Why A Sale At $10 Or More Makes The Most Sense For New Senior Investment Group's Shareholders

Summary

• New Senior has announced it is “exploring alternatives to maximize shareholder value.”.
• We think this is a great idea, and will lead to better returns for shareholders.
• The mostly likely outcome in our view is an outright sale of the company to a third party.
• Our “fair value” estimate remains $10 to $14.

The Big Announcement

Last Friday during the company's fourth-quarter conference call, New Senior Investment Group's (NYSE:SNR) CEO Susan Givens announced:

In addition to our fourth quarter results and dividend, today we announced that our Board of Directors had been exploring strategic alternatives in an effort to maximize shareholder value. Our Board engaged JP Morgan [Securities LLC as its financial advisor and Skadden, Arps, Slate, Meagher & Flom LLP as its legal advisor] to help us conduct a thorough review of a variety of options.

Source: New Senior's Q4 conference call

Now, an announcement by a company that it is "exploring strategic alternatives in an effort to maximize shareholder value" could mean a lot of different things, for example it could indicate:

• Asset sales
• Split-off
• Spin-off
• A sale of the company

In the case of SNR, I don't think it's any of the first three, leaving us with the company potentially being sold outright, and here's what's leading me to that conclusion.

The company just completed $296 million of asset sales in Q4 (equal to more than 10% of its total portfolio). There was no announcement of a similar nature made prior to those asset sales taking place - so there should be no reason to expect any different this time around.

And a split-off or spin-off doesn't make logical sense either. SNR is already a "pure play publicly traded senior housing REIT" meaning there's no value to be strategically "unlocked" by breaking up or repackaging the company's holdings. Which leaves us with a "takeover" or outright sale.

This strategy makes perfect sense to us, and we welcome it, as our team has long felt that the public markets were misunderstanding the inherent value present in New Seniors portfolio (more on that below).

Now, it appears Fortress (FIG), the external manager in charge of SNR's assets, has come to that same conclusion. It could also have something to do with the fact that Softbank (OTCPK:SFTBY) closed its acquisition of Fortress on Dec. 27, 2017.

What the Public Markets Have Been Failing to Appreciate About New Senior

Ask anyone who's familiar with New Senior what they think of the company, and the vast majority of the time, the conversion will inevitably to lead to a discussion about the dividend.

SNR shares currently yield 12.84% against an annual dividend of $1.04 and the company hasn't raised its dividend payout since 2015. For the year just ended 2017, that $1.04 dividend compared against FFO of $0.98, AFFO of $1.04 and normalized FAD of $0.95. While those figures already seem pretty "dicey" to begin with, it got worse after the company sold $296 million of assets in Q4.

For the fourth quarter ended December 31st, the company's quarterly payout of $0.26 looked, frankly speaking, "unsustainable" against Q4 FFO of $0.19, AFFO of $0.24 and normalized FAD of $0.23. If you haven't been following the story of SNR up to now, the unsustainable nature of the company's dividend has been a point of contention for most of the past year, if not longer (SNR came onto our radar in 2017).

And that argument has a lot merit, mind you. Thanks to the unsustainable nature of the company's payout, the value of SNR's shareholders equity has fallen precipitously - from $822 million in 2015 to $506 in the most recent quarter, or a loss of about $3.85 per share. This, in turn, supports the theory that SNR should probably cut its dividend.

But this type of argument is fraught with problems, owing to its very nature. What will, or should, the dividend be cut to? Or, what is the appropriate dividend yield for the shares after the cut has been made?

It ends up turning into a guessing game, even at the best of times. However, our team chooses to look at it from a slightly different perspective. Instead of looking at what the company is, or would be paying out to shareholders, we look to what type of distribution an owner could pay themselves, from a control perspective.

This type of approach has several advantages, one of which is that tends to be fairly predictive in helping to identify the values at which entire companies change hands, as the owners of these businesses are not concerned about the value of the current dividend, but rather the capacity to pay themselves a dividend, if they owned the entire company.

So, when we attempt to determine the value of SNR's share price, rather than engaging in a debate about what SNR's dividend ought to get cut to and what the appropriate yield of that dividend should be - we'll instead look to the value of New Senior's current cash flows, what those cash flows might look like in 5 years time, and what the appropriate risk would be for a company that owns retirement homes.

Valuation: What Is the Value of New Senior Today?

Heading into the fourth quarter of 2017, SNR had a "run-rate" of free cash flow of about $16.5 million per quarter, or $66 million per year. In the fourth quarter, SNR's portfolio metrics were all down about 10% from the year ago period.

Remember that the company divested a little more than 10% of its book in Q4. Given that the divested properties were towards the lower-end of SNR's portfolio in terms of their quality, their absence is a little less noticeable, which is how we get to a 10% drop off in performance.

Meanwhile SNR's debt is an ongoing part of its business, backed by assets - essentially a mortgage on the properties - and the company doesn't have any major balloon payments coming due as these were all dealt with for the most part in Q4 (proceeds from the asset sales) so we don't need to build in a plan to repay the debt as part of our valuation.

That leaves us with $60 of recurring cash flow that is available to be distributed to shareholders ("FCFE"), whoever they may be.

The shares of New Senior have received a beta of 0.90x from the market according to Yahoo! While I'm not brave enough to follow the CAPM framework "blindly," this figure makes sense to me given our view that retirement centers are, relatively speaking anyway, a pretty "low-risk" business.

