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Executives

Tim Bonang - VP, IR

Bruce Mackey - President and CEO

Paul Hoagland - Treasurer and CFO

Scott Herzig - COO

Analysts

Darren Lehrich - Deutsche Bank

Daniel Bernstein - Stifel Nicolaus

Mike Petusky – Noble Financial

Five Star Quality Care (FVE) Q3 2012 Earnings Call October 29, 2012 10:00 AM ET

Operator

Ladies and gentlemen, good day and welcome to the Five Star Quality Care third quarter 2012 financial results conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Mr. Tim Bonang. Please go ahead sir.

Tim Bonang

Thank you operator, and good morning everyone. Joining me on today’s call are Bruce Mackey, Five Star’s president and CEO; and Paul Hoagland, Five Star’s treasurer and CFO; and Five Star’s new chief operating officer, Scott Herzig.

The agenda for today’s call includes a presentation by management, followed by a question-and-answer session. I would also note that the recording and retransmission of today’s conference call is strictly prohibited without prior written consent of Five Star.

Before we begin, 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 other securities laws. These forward-looking statements are based on Five Star’s present beliefs and expectations as of today, October 29, 2012.

The company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today’s conference call other than through filings with the Securities and Exchange Commission regarding this reporting period.

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

Before I turn the call over to Bruce, I want to take a moment to explain some of the changes we made to the supplemental information contained in our press release. The first major change was based on feedback we received from investors and analysts who asked for more transparency around our core private pay independent and assisted living business. Within our senior living segment, we broke out three distinct areas, which include private pay, independent, and assisted living communities; continuing care retirement communities or CCRCs; and standalone nursing.

The second change we made this quarter was the addition of operating trends for our managed communities. Since 2011, we have begun to manage communities in addition to leasing and owning communities. We consider this a growing and important part of our business, and understand that it is necessary to provide investors with information to evaluate it. We hope that both of these changes help investors and analysts better understand our business.

And now, I would like to turn the call over to Bruce.

Bruce Mackey

Great. Thank you Tim, and thank you all for joining us on our 2012 third quarter earnings call. As Tim just mentioned, we did make some changes to our supplementary reporting that we think are helpful for the investment community to better evaluate and focus on our strong and growing core private pay business. We would be happy to answer any questions you may have about these changes during the question and answer session of this call.

The third quarter of 2012 marked Five Star’s 15th consecutive quarter of profitability with income from continuing operations of $0.07 per share. Income from continuing operations for the third quarter of 2012 included a tax adjustment of approximately $825,000, which benefited the third quarter provision for income taxes.

In addition, there was an expense for $350,000 attributable to a past-period billing adjustment. Taking into account these two items, income from continuing operations was $0.06 per share.

It is important to note that EBITDARM, adjusted for nonrecurring items, was up an impressive 22% from last year at $11.8 million. And, this was in spite of the 11% Medicare cuts enacted last October. We have clearly proved our ability to offset this loss in revenues while continuing to grow our private pay senior living business and remain profitable.

Moving on, in August we made an announcement that Scott Herzig, formerly a Five Star divisional vice president of our western division, was appointed chief operating officer effective September 4.

We are excited to have Scott on board as our new chief operating officer. He has significant experience in the industry, and because he’s been with Five Star for over 10 years, he knows our people, our systems, and our residents. Scott is well-equipped to help us maintain and grow occupancy.

On a high level, the third quarter was highlighted by a number of transactions, including the sale of the pharmacy business, the addition of substantially more private pay senior living communities, and the agreement to sell to skilled nursing facilities. That, in total, further improved our product mix and lessened our reliance on government funding. We now derive 75% of our accumulated revenues from residents’ private resources and 92% of our total company revenues now come from senior living.

In September, we completed the sale of our institutional pharmacy business to Omnicare for gross proceeds of $37.8 million and recognized a gain on the sale of $23.3 million. The proceeds we used to repay the outstanding balance on our $150 million revolving credit facility. The Five Star management team worked diligently over the last year to finalize and close on this transaction.

We think it’s a significant milestone and helps simplify the Five Star story for investors. The sale also reduces our government reimbursement exposure, increases our margins, and improves our liquidity position that will allow us to require additional private pay senior living communities on our own balance sheet.

