Five Star: A Professional Opportunity For The Retail Investor

Summary

• Five Star is trading well below intrinsic value with an upside of over 100%.
• The company should be more profitable over time as they focus on their more profitable revenue streams, assisted living, and rehab/wellness clinics.
• Five Star has possible tailwinds which should drive revenue/profitability higher over the long term.
• Professional investors are not able to buy enough shares of the stock due to a low float, which creates an opportunity for individual investors.

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Investment Thesis

Five Star Senior Living Inc. (FVE) is currently trading at least 15% below its intrinsic value and has an upside of over 100%. In the mid to long term, the stock could be worth even more due to the company transitioning out of unprofitable assisted living and skilled nursing facilities. After the transition is complete (in early- to mid-2022), the company should be more profitable than it is today. Five Star should also benefit from tailwinds such as raising occupancy rates in their facilities and industry-wide growth.

Background

Five Star Senior Living operates and manages assisted living facilities, skilled nursing facilities, and rehab and wellness clinics.

How Did We Get Here

All companies which trade under their intrinsic value need to be heavily scrutinized as the market generally does not give such great opportunities for free. This stock reminds me of a quote from Seth Klarman's book, Margin of Safety.

"If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, "What a great bargain!" but, "What's wrong with it?"

So, let's take a mini history tour of Five Star to see why it's trading so low and to answer the question, what's wrong with it?

Prior to 2018, Five Star had increasing revenues but also increasing lease payments to its largest landlord SNH (now known as Diversified Healthcare Trust (DHC)). In 2018, the financials of FVE showed signs of major deterioration. There was a drop-off in revenue of $27M while lease payments increased by $3M. This squeezed FVE's margins, and they defaulted on their lease.

The company had signed lease agreements on unfavorable terms which was a major reason for the default. FVE entered 'Triple Net Lease' agreements in which the tenant pays for all expenses related to the property plus pays the landlord for use of the property. On top of annual rent, the lease also specified FVE to pay a:

"percentage rent equal to 4.0% of the increase in gross revenues at SNH's senior living communities over base year gross revenues as specified in the applicable lease."

Source: FVE 2018 10-K

At this point, Five Star was on the verge of bankruptcy. But as FVE is the largest lessee of SNH's properties, it wasn't in SNH's best interest to allow Five Star to go bankrupt. So SNH essentially bailed out FVE by restructuring their agreements.

Restructure

In exchange for terminating the old agreements, SNH received 34% of FVE's stock and turned Five Star into a manager of SNH's property vs the operator (at this point in the story, SNH changed their name to DHC, so from now, I'll refer to SNH as DHC). One might ask what's the difference between being a manager over an operator? The main change is that DHC receives all revenue generated on the property and Five Star is paid a fee for managing the property. Whereas prior, all revenue generated belonged to FVE and DHC received a fee for allowing Five Star to use their property.

The main points of the new management agreements are as follows:

• All operating costs FVE incurs will be reimbursed by DHC.
• All revenue generated on the property belongs to DHC.
• 5% of gross revenue realized and 3% of all construction costs will be paid to FVE as a management fee.
  • FVE can also receive a bonus for reaching EBITDA targets (a performance bonus).

* Note: all the above changes took place on January 1, 2020.

This restructuring massively de-risked Five Star by changing the structure from operating the properties to managing properties. FVE no longer pays a lease to generate revenue. This lowers costs and makes Five Star a more profitable company. The downside of this structure is that it caps the upside for Five Star. But it also limits the downside. If business booms, DHC will be the major beneficiary passing along slightly higher management fees to FVE. But if business declines, FVE will take in a lower fee, and DHC will incur most of the losses.

Outlook and Tailwinds

Since the restructuring, Five Star has been significantly more profitable, generally posting positive quarterly operating income and operating cash flow. Quarterly net income would be positive under normal circumstances, but FVE is currently incurring costs associated with transitioning out of skilled nursing and continued care retirement communities.

Another reason Five Star defaulted on its leases was a downward trend in revenue. In order to remain profitable and maximize their assets, DHC and FVE determined that they needed to transition out of skilled nursing and continued care retirement communities as these facilities were deemed to be unprofitable. Their plan is to focus on assisted living and rehab/wellness facilities. DHC is targeting to complete their transition by January 1st, 2022. The illustration below shows the revenue mix pre- and post-transition.

Source: FVE Q2 2021 Investor Presentation

Cutting out these underperforming revenue streams bodes well for Five Star as their management fee is contingent on a percentage of gross revenue, and therefore, on each facility being profitable. This is a smart move by management and should pay off in the future.

Although profitability is rising, one area of concern is a decrease in the total revenue over time. This is partially due to the transition as the company is losing a portion of overall revenue in order to gain profitability. It is also due to a decline in occupancy rates for their facilities (as shown in the illustration below).

Source: Author compiled from FVE 10-Q's and Q1 and Q2 2021 Investor Presentations

Normally, this would be a major concern. But since the beginning of the pandemic, the industry has shown record-low occupancy rates. In the 1st quarter of 2021, the average assisted living occupancy rate was 75.4%. According to the National Investment Center for Seniors Housing & Care (NIC):

"Assisted living occupancy increased to 76.9%, up from its pandemic low of 75.4% in the first quarter of 2021 but still below its pre-pandemic level of 85.0%."

