot of foot traffic at a lot of our buildings. That's always been there. It's really getting them in and that stuff is happening. It's getting them to “close the deal.”

Frank Morgan – Jefferies & Co.

I know you mentioned some labor cost initiatives in some of your weaker census buildings. Any particular regions or pockets where you're seeing that weakness?

Bruce Mackey

No. I would say it's really spread out in terms of where we're attacking some of that labor reduction. In terms of pockets of weakness on the occupancy side, it's probably consistent with what we said in the first quarter. Arizona remains a very tough marketplace. Areas in California remain fairly tough. Florida remains tough. I think those are probably some of our toughest markets right now.

Frank Morgan – Jefferies & Co.

And then I'll ask one more and hop out and let somebody else ask. But in terms of looking at the volume trends in the rehab space, it looks like that was down. I know we got reports out of Health Stuff this morning seeing some – starting to see some good growth. Any commentary? Has that trend in any way improved so far and so far in the third quarter? Have you seen any kind of improvement there on the occupancy or on the admit side or discharge side?

Bruce Mackey

Yes. July did pick up a little bit. But we really need to get our refurbishment done of the rehab hospitals. I think that is really more what we're looking toward to really drive that for us. But, from the normal operations, we have seen a slight uptick in July.

Frank Morgan – Jefferies & Co.

Okay. And the refurbishment is really – you're talking about being completely done with everything by early next year. Like January, February of next year?

Bruce Mackey

In Woburn, we're looking to get the first wing done by November. And at Braintree, we're looking at end of the year as an optimistic goal. But to be realistic, it's probably going to be sometime in January.

Frank Morgan – Jefferies & Co.

Okay. Thanks.

Bruce Mackey

Okay. Thanks, Frank. Good talking to you.

Operator

Our next question comes from Kevin Ellich with RBC Capital Markets.

Kevin Ellich – RBC Capital Markets

Good afternoon, guys. Thanks for taking my questions.

Bruce Mackey

Hey, Kevin.

Kevin Ellich – RBC Capital Markets

First of all, I was wondering if you could give us a little bit more color or granularity about the move-ins versus move-outs that you saw this quarter.

Bruce Mackey

Quarter-over-quarter, admissions were slightly down in the second quarter compared to the first quarter. And they were down Q2 on a same-store basis compared to Q2 of '07. But they're still significant. We still saw over 5,000 admissions during that time frame.

Kevin Ellich – RBC Capital Markets

Okay. So then you would say that there's fewer people are moving out? Is that why we saw a little tick-up here on the occupancy?

Bruce Mackey

You mean recently into July?

Kevin Ellich – RBC Capital Markets

Yes. Exactly.

Bruce Mackey

I really haven't looked at July admissions and discharges as of yet, but that's a possibility. But like I said, I think a lot of our programs that we've been putting in place over the last few quarters, some of them are starting to bear fruit.

Kevin Ellich – RBC Capital Markets

Okay. And then just wondering to get your updated thoughts on maybe a share buy back?

Bruce Mackey

Sure. It's something that our Board looks at from time-to-time. Right now, I think we're facing some of the tougher capital markets, the credit markets that we've seen really in a long, long time. At this time, I think the preservation of our cash is really important to us. In the short-term – short-term could last a quarter or two, it could be a little bit more, depending on what the market dictates. We're not going to be actively buying back our stock right now.

Kevin Ellich – RBC Capital Markets

Okay. Got it. And then with the three new facilities that you took on in that last transaction with senior housing, the underperforming facilities, what was the occupancy?

Bruce Mackey

I'm sorry, Kevin, can you repeat that question?

Kevin Ellich – RBC Capital Markets

The three wholly-owned properties that you took on with the New Seasons deal –

Bruce Mackey

Yes.

Kevin Ellich – RBC Capital Markets

what was the occupancy of those facilities?

Bruce Mackey

Well, one – I said they range from 50% to 80%. You can see one was at 50%, one was at 80%. The other one was probably like around 70%, somewhere in that range.

