Emeritus Corporation: Reckless Growth And Chaos Is The Real Story
Emeritus Corporation (NYSE:ESC) is an operator of senior living communities in the United States. Emeritus operates a portfolio of communities, which are purpose built for services including assisted living, specialized (Alzheimer's and dementia) care, and in-home nursing. The story here is good, baby boomers getting older will seek out senior living and Emeritus is well positioned to capitalize from this trend. The true story, however, appears much darker.
Background
Emeritus Corporation reminds me of the for-profit education sector. Back in 2008 and 2009, many who found themselves unemployed went back to school to improve their chances of re-entering the workforce and improving their earning power. Investors quickly caught on to this trend and looked for profit in education stocks. When the truth behind these companies came out -that students were saddled with debt and a degree from these institutions did not increase earning power, the stocks began to get hammered and have struggled ever since. The government then became interested in reforms, enrollment began to fall, and the stocks followed. So how does this all relate to Emeritus Corporation? I believe that there are many similarities between these two stories. In both cases investors saw a sector that would benefit from changing tastes and preferences, while ignoring what was really happening to those who are using the services.
Why The Bullish Case
There is most definitely a bullish case here, although that is the case for many stocks that eventually go down once the market figures out what is going on. The changing demographics in the United States will serve Emeritus Corporation well.
The table above is the predictions from the United States Census Bureau regarding the changes in population over the next eighteen years. Emeritus's target market, which is those 75 and older, is projected to grow by 78% over the next eighteen years. Additionally, diseases such as Alzheimer's for which Emeritus provides living communities, are projected to grow. According to the Alzheimer's Association, there are currently 5.4 million Americans with Alzheimer's disease, which includes one in eight Americans over the age of 65. They project that in 2013, 500,000 Americans will develop Alzheimer's and that number is expected to double by 2050. The number of baby boomers over 65 is going to continue to grow as the first baby boomers turned 65 in 2011 and all baby boomers will be over the age of 65 by 2029. Emeritus has a very large geographical footprint, which includes 480 communities in 45 states.
Here is the breakdown of communities by type.
The bullish case is mainly predicated on the demographics story. Like many stories, however, when you look below the surface it is not nearly as attractive and represents what I believe a good short.
The Big Picture Case
Occupancy Rates Stabilizing, But Still Lower
The chart above shows the average stabilized occupancy rates for Senior Housing, Independent Living (IL), and Assisted Living (AL). Year over Year, Independent Living occupancy rates were up 30 basis points while Assisted Living occupancy rates increased 50 basis points YoY. For Senior Housing (IL+AL) occupancy rates decreased 10 basis points to 89.6% but were up 30 basis points YoY. In states where Emeritus has the most exposure rates declined more than the national trend. Florida, California, and Texas all saw occupancy decreases of 30 basis points versus the national decline 10 basis points. 11% of all Emeritus units are in Florida, 13% of Emeritus units are in California, and 11% of Emeritus units are in Texas.
Weak Rent Growth
Rent growth year over year remains weak. More worrisome for investors should be that rent growth is actually declining in the states where Emeritus has the most exposure. (Florida, California, and Texas). Overall senior housing rent growth was down 40 basis points sequentially, while rents have risen 1.7% YoY. So despite the story that people are seeking to move into senior living as they age, it certainly isn't as strong as Emeritus would have hoped. This is reflected by the weak rent growth and subpar occupancy rates.
Aggressive Growth, But Too Aggressive?
Emeritus was founded in 1993 with only one location, but by 2006 it had expanded to over 200 units, 103 of which it owned. Now in 2013, it owns 192 communities and operates 483 communities, and leased 269 communities. This growth has come by acquisitions, financed by debt of course, leaving Emeritus's balance sheet highly leveraged.
The average Financial Leverage of an S&P 500 company is around 2.5, according to Morningstar. The debt-to-equity ratio is roughly in-line with the Financial Leverage ratio, coming in at 9.355.