That just leaves us with the growth rate, which is always open to some interpretation. Simply put, our team really likes the senior's housing business for three distinct reasons:

• A "demographic dividend" in terms of the sheer number of people that will be reaching +75
• Inflation-adjusted pricing on rents
• Above-average spending directed towards health and wellness categories

We'll use two scenarios to adjust for the risk:

2% growth rate to account just for basic inflation

$60M FCF / ( 9.3% - 2.0% ) = $10.02 fair value

4% growth rate, or our "base case" which includes 2% inflation and "above-trend" spending on health-care.

$60M FCF / ( 9.3% - 4.0% ) = $13.80 fair value

Granted, the $13.80 fair value seems like a bit of a "stretch" today - at least in terms of realizing that price in a sale - given that it represents 71% upside from Thursday's closing price.

But that doesn't mean that the $13.80 value is any less meaningful, or "true." And I'll add that if a prospective buyer were to agree with this outlook for the business, it only suggests that a deal would be reached sooner, and not later, as the buyer would be "motivated" to take action.

Who Would Be Interested in Buying New Senior?

There are many different parties that could potentially be interesting in buying New Senior from its shareholders, but they can basically be broken down into two categories:

• A larger REIT
• A private firm

According to New Senior's CEO Susan Givens, a larger REIT could tap into some pretty lucrative synergies in acquiring New Senior's portfolio of independent living "IL" facilities:

Approximately 80% of our portfolio is concentrated in independent living properties where there has been less new competition. The level of new construction for IL remains at less than half the level of AL. Independent living is really the gateway to senior housing. The lower price point combined with the lower acuity environment make it an attractive option for a larger number of seniors.

Source: SNR's Q4 Conference Call

Not only could an acquisition of SNR be accretive in terms of an investment in the less competitive IL market, but gaining access to SNR's IL properties could also offer a profitable avenue for AL property owners to acquire tenants, as IL tenants graduate into a higher acuity care environment. For a private investor, there would also be value in SNR beyond what it is worth today.

As a publicly traded REIT, SNR is subject to constant scrutiny from the market in terms of its quarterly results (see this month's discussion on NOI trends as a recent example) and other corporate decisions such as 2016's decision to buy back stock (mentioned on the Q4 conference call).

Taking the company private would allow its owners to not only restructure the company's debt (including refinancing more than $700M in variable notes) but also take more aggressive actions in terms of maximizing its value - by any means necessary - be it through continued asset sales or restructuring the company's operations.

It's difficult to say which scenario is more likely, but it appears SNR would have the most value to a private owner - for example another private equity firm - given the issues Fortress has been faced with over the past year, in terms dealing with the perceptions of the public markets.

A sale to a private owner would not only help realize the highest sale price for SNR's shareholders today but at the same time, offer the most synergistic benefits to a strategic buyer.

Reasons Not to Be Too Surprised by the Latest Announcement

In hindsight, there have been signs leading up to the recent announcement indicating that Fortress was already taking actions to "maximize shareholder value." These include:

• Eliminating government funded payees from its client base
• Refocusing the portfolio on IL properties
• Removing exposure to CCRC properties
• Rebalancing the "mix" between Managed Properties and Triple-Net Leased Properties (NNN)
• The asset sales in Q4 to remove lower-performing assets

The slides below are from SNR's Q1 2015 Supplemental Presentation (top) and its Presentation from Q4 2017 (bottom).

Contrasting the two presentations we can see:

• SNR has gone from being 90% private pay to 100% private pay
• IL properties today account for 82% of NOI compared to 64% two years ago
• It has greatly reduced its exposure to CCRC properties which carry additional risks
• SNR has adopted a "neutral" exposure to the mix between Managed/NNN Properties

It's important to keep in mind when considering the prospects of a sale of SNR's portfolio that the senior's care market is highly fragmented, with many small, private owners. This has many implications of course but in terms of finding a strategic buyer, one of the challenges SNR management faces is "window dressing" the portfolio, so to speak.

That's because for a REIT or private investor that wanted to make incremental "bolt-on" acquisitions to its existing portfolio, it wouldn't be impossible to accomplish that by making one-off purchases from privately held "mom and pop" retirement homes.

But at the same time, a "bolt-on" strategy may ultimately carry with it higher transaction expenses for the buyer, by way of legal and real estate fees, and more time spent negotiating each deal. However, the fact remains that SNR is better served by delivering a "niche" or focused product for sale in the market.

And it seems that is exactly what management has done in recent years, along with shedding the risk of its CCRC exposure and eliminating some lower-value properties in Q4 that would have detracted from the overall value of the portfolio. Granted, these strategic moves may not have been made with the sole intention of an outright sale in mind - they would have additionally served to improve the value of the company's offering in the public markets as well.

But given where we find ourselves today, it should provide investors with an added degree of confidence that the team in charge of executing the newly announced strategy already has a clear vision in mind.

Conclusion

An outright sale of SNR was not part of our investment thesis - and by all means, there are certainly no guarantees that one will end up taking place.

But a valuation of the company's portfolio using a control perspective and a free cash flow framework was, and now months later, we believe that we have found ourselves strategically aligned with the company and its forthcoming plans, as announced on the latest earnings call.

Disclaimer: The above research does not constitute investment advice nor is it a recommendation to take action in any investment security. You are encouraged to conduct your own research and due diligence before taking investment action, including a careful review of the risks associated with the security in question, an evaluation of the security for suitability within your own set of circumstances and consultation with a professional financial advisor if you have one. Any positions disclosed are subject to change and without warning.

Analyst’s Disclosure: I am/we are long SNR. 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.