Description
Filed with the SEC from Oct 11 to Oct 17:
Emeritus (ESC)
Saratoga Partners decreased its holdings to 2,312,511 shares (5.1%) by selling 818,765 from Oct. 3 through Oct. 11 for $21.47 to $23.15 each.
BUSINESS OVERVIEW
Overview
Emeritus was founded in 1993 and is one of the largest and fastest-growing operators of senior living communities in the United States. We own and operate a portfolio of high-quality, purpose-built communities providing services to our residents including independent living, assisted living, specialized memory care, and, to a lesser extent, skilled nursing care. We strive to provide a wide variety of supportive living services in a professionally staffed environment that enables seniors to live with dignity and independence. Our holistic approach enhances every aspect of our residents’ lives by assisting them with life enrichment activities including transportation, socialization and education, housing, and 24-hour personal support services, such as medication management, bathing, dressing, personal hygiene, and grooming. The average age of our residents is 85.
The Senior Living and Memory Care Industry
The senior living industry offers various types of settings across a continuum of care for the senior population. Our primary area of focus is assisted living, which provides a cost-effective and life-enriching alternative for seniors as compared to other settings such as skilled nursing or home healthcare. We are one of a limited number of national operators of assisted living communities with a proven record of acquisition and development success across diverse geographic markets. The assisted living industry is highly fragmented and characterized by numerous local and regional operators. We believe the industry will be the focus of increased consolidation activity.
The term “assisted living” may also be known as residential care, adult living facility, supported care, adult foster home, retirement residence, etc. (collectively “assisted living”). We believe that the assisted living and memory care industry is the preferred residential alternative for seniors who cannot live independently due to physical or cognitive frailties but who do not require the more intensive medical attention provided by a skilled nursing facility.
Assisted living provides housing and 24-hour personal support services designed to assist seniors with the activities of daily living, which include bathing, eating, personal hygiene, grooming, medication reminders, ambulating, and dressing. Certain of our assisted living communities offer higher levels of personal assistance for residents with Alzheimer’s disease or other forms of dementia, in addition to our free-standing memory care communities.
We believe that our assisted living business, because it is needs-driven, has been relatively resistant to economic downturns and will continue to benefit from other trends and factors in the industry including growing consumer awareness of the types of services we provide and the increase in the number of seniors looking for care outside of their homes. Other trends and factors include:
Consumer Preference. We believe that assisted living is preferred by prospective residents as well as their families, who are often the decision makers for seniors. Assisted living is a cost-effective alternative to other types of care, offering seniors greater independence while enabling them to reside in a more residential environment.
Cost-Effectiveness. Assisted living services generally cost considerably less than skilled nursing services located in the same region. We believe that the cost of assisted living services compares favorably with home healthcare, particularly when costs associated with housing, meals, and personal care assistance are taken into account. According to the 2011 MetLife Market Survey of Nursing Home, Assisted Living, Adult Day Services, and Home Care Costs published in October 2011, the national annual average cost of a year in a skilled nursing home in 2011 was $87,235 for a private room and $78,110 for a semi-private room compared to an annual average cost of $41,724 in an assisted living facility.
have had some impact on the financial resources of seniors and their families, we have yet to witness any significant occupancy declines.
Supply/Demand Imbalance. While the senior population continues to grow significantly, the supply of assisted living units is not growing at a similarly rapid rate. We believe that high construction costs, costs and availability of capital and credit, and the cost of liability insurance for smaller operators have constrained the growth in the supply of assisted living facilities. New construction continued to be minimal throughout 2011. We believe that growth in the senior population, increased affluence of this generation of senior citizens, baby boomers beginning to reach age 65 in 2011, and the diminished role of the family in providing senior care has led and will continue to lead to supply and demand imbalances.
Competitive Strengths
We believe that the following competitive strengths position us to capitalize on the favorable trends occurring within the healthcare industry and senior living markets.
Quality Care and Value . We focus on providing service of the highest quality and value to our residents.
Proven Consolidator in Fragmented Industry. The assisted living industry is highly fragmented with significant opportunities for consolidation. As of January 1, 2011, the top ten operators in the industry controlled just one-third of the estimated investment grade assisted living units.
Experienced Multidisciplinary Management with Industry Relationships. Our 16 senior management team members collectively have over 300 years of management experience in the healthcare industry, ranging from independent living to skilled nursing care facilities.
Successful Joint Venture Relationships . Our acquisitions of communities through joint ventures provide current cash flow as well as pathways to ownership of the communities. In 2006, we entered into a joint venture with an affiliate of Blackstone Real Estate Advisors (“Blackstone”), which we refer to as the “Blackstone JV”. The Blackstone JV owned 24 communities, which Emeritus managed for a fee. In addition to earning management fees, we recovered our original investment through cash equity distributions. Under the terms of the joint venture agreement, we were entitled to distributions in excess of our 19.0% ownership percentage based upon specified performance criteria (the “Promote Incentive”). In June 2011, we purchased Blackstone’s 81.0% equity interest in the Blackstone JV and added these communities to our Consolidated Portfolio. We earned a Promote Incentive of $26.6 million, which was applied to the purchase price of our acquisition of Blackstone's equity interest. For further information, see Note 4, Acquisitions and Other Significant Transactions— 2011 Blackstone JV Acquisition in Notes to Consolidated Financial Statements.
In 2010, we entered into a second joint venture (the “Sunwest JV”) with an affiliate of Blackstone, as well as an entity controlled by Daniel R. Baty, a founder of Emeritus and our Chairman (“Columbia Pacific”). The Sunwest JV purchased 144 communities in 2010, of which 139 are included in our Operated Portfolio and which we manage for a fee. In addition to the $19.0 million in cash we paid for our 6.0% ownership interest, we will be required to make a $2.0 million capital contribution before August 2012. Similar to the Blackstone JV, the agreement with the Sunwest JV provides that we have the right of first refusal to purchase these communities and the opportunity to earn a promote incentive. For further information, see Note 2, Investments in Unconsolidated Joint Ventures—Sunwest Joint Venture in Notes to Consolidated Financial Statements.
Business Strategy
Our business strategies include the following:
Continued Focus on Improving Customer Satisfaction. Our approach to care and our commitment and ability to address all of our residents’ needs, ranging from their physical health to their social well-being, have helped drive operating improvements in our business. We believe that this “holistic approach” enriches the quality of life and care for our residents. By providing alternatives like non-related companion living, diabetes management, unique memory care programs, and other flexible programming designed to meet the needs of the individual in our communities, we increase customer satisfaction and thereby increase occupancy and enhance revenue. We believe that our ongoing focus on customer satisfaction, rates, and occupancy will generate the incremental growth in margins we are striving to achieve.
Focus on Appeal to the Middle Market. The market segment most attractive to us is middle to upper-middle income seniors aged 75 and older who live in smaller cities and suburbs with populations of 50,000 to 150,000 persons. We believe that this segment of the senior community is relatively large and geographically broad and is generally composed of seniors who are financially capable of purchasing our services.
Expand Memory Care Markets. The demand for memory care services continues to grow. As of December 31, 2011, we operated approximately 5,200 units in our Consolidated Portfolio and 6,800 units in our Operated Portfolio that offer this type of care in a mix of both free-standing communities and as part of our standard assisted living communities. The dementia care wings within many of our assisted living communities enable us to retain residents who may require dementia care services in the future, and who would otherwise be required to move to an alternative care setting. Where appropriate, memory care residents and/or their families may choose to share “companion living” apartments for therapeutic reasons as well as to provide a lower cost alternative for those residents.
We will continue to explore new and existing markets where there is a significant demand for memory care services, including the addition of memory care units to existing communities. We believe our memory care programs, such as our signature Join Their Journey® and Brain Health Lifestyle® programs, are unique and appeal to this market segment. For example, our Join Their Journey® program focuses on care that creates a familiar environment with individualized service and care plans to enhance the residents’ overall quality of life. In 2010, we appointed nationally recognized neuropsychologist Dr. Paul Nussbaum as Director of Brain Health as part of our commitment to improving brain health in our residents, their families and our employees.