In terms of the balance sheet, Emeritus is currently carrying just over $1.5 billion in long-term debt versus just over $4.6 billion in assets. It should be noted that much of the assets is in owned real estate and is thus not very liquid. Additionally, this exposes Emeritus to the vagaries of the real estate market, for better or worse.
Decreasing Shareholders' Equity
There are several reasons for decreasing shareholders' equity, in the case of Emeritus, none of these are beneficial to shareholders. Dividends and share repurchases can both decrease shareholders' equity, however in the case of Emeritus there is no dividend and no share repurchase.
The decrease in shareholders' equity in Emeritus is due mainly to the increase in debt obligations on the balance sheet. There was also roughly a 1% increase in expenses from 2011 to 2012 but this is minimal compared to the increase in debt. So why has the company been taking on so much debt? Well this ZIRP isn't going to last forever, so many companies have taken advantage of it by issuing debt to repurchase shares or increase a dividend such as Apple. In the case of Emeritus, however, this has been done recklessly and not in the best interest of shareholders. The Chairman of the Board, Daniel R. Baty has engaged in numerous transactions with Emeritus since 2007. All of these transactions have been approved by a committee of independent directors, I think that some of these transactions, while stopping short of being bad for the company, certainly have not helped the balance sheet. Mr. Baty is the principal owner of Columbia Pacific, a private company which engages in senior living in India and Asia. It also has interests in the United States and Canada. Mr. Baty has a clause in his contract that limits potentially competitive ventures. From the 10-K:
Mr. Baty's potentially competitive activities are limited by a shared opportunities agreement between him and the Company. Under the terms of this agreement, Mr. Baty and Columbia Pacific must immediately present to the Company all investment opportunities in senior living communities and ancillary businesses in the United States, Canada, and China. For transactions in the United States and Canada, we then have the option to participate in the investment opportunity through an ownership interest and/or management contract as set forth in the agreement. For transactions in China, we have the option to invest in the opportunity up to 50% of the equity value and compete for management or consulting services.
This does prevent conflicts of interest, but I think it has led to an increase in acquisitions as Emeritus essentially has two entities that are looking for potential acquisitions. Additionally, of concern for me is that Mr. Baty has been financing some recent transactions and has been supporting operations.
As of December 31, 2012, we manage six communities owned by Mr. Baty or Columbia Pacific. Mr. Baty was also the guarantor of a portion of our obligations under a 24-community lease with an entity in which Mr. Baty has an ownership interest.
This isn't to say that there is a conflict of interests here that is being materially harmful to Emeritus shareholders, rather that the current setup is seemingly encouraging Emeritus to acquire more properties, in a manner that I believe is too aggressive. Emeritus has forsaken a sound balance sheet for high growth, leaving it in a highly leveraged position. It actually hasn't seen the growth it would have hoped, as occupancy still hasn't recovered. This current position is unsafe especially considering that Emeritus is in an area that exposes it to government regulations, real estate market fluctuations, and lawsuits from customers.
Life and Death in Assisted Living: The Expose
I am talking about the ProPublica and FRONTLINE expose of the assisted living sector. The report, titled "Life & Death in Assisted Living: The Emerald City" detailed some horrors. The accompanying TV special, which you can view here, was worse. I am generally hesitant to make investment decisions based on something like this, after all there have been reports about the conditions in Amazon's warehouses, exposes of how Wal-Mart treats workers, etc. I think this will present more of a problem for Emeritus. It is important to note that it is not a nursing home, it is "Senior Living" which is highly unregulated and could come under more government scrutiny after the FRONTLINE report. There is some important information in the report which I believe bolsters the short case in this particular case. This part of the report talks about how during the housing crash, Emeritus was desperate to fill rooms and began offering deals to people who Emeritus was allegedly unable to properly care for. Here is part of the said report:
"Our stock price plummeted," recalled Granger Cobb, Emeritus's chief executive officer, who joined the company as part of the Summerville deal. The company's occupancy rates had been trending skywards. Now they went flat. At Emerald Hills, the economic slowdown that summer was making life tough for Melissa Gratiot, the lead sales agent. "It was way harder to move residents in," she remembered. But there was some good news. She was close to a significant sale, this one to a couple. Gratiot worked the pitch. She talked with the family. She emailed. She gave them a tour of the facility's memory care unit, called The Emerald City. She told the family she'd received approval from higher ups to offer the family "a phenomenal deal." Gratiot closed the sale. On Aug. 29, 2008, Myron and Eric signed the contract, and the family opened its wallet: A $2,500 initial move-in fee; $4,625 for Joan's first month in Room 101; another $2,500 for Myron. There had been one oversight, though. No one at Emeritus with any medical training had ever even met Joan, much less determined whether Emerald Hills could safely care for her.