Kevin Ellich – RBC Capital Markets

How long do you think it would take to get those properties up to kind of that 80% level, those other two?

Bruce Mackey

It will take some time. It will take – probably the one that's at 50%, I can see taking over a year. But that was a property that had banned admissions for well over a year before we took over. We took over on July 1. Since then, we've seen the occupancy/deposits go up by about four or five now at this point. So we're starting to make movement in the right direction. We've got a new regional team down there that I think is doing a pretty good job. We're assessing the leadership in the buildings and the marketing teams, putting our programs into place. I'm just focused on those three, but really the overall ten buildings. The overall ten are at 82%. Our goal is to get those back up to overall where we are right now, 88.5%, somewhere in that range.

Kevin Ellich – RBC Capital Markets

And then just going back to the rent expense, I think Fran mentioned that the annualized is going to be $166 million.

Fran Murphy

That's right.

Kevin Ellich – RBC Capital Markets

If we annualize Q2, we get to $157 million. What's causing that increase yet in Q3? Is that because those new properties weren't accounted for in Q2?

Fran Murphy

Right. The New Seasons acquisition took place on July 1. And then we purchased two more – acquired two more facilities beginning August 1.

Kevin Ellich – RBC Capital Markets

Excellent. That's all I had. Thanks, guys.

Bruce Mackey

Thanks, Kevin. Good talking to you.

Operator

Gentlemen, we'll move on to Derrick Dagnan with Avondale Partners.

Bruce Mackey

Hi, Derrick.

Derrick Dagnan – Avondale Partners

Good afternoon. I think in your prepared remarks, you touched on food and utility costs. Did you actually give us any real inflation numbers? Or at least could you discuss that if you didn't?

Fran Murphy

Well, we didn't. Looking at same-store food costs, Derrick, we saw a 5.2% year-over-year growth for the second quarter. Utilities were up 6.8%.

Derrick Dagnan – Avondale Partners

Okay. And on the – I want to follow up on the rate side, the average daily rate. Are you seeing a lot of discounting in your markets? If not, are you doing any – how much – how active are you on suspending move-in fees or giving away free month's rent, things like that?

Bruce Mackey

It's really – if you look at it on market-by-market basis. I can tell you in some of the markets we are seeing some significant discounting of rates by our competition. We really haven't resolved to that yet, where we're discounting rates. This is consistent with what we did even three years ago in good times when we were at 91% occupied. If we've had a building that had a sizable number of units open, we will look at reducing concession or moving fees as well as two months free rent on a two-year deal. Those are programs we've had in place now that we've always had in place. So we do look to that. Those might be now a little bit higher than we've had in the years past, in terms of the number of more buildings that are utilizing those. But it's something that we do look to.

Derrick Dagnan – Avondale Partners

Okay. The last one I will ask and I'll jump back. Is any impact – or what's your view, at least, on the change in the REET tax law? And the relationship between you and senior housing?

Bruce Mackey

Sure. This was the tax law that was put into place with President Bush signing the housing bill a week or two ago. It was like what the hotel REET did a few years ago and being affiliated – we actually saw what happened on the hotel side. One of the things I think it leads to is greater volatility in the financial results for the REET. Might also have an increased competition for acquisition. So it really remains to be seen how it's going to impact the health care and senior living space. Right now; we don't see any need to change how we do business. But if we can't compete for new acquisitions or it makes sense, then we'll have to look at it perhaps a new way of doing business. The short-term answer is I don't think we're adjusting how we're doing business going forward, but it's something we will have to look at as really the rules develop and strategy plays out.

Derrick Dagnan – Avondale Partners

Thanks. I'll hop back.

Bruce Mackey

Okay, Derrick.

Operator

And next up from Stifel Nicolaus, we have Jerry Doctrow.

Bruce Mackey

Hey, Jerry.