Selective Acquisitions and Developments. We will continue to pursue strategic opportunities to purchase, lease, or manage communities that will allow us to increase our capacity and improve our operating efficiencies, with a particular focus on acquiring local and regional operators of assisted living communities. In addition, we will selectively evaluate development opportunities, including adding units to existing communities, in strong markets where our existing occupancy is high and rates are favorable. We recently entered into a consulting agreement with an affiliate of Columbia Pacific under the terms of which we are providing systems, programmatic and operational support in connection with the affiliate’s senior housing investment activities in China, including the development of a rehabilitation care center that is scheduled to open in Shanghai in mid-2012. We anticipate that we will enter into a joint venture with Columbia Pacific during the first half of 2012 to pursue additional senior housing investment opportunities in China.
Expand Our Ancillary Services. We plan to increase the scope of the ancillary services we offer to our residents, including rehabilitation services. While a majority of our communities currently offer rehabilitation services, all of these services are currently outsourced to third-party providers. Entering the rehabilitation services market as a provider would allow us to expand the rehabilitation services that we provide directly to our residents, resulting in increased revenues from these services, and potentially enable our residents to stay in our community homes longer. In October 2011, we acquired a 51.0% stake in a company that sells durable medical equipment and personal care supplies.
Develop Post-Acute Care Business. Various healthcare reform provisions became law upon enactment of the Patient Protection and Affordable Care Act and the Healthcare Education and Reconciliation Act, both enacted in 2010 (collectively, the “ACA”). The ACA will significantly impact Medicare reimbursement to hospitals because it expands the scope of accountability from hospital-based care to a continuum of care that includes pre-acute, inpatient acute, and post-acute care. The ACA transitions the Medicare provider payment system from pay-per-service to pay-per-episode, or “bundled” payments, making hospitals, physicians, and post-acute providers collectively responsible for the cost and quality of entire episodes of care. Beginning in October 2012, hospitals will be penalized for 30-day readmissions related to certain conditions.
We believe that we are well positioned to be a leader in the post-acute transitional care continuum, due to our national footprint and provision of all levels of post-acute care, and believe that this will result in increased occupancy and revenue. Currently, we are focusing on transitional care awareness, building hospital partnerships and program development.
Resident Services
Our assisted living communities offer residents a full range of services based on individual resident needs in a supportive “home-like” environment. The services we provide to our residents are designed to respond to their individual needs and to improve their quality of life.
Basic Services . All of our residents receive basic services that include meals and snacks, social and recreational activities, weekly housekeeping and linen service, apartment maintenance, a 24-hour emergency response system, and transportation to appointments and excursions. We make licensed nurses available to evaluate the residents’ care needs and promote wellness.
Assisted Living Services. Our residents may purchase additional services based on the recommended level of care or assistance required for the activities of daily living (“ADLs”), which are dining, bathing, dressing, grooming, and personal hygiene. A thorough evaluation of each resident’s needs, in collaboration with the resident’s physician and family, determines the recommended level of care. In addition to assistance with ADLs, we also provide assistance with medication management, recreational activities and social support, behavior modification and management, and diabetes management, among other services.
Memory Care Program. We have designed our memory care program to meet the health, psychological, and social needs of our residents diagnosed with Alzheimer’s or related dementia. In a manner consistent with our assisted living services, we help structure a service plan for each resident based on his/her individual needs. Some of the key service areas providing individualized care to our residents with Alzheimer’s or related dementias center around a personalized environment, activities planned to support meaningful interactions, specialized dining and hydration programs, and partnerships with families and significant others through support groups, one-on-one meetings, educational forums, and understanding behavior as a form of communication. We endeavor to provide residents with an optimal quality of life, which includes life enrichment by giving each resident a sense of purpose.
Respite Care. Most of our communities offer short-stay respite care, whereby a resident may live with us temporarily while transitioning from a hospital or nursing home stay or when a family member or caregiver is on vacation. We also offer the opportunity for a prospective resident to stay with us for a short time before making a final decision to move in. Short-stay residents receive all of the same services as our permanent residents. For seniors living on their own or with family members, we offer adult day programs, which provide individual adult care plans that include recreational and social activities as well as meals.
Skilled Nursing. Our Consolidated Portfolio includes 974 licensed skilled nursing beds, which are included in certain of our assisted living communities. In addition to assistance with ADLs, these communities provide 24-hour nursing care, rehabilitation therapy, post-surgical care, infusion therapy, dialysis care and hospice care, among other specialty services.
Financial Services. We help seniors meet their financial needs by partnering with senior financial solution providers such as:
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Elderlife Financial Services (“Elderlife”). Elderlife provides lines of credit to help prospective residents pay for our services. An Elderlife line of credit provides seniors and their families an alternative way to finance senior living. For some, this eliminates a significant obstacle to moving into a senior living community.
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Life Care Funding Group. The Life Care Funding Group helps prospective residents raise funds to pay for our services through the life settlement market. A “life settlement” is the sale of an in-force life insurance policy for an amount much greater than the cash surrender value from the insurance company.
Personal Care Program . In the latter half of 2011, we launched our Personal Care Program. Through this program, we offer personal care and hygiene products such as diabetic supplies, incontinence and ostomy supplies, and other items to residents.
Service Revenue Sources
We rely primarily on our residents’ ability to pay our charges for services from their own or family resources and expect that we will continue to do so for the foreseeable future. Although care in an assisted living community is typically much less expensive than in a skilled nursing facility, we believe that only seniors with income or assets meeting or exceeding the regional median can afford to reside in our communities.
As third-party reimbursement programs and other forms of payment continue to grow, we will evaluate and selectively participate in these alternative forms of payment depending on the level of reimbursement provided in relation to the level of care provided. We also believe that private long-term care insurance will increasingly become a revenue source in the future, although it is currently not significant. Our primary source of community revenue comes from residents’ private resources; all other service revenue sources constituted approximately 12.8% of our Consolidated Portfolio revenues in 2011.
Management Activities
We provide management services to independent and related-party owners of assisted living communities, including our joint ventures. We managed 150 communities as of December 31, 2011 and 173 communities as of December 31, 2010. Of the 150 managed communities, 141 are owned by joint ventures in which we have an interest and nine are owned by third parties. Most of our management agreements provide for fees equal to 5.0% of collected community revenues. Our management agreements with the Sunwest JV, representing a combined total of 139 managed communities as of December 31, 2011, are automatically renewed for successive one-year periods after the end of the initial term unless (a) notice of non-renewal is given by either party 90 days prior to the expiration of the then-current term or (b) an agreement is otherwise cancelled upon the occurrence of certain events specified in the agreement. Terms of our other management agreements range from two to five years and may be renewed or renegotiated at the expiration of the term.
Total management fees were approximately $21.1 million for 2011, $11.9 million for 2010, and $5.7 million for 2009. For further discussion, see Management’s Discussion and Analysis of Operations and Financial Condition—Results of Operations.
Marketing and Referral Relationships
Our operating strategy is designed to integrate our senior living communities into the continuum of healthcare services offered in the geographic markets in which we operate. One objective of this strategy is to enable residents who require additional healthcare services to benefit from our relationships with local hospitals, physicians, home healthcare agencies, and skilled nursing facilities in order to obtain the most appropriate level of care. Thus, we seek to establish relationships with local hospitals, through joint marketing efforts where appropriate, home healthcare agencies, alliances with visiting nurses associations and priority transfer agreements with local, high quality skilled nursing facilities. In addition to benefiting residents, the implementation of this operating strategy has strengthened and expanded our network of referral sources.
As part of our Safely Somewhere initiative, we offer free home visits to seniors. The objective of this program is to determine and work with potential residents, their families and physicians on an outcome that will meet their needs. Our home visit services include social visits, safety checks and evaluations to identify home and care needs. We offer post-hospital or nursing facility discharge follow-up and coordination with families and referral sources. We believe that by working with them to resolution, potential residents are more willing to view Emeritus as an option while also improving our community network.