The acquisitions that is referred to is the Summerville Senior Living, Inc. acquisition, made in 2007. The Summerville acquisition was the largest acquisition it had made to date. Summerville had 81 facilities in 13 states, and the acquisition increased the size of Emeritus by almost 30%. Obviously that acquisition was ill-timed and as the housing market froze up Emeritus struggled greatly. As many Emeritus facilities are costly, targeted at upper-middle class families, the housing market crash hurt occupancy rates. Many seniors needed to sell their house before moving into an Emeritus facility and were unable to sell their houses. This is around the time that Emeritus's troubles started coming to light. In October of 2007 a nurse at one facility wrote to management highlighting some of the problems that she saw at the facilities.
Then in 2008 a State of California Investigation Report substantiated claims of "Lack of care and supervision," as well as claims of an inadequate number of staff to provide the appropriate care level. These accusations were substantiated by the report filed by Licensing Program Analyst Betty Smith.
She backed up the claims by saying:
Interviews revealed on one occasion at approximately 10 p.m. a resident was waiting outside for at least 15 minutes to be let in the building. She was finally let in after a visitor was leaving the building. It was also reported residents are not being bathed as scheduled and the caregiver is Signing off as if resident is being bathed. It was also report resident #3 (see LlC 811) is in need of an increase in bathing due to incontinence and odor. Currently there are only two caregivers during the 11 p.m. to 7 a.m. shift. It was also reported several of residents (see LlC 811) may need a higher level of care. LPA reviewed the resident's file and found the physician's reports are in need of an update.
In the case of Joan Boice, her family won a wrongful death lawsuit against Emeritus Corp. in March of this year. The jury found Emeritus guilty of wrongful death, elder abuse, and fraud. The jury then hammered Emeritus with $500,000 in compensatory damages and $23 million in punitive damages, to be paid to the Boice family. Emeritus, which offered the family a $3.5 million settlement soon after Boice's death, of course was "extremely disappointed" with the outcome of the case. CEO and President Granger Cobb said "Emeritus is extremely disappointed with the outcome of this trial and does not believe it is a fair reflection of the care that was provided to this resident in 2008."
Affordable Care Act Could Increase Expenses in 2014
Since Emeritus does not operate nursing homes, it is not regulated by federal law, but rather by state laws. Given how quickly Emeritus (and other companies like this) expanded many states simply modified existing laws rather than creating a new code. I believe that the age of relatively little regulation in this sector is drawing to a close, and that business practices as well as the quality of care in these type of facilities will be more tightly regulated in the future. Emeritus, while being cash flow positive, has incurred substantial losses from operation, losing $84 million in 2012, $71 million in 2011, and $57 million in 2010. With the exception of 2005, Emeritus has operated at a loss since its inception in 1993. In 2013 alone the company faces minimum annual payments (on total debt of $2.1 billion) of $148 million, combined with capital lease and financing obligations with minimum annual payments of $299.9 million. This brings the total minimum annual payment in 2013 to nearly $350 million, and while analysts expect revenues to be $1.92 billion in 2013, this still leaves Emeritus in a highly leveraged position entering into a critical and still very murky 2014. The reason 2014 could spell trouble for Emeritus is that specific parts of the Affordable Care Act that will come into effect in 2014 will cause costs to rise for Emeritus. From the "Risks" section of the 10-K:
The specific provisions of the ACA will be phased in over time through 2018. Based on our current assessment, although there are additional expenses that will be incurred in 2013, we do not expect that the ACA will result in a material increase in our operating expenses in 2013. However, we could see significant cost increases beginning in 2014 when certain provisions of the legislation are required to be implemented.