Jerry Doctrow – Stifel Nicolaus

Hi. A handful of things. CapEx, I think, Fran maybe touched on this. I want to clarify what maintenance CapEx and maybe other CapEx was in the quarter.

Fran Murphy

The – we've got a few large renovation jobs going on. I would – I think those are about $5 million for the quarter. That would leave – what I would consider about $12 million of normal-type renovations at all of our communities. Most of that will be reimbursed by senior housing. Then we're left with maybe $2 million or $3 million or rather $3 million or $4 million per quarter that is CapEx to Five Star on a net basis.

Jerry Doctrow – Stifel Nicolaus

Thanks. And then Bruce, I guess just on – I don't know, sort of a little bit bigger picture strategy. I think – you identified yourself occupancy as being the key issue. I guess it seems to me that when I was looking at the same store numbers versus the total numbers that – and obviously New Seasons is maybe a more dramatic example of this because the properties you took on. But it seems to me that the numbers on a same-store basis are trending reasonably well, but you keep complicating your life by taking on new properties. In some cases, some troubled. Wouldn't the Company be better served, basically by not adding additional assets and just focusing the resources you have on driving occupancy at the existing portfolio?

Bruce Mackey

I think, Jerry, if you take a look at the majority of the assets we've taken on, 31 communities. Actually, it's a probably good idea to think about what the occupancy is. The ten that we took on from New Seasons was 82%. Of those ten, I'd say two or three are significantly challenged. Devon being the one that I talked about. There were clear reasons why that is a turnaround situation. Then we took on 21 communities prior to that, probably at an average occupancy of 89%. I'd say maybe of those 21 there were really one that was significantly low, maybe even two. One was the Welldub [ph] community in Minnesota. That property is an Alzheimer's which is doing very, very well, and assisted living which really has yet to figure it out. We're working on that. So I think for the most part, we are taking on stabilized assets and really not looking at turnaround situations. Or if we do go in there and it is a turnaround situation, it's something like a Devon that we know really what the problems are and we know what we can do to turn it around. It might take time.

Jerry Doctrow – Stifel Nicolaus

Right. But even if you're adding stabilized, there's obviously a requirement for resources, both at the corporate level, adding regional staff and all that stuff. That's got to be a distraction from just running what you've got. Is there – I don't see what's the great advantage in this market, particularly, with prices maybe still moving lower yet. We'll see how it plays out – in adding additional assets?

Bruce Mackey

No. We do look very carefully in making sure that we're getting a good price. We haven't overpaid historically. I think we've shown a very good – that we have done a very good job on our own core operations. I think, A, you're right, occupancy is down right now. But I think we've done a pretty good job watching our expenses and controlling our G&A. I think you'll see us bring that to new acquisitions. So we do make sure that we're not overpaying. We really did pull back in 2006, 2007 from acquisitions when pricing really got out of control. We think now is a good opportunity.

Jerry Doctrow – Stifel Nicolaus

Okay. And then the one other thing I wanted to – I was wondering if any considerations have been given to buying back converts? Obviously, you talked about capital markets being tight and stuff at this point. The UBS thing with the line in place, obviously they're giving you more flexibility. I think the way we've been looking at the converts is a pretty attractive, essentially, risk free return from buying those. Any thought about buying something like that rather than buying assets?

Bruce Mackey

That's something that we'll look at. The converts right now are 3 3/4 paper to us, not payable for another – they'll be put to us October, I think, of 2013. So we still have about five years outstanding on those. But we will look at it.

Jerry Doctrow – Stifel Nicolaus

But by a purchase – I mean some of the – the other companies we're looking at are buying back debt at a significant discount.

Bruce Mackey

No – yes, I completely understand buying it back. We have to look at that. Like I say, right now, it's very cheap paper for us. The credit markets are still very tight, but we'll see what happens. If there is an opportunity, we will take a look at it.

Jerry Doctrow – Stifel Nicolaus

Okay. Thanks. I think that's all from me.

Bruce Mackey

Okay. Thanks, Jerry.

