Diversified Healthcare Trust (DHC) 2005 Q3 法說會逐字稿

Good day and welcome to the Senior Housing Properties Trust third-quarter 2005 earnings results conference call. This call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to the Manager of Investor Relations, Mr. Tim Bonang. Please go ahead, sir.

Thank you, Richard. Joining me on today's call are David Hegarty, President and Chief Operating Officer and John Hoadley, Chief Financial Officer. The agenda for today's call includes a presentation by management, followed by a question-and-answer session.

Before we begin today's call, I'd like to state that today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and federal securities laws. These forward-looking statements are based on Senior Housing's present beliefs and expectations as of today, October 31, 2005.

The Company undertakes no obligation to revise or publicly release the results of any revision to the forward-looking statements made in today's conference call other than through filings with the Securities and Exchange Commission regarding this reporting period. Actual results may differ materially from those projected in these forward-looking statements. Additional information concerning factors that could cause those differences is contained in our Form 10-K and 10-Q, filed with the Securities and Exchange Commission, and in our Q3 supplemental operating and financial data found on our website at www.SNHREIT.com. Investors are cautioned not to place undue reliance on any forward-looking statements.

And with that, I'd like to turn the call over to Dave Hegarty.

Thank you, Tim. Good afternoon, everyone. Welcome to our third-quarter 2005 investor conference call. Overall, the third quarter was characterized by positive trends in our tenants' occupancy and coverage ratios. Our largest tenant, Five Star, continues its evolution as a strong and growing force in the senior healthcare industry. There are also some positive developments regarding the litigation with HealthSouth that I'll talk about.

First, our funds from operations, or FFO, for the third quarter decreased to $25.9 million or $0.38 per share from $23.4 million or $0.37 per share in the same period for 2004. This is a 10% increase in FFO and a 3% increase in FFO per share. These increases occurred despite an additional $275,000 in HealthSouth's litigation costs in the third quarter of 2005; higher interest rates, which increased the cost of our revolver; and the added dilution from the issuance of 5 million common shares in December 2004. Generally, we've seen occupancy levels continue to improve year over year and sequentially.

The most significant improvements in occupancy have been in the assisted living segment of our portfolio. Our assisted living portfolio improved to 90% occupancy in the third quarter from 84% occupancy in the second quarter, with most of the increase coming from the Alterra portfolio.

Our independent living remained constant at about 91% occupied during both the second and third quarters of 2005, which is an increase from 88% occupied from the comparable period in 2004.

The occupancy at our skilled nursing facilities decreased slightly from 90% in the third quarter from 91% in the second quarter. In all but one case, the positive trends in occupancy and private payor mix resulted in improvements in our coverage ratios. Our largest lease to Five Star, which includes properties managed by Sunrise, took a dip in the third quarter to 1.11 times from 1.17 times coverage. And as I will discuss in more detail in a moment, Five Star has exercised the termination option for 12 of the 30 management contracts in this lease, which may have a positive impact on the leases' coverage ratio in the future. Currently, the 7% management fees paid to Sunrise at these properties are senior to SNH's rent. And after Five Star takes over the operations at these 12 properties, these management costs become subordinated at the properties.

On a pro forma basis, the coverage ratio for this lease would have been 1.3 times during the last quarter after eliminating the management fees for 12 of the 30 management agreements. The coverage ratio for the 101 properties leased and directly operated by Five Star increased to 1.77 times from 1.68 times for the prior quarter. And the Sunrise lease that is guaranteed by Marriott International modestly improved to 1.27 times from 1.25 times. And then New Seasons lease had an improvement in coverage from 1.17 times for 1.11 times, primarily due to new rate increases and cost controls. And Alterra's coverage ratio increased to 1.87 times from 1.68 times.

Today, Senior Housing continues to be one of the strongest healthcare REITs in the industry, with about 85% of our revenues coming from properties where about 80% or more of the revenues are from private -- residents' private resources. Essentially, all of our tenants except the five private companies in Alterra are either publicly traded or have investment grade-rated guarantees. Soon, we expect Alterra to become a public company under the name of Brookdale Senior Living. The advantage of dealing with public companies is there is much more transparency for our investors to evaluate their creditworthiness.

Now, there have been several developments with Five Star since our last quarterly conference call. In August 2005, Five Star completed a $58 million equity issuance, the second equity offering in a year. At the end of last quarter, we had a $24 million mortgage loan to Five Star. And that market mortgage was prepaid to us in August with a portion of the proceeds from Five Star's recent equity offering. As of their August 24 filing, Five Star had approximately $44 million in cash and 0 outstanding on its $25 million revolving credit facility with Wachovia Bank.

One of the most significant events that occurred during the third quarter was Five Star's announcement in September that they had notified Sunrise that they are exercising a termination option for the management of 12 of the 30 properties in our largest lease. Sunrise will continue to manage the remaining 18 communities in this lease. The effect of Five Star's termination of the 12 management contracts with Sunrise is a positive for SNH both in the short-term and in the long-term. In the short-term, it will immediately improve the coverage ratio on the portfolio, increasing it to a pro forma 1.3 times, which is an improvement over the current 1.11 times coverage. And for Five Star, the elimination of these 12 management contracts with Sunrise removes $8 million of the $18 million annual management fees that Five Star pays to Sunrise.