Quality Assurance
We have an ongoing quality assurance process that occurs in each of our communities. Our program is designed to achieve resident and family member satisfaction with the care and services we provide. We perform quality assurance audits of care and operational systems on an ongoing basis using the Comprehensive Process Review (“CPR”) auditing tool. Our quality and risk management team developed the CPR auditing tool in collaboration with other departments at the community, regional, and divisional levels. We review and evaluate all areas of community operations and care systems using this comprehensive process. The audit includes an inspection of the community that evaluates three major areas: quality of care, quality of life, and community practices and behavior. On a regular basis, we monitor our customer and employee satisfaction and their perception of the quality of our services through surveys and our Ethics First compliance and anonymous reporting program.
Our communities have established ongoing resident and/or family meetings through care conferences and/or family night meetings. We obtain feedback, recommendations, and suggestions to improve overall quality performance of the community from the residents, responsible parties, and staff. The CPR, Ethics First compliance program, resident care conferences, and family night meetings are significant components of our continuous quality improvement program. We use these processes to benchmark our ongoing efforts to improve quality, enhance customer satisfaction, and minimize risk exposure.
Administration
We employ an integrated structure of management, financial systems, and controls to support quality services at our communities and to maximize operating efficiency and contain costs. In addition, we have developed the internal procedures, policies, and standards we believe are necessary for effective operation and management of our communities. We have recruited seasoned key employees with years of experience in the senior living services field and believe we have assembled the administrative, operational, and financial personnel who will enable us to continue to manage our operating strategies effectively.
CEO BACKGROUND
H. R. Brereton Barlow (age 61) has served as a member of our board of directors since March 2011. Mr. Barlow has served as the Chief Executive Officer of Premera Blue Cross since 2000. Mr. Barlow joined Premera in 1997 as its Chief Financial Officer and was promoted to serve as Chief Operating Officer. Previously, he served as Chief Financial Officer of Health Net, a major subsidiary of Health Systems International, a health maintenance organization, and AHI Healthcare Systems Inc., a primary and specialty care provider network. Prior to his employment with Health Net and AHI Healthcare Systems Inc., Mr. Barlow was a partner with Deloitte & Touche, LLP and he is a certified public accountant. Mr. Barlow currently serves on several boards of directors, including Blue Cross Blue Shield Association, National Institute for Health Care Management, Premera Blue Cross, and Washington Healthcare Forum. He also serves on the advisory boards of Seattle University’s College of Nursing and the University of Washington’s Foster School of Business. Mr. Barlow brings to the Board extensive executive experience in the healthcare industry, particularly in accounting, finance and operations.
Stuart Koenig (age 59) has served as a member of our board of directors since September 2007, when we completed the Summerville acquisition. Mr. Koenig has been associated with Apollo Real Estate Advisors since 1995 and is a partner of the firm and its Chief Financial Officer. Prior to 1995, Mr. Koenig was a Vice President in the Real Estate Principal Investment Area of Goldman, Sachs & Co. where he served as Controller and Director of Investor Relations for the Whitehall real estate investment funds. We believe Mr. Koenig is qualified to serve on our board of directors because he brings extensive executive experience in real estate and healthcare industry investments, investor relations, financial management and executive compensation.
Robert E. Marks (age 60) has served as a member of our board of directors since July 2005. Since 1994, Mr. Marks has been the President of Marks Ventures, LLC, a private equity investment firm. Mr. Marks is a director and Chairman of the Audit and Finance Committee of Denny’s Corporation, as well as a member of the Board of Trustees of the Fisher House Foundation, a member of the Board of Trustees of the Greenwich, Connecticut Public Library, a member of the Board of Trustees of the Greenwich Field Club, a member of the Board of Trustees of The International Rescue Committee and a member of Stanford University’s Alumni Committee on Trustee Nominations. We believe Mr. Marks is qualified to serve on our board of directors because he brings extensive finance, investment and executive compensation experience in service industries.
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
Emeritus is the nation’s largest provider of assisted living and Alzheimer’s/memory care services. As of December 31, 2011, we operated 478 senior living communities in 44 states.
Fiscal 2011 in Review
Emeritus’ results for fiscal 2011 reflect the resiliency of our business model, the needs-driven nature of our primarily assisted living business and the talent and dedication of our employees. Our business has performed well this year despite the ongoing economic downturn. We continued to execute our business strategy, which includes acquisitions, as discussed in detail in Business—Business Strategy , in this Form 10-K. Our business fundamentals remain consistent, as evidenced by growth in 2011 revenue, revenue per unit, and average occupancy rate in our Same Community Portfolio (as defined below under Same Community Portfolio ).
In 2011, total operating revenues increased to $1.3 billion from $1.0 billion in 2010 and $898.7 million in 2009. Operating income from continuing operations was $61.7 million in 2011 compared to $59.6 million in 2010 and $48.9 million in 2009. We recorded a net loss attributable to our common shareholders of $71.9 million in 2011 compared to net losses of $57.0 million in 2010 and $53.9 million in 2009. Positive cash flows generated by operating activities amounted to $74.1 million in 2011 compared to $83.7 million in 2010 and $64.0 million in 2009.
Looking Ahead to 2012
The United States economy remains sluggish and we cannot predict future economic conditions or their impact on our financial condition and results of operations. However, we continue to believe that the needs-driven nature of our business, potential pent-up demand and reduced supply of new senior housing construction in our sector will support improved operating performance, especially if combined with economic recovery.
For 2012, we expect moderate revenue growth driven by increased Same Community Portfolio revenues and 2011 community acquisitions that will reflect a full year of revenue in 2012. We expect modest consolidated operating margin improvement, given our current revenue and expense expectations, and we expect that general and administrative expenses as a percentage of total operated revenue will be consistent with 2011.
As part of our long-term strategy, we intend to continue to selectively pursue acquisitions.
The two basic drivers of our community revenues are the rates we charge our residents and the occupancy levels we achieve in our communities. In evaluating the rate component, we utilize the average monthly revenue per occupied unit, computed by dividing the total operating revenue for a particular period by the average number of occupied units for the same period. In evaluating the occupancy component, we track the average occupancy rate, computed by dividing the average units occupied during a particular period by the average number of units available during the period.
We rely primarily on our residents’ ability to pay our charges from their own or family resources and expect that we will do so for the foreseeable future. Private pay residents represent 87.2% of our payor mix. We believe that only residents with income or assets meeting or exceeding the regional median can afford to reside in our communities, and that the rates we charge and our occupancy levels are interrelated. Therefore, we continuously evaluate rate and occupancy in each community to find the optimal balance so that we can benefit from our increasing capacity and anticipated future occupancy increases. Although our business is primarily needs-driven, we believe that our occupancy growth has been slowed due to the ongoing economic downturn, as some seniors and their families have postponed moves for financial reasons, and we believe that high unemployment has enabled family members and others to provide home care for seniors.
Revenues from government reimbursement programs, which are the federal Medicare and state Medicaid programs, represented 12.8% of our community revenues in 2011 compared to 11.3% in 2010 and 9.9% in 2009. This increase is due primarily to the lease acquisition of 27 communities in November 2010 that included 450 skilled nursing units, most of which receive Medicare reimbursement. Future changes in revenues from Medicare and Medicaid programs in our existing communities will depend upon factors that include resident mix, levels of acuity among our residents, overall occupancy and government reimbursement rates. There continue to be various federal and state legislative and regulatory proposals to implement cost containment measures that would limit payments to healthcare providers in the future. On July 29, 2011, CMS issued its final rule reducing Medicare reimbursement rates by an average of 11.1%, which took effect on October 1, 2011. Although we believe that we can offset a portion of the decrease through cost savings and improved occupancy in our skilled nursing operations, the potential impact of the lower reimbursement levels totals approximately $8.0 million annually, beginning with the October 1, 2011 effective date. We are currently unable to estimate the potential impact of other possible governmental cost containment measures.