Operator

Our next question comes from Stefan Mykytiuk with Pike Place Capital.

Bruce Mackey

Hey, Stefan.

Stefan Mykytiuk – Pike Place Capital

Hi. How are you? Good afternoon. A couple of questions, just to go back to this occupancy issue, the move-ins versus move-outs. It sounds like from what you're saying, you're not experiencing this higher churn that some of the other companies are talking about where move-ins are very high, but the move-outs are also very high. That's what's causing the occupancy challenge. You're saying it's really just your move-ins are not doing as well and that's really the issue?

Bruce Mackey

It's probably a combination of both in all honesty. We have seen the back door, “being open.” That some people unfortunately moving on to higher levels of care or passing away for the most part. So that is a cause. If we could slow that down – that's obviously difficult to slow down, that would significantly help us out. No question about it. But I threw out a figure earlier we probably had 5,000 admissions during the second quarter of 2008. We saw a number of discharge – along those same lines. Obviously, 5,000 may be a little bit high on the discharge side.

Stefan Mykytiuk – Pike Place Capital

And the move – are you really able to nail down the move – the reasons for the move-outs that closely to know that it's higher – moving to higher level of care or people dying as opposed to people moving back to their homes or in with their families trying to save money?

Bruce Mackey

We do track all of our discharges and for the most part, that's what it is. Now, we do notice that people are moving back to save money as well. I don't think that's really a significant number of our discharges now. It's probably ticked up a little bit over the last couple of quarters. But for the most part people are moving on unfortunately, through passing away or for needing higher level of care.

Stefan Mykytiuk – Pike Place Capital

And then on this New Seasons deal, how was it that you – how do you decide that you're going to buy three of the facilities and lease ten others versus leasing them all or buying them all? How did that work out that you ended up buying those three?

Bruce Mackey

Well, there's two separate transactions. First, we did lease all ten. That was negotiated between New Seasons and us. And then in a separate transaction, we negotiated with Senior Housing to purchase the three. The three we looked at really had the room for the – what I believe is the most upside in the portfolio. So we got a nice rent reduction for buying the three out on that whole lease. And then like I said, we effectively bought those for about $45,000 a unit. I keep coming back to this property at Devon being 50% occupied. If we can get that building to stabilize, we're going to significantly enhance the value of that community. Stuff in the Pennsylvania market could be going for – in a normal market, somewhere around $150,000 per unit, wouldn't be unreasonable.

Stefan Mykytiuk – Pike Place Capital

And back to the rehab hospitals, then, or the – the fact that you're doing these renovations, is that in and of itself impacting your occupancy there? Or is it just that you want to get them spruced up because you're not able to really attract good referrals without a nicer looking facility?

Bruce Mackey

It's really that. Right now, we're tackling wings that have been closed for a number of years, long before we took over.

Stefan Mykytiuk – Pike Place Capital

Okay. So that's not limiting the amount of people you can actually have there? Those wings were empty anyway?

Bruce Mackey

That's right.

Stefan Mykytiuk – Pike Place Capital

Okay. All right. And then how long after you get these things renovated, how – do you work on the marketing program ahead of that? Or do you have to really wait until you've got those renovations in place and then you can really start to market and – ?

Bruce Mackey

No. We start before hand, put up placards and let people know the changes that we're making. Working with the doctors and referral hospitals to let them know the improvements that are putting into place and the capital we're spending on the hospitals. Make it a place that they want to discharge their patients to and let them know its coming.

Stefan Mykytiuk – Pike Place Capital

What's the competitive situation like in that market? Once you've got these renovated, is there a lot of competition there or is it – ?

Bruce Mackey

The Boston market is a competitive market. There's a lot of established hospitals up in the area. We have what we believe are two of the finest hospitals. One of the hospitals is really a little bit north and west of downtown Boston. The other is south of Boston. So we're really targeting those people that don't want to drive to Boston for rehab care.

Stefan Mykytiuk – Pike Place Capital

Okay. Great. Thanks.