We had some substantial acquisition activity during and immediately following the third quarter. Since July 2012, we have begun to manage 10 senior living communities with approximately 2,000 units located across six states, increasing our management business on a pro forma basis to 22% of our total units.

There are two remaining Sunrise senior living communities with 757 units that we expect to begin managing during the fourth quarter. Taking into account our recent acquisition activity, on a pro forma basis, Five Star operates just over 30,000 units and we will be the fifth largest operator, public or private, of senior living units in the country. According to a 2012 report issued by the American Senior Housing Association, or ASHA, Five Star is now also one of the top 50 owners of senior living units in the country.

In October, we entered into an agreement to sell two skilled nursing facilities located in Michigan with 271 units, which are dependent on Medicare reimbursement. Historically, they were included in discontinued operations. We are encouraged by this transaction and will continue to look for more opportunities to reduce our exposure to government funding.

In the third quarter, our senior living business, which includes independent and assisted living communities, continuing care retirement communities, and skilled nursing facilities, produced $72.9 million in EBITDARM. This is up 3% from last year. Independent and assisted living EBIDARM grew by an impressive 8% since last year.

We now report occupancy and average daily rate statistics on our managed communities, which, a quarter end, included 30 senior living communities with approximately 4,500 units, the vast majority of which are private pay. Occupancy for the third quarter was 87.4%.

Management fee revenues have grown 250% to $1.3 million since the third quarter of last year and we expect additional growth in this revenue line next quarter from our recent acquisitions. We don’t have comparable same-store data yet at this point, but as we continue to grow this business we will discuss the operating results on future earnings calls.

Moving on to our rehabilitation hospitals, which account for 8% of total revenues, they’re generated $2.6 million of EBIDARM during the quarter, which is up about 1% from last quarter. Occupancy was up 100 basis points to 60.7%. EBIDARM for the third quarter is down about 13% from last quarter. However, our year to date EBIDARM is up 5% over last year. As you may recall, EBIDARM from our hospitals increased by 28% for the full year of 2011.

We are continuing to make and hold on to our recent performance improvements. We are remodeling a traumatic brain injury unit at Braintree Hospital which should be completed in the fourth quarter of this year. We are also working on opening a new transitional care unit at a New England rehabilitation hospital which we hope will be fully functional in late 2013.

In summary, we gained positive traction this quarter with regard to several items. First, we saw growth in both our overall and same-store operating results compared to last quarter. More importantly, our core independent and assisted living communities grew occupancy by 40 basis points since last quarter.

Second, average daily rate for our core independent and assisted living communities was up 1.2% from last year. Third, other [unintelligible] operating expenses were down 80 basis points as a percentage of revenue from last year, which is proof that we’ve been focused on, and successful in, controlling costs.

Lastly, EBITDA grew by 22% since last year, in spite of the drastic cuts to our skilled nursing Medicare rates. We have clearly experienced external growth from acquisitions but we have also been focused on, and grown, our same-store business as well. As we have said before, one of our top priorities is improving occupancy, and, as we work diligently to get it back over 90%, which it was prior to 2007, we will see even greater improvement in our results, and, in turn, shareholder value.

At this point, I would like to turn the call over to our new chief operating officer, Scott Herzig, to provide more detail on our operating results. Scott?

Scott Herzig

Thank you, Bruce. Senior living occupancy was 85.7% for the third quarter, which was down 30 basis points from last year but up 20 basis points from last quarter. Some of our CCRCs are undergoing capital refurbishment projects that impacted occupancy this quarter, but will be positive in the long run.

Occupancy at our skilled nursing facilities continues to decline in line with macro industry trends, but we continue to try and make progress toward stabilizing this business. Occupancy at our core independent assisted living business remains strong at 88% for the third quarter, which is up 40 basis points from last quarter.

On a positive note, total senior living admissions were slightly ahead of last quarter and up from the same period last year. Same store senior living occupancy was down 30 basis points from last year. However, it was up 50 basis points from last quarter, which is an encouraging sign. As of last Thursday, senior living occupancy was 86.2% and independent and assisted living occupancy was 88.2%.