We also earn management fee revenues by managing certain communities for third parties, including communities owned by related parties and by joint ventures in which we have an ownership interest. The majority of our management agreements provide for fees equal to 5.0% of gross collected revenues.
Same Community Portfolio
Of the 328 communities included in our Consolidated Portfolio as of December 31, 2011, we include 262 communities in our “Same Community Portfolio.” Our Same Community Portfolio consists of communities that we have continuously operated from January 1, 2010 to December 31, 2011 and does not include properties where new expansion projects were opened during the comparable periods, communities in which we substantially changed the service category offered, or communities accounted for as discontinued operations.
Consolidated Results of Operations: 2011 Compared to 2010
Net Loss Attributable to Emeritus Corporation Common Shareholders:
We reported a net loss attributable to Emeritus Corporation common shareholders of $71.9 million for 2011 compared to $57.0 million for 2010. As discussed below in the section Liquidity and Capital Resources , the Company has incurred significant losses since its inception but has generated positive cash flow from operating activities since 2001.
The $14.9 million increase in net loss is due primarily to non-operating items, including a $20.2 million increase in loss from discontinued operations, which represents impairment charges and costs to sell certain underperforming communities. Non-operating income and expense included a $42.3 million increase in interest expense, due primarily to community acquisitions, and a $42.1 million gain on the acquisition of the Blackstone JV communities.
Operating income from continuing operations increased by $2.1 million to $61.7 million in 2011. The increase in operating income reflects the acquisition of communities and an increase in management fee revenues, offset by an increase in transaction costs.
Liquidity and Capital Resources
The United States economy experienced a significant decline in the housing market, significant declines in consumer confidence, and a related weakness in the availability and affordability of credit during 2008 that led to the economic recession that continued into 2009 with only moderate signs of a recovery during 2010 and 2011. We believe that the recovery is likely to continue to be slow in 2012. However, we believe that the needs-driven demand for our services continues to grow and remains resilient due, in large part, to an increasingly aging population as well as limited new senior living construction, as evidenced by our relative stability in Same Community occupancy and improvements in average rates.
At December 31, 2011, we had cash on hand of $43.7 million compared to $110.1 million at December 31, 2010.
The Company has incurred significant operating losses since its inception, and we had working capital deficits of $100.1 million and $17.7 million at December 31, 2011 and 2010, respectively. The deficit increased primarily because we used cash in 2011 to invest in community acquisitions and property and equipment. Due to the nature of our business, it is not unusual to operate in the position of a working capital deficit because we collect revenues much more quickly, often in advance, than we are required to pay obligations, and we have historically refinanced or extended maturities of debt obligations as they become current liabilities. Our operations result in a very low level of current assets to the extent cash has been deployed in business development opportunities or to pay down long-term liabilities. Along those lines, the working capital deficit as of December 31, 2011 included a $19.9 million deferred tax asset and, as part of current liabilities, $39.3 million of deferred revenue and unearned rental income. A $19.9 million deferred tax liability is included in other long-term liabilities. We do not expect the level of current liabilities to change from period to period in such a way as to require the use of significant cash, except for $43.5 million in scheduled balloon payments of principal on long-term debt maturing during the next 12 months, which is included in current portion of long-term debt as of December 31, 2011. We intend to refinance, extend, or retire these obligations prior to their maturities. Given the continuing instability in worldwide credit markets, there can be no assurance that we will be able to obtain such refinancing or be able to retire the obligations.
Sources and Uses of Cash
We expect to use our cash to invest in our core business as well as other new business opportunities related to our core business. As discussed above, we expect to refinance or extend our balloon payments in 2012; however, if we are unable to do so, we believe the Company would be able to generate sufficient cash flows to support its operating and investing activities and financing obligations for at least the next 12 months by conserving its capital expenditures and operating expenses or selling communities or a combination thereof. In connection with Emeritus’ guarantees of certain debt and lease agreements, we are required at all times to maintain a minimum $20.0 million balance of unencumbered liquid assets, defined as cash, cash equivalents and/or publicly traded/quoted marketable securities. As a result, $20.0 million of our cash on hand is not available to fund operations and we take this into account in our cash management activities.
We may use our available cash resources to make proportionate capital contributions to our equity method investees. We may also seek strategic acquisitions to leverage existing capabilities and further build our business in support of our growth strategy. Significant acquisitions and/or other new business opportunities will likely require additional outside funding. We do not plan to pay cash dividends to our common shareholders in the foreseeable future.
Summary of Critical Accounting Policies and Use of Estimates
Critical accounting policies are those that we believe are both most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in our reporting materially different amounts under different conditions or using different assumptions.
We believe that our accounting policies regarding investments in joint ventures, asset impairments, goodwill impairment, stock-based compensation, leases, self-insurance reserves, and income taxes are the most critical in understanding the judgments involved in our preparation of our financial statements. Those financial statements reflect our revisions to such estimates in income in the period in which the facts that give rise to the revision became known. For a summary of all of our significant accounting policies, see Note 1, Description of the Business, Basis of Presentation, and Summary of Significant Accounting Policies .
Investments in Joint Ventures
We have investments in joint ventures with equity interests ranging from 6.0% to 51.0%. Generally accepted accounting principles (“GAAP”) require that at the time we enter into a joint venture, we must determine whether the joint venture is a variable interest entity and, if so, whether we are the primary beneficiary and thus required to consolidate the entity. In performing this analysis, we consider various factors such as the amount of our ownership interest, our voting rights, the extent of our power to direct matters that significantly impact the entity’s activities, and our participating rights. We must also reevaluate each joint venture’s status quarterly or whenever there is a change in circumstances such an increase in the entity’s activities, assets, or equity investments, among other things.
Asset Impairments
When facts and circumstances indicate that the carrying values of long-lived assets may not be recoverable, we evaluate long-lived assets for impairment. We first compare the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss based on the asset’s estimated fair value. For community assets, the fair value of the assets is estimated using a discounted cash flow model based on future revenues and operating costs, using internal projections. For our investments in unconsolidated joint ventures, we determine whether there has been an other-than-temporary decline in the carrying value of the investment by using a discounted cash flow model to estimate the fair value of individual assets inside the joint venture. For our investments in marketable equity securities, we must make a judgment as to whether a decline in fair value is other-than-temporary. For other assets, we use the valuation approach that is appropriate given the relevant facts and circumstances.
Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including forecasting asset useful lives.
Further, our ability to realize undiscounted cash flows in excess of the carrying values of our assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions, and changes in operating performance. As we periodically reassess estimated future cash flows and asset fair values, changes in our estimates and assumptions may cause us to realize material impairment charges in the future.
Goodwill Impairment
We test goodwill for impairment on an annual basis, or more frequently if circumstances indicate that goodwill carrying values may exceed their fair values. If the carrying amount of goodwill exceeds the implied estimated fair value, an impairment charge to current operations is recorded to reduce the carrying value to the implied estimated fair value.
In 2011, we early adopted Accounting Standards Update No. 2011-08, Testing Goodwill for Impairment (“ASU 2011-08”). This revised standard is intended to reduce the cost and complexity of the annual goodwill impairment test by providing companies with the option of performing a “qualitative” assessment to determine whether a further impairment test is necessary. As a result, we first assess a range of qualitative factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for our products and services, regulatory and political developments, and entity specific factors such as strategies and financial performance when evaluating potential impairment for goodwill. If, after completing such assessment, it is determined that it is “more likely than not” that the fair value of a reporting unit is less than its carrying value, we proceed to a two-step impairment test, whereby the first step is comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered to not be impaired and the second step of the test is not performed. The second step of the impairment test is performed when the carrying amount of the reporting unit exceeds the fair value, in which case the implied fair value of the reporting unit goodwill is compared with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.