Bruce Mackey

All right. Thank you.

Operator

Next up from UBS we have Donald Hooker.

Bruce Mackey

Hey, Don.

Donald Hooker – UBS

Great. Good afternoon. Thanks for taking my call. Looks like you had some good success with your wages line. I know in the past you sort of guided us and sort of seen the – talked about wages and benefits. I think I recall in the 51%- ish range. I don't know if I'm seeing things, but I look over the past four quarters and you seem to be dipping under 50%. And this quarter, pretty nicely under 50% as well. Can you talk about what's driving that? Are we seeing a change there permanently? Where that's coming in? How do we look at that going forward? How do we think about your wages and benefits costs going forward?

Bruce Mackey

We are. Hopefully – we look to hopefully – acquisitions will play a part in that. And that will drive that back up, in terms of the overall dollars, not really necessarily the percentage. But it is something we will look to manage very closely. We think we've got great control over that. I really benefit a lot of that – or give a lot of credit of that to Rosemary and her operations team for making sure that we keep that in check.

Donald Hooker – UBS

I guess what I'm getting at is in the past, you talked about a certain range. Is that sort of becoming invalid now?

Bruce Mackey

I think that's true to some extent. Yes, I think we've probably hit a new range. You're right. I think Tim and myself did that same exercise. We used to guide people in the 51% to 52% range, and we haven't said that in a little while now. We've been below 51% now for a number of quarters, I think most of 2007 and 2008. So I think you're right, we are at a new metric now.

Donald Hooker – UBS

That's fair. But like you said, some of the acquisitions might create some noise there. And I guess I'll finish up here, because other people have asked a lot of questions I had. Just kind of looking ahead, I'm trying to think about your pharmacy business. Again, your margins have kind of moved around there a bit. Is this like a normal run rate? Or how do we think about operating margins there going forward?

Bruce Mackey

It's going to be in the 5% to 6% range. I think we've been there for three quarters now. We're a little on the lower end of the 5% to 6% range than we have been in the past. We're working to drive that back up. I don't think we're far away from it, where we want it to be. I expect it to tail back up over the next couple quarters. We're going to be adding, hopefully, well over a 1,000 new customers to the pharmacy business, as well as some of the initiatives I talked about in my prepared remarks. I think they'll all have – they'll all lend a hand, if you will, to impact margins favorably.

Donald Hooker – UBS

Okay. I'll hop out. Thanks, guys.

Bruce Mackey

Thanks. Good talking to you, Don.

Operator

Next up, we have Michael Potter with Monarch Capital.

Michael Potter – Monarch Capital

Hey, Bruce.

Bruce Mackey

How are you doing?

Michael Potter – Monarch Capital

I guess my question is more of a corporate structural issue. Over the past 30 days, a lot has been put in print publicly about the conflict of interest between RMR Group, who basically controls our Board of Directors and is the management company, and what's best for shareholders. Has the Board discussed any sort of restructuring in order to get this conflict of interest by the way side?

Bruce Mackey

Let me just – we have a shared services arrangement, so we're not managed by RMR. There is a shared services agreement by RMR. The Board is made up of three independent directors and then two managing directors. One of our two managing directors is a managing director of other RMR-affiliated companies. I just want to set the record straight on that.

Michael Potter – Monarch Capital

But some of those independent directors are also on the boards of other –

Bruce Mackey

RMR affiliates.

Michael Potter – Monarch Capital

affiliated with RMR, correct?

Bruce Mackey

That's correct. None of those companies do business with Five Star.

Michael Potter – Monarch Capital

And two of senior management, yourself included, are also employees of RMR?

Bruce Mackey

That is also correct.

Michael Potter – Monarch Capital

Okay.