As explained to us by the management of Five Star, as the operator, they expect to increase the profitability at these 12 communities by controlling the costs, being more focused on the operations as a direct manager, using its own captive for insurance rather than Sunrise's captive, and taking possession of the property's working capital in FF&E reserves.

As announced earlier today, the effective date of the termination of these management contracts was accelerated from December 29 to November 1. Starting tomorrow, Five Star will be directly operating these communities. And coinciding with the timing of this termination, we're entering into a $58 million sale leaseback transaction with Five Star to six assisted living properties. These properties are 100% private pay and will be added to the master lease with Five Star, and the rent will be increased by $5.2 million per annum, which equates to a 9% initial return.

As we stated before, we believe it is a real positive to SNH's investors to have Five Star as a tenant. Today, Five Star is one of the largest assisted living providers in the country. And as a public entity, Five Star also provides SNH investors with a high level of transparency. As a public entity -- more importantly, the relationship dovetails with our goal of owning high-quality properties that are officially managed by creditworthy tenants.

Now moving on to the HealthSouth litigation, I will caution that my discussion will be somewhat limited because of the pending litigation. But in September, the Massachusetts Superior Court proved the October 2004 action we took to terminate HealthSouth's lease for two rehabilitation hospitals that we own in Massachusetts. Because HealthSouth failed, as is required by our contract, to provide timely and accurate financial reports. This court ruling was a positive development for SNH.

An additional new piece of information came to light during these proceedings. According to affidavits submitted by HealthSouth, the two hospitals produced cash flow for the 2004 fiscal year of approximately $14 million in excess of the $8.7 million paid by HealthSouth to SNH. We have received a court order requiring a receiver to be appointed to oversee the cash flow of these properties and to hold these amounts in escrow until resolution of this litigation. Resolution of this litigation would be a positive for SNH for a number of reasons -- the elimination of approximately $1.4 million of annual legal fees alone works out to $0.02 per share of FFO. Assuming we ultimately prevail in this dispute, the releasing of the operations to another qualified operator at a potential high rate would be an obvious benefit for SNH.

Now due to the appeal process and risks of litigation, we don't know the timing or what the final outcome of this matter will be.

Now I'd like to turn to the general acquisition environment. The acquisition environment remains very competitive. During the quarter, our organization evaluated over $1.2 billion of investment opportunities, and we submitted bids on about two-thirds of those situations. As you all note, there is a tremendous amount of capital-chasing yield investments. In fact, we've even been seeing capital sources leading the bidding with an operated to be determined later. For most of those properties we pursued, our greatest competition has been financial advisers or investors, including occasionally the healthcare REITs. When we approach an investment situation, we consider a number of factors, such as the credit quality of the tenant, the return on investment, the cost per unit and replacement costs. We typically focus on entering into 10 to 15-year minimum leases. We try to match these long-term lease agreements with equity and long-term debt capital.

Many of the successful bidders today use high amounts of short-term leverage, which makes it difficult for us to be competitive. Today, our objective is to focus on winning a few decent transactions per year, and we are optimistic that we will be able to succeed at this goal.

Another topic of interest for investors is clearly our dividend level. Soon after the end of the third quarter, we declared a dividend of $0.32 per share, which represents 84% of our FFO for the quarter. Our Board seriously considers the dividend level on a quarterly basis, and they are currently comfortable with this payout ratio. The Board will again consider the dividend level at their next scheduled meeting. And we believe our dividend provides an attractive yield to existing and potential shareholders.

I will now turn the presentation over to John Hoadley, our CFO, to discuss the quarter's financially results in more detail.

The revenues for the quarter ended September 30, 2005 were $40.2 million, which is a $4.5 million increase or 11% over 2004 revenues for the comparable period. Rental income increased because of the full impact of rents from our real estate acquisitions totaling $184.3 million made since July 1, 2004. Interest and other income for the 3 months ended September 30, 2005 includes $352,000 of mortgage interest income related to the $24 million of mortgage financing provided to Five Star in June 2005 that was repaid in August after Five Star completed its secondary equity offering.

Interest expense increased due to our assumption of $48.8 million of debt in connection with the LifeTrust America acquisition during the fourth quarter of 2004 and higher interest costs associated with our revolving bank credit facility. Our weighted average balance outstanding and interest rate under our revolving bank credit facility was $74.6 million and 4.7% and $32.7 million and 3% for the 3 months ended September 30, 2005 in 2004 respectively. As you can see, our short-term borrowing rates increased by 170 basis points as a result of the rate increases by the Federal Reserve Bank since the summer of 2004, which was offset somewhat by the reduction in our borrowing spread when we refinanced our revolving bank credit facility at the end of July 2005.

General and administrative expenses