Emeritus is comprised of a single reporting unit. We performed our qualitative assessment as of October 31, 2011 and determined that it was not “more likely than not” that the fair value of our reporting unit was less than its applicable carrying value. Accordingly, it was not necessary to perform the two-step impairment test and no goodwill impairment was recognized in 2011.
Our impairment loss assessment contains uncertainties because it requires us to apply judgment to estimate whether there has been a decline in the fair value of our Company reporting unit, including estimating future cash flows, and if necessary, the fair value of our assets and liabilities. As we periodically perform this assessment, changes in our estimates and assumptions may cause us to realize material impairment charges in the future.
Stock-Based Compensation
We measure the fair value of stock awards at the grant date based on the fair value of the award and recognize the expense over the related service period. For stock options, we use the Black-Scholes option pricing model, which requires the input of subjective assumptions. These assumptions include estimating the length of time employees will retain their stock options before exercising them (“expected term”), the estimated volatility of our common stock price over the expected term and the expected dividend yield. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those stock awards expected to vest. We estimate the forfeiture rate based on historical experience. Changes in our assumptions could materially affect the estimate of fair value of stock-based compensation; however, a 10.0% change in our critical assumptions including volatility and expected term would not have a material impact for fiscal year 2011.
The Company’s restricted stock awards vest only upon the achievement of performance targets. GAAP requires recognition of compensation cost only when achievement of performance conditions is considered probable. Consequently, our determination of the amount of stock compensation expense requires a significant level of judgment in estimating the probability of achievement of these performance targets. Additionally, we must make estimates regarding employee forfeitures in determining compensation expense. Subsequent changes in actual experience are monitored and estimates are updated as information is available.
Leases
We determine whether to account for our leases as operating, capital, or financing leases depending on the underlying terms. As of December 31, 2011, we operated 141 communities under long-term leases with operating, capital, and financing lease obligations. The determination of this classification under GAAP is complex and in certain situations requires a significant level of judgment. Our classification criteria is based on estimates regarding the fair value of the leased communities, minimum lease payments, effective cost of funds, the economic life of the community, and certain other terms in the lease agreements.
Self-Insurance Reserves
We use a combination of insurance and self-insurance mechanisms to provide for the potential liabilities for certain risks, including workers’ compensation, healthcare benefits, professional and general liability, property insurance, and director and officers’ liability insurance.
We are self-insured for professional liability risk with respect to 237 of the 328 communities in our Consolidated Portfolio. The other 91 communities are insured with conventional indemnity policies. The liability for self-insured known claims and incurred but not yet reported claims was $24.5 million and $10.8 million at December 31, 2011 and 2010, respectively. We believe that the range of reasonably possible losses as of December 31, 2011, based on sensitivity testing of the various underlying actuarial assumptions, is approximately $23.1 million to $30.6 million. The high end of the range reflects the potential for high-severity losses.
We are self-insured for workers’ compensation risk (except in Texas, Washington, and Ohio) up to $500,000 per claim through a high deductible, collateralized insurance program. The liability for self-insured known claims and incurred but not yet reported claims was $26.3 million and $17.5 million at December 31, 2011 and 2010, respectively, which is included in accrued employee compensation and benefits in the consolidated balance sheets. We believe that the range of reasonably possible losses as of December 31, 2011, based on sensitivity testing of the various underlying actuarial assumptions, is approximately $24.0 million to $28.6 million.
For health insurance, we self-insure each participant up to $200,000 or $350,000 per year, depending upon the particular coverage plan, above which a catastrophic insurance policy covers any additional costs. The liability for self-insured incurred but not yet reported claims is included in accrued employee compensation and benefits in the consolidated balance sheets and was $9.5 million and $7.8 million at December 31, 2011 and 2010, respectively. A 10.0% change in the estimated liability at December 31, 2011 would have increased or decreased Operated Portfolio expenses during 2011 by approximately $951,000. We share any revisions to prior estimates with the communities participating in the insurance programs, including those that we manage for third parties such as the Sunwest JV, based on their proportionate share of any changes in estimates. Accordingly, the impact of changes in estimates on our consolidated income from operations would be less sensitive than the difference indicated above.
Liabilities associated with the risks that are retained by Emeritus are not discounted and we estimate them, in part, by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. For professional liability and workers’ compensation claims, we engage third-party actuaries to assist us in estimating the related liabilities. In doing so, we record liabilities for estimated losses for both known claims and incurred but not reported claims. These estimates are based on historical paid and incurred losses and ultimate losses using several actuarial methods. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Changes in self-insurance reserves are recorded as an increase or decrease to expense in the period that the determination is made.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Overview
A summary of activity for the first six months of 2012 compared to the same period for 2011 is as follows:
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Total operating revenues increased $27.4 million, or 3.8%, to $749.4 million from $722.0 million for the prior-year period.
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Operating income from continuing operations increased $12.5 million to $42.2 million from $29.7 million for the prior-year period. Our net loss attributable to Emeritus Corporation common shareholders was $41.1 million compared to $364,000 for the prior-year period. Our prior period results included a $42.1 million gain on the acquisition of the Blackstone JV Communities offset by transaction costs of $8.6 million during the period, which transaction costs included $6.2 million resulting from our buyout of certain communities subject to a cash flow sharing arrangement.
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Average occupancy of our portfolio of owned and leased communities (the “Consolidated Portfolio”) increased to 86.5% from 86.0% for the prior-year period.
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Average rate per occupied unit increased 1.9% to $4,136 from $4,058 for the prior-year period.
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Net cash provided by operating activities was $68.5 million compared to $17.5 million for the prior-year period.
Sources of Revenues
We generate revenues by providing senior housing and related healthcare services to the senior population. We are the largest provider of assisted living and memory care services in the United States, with a capacity for approximately 50,000 residents. Assisted living and memory care units comprise approximately 85% of our total Operated Portfolio.
The two basic drivers of our community revenues are the rates we charge our residents and the occupancy levels we achieve in our communities. In evaluating the rate component, we utilize the average monthly revenue per occupied unit, computed by dividing the total operating revenue for a particular period by the average number of occupied units for the same period. In evaluating the occupancy component, we track the average occupancy rate, computed by dividing the average units occupied during a particular period by the average number of units available during the period.
We rely primarily on our residents’ ability to pay our charges from their own or family resources and expect that we will do so for the foreseeable future. Private pay revenues represent 87.6% of our payor mix in the first six months of 2012. We believe that only residents with income or assets meeting or exceeding the regional median can afford to reside in our communities, and that the rates we charge and our occupancy levels are interrelated. Therefore, we continuously evaluate rate and occupancy in each community to find the optimal balance so that we can benefit from our increasing capacity and anticipated future occupancy increases. Although our business is primarily needs-driven, we believe that our occupancy growth has been slowed due to the ongoing economic downturn, as some seniors and their families have postponed moves for financial reasons, and we believe that high unemployment has enabled family members and others to provide home care for seniors.
Revenues from government reimbursement programs, which are the federal Medicare and state Medicaid programs, represented 12.4% of our community revenues in the first six months of 2012 compared to 12.9% in the comparable 2011 period. Future changes in revenues from Medicare and Medicaid programs in our existing communities will depend upon factors that include resident mix, levels of acuity among our residents, overall occupancy and government reimbursement rates. There continue to be various federal and state legislative and regulatory proposals to implement cost containment measures that would limit payments to healthcare providers in the future. On July 29, 2011, the Center for Medicare and Medicaid Services (“CMS”) issued its final rule reducing Medicare reimbursement rates by an average of 11.1%, which took effect on October 1, 2011. Although we have taken steps to offset a portion of the decrease through cost savings and improved occupancy in our skilled nursing operations, the potential impact of the lower reimbursement levels totals approximately $8.0 million annually, beginning with the October 1, 2011 effective date. We are currently unable to estimate the potential impact of other possible governmental cost containment measures.