Bruce Mackey

The Board has discussed it and we look at – we have a contract with REET Management and Research. And that contract is up every year. It's voted on by those three independent directors. Right now, we're still under that contract. That contract will be looked at again every year. It has to be justified. Fran and myself have to justify the need for that contract. I think we've had a lot of benefits as a result of that contract. I don't think we'd be the company we are today without our relationship with RMR. If you look at where we are from a G&A point of view, I think it would cost a lot more for us to do business as a separate company outside of RMR. A lot of the deals that we've gotten over the years wouldn't have been possible without that relationship with RMR. I think if you looked at us where we were five years ago, six years ago when we started off, we had 56 skilled nursing facilities that were having a tough time.

We lost $13 plus million our first year of being a public company. Because of our relationship with RMR, we were still able to do leases and lease really attractive high-quality independent assisted living communities. That shift in the business has really driven us to profitability and made us one of the top providers in the senior living space today. To where we are now, a profitable company and have been a profitable company for about four years. I don't think those relationships would have – I don't think not having that relationship would have really – we wouldn't be where we are today because of that. I think the last thing I want to say on that is, if you look at our capital finance, our line of credit with Wachovia, I think has been a benefit because of our relationship with RMR. I'm just trying to say some of the positives that have come out because of the relationship with RMR. It's something that the independent directors do look at on an annual basis and have to justify that that relationship continues to make sense going forward.

Michael Potter – Monarch Capital

There's no question, there are pros and cons of the relationship with RMR. I don't think anybody, at least that I've read, has said, let's get rid of the relationship with the management agreement with RMR. It's just more along the lines of corporate governance and conflict of what's best for shareholders, because the return for shareholders for this company has been horrendous. Operationally, you're right. You guys have done well, but coming – when we have the issues of the investors that have been long-term investors, sitting here not being rewarded for it or wanting some sort of return of their capital, a lot of cash was raised at significantly higher prices. Now we have an opportunity to return some of that cash. And there is a conflict of how RMR gets paid under its agreement versus, again, what perhaps is best for the shareholders at this time.

Bruce Mackey

I don't think the cash we pay to RMR is really a result of how much cash we have in our balance sheet.

Michael Potter – Monarch Capital

Well, the conflict is whether or not to seek acquisitions which increases what RMR gets paid under the management agreement versus shrinking our capital structure right now. We're taking the opportunity and buying our assets back at significantly discounted rates.

Bruce Mackey

The last thing I'll say, and we probably could have this discussion for a while here. If you look at all the senior living operators, we are all down significantly from where we were six months, 12 months ago. I don't think our relationship with RMR has impeded us or driven us down. It's really been general marketing conditions that have had the overriding theme of driving us all down.

Michael Potter – Monarch Capital

Okay. But – I don't want to beat a dead horse. Obviously, RMR and yourselves have made the agreement to hold on to our cash. I would just – sooner or later, the shareholders deserve a return.

Bruce Mackey

I don't disagree with you. When we look at the tight credit market that I've talked about, long-term as those stocks come back to a more normal level, and we can free our auction rate securities, I think there will be a lot of opportunities to take advantage of that.

Operator

Let's take our next question coming from George Walsh with Gilford Securities.

George Walsh – Gilford Securities

Bruce, could you itemize the discontinued loss from discontinued operations for the quarter?

Bruce Mackey

Could I itemize it?

George Walsh – Gilford Securities

Yes. Just what went on there? It's been the $748,000.

Bruce Mackey

Yes. We have two senior living properties right now that are in discontinued operations. I can tell you both of those properties. We have interest in someone acquiring them. And we hope to move them to P&S stages or at least LOI stages fairly soon. Second, we have a long-term care pharmacy in there. Again, we actually have an LOI on that; we're working on a P&S. Second – or the last thing that's in there is our mail-order pharmacy. Again, we actually have one LOI and we're looking to see if we can get another LOI and then move those out. I don't think any of those sales will have an impact on our operations other than moving the discontinued amounts down to zero. I think that will probably take two quarters to happen. Then on the pharmacy side, there might be some small gain, but I don't think it's going to be anything significant.

George Walsh – Gilford Securities

Okay. But going forward, you had a bigger impact last quarter, less this quarter. Should this be a line item that pops up less? Or will not be cropping up the rest of this year?