Obviously the entire healthcare industry is faced with similar risks, but the ACA also targeted skilled nursing facilities, which apparently Emeritus falls under. Now skilled nursing facilities are required to submit and certify to the Secretary of the U.S. Department of Health and Human Services and the Inspector General more detail on organizational structure, financial data, clinical and other data, as well as increased information on directors and managing employees.
Questionable Response To FRONTLINE/ProPublica Report
Whenever a report like the FRONTLINE/ProPublica expose comes out, a company has to at least try to defend itself against the allegations or start a positive marketing campaign. In the case of Emeritus, it chose to market itself positively. The execution of this, however, was laughable.
Source: PBS.org
Apparently what happened was an employee inadvertently forwarded the email to someone at ProPublica. Its response to this is to ask its employees to brag about the quality of Emeritus's service. Not to launch an advertising campaign like BP did after the oil spill, but to ask its employees to write great stuff about it on Facebook and Twitter. That this email got out is not surprising to me, as it seems with all the evidence I have provided that Emeritus employees are overworked and are not pleased with the management.
Reckless Expansion
Part of the reckless expansion I talked about earlier has been detrimental to Emeritus's shareholders. Again, from the 10-K:
Our historical losses have resulted, in part, from occupancy levels that were lower than anticipated when we acquired or developed our communities. While occupancy levels increased in 2012 in our Same Community Portfolio (the 293 communities we have operated continuously since January 1, 2011), our historical performance has been mixed. Our occupancy levels may not increase in the future and may never reach levels necessary to achieve net income.
As is admitted, Emeritus's management has not done a good job in judging what the occupancy rates would be, leading to larger than expected losses.
Comparables
| Emeritus Corp. | Brookdale Senior Living (BKD) | Ventas, Inc. (VTR) | |
| Market Cap | $1.12 B | $3.42 B | $17.91 B |
| Price/Sales | .68 | 1.40 | 6.83 |
| P/E | N/A | N/A | 42.24 |
| EV/EBITDA | 16.66 | 15.30 | 18.42 |
| Financial Leverage (NetDebt/EBITDA) | 10.1 | 6.18 | 5.72 |
Emeritus is nearly twice as leveraged as its competitors while being roughly in-line on an EV/EBITDA basis. It should be noted again that Emeritus has negative earnings.
Summary
Looking at the big picture I see Emeritus Corp. as a company that was started with a certain goal, but as time progressed and management changed, that goal began to slip. Originally it wanted to provide apartment style alternatives to nursing homes. Now, however, it focused so much on expanding that it left communities under-staffed and in chaos as a former employee put it. I believe that at current levels, Emeritus represents a very attractive opportunity to short what, by all means, is a troubled company. Here is a summary of my short thesis:
- Weak industry trends
- Shaky balance sheet
- Excessive expansion, leading to said balance sheet weakness
- Management demonstrating that it hasn't been accurate in judging acquisitions
- Lawsuits/blowback from FRONTLINE and ProPublica expose
- Increasing government regulation in the sector
- ACA provisions leading to higher costs and lower earnings in 2014
- Operating cash flow down 33% YoY in the most recent quarter
- Not cheap on an EV/EBITDA basis, yet it is the most highly leveraged.
I believe the downside to this short is limited, at least over the next 18-24 months. Analysts are expecting -$1.08/share versus a loss of $2.16 this year. I believe the estimates are generous, especially considering the ACA provisions coming into effect. The company has been feeding investors and Wall Street a story of growth yet has been overlooking the people that it is supposed to be caring for and in the process has created a dangerously leveraged balance sheet.
Disclosure: I am short ESC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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