We also earn management fee revenues by managing certain communities for third parties, including communities owned by related parties and by joint ventures in which we have an ownership interest. The majority of our management agreements provide for fees equal to 5.0% of gross collected revenues.
In addition to our monthly management fee, we receive reimbursement for operating expenses of managed communities. During the current year, we determined that the Company is the primary obligor for certain expenses incurred and those reimbursed operating expenses should be reported gross versus net as had been reported in prior periods. Consequently, such expenses should be reported as costs incurred on behalf of managed communities and included in total operating expense in our condensed consolidated statements of operations with a corresponding amount of revenue recognized in the same period in which the expense is incurred and the Company is due reimbursement.
The prior period financial statements included in this filing have been revised to reflect this correction, which increased our total operating expenses and total operating revenues by $56.5 million for the three months ended June 30, 2011 and $114.6 million for the six months ended June 30, 2011.
These revisions were limited to total operating revenues and expenses and had no impact on the Company’s condensed consolidated balance sheets and statements of cash flows, operating income from continuing operations, or net loss. We do not consider such revisions to be material to any previously issued financial statements.
Same Community Portfolio Analysis
Of the 327 communities included in our Consolidated Portfolio as of June 30, 2012, we include 295 communities in our Same Community Portfolio. For purposes of comparing the three months ended June 30, 2012 and 2011, we define same communities as those communities that we have continuously operated since January 1, 2011, and did not include properties where we opened new expansion projects during the comparable periods, communities in which we substantially changed the service category we offered, or communities we accounted for as discontinued operations.
Liquidity and Capital Resources
The United States economy experienced a significant decline in the housing market, significant declines in consumer confidence, and a related weakness in the availability and affordability of credit during 2008 that led to the economic recession that continued into 2009 with only moderate signs of a recovery during 2010 and 2011. We believe that the recovery is likely to continue to be slow throughout 2012. However, we believe that the need-driven demand for our services continues to grow and remains resilient due, in large part, to an increasingly aging population as well as limited new senior living construction, as evidenced by our improvements in same community occupancy and average rates.
As of June 30, 2012, we had cash and equivalents on hand of $74.8 million compared to $43.7 million at December 31, 2011.
The Company has incurred significant operating losses since its inception, and we had working capital deficits of $73.0 million and $100.1 million as of June 30, 2012 and December 31, 2011, respectively. Due to the nature of our business, it is not unusual to operate in the position of a working capital deficit because we collect revenues much more quickly, often in advance, than we are required to pay obligations, and we have historically refinanced or extended maturities of debt obligations as they become current liabilities. Our operations result in a very low level of current assets to the extent cash has been deployed in business development opportunities or to pay down long-term liabilities. Along those lines, the working capital deficit as of June 30, 2012 included a $22.1 million deferred tax asset and, as part of current liabilities, $37.0 million of deferred revenue and unearned rental income. A $22.1 million deferred tax liability is included in other long-term liabilities. We do not expect the level of current liabilities to change from period to period in such a way as to require the use of significant cash, except for $30.9 million in balloon payments of principal on long-term debt maturing during the next 12 months, which is included in current portion of long-term debt as of June 30, 2012. We intend to refinance, extend, or retire these obligations prior to their maturities. Given the continuing instability in worldwide credit markets, there can be no assurance that we will be able to obtain such refinancing or be able to retire the obligations.
Sources and Uses of Cash
We expect to use our cash to invest in our core business as well as other new business opportunities related to our core business. As discussed above, we expect to refinance or extend our balloon payments of debt principal in the next 12 months; however, if we are unable to do so, we believe the Company would be able to generate sufficient cash flows to support its operating and investing activities and financing obligations for at least the next 12 months by conserving its capital expenditures and operating expenses or selling communities or a combination thereof. In connection with Emeritus’ guarantees of certain debt and lease agreements, we are required at all times to maintain a minimum $20.0 million balance of unencumbered liquid assets, defined as cash, cash equivalents and/or publicly traded/quoted marketable securities. As a result, $20.0 million of our cash on hand is not available to fund operations and we take this into account in our cash management activities.
We may use our available cash resources to seek strategic acquisitions to leverage existing capabilities and further build our business in support of our growth strategy. Significant acquisitions and/or other new business opportunities will likely require additional outside funding. We do not plan to pay cash dividends to our common shareholders in the foreseeable future.
Other than normal operating expenses, we expect that cash requirements for the next 12 months will consist primarily of capital expenditures. We expect to increase expenditures for remodeling and refurbishment of existing communities, systems and technology investments in the communities and in the support infrastructure.
Financial Covenants and Cross-Defaults
Many of our debt instruments, leases and corporate guarantees contain financial covenants that require that the Company maintain specified financial criteria as of the end of each reporting period. These financial covenants generally prescribe operating performance metrics such as debt or lease coverage ratios, operating income yields, fixed-charge coverage ratios and/or minimum occupancy requirements. Others are based on financial metrics such as minimum cash or net worth balances or have material adverse change clauses. Remedies available to the counterparties to these arrangements in the event of default vary, but include the requirement to post a security deposit in specified amounts, acceleration of debt or lease payments, and/or the termination of related lease agreements.
In addition, many of the lease and debt instruments contain cross-default provisions whereby a default under one obligation can cause a default under one or more other obligations. Accordingly, an event of default could have a material adverse effect on our financial condition if a lender or landlord exercised its rights under an event of default.
As of June 30, 2012, the Company has approximately $1.6 billion outstanding of mortgage debt and notes payable comprised of the following:
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Mortgage debt financed through Freddie Mac and Fannie Mae of approximately $1.1 billion, or approximately 70.3% of our total debt outstanding. These obligations were incurred to facilitate community acquisitions over the past few years, were issued to single purpose entities (each an “SPE”) and are secured by the assets of each SPE, which consist of the real and personal property and intangible assets of a single community. The debt is generally nonrecourse debt to the Company in that only the assets or common stock of each SPE are available to the lender in the event of default, with some limited exceptions. These debt obligations do not contain provisions requiring ongoing maintenance of specific financial covenants, but do contain typical events of default such as nonpayment of monetary obligations, failure to maintain insurance coverage, fraud and/or misrepresentation of facts, unauthorized sale or transfer of assets, and the institution of legal proceedings under bankruptcy. These debt instruments typically contain cross-default provisions, which are limited to other related loans provided by the specific lender. Remedies under an event of default include the acceleration of payment of the related obligations.
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Mortgage debt financed primarily through traditional financial lending institutions of approximately $358.6 million, or approximately 22.6% of our total debt outstanding. These obligations were incurred to facilitate community acquisitions over the past few years, were typically issued to and secured by the assets of each SPE, which consist of the real and personal property and intangible assets of a single community. The debt is generally recourse debt to the Company in that not only are the assets or common stock of each SPE available to the lender in the event of default, but the Company has guaranteed performance of each SPE’s obligations under the mortgage. These debt obligations generally contain provisions requiring ongoing maintenance of specific financial covenants, such as debt service coverage ratios, operating income yields, occupancy requirements, and/or net operating income thresholds. Our guarantees generally contain requirements to maintain minimum cash and/or net worth balances. In addition, the mortgages contain other typical events of default such as nonpayment of monetary obligations, failure to maintain insurance coverage, fraud and/or misrepresentation of facts, unauthorized sale or transfer of assets, and the institution of legal proceedings under bankruptcy. These debt instruments may contain cross-default provisions, but are limited to other loans provided by the specific lender. Remedies under an event of default include the acceleration of payment of the related obligations.
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Mezzanine debt financing in the amount of $111.9 million provided by real estate investment trusts (“REIT”s) to facilitate community acquisitions, or approximately 7.1% of our total debt outstanding. These obligations are generally unsecured or are secured by mortgages on leasehold interests on community lease agreements between the specific REIT and the Company, and performance under the debt obligations are guaranteed by the Company. Our guaranty generally contains a requirement to maintain minimum cash and/or net worth balances. Typical events of default under these obligations include nonpayment of monetary obligations, events of default under related lease agreements, and the institution of legal proceedings under bankruptcy. Remedies under an event of default include the acceleration of payments of the related obligations.