Source: NIC.org

Overall, the facilities Five Star manages have experienced slightly lower occupancy rates than the industry average. But their rates have not deviated enough from the average to suggest there is a demand problem specific to FVE.

Five Star should benefit from this tailwind as occupancy rates are expected to rise post-pandemic. And therefore, the revenue figures shown in Q1 and Q2 of 2021 ($50.5M and $46.8M respectively) should be quarterly revenue lows for the near future.

As shown in the graphic below, over the long run, the assisted living market is expected to grow due to a larger over 65 population and increasing life expectancies in the United States.

Source: FVE Q2 2021 Investor Presentation

All of this provides evidence that the low occupancy rates shown in Q1 of 2021 are a short-term problem which should self-correct over time.

Management also believes that they will be able to decrease costs for their senior living communities, as shown in the graphic below.

Source: FVE Q2 2021 Investor Presentation

This is another potential tailwind for FVE, as this would make them more profitable over time. But as Five Star is still in the transition phase of their plan, it will likely take years for FVE to realize these cost efficiencies.

Valuation

The outlook for Five Star is optimistic especially considering the tailwinds which could generate stronger revenue and profitability. But my valuation doesn't take those into account. The stock is trading below intrinsic value and therefore no tailwinds or catalysts are needed in order to make a profit. As long as FVE doesn't go bankrupt and can generate minimal cash flow, the stock should increase in value.

Generally, I like to perform multiple DCF models in order to project a range that the stock should be trading in.

The first DCF valuation model is what I would consider a 'worst-case scenario' with zero growth. This model values the company at $4.85/share.

Source: Author's Work

Under the scenario that Five Star won't go bankrupt and will make a very small profit, the stock is trading below fair value.

The second DCF model I built is what I consider a 'conservatively realistic' model. This model projects revenue based on senior living occupancy rates of 60% (10% less than its recent lows) and cash from operations equal to 21% of revenue (which is FVE's average since the restructure). Based on those assumptions, this model values the Five Star at $10.13/share.

Source: Author's Work

In this scenario, the value of the stock is significantly undervalued by close to $6/share. And none of these projections include any of the possible tailwinds mentioned above which could push the value even higher.

In addition, the company currently has a strong balance sheet with almost $100 million in cash and net PPE of about $187 million. FVE also has a tangible book value of $6.36/share. All of this provides extra safety for investors if the business generates less cash flow than expected.

Why is it trading so low?

Now we understand why the stock has declined recently, why the prospects for the future look more optimistic, and that FVE is trading below intrinsic value. So now let's answer the question I proposed earlier... what's wrong with it?

The answer is not a lot. Part of the reason the stock is trading so low is that it's a complicated stock. Remember my summary about the background of the company and the information about triple net leases, SNH/DHC receiving stock, changing management agreements, etc. My guess is that at that point at least half of those who clicked the article stopped right there. And the rest of you still have a massive headache from reading about that (I know I do). That's part of the reason it's trading so low; most people don't understand it or would require a lot of time (that the average investor doesn't have) to figure it out.

There are also structural issues with this stock causing it to trade under intrinsic value. FVE is a small stock with a low float (66% held by insiders), and not many shares trade on a daily basis. For those reasons, most institutional/professional investors cannot buy enough shares to make material gains for their fund. Since over 51% of the company is held by insiders, an activist investor wouldn't be able to buy enough shares to gain any influence over management and potentially unlock its value.

There is value to be gained by buying shares of Five Star, but the average person doesn't understand it and professionals can't purchase large quantities of it.

Risks

There are two main risks associated with Five Star. The first is concentration risk. FVE is heavily reliant on DHC as 100% of their management fee revenue is generated from DHC. This translates to 28.3% of FVE's revenue in 2020. If DHC decided to transition to another management company, liquidate any portion of assets managed by FVE, or struggles overall, Five Star could be greatly affected.

The second risk is insider ownership. Adam Portnoy and companies connected to him (ABP Trust, ABP LLC, and DHC) own in total just over 51% of FVE's stock. According to DHC's 2020 10-K filing, DHC has no employees and is solely managed by RMR LLC (a subsidiary of the RMR Group). Adam Portnoy is the CEO of the RMR Group, a managing trustee of DHC, and a managing director of FVE. The main point here is that one individual has significant influence over all these companies (including FVE) and investors are depended on his ability to manage them effectively.

One other minor risk is liquidity risk. As this stock trades a relatively low number of shares daily, there is a risk that one would not be able to sell any or all the stock owned in any one day. This is mainly a problem for investors with larger sums of money to invest.

The Bottom Line

Five Star's stock currently provides investors asymmetric risk as it is trading below intrinsic value and has a conservative upside of over 100%. Five Star should be able to benefit from senior living occupancy rates normalizing post-COVID and might be able to create cost efficiencies in the future. This provides individual investors an opportunity to capitalize on the current mispricing of the stock and generate large returns in the short term.

Disclosure: I/we have a beneficial long position in the shares of FVE either through stock ownership, options, or other derivatives. 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.