Bruce Mackey

Well, it cropped up less this quarter than last quarter. Or we had less of a loss, because I think in the first quarter we wrote down the value of some of those. Yes. I would think Q2 is more of a stabilized level where that should be. Our goal is as we sell some of these properties or pharmacies, that will decrease even further.

George Walsh – Gilford Securities

Okay. And what's the schedule on the capital ex-reimbursement for the balance of the year? Should there be something for Q3 and Q4? And what's that total amount again, that reimbursement was going to be about $29 million or – ?

Fran Murphy

That's right. We have $29 million that we can sell to senior housing. We sell it quarterly, and we will sell probably $10 million to $15 million each quarter.

George Walsh – Gilford Securities

Okay. Did any come in, in Q2?

Fran Murphy

Yes. Around –

Bruce Mackey

I would say $13 million, maybe.

Fran Murphy

Yes, that's right.

George Walsh – Gilford Securities

Okay. And just the overall occupancy now with the new facilities, what is that figure at this point, including everything where you are today?

Bruce Mackey

With the new facilities, it was 80.1%, George.

George Walsh – Gilford Securities

Okay. That's a big shift. Is that something that – how is that going to move going forward for the Company, in terms of how quickly can that be moved up to a mid-80s or whatever? What are your targets?

Bruce Mackey

88.1%.

George Walsh – Gilford Securities

For everything?

Bruce Mackey

For everything.

George Walsh – Gilford Securities

Right now it's 88.1%?

Bruce Mackey

Correct.

George Walsh – Gilford Securities

Okay. All right. And any comments on what you're seeing in terms of new construction in senior facilities?

Bruce Mackey

It's tailing down. Sunrise just publicly announced two days ago that they're significantly reducing their new construction. I'd say, they're probably the largest developer on the public company side that was out there developing. We're seeing construction slow down in most of the markets that we operate in. I think you're still seeing stuff come online right now. These are mostly projects that were funded and started over two, three years ago. That will really start to tail off at the end of 2008. I would expect a significant decrease into 2009. 2008, though, the overall numbers should be comparable with where they were in 2007.

George Walsh – Gilford Securities

Okay. Anything – any general comments – the big theme is that, lack of construction and the rise in the demographics, and the age group, and the lack of construction. Should – over time here, equal a – actually a shortage of supply which is really in contrast to the general real estate market. Anything about that versus anything you – the current occupancy trends versus that potential demand. Do you see those converging? Those two trends converging further out into, say, early 2009?

Bruce Mackey

It's possible. I think you hit it right on. Long-term, the demographics in this industry, I think, are very, very positive and we're going to take advantage of those demographics. I think it's just navigating through these challenging times right here which could be a few quarters. We're working very hard to get our occupancy back up. I've outlined a number of initiatives that we're working on. We believe they'll have great success. But I think once the macroeconomic conditions really are overshadowed and move beyond, that's when I think you'll see things really pick up.

George Walsh – Gilford Securities

I'm just trying to get a sense of how much the demographic trends could work against just the more stabilized real estate market, as opposed to really getting better and helping out sooner. Like maybe early '09 or something like that?

Bruce Mackey

Like I said, we've seen some slight changes right now in terms of improvement. Albeit it's only been a few weeks.

George Walsh – Gilford Securities

Okay. All right. Thanks, Bruce.

Bruce Mackey

Okay, George. Good talking to you.

George Walsh – Gilford Securities

Thanks.

Operator

And gentlemen, we have approached the top of the hour. I'd like to turn the conference back over to Bruce Mackey for additional or closing remarks.

Bruce Mackey

Great. Thank you all for joining us on today's call. We look forward to updating you on our progress on the third quarter call. Thank you.

Operator

And that concludes today's conference call. Thank you for your participation. Have a good day.

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Source: Five Star Quality Care, Inc. Q2 2008 Earnings Call Transcript
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