As of June 30, 2012, we operated 141 communities under long-term lease arrangements, of which 116 were leased from publicly traded REITs. Of the 141 leased properties, 50 contain provisions requiring ongoing maintenance of specific financial covenants, such as rent coverage ratios. Other typical events of default under these leases include nonpayment of rents or other monetary obligations, events of default under related lease agreements, and the institution of legal proceedings under bankruptcy. Remedies in these events of default vary, but generally include the requirement to post a security deposit in specified amounts, acceleration of lease payments, and/or the termination of the related lease agreements. As of June 30, 2012, we were in violation of financial covenants in a debt agreement covering two communities with an aggregate outstanding principal balance of $15.2 million. This loan matures in November 2012 and we are in negotiations to refinance it. We obtained waivers from the lender through June 30, 2012 and, as such, are in compliance as of that date. As required, we will test for compliance again on the next measurement date of September 30, 2012.
Off-Balance Sheet Arrangements
We currently have no off-balance sheet arrangements other than community operating leases. For additional information on the community operating leases, see the discussions of Community Lease Expense contained elsewhere in this section.
Significant Accounting Policies and Use of Estimates
Significant accounting policies are those that we believe are both most important to the portrayal of our financial condition and results of operations, and require our most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in our reporting materially different amounts under different conditions or using different assumptions.
We believe that our accounting policies regarding investments in joint ventures, asset impairments, goodwill impairment, stock-based compensation, leases, self-insurance reserves, and income taxes are the most critical in understanding the judgments involved in our preparation of our financial statements. Those financial statements reflect our revisions to such estimates in income during the period in which the facts that give rise to the revision become known. For a summary of all of our significant accounting policies, see Note 1, Description of the Business, Basis of Presentation, and Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements in our 2011 Annual Report on Form 10-K.
Investments in Joint Ventures
We have investments in joint ventures with equity interests ranging from 6.0% to 51.0%. Generally accepted accounting principles (“GAAP”) requires that at the time we enter into a joint venture, we must determine whether the joint venture is a variable interest entity and if so, whether we are the primary beneficiary and thus required to consolidate the entity. In performing this analysis, we consider various factors such as the amount of our ownership interest, our voting rights, the extent of our power to direct matters that significantly impact the entity’s activities, and our participating rights. We must also reevaluate each joint venture’s status quarterly or whenever there is a change in circumstances such as an increase in the entity’s activities, assets, or equity investments, among other things.
Asset Impairments
When facts and circumstances indicate that the carrying values of long-lived assets may not be recoverable, we evaluate long-lived assets for impairment. We first compare the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss based on the asset’s estimated fair value. For community assets, the fair value of the assets is estimated using a discounted cash flow model based on future revenues and operating costs, using internal projections. For our investments in unconsolidated joint ventures, we determine whether there has been an other-than-temporary decline in the carrying value of the investment by using a discounted cash flow model to estimate the fair value of individual assets inside the joint venture. For our investments in marketable equity securities, we must make a judgment as to whether a decline in fair value is other-than-temporary. For other assets, we use the valuation approach that is appropriate given the relevant facts and circumstances.
Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment to estimate future cash flows and asset fair values, including forecasting asset useful lives. Further, our ability to realize undiscounted cash flows in excess of the carrying values of our assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions, and changes in operating performance. As we periodically reassess estimated future cash flows and asset fair values, changes in our estimates and assumptions may cause us to realize material impairment charges in the future.
Goodwill Impairment
We test goodwill for impairment on an annual basis, or more frequently if circumstances indicate that goodwill carrying values may exceed their fair values. If the carrying amount of goodwill exceeds the implied estimated fair value, an impairment charge to current operations is recorded to reduce the carrying value to the implied estimated fair value.
In 2011, we early adopted Accounting Standards Update No. 2011-08, Testing Goodwill for Impairment (“ASU 2011-08”). This revised standard is intended to reduce the cost and complexity of the annual goodwill impairment test by providing companies with the option of performing a “qualitative” assessment to determine whether a further impairment test is necessary. As a result, we first assess a range of qualitative factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for our products and services, regulatory and political developments, and entity specific factors such as strategies and financial performance when evaluating potential impairment for goodwill. If, after completing such assessment, it is determined that it is “more likely than not” that the fair value of a reporting unit is less than its carrying value, we proceed to a two-step impairment test, whereby the first step is comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered to not be impaired and the second step of the test is not performed. The second step of the impairment test is performed when the carrying amount of the reporting unit exceeds the fair value, in which case the implied fair value of the reporting unit goodwill is compared with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.
Emeritus is comprised of a single reporting unit. We performed our qualitative assessment as of October 31, 2011 and determined that it was not “more likely than not” that the fair value of our reporting unit was less than its applicable carrying value. Accordingly, it was not necessary to perform the two-step impairment test and no goodwill impairment was recognized in 2011. We also noted that there were no facts or circumstances during the first six months of 2012 that indicated that our carrying value exceeded the estimated fair value of the Company as of June 30, 2012.
Our impairment loss assessment contains uncertainties because it requires us to apply judgment to estimate whether there has been a decline in the fair value of our Company reporting unit, including estimating future cash flows, and if necessary, the fair value of our assets and liabilities. As we periodically perform this assessment, changes in our estimates and assumptions may cause us to realize material impairment charges in the future.
CONF CALL
Ken Avalos - IR, ICR
Thanks, operator. Good afternoon and thank you for joining us on the Emeritus Corporation fourth quarter and year-end 2008 conference call. On the call with today are Dan Baty, Chairman and Co-CEO; Granger Cobb, President and Co-CEO; and Ray Brandstrom, Chief Financial Officer.
Before we begin, I would like to remind everyone of the Safe Harbor statements under the Private Securities Litigation Reform Act of 1995. The following prepared remarks contain forward-looking statements and management may make additional forward-looking statements in response to your questions. These statements do not guarantee future performance and therefore undue reliance should not be placed on them.
For a more detailed discussion on the factors that could cause actual results to differ materially from those suggested in any forward-looking statements, we refer you to the Company’s most recent 10-K filing.
With that, it is my pleasure to turn the call over to Mr. Dan Baty. Dan, please go ahead.
Dan Baty - Chairman and Co-CEO
The key measures in looking how Emeritus is doing are pretty simple; it’s occupancy, rate, and margin. A lot of effort, operations goes into getting these results, but they provide a pretty good guide to our progress. Over the last eight months or so, our occupancy has been basically flat. Our rate over the last year has gone up 6%. Our operating margin has increased by 1.5 points. Overhead on a dollar basis has been flat for the past year.
Our goal this year is to manage our cost, to pick up one to two points spread between our cost and our revenue. From operations then we anticipate a good and improved in ’09. In addition, we have high expectations of growth. We earn the best financial position of any of our peers and we have a strong operating team. Our average tenure for our six divisional operating people is eight years with the Company. So, it’s very stable, very experienced and we look at it as a good time and good opportunity.
Senior housing has traditionally been a counter-cyclical business. ESC Emeritus is doing well and there is nothing to indicate it will not continue to do so. Ray?
Ray Brandstrom - EVP Finance, CFO and Secretary
Thank you, Dan. Good afternoon everyone. I’d like to begin by discussing our fourth quarter results, given an update on our balance sheet, and finish by providing some comments regarding our 2009 financial guidance.
It’s important to note that the fourth quarter of 2008 marks the first quarter of comparable year-over-year financial results in relations to the Summerville merger, which added 81 communities in 13 states comprising 7925 units to our consolidated portfolio. This transaction closed on September 1st of 2007.
For the year, total revenue was $769.4 million. For the fourth quarter total community revenue was $202.2 million compared to $182.5 million in the fourth quarter of 2007, an increase of $19.7 million or 11% over the prior year quarter. $11 million of this increase is related to rate growth with the balance attributed to acquisitions.