Looking now at our senior living average daily rate, rates are down on an overall and same store basis, mainly due to a change of mix in our business as well as residents looking for less expensive options. We expect overall annual private pay rate growth in the 2-3% range, which has been tempered due to new and existing residents seeking smaller, more inexpensive units. Our independent assisted living rates are up 1.2% from last year, and we will continue to push rates where we can.

On a final note, I want to mention how excited I am to be in the COO position here at Five Star, a company with which I have a long history. The main purpose of this business has always been about providing the highest level of care and services to our residents on a daily basis in each and every Five Star community.

Under my direction, I will challenge our executive directors to continue to search and find ways to raise the bar in this area. I can also assure you that occupancy growth is another priority, and I think that these two things go hand in hand. I have seen this throughout my career from a quality perspective, that residents benefit most from living in a vibrant and well-populated community.

To this end, I will work to strengthen our sales culture and continue to provide the best tools available to the field to drive sales and improve occupancy. We have already made great progress on that front, for example, by continuing the successful implementation of our new CRM system and sales training modules for our sales team to help make them more effective.

Anyone who knows our company knows that Five Star continually invests in our people and our properties to keep them competitive and to help provide the best possible care and services to our more than 25,000 residents every day.

With that, I will turn the call over to Paul Hoagland.

Paul Hoagland

Thank you, Scott, and good morning everyone. Thank you for joining us. I will review our year over year quarterly financial results for the third quarter of 2012.

Senior living revenues were $277.6 million, up 0.7 of a point. This increase was due primarily to the revenues from four communities we began to operate since last year, which contributed $2.6 million of revenues. Management fee revenues, which are revenues from the 30 senior living communities we manage, were $1.3 million for the quarter and we expect to earn approximately $9 million in management fees annually from the properties that we currently manage, including those we anticipate that we will close on later this year.

Senior living wages and benefits were $137.8 million, a 1.2% increase from last year. $600,000 of this increase was from the four communities we acquired or leased since last year. Total senior living wages and benefits were 49.7% of senior living revenues, which was a 30-basis point increase from last year.

Other senior living operating expenses were $66.9 million, down 2.2% from last year, and represent 24.1% of senior living revenues, an 80-basis point decrease from last year. This decrease was the result of many reductions in many areas, such as supplies, utilities, and insurances, and are continuing evidence of the positive operating and financial leverage as we increase our size and buying power.

Moving on to other income statement items, general and administrative expenses during the quarter were $14.6 million, up 1.3% from last year and represent 4.4% of total GAAP revenues. However, G&A, when factoring in total revenues for all owned, leased, and managed communities, was 4.2% for the quarter. Rent expense was $50 million, up 0.8 of a point from last year but flat as a percentage of revenues to our senior and hospital revenues.

Income tax expense was $426,000, which is favorable to the first two quarters of 2012. We have trued up our year to date tax provision, which was favorably impacted by real, employment-based tax credits. Interest expense was $1.8 million and depreciation and amortization was $6.3 million.

I’ll now review our liquidity, cash flow, and selected balance sheet items. Operating cash flows were $13.9 million. We invested $11.9 million of capital into our existing communities and sold $4.2 million of long term capital improvements. At September 30, 2012, we had cash and cash equivalents of $14.3 million.

EBITDA, excluding nonrecurring items, was $11.8 million, a 22% increase compared to $9.6 million last year.

Moving on to the balance sheet, our accounts receivable management remains strong, and as of September 30, 2012 the number of days sales outstanding for our consolidated operations was 17.5 days. At quarter end, we had approximately $337 million of net property and equipment, which includes the 31 properties directly owned by Five Star, 12 of which are unencumbered by debt.

We had $24.9 million of senior notes and $46.6 million of mortgage notes payable, which includes $7.6 million related to the discontinued operations. Our two revolving credit facilities are currently undrawn, so today we have a total of approximately $185 million of capacity.

At the end of the quarter, our leverage was 19% of book value and 13% of assets. We believe we’re in compliance with all material terms of our credit, note, and mortgage agreements.

