Brookdale Senior Living (BKD)
Investment Research Report

A Special Opportunity
We love the business of Senior Living.  It has all the right demographics going for it. That’s why we recently added Welltower (HCN, $69) to our list of favored investments.  We also love special opportunities.  That is what brings us to Brookdale Senior Living.  The stock has been beaten down 70% from its all-time high of $54 in 2006 and 55% from its 52-week high of $39 last year.

It is really hard finding a leading company in a solid growing industry that has been dumped by investors.  With that in mind, we decided to take a look at Brookdale. What we found was something truly special.  But first let’s set the stage by looking at Welltower.

Welltower is the biggest REIT investing exclusively in Senior Living.  REITs are the best form of organization for facilities-based companies because of the special tax treatment they receive.  More and more companies are turning to this strategy and investors have welcomed the moves.  REITs do not pay income taxes so long as at least 90% of profits are paid out to stockholders in the form of dividends.  In the present zero interest rate environment, REIT dividend yields of 5%-7% are highly appealing to investors.

Because of tax benefits and yields, REITs are valued higher than the very same company operating as a tax-paying corporation. Thus REITs are valued on their cash flow from operations or FFO.  This is almost always higher than earnings per share which makes it easier and less costly to grow a company.  So with that background, let’s first take a peek at the Brookdale business.  They are really quite successful at what they do.

Top Quality Operator
Brookdale is the leader in the Senior Living industry, operating over 1100 communities, serving over 100,000 residents in every part of the United States.  Brookdale is both a real estate owner as well as the largest operator.  For the reasons just described, this is not the most efficient organization structure.  This is costing the company and its stockholders dearly.

Everything else about Brookdale rates five stars.  Its facilities are all upscale, appealing to the private pay customer.  Occupancy levels range between 86%-90%.  85% of residents are in Independent Living facilities which is a good sign for keeping high occupancy levels for the future.  With these stats, it is obvious that Brookdale is the expert at operating Senior Living facilities.

Brookdale offers a Full Life service for residents starting at age 75 and older.  So as Father Time marches on, Brookdale is assured of having a steady list of customers for services related to advanced aging.

Recent Results
Company revenues have grown organically about 4% annually.  To this was added Emeritus Senior Living that was acquired for $3 billion in 2014.   The combination of these two sources resulted in revenue growth averaging 32% in recent years.  Consolidation and financial costs of the acquisition of Emeritus have produced temporarily wider losses but costs should come down starting this year.

The Opportunity
If Welltower is such a good idea, you might wonder why bother with Brookdale?  After all, aren’t they in the same business?  The answer is no, they are not, but they should be.  Here is the key difference:  Welltower is an investor in real estate.  They are not operators.  Brookdale is both an investor as well as an operator.  The stock market values Brookdale at a serious discount for this reason.

Some of Wall Street’s smartest investors are pressuring Brookdale to either spin off its $8 billion in real estate assets into an REIT or to simply convert the present business to an REIT.  We think something big will happen.  Hedge funds own almost 50% of Brookdale stock, which is really powerful money.  We want to follow their lead. Hedge fund managers recognize the fact that the Senior Living industry needs capital to serve a growing retirement age population.  There is no disputing Brookdale’s proven industry leadership.  The issue is finding the best way to finance growth.  Until recently, management has resisted the pressure but things are beginning to change.

On March 1, the company announced it was replacing two of its most senior executives, the company President and Executive Vice President.   This is a tangible sign that major changes are coming.

We believe these changes will lead to one of three possible outcomes, any one of which will benefit stockholders.  In the first scenario, the company does nothing and the stock languishes around present levels.  In this case the company becomes a takeover candidate.  The stock is selling just a couple dollars a share above book value and the market for Senior Living properties is white-hot.  So if this is the worst outcome that would not be a bad thing.  A takeover price of $25-30 is reasonable.

The next possibility:  The newly appointed management focuses on improving its cost efficiency following the Emeritus acquisition.  Both Funds From Operations and EPS benefit.  This is a reasonable possibility also.  The acquisition of Emeritus Senior Living was intended to benefit operating and administrative costs through greater clustering of combined facilities.  There were very few benefits achieved under the old management.

Finally, there is the REIT conversion or spinoff option.  Here is a preview of what could happen:  Valuing existing Funds From Operations of $1.58 per share and applying an average REIT multiple of 20 times, results in a price of over $30 per share.

Remember, nothing is going to happen overnight and the devil is always in the details, but these three scenarios provide an idea of the possibilities.  Best of all, with the stock at currently depressed levels, there is little value placed in Brookdale’s potential.

Financial Condition: Further Pressure For Change
Brookdale’s balance sheet illustrates why the pressure for change has a good chance of translating into benefits for stockholders.  The company has cash of $90 million and long-term debt of $6.0 billion.  Brookdale used its equity to finance $1.6 billion of the $3 billion Emeritus acquisition, but the current depressed price takes away the option of selling more stock to raise equity.  This puts pressure on management to increase cash flow, ultimately increasing the level of cash and starting to pay its first dividend.

At the same time, Brookdale’s biggest assets are understated.  It owns $8 billion in Senior Living facilities and related assets.  In this strong property market, these assets could easily be worth $10-$12 billion.

Stock Price, Historical Chart