Looking at average rate per unit, excluding our December acquisitions, our average rate per unit for the fourth quarter of 2008 compared to the fourth quarter of 2007 increased 6% to $3498 from $3300, a level in line with our expectations. On a sequential quarter basis, our average rate per unit, again, exclusive of our December acquisitions, increased 1.4% from $3449 in the third quarter. The average rate for the month of December which was inclusive of the new acquisitions, was approximately $3620.
Average occupancy for the fourth quarter was 86.4%, which was essentially flat with the third quarter. Same-store occupancy was down 50 basis points from the fourth quarter of 2007. We believe the sequential quarter stability in our occupancy in the current economic climate speaks to the effectiveness of the programs and initiatives we implemented since last year as well as a need driven demand for assisted living in Alzheimer's business.
Outside of the impact of our acquisitions, we experienced only 3% growth in our operating expenses, primarily due to the beneficial of cost adjustments of our self-insured programs, professional liability, and workers’ compensation. Excluding the beneficial impact of these adjustments in the quarter, fourth quarter margins in 2008 improve by 40 basis points to 35.9% from 35.5% in the fourth quarter 2007.
General and administrative expenses were $14.8 million in the fourth quarter of 2008 compared with $14.6 million in the fourth quarter of 2007. General and administrative expenses as a percent of total operated community revenues was 6.4% in the fourth quarter of 2008 compared to 7% for the fourth quarter of 2007.
Property related expenses include interest on a GAAP basis for the quarter of $25.9 million and rent on a GAAP of $24.4 million. Cash interest for the fourth quarter was $21 million and cash rent in the fourth quarter was $25.3 million. We filed a supplement to our press release today that provides a schedule of cash rent and interest along with depreciation for the fourth quarter of 2008 and a projection for first quarter 2009.
Routine capital expenditures totaled $3.9 million in the fourth quarter or $175 per unit. We define routine capital expenditures as cost to maintain the communities for their intended business purpose and exclude expenditures for acquisitions, development, expansions or repositioning for revenue enhancements.
The Company’s fourth quarter 2008 adjusted EBITDA increased 11% over the prior year quarter to $40.4 million from $36.3 million in the fourth quarter of 2007. Adjusted EBITDA was $37.1 million in the third quarter. Beginning with the fourth quarter, we are reporting from cash from facility operations. Including the $6.5 million beneficial impact of the self-insurance adjustments previously discussed, cash from facility operations were $0.38 in the fourth quarter of 2008.
Turning to our balance sheet, as of December 31, 2008, the Company had approximately $27 million of cash and had no outstanding borrowings under the Company’s $25 million credit facility.
On December 31st, total assets were $2.1 billion, including $1.7 billion of net investment in properties. Total debt was $1.6 billion with $1.4 billion related to mortgage debt and $190 million related to capital lease obligations. Shareholder equity was $359.4 million.
Now, let me update our updates related to our debt and significant progress we made during the fourth quarter. As a result of the financing we completed during the quarter, we have no material maturities in the near term. Of the $18.3 million of current portion of long term debt reflected on the balance sheet at December 31, 2008, $11.8 million is related to properties held-for-sale. Beyond that, we have $46 million of mortgage debt that matures in 2010. We currently – are currently evaluating various financing alternatives for these portfolios and based upon our recent experiences we believe we’ll complete these refinancings on terms acceptable to the Company.
Regarding development activity, we had no openings in the fourth quarter. However, a 38-unit free-standing Alzheimer's community opened in the first quarter of 2009. We also had a 22-unit expansion in an existing community opened in the first quarter of 2009.
Now, let me turn to transaction activity during the quarter. In October, the Company closed on the purchase of 10 communities from affiliates of healthcare REITs, which were formerly leased by us and represent 693 units. In December, we closed on an agreement to lease 11 communities comprised of 1462 units from affiliates of healthcare property investors. The term of lease is 10 years with a purchase option beginning at the end of the fifth year and continuing through the end of the lease term.
The Company also purchased five communities from affiliates of Ventas in December that were formerly leased by the Company and are comprised of 432 units. This acquisition increases the Company’s portfolio of owned properties to 164 or 61.2% of the total consolidated portfolio now consisting of 268 communities.
The Company filed 8-Ks providing specific details on each of these transactions. During the quarter, the Company also closed on an agreement to leas two communities comprising 254 units.
I am going to finish with a discussion of guidance for 2009 with providing range for a few key operating metrics. The Company will not be totally immune the general financial and economic conditions, but we do believe our long term goals are achievable given our existing portfolio, the need driven nature of our business, and our programs, systems, and experienced field management.
Based on our fourth quarter 2008 performance and our initial indications of first quarter activity, we are establishing full year 2009 revenue guidance of $865 million to $885 million. We expect G&A as a percent of total operating revenue to be at or below our rate of 6.4% as reported for the fourth quarter of 2008.
In the first quarter of 2009, we expect GAAP rents to range between $29.2 million and $29.5 million and GAAP interest to range between $26.5 million and $27 million. We expect cash rents range between $27.5 million and $27.8 million in the first quarter and cash interest to range between $22.1 million and $22.4 million.
Finally, we expect routine CapEx for the year to run between $600 and $700 per unit, which along with additional routine capital expenditures related to the December acquisitions, will run between $18 million and $20 million.
With those comments, I will turn the call over to Granger Cobb, our Co-CEO and President. Granger?
Granger Cobb - President and Co-CEO
Thank you, Ray. Good afternoon everyone and thank you for your interest. Our fourth quarter results demonstrate the effectiveness of the new structure and systems, which were fully implemented in the first half of 2008. The combination of annual rent increases, level of care revenue capture, and a community specific approach to street rate pricing drove the strong sequential increase in average revenue per occupied unit, which brought us to the 6% year-over-year RPU unit.
The fact that we were able to keep occupancy stable at the same time demonstrates that the underlying business fundamentals are holding up. For this quarter, we have a meaningful same-store comparison of 244 communities, which comprises 91% of our consolidated portfolio. In this group, we grew average rate per unit by 6% and we held expense growth after normalizing for the beneficial impact of the insurance adjustments to less than 3%, resulting in operating cash flow growth of over 25% relative to Q4 of 2007. As you can see from our Q4 over Q4 operating metrics, the Company is becoming more efficient and we believe going forward that we can continue to hold year-over-year cost increases to a lower percentage than year-over-year revenue increase thus resulting in continued margin improvement.
One of the reasons for our optimism relates to expense control. Our risk management outcomes continue to improve, resulting in significantly reduced cost associated with our self-insurance programs for general and professional liability and workers’ compensation. Also, utility increases are expected to moderate relative to prior years and we anticipate continued progress as a result of a newly deployed system tracking and managing daily labor hours to ensure appropriate and efficient staffing.
In terms of the overall economic climate, we remain very cognizant of the risks in the market, and we continue to diligently monitor the activity levels and competitive landscape on a community-by-community and market-by-market basis. Demand so far has held steady and this is consistent with our previous experience in down economic cycles.
With 15 days left in the first quarter, we are pleased to report that our occupancy should come in flat to slightly up relative to Q4 and our rate is holding. While the operating environment in certain markets maybe in flux, we are well prepared with our data systems and regional oversights to quickly identify and respond to any changes in consumer needs or desires.
With our high quality, moderately priced portfolio, high percentage of need-driven assets, and experience managing cost, we are well positioned to continue to improve occupancy rate and margin as we move forward over time. We have spent the last year implementing scalable structures and systems to better monitor and manage our key business drivers. Our operating teams are now comfortable with this structure and proficient with the systems as our operating results have begun to demonstrate. We are fortunate to be in a business where the primary driver is the demographics associate with an ageing population. Beyond that, it is all about execution, and we feel we have the structure, systems, and personnel to continue to grow the business in both the short and long term.
With that, thank you for taking the time to listen and I think I’ll turn it back over to the operator for questions.
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Fund Letters