During the third quarter, Five Star continued some performance improvements on many fronts. Our growth in EBITDA is especially encouraging, as we continue to improve upon the previous year in spite of the significant CMS rate cut. Our strategy of changing our [unintelligible] mix toward private pay senior living as we acquire, lease, or mange new properties is very positive to the improvement in our shareholder value.

The completion of the sale of our pharmacy business during the quarter continues to align our focus on our core senior living business and will save us over $1 million in annual interest expense, or just over $0.02 EPS.

We have added five more managed communities during the quarter, and will continue to grow this piece of our senior living business, which provides positive operating and financial leverage to our entire portfolio.

We ended the quarter with approximately $185 million of borrowing capacity and are actively evaluating acquisition opportunities and improvements within all areas of our business to increase shareholder value.

With that, Bruce, Scott, and I would like to open it up to questions from you. Thank you very much.

Question-and-Answer Session

Operator

[Operator instructions.] One moment for our first question. And that will be from Deutsche Bank and the line of Darren Lehrich. Please go ahead.

Darren Lehrich - Deutsche Bank

I wanted to ask first of all about the supplemental reporting, and the additional disclosure with regard to CCRC. Just maybe if you could spend a moment helping us think about how you see that particular piece of your business progressing. Scott, I think I heard you mention that there’s some capital plans that are playing out there. So perhaps you could just expand on that and tell us how you think that’s going to impact the results over the next year or so.

Paul Hoagland

Our continuing care retirement community, as far as just they are all rental CCRCs. None of these are buy-ins on that regard. They’re always undergoing capital plans at a lot of our communities, a lot of our CCRCs, and ones we took over about 10 years or so ago. And we’ve been doing a good job of remodeling over the years, and we’ll continue to do so.

We do have a few more folks right now on our skilled portion of our CCRCs. So if I look at our CCRCs, they include about 25 [million units] of skilled nursing, and are about 80% private pay and then Medicare and Medicaid, mostly Medicare.

But we are, right now, there’s probably about five or six communities undergoing significant skilled nursing remodeling. Two of them, actually, we shut down portions of our skilled nursing wings as we remodeled them, and what we’re really focused on is moving toward, with some of them, our semi-private going to private rooms, where we can, and then trying to focus on that short stay Medicare resident that’s coming in for a [unintelligible] fix or something like that.

Darren Lehrich - Deutsche Bank

And then the five or six that you’re remodeling, just the timeline on getting those completed? It sounds like they’re a little more extensive projects.

Paul Hoagland

They are. They range anywhere from six months to about a year.

Darren Lehrich - Deutsche Bank

And then I wanted to switch gears a little bit just to the pricing commentary, and you, I guess, are shooting for 2-3% rate growth, with a little bit lower this quarter. I guess I just want to understand how you think you’re going to be able to drive a little bit better pricing leverage as we go forward. Was there anything in the quarter that you thought held back your rate growth?

Paul Hoagland

Nothing significant. As we continue to drive our occupancy in the right direction, higher, I think we’ll get more and more powerful rate growth. We do have a pretty formal process here at Five Star, where we approve rate, and we’ve done that for 2010. So I know our in-house residents will see rate growth in that 3% range, and then we’ll be [guessing] the Street rates as well. And then as selected markets become stronger in terms of penetration and occupancy, again, you’ll see less discounts. We’ll probably see even more rate growth down the line.

Darren Lehrich - Deutsche Bank

And then just last housekeeping item, you mentioned a $300,000 prior period adjustment Paul, I just want to make sure I knew what that was in the quarter.

Paul Hoagland

Yeah, it was a Medicare adjustment that we booked revenues for our prior period that we’re reserving right now and being a little conservative. We think we might have to pay that back.

Operator

[Operator instructions.] The next question will come from Stifel Nicolaus and the line of Daniel Bernstein.

Daniel Bernstein - Stifel Nicolaus

I wanted to go into the rate growth just a little bit more. Are you seeing widespread trade down from residents across your property types, at both the IL, AL, and CCRCs? Or is it isolated to a certain type of unit type that you manage or lease?

Paul Hoagland

Definitely not widespread, but you do see in some markets, where people prefer the studio as opposed to the two bedrooms in trying to save the money on a monthly basis. But in all honesty, you go to other markets and it’s the two bedrooms that are most sought after units. So you really do see it different market by market. But if I had to look company wide, the prevalent thing, again, I think the more popular option right now is the more price point in terms of the other studios or the one bedrooms. But I wouldn’t say it’s widespread.

Daniel Bernstein - Stifel Nicolaus

And you weren’t significantly discounting in the quarter to boost occupancy. The annual drop there or flatness in the rate was really more related to people trading down. It wasn’t any kind of major discounting program on your part.

Paul Hoagland

Nothing more than you’ve seen in prior quarters, correct. If you look at discounting over the last several years, it’s a lot [unintelligible] now than it was two or three years ago.

Daniel Bernstein - Stifel Nicolaus

And then on the skilled nursing side, there’s normal Q3 seasonality, but the occupancy really came down about 70 basis points, rate was down. Was there anything in particular outside of seasonality that accentuated the drop in occupancy and rate in the third quarter on a sequential basis?

Paul Hoagland

One of the big things that we had is a few of those projects that I mentioned on the last Q&A, last questioner. There were some skilled nursing units that were completely shut down companywide. So we can pull them out of service, but the unit count is still in there. But they’re all residents, because we’re remodeling the entire unit. So that definitely had an impact at a few of our locations.

Daniel Bernstein - Stifel Nicolaus

Do you have an estimate of what that impact might be? A couple basis points?

Paul Hoagland

It’s definitely a couple of basis points. Off the cuff, you’re probably talking 60-odd residents. So I’m thinking maybe 60 to 80 potential. But I think the positive here, too… Not only are we going to get those back into the system at some point, but these are potentially prior Medicaid residents that we’re almost opting out of the program, if you will, focused on much higher reimbursement Medicare or private pay HMO, things like that.

Daniel Bernstein - Stifel Nicolaus

And then I have one question on the managed communities. What you reported wasn’t exactly same store, because it went from 25 properties to 30 properties. You have any data on same-store sequential performance on the 25 properties that you managed in the second quarter?

Paul Hoagland

We don’t that we’re talking about right now. I think we will [unintelligible]. But I can tell you overall we are seeing nice growth in our management business, particularly the Bell properties that we took on in 2011. We’ve seen some nice growth at a lot of [beach] communities as well. I know we just Chevy Chase [community] last year, which was down a little bit last week. That was down a little bit more than when we took over, but it’s definitely turning in the right direction. So I think the overall pool is doing well, and it’s on a slight but upward trajectory.

Daniel Bernstein - Stifel Nicolaus

And you still have some properties in the managed portfolio that are still under redevelopment or under major refurbishment, correct?

Paul Hoagland

Correct. We’ve got one or two of the [V and Bells] that are going through major development. And then a lot of the Sunrise ones that we’ve taken on recently. And I guess my comment to kind of the [unintelligible] the Sunrise community, because we’re still getting our arms around those, some of those will have some significant remodeling as well. We really can’t quantify it yet, but we’ve got easily one or two in there that could be big projects.

Operator

And from the line of Mike Petusky of Noble Financial, please go ahead.

Mike Petusky – Noble Financial

I guess a question around the capacity. Your balance sheet has never been in better shape in recent memory, and I guess my question is what are you guys seeing out there in terms of potential M&A and what does pricing look like, and just any color you can give around that issue.

Bruce Mackey

We continue to evaluate transactions, and at all times are looking at a multitude. We have seen a little bit of uptick here in transactions that are under consideration. Pricing really has not moderated. Cap rates are very competitive. But we’re cautiously optimistic that we will start investing and deploying our balance sheet capability here as the year ends and the year opens.

Mike Petusky – Noble Financial

So fair to say that, in the next, say, 6-12 months we’ll be probably, in your view at least, as you see it now, more active than, say, the last six months or so?

Bruce Mackey

Yes.

Operator

And for closing remarks, I’ll turn the call back over to Bruce Mackey. Please go ahead.

Bruce Mackey

Thank you all for joining us today. We look forward to updating you on our fourth quarter and year end results early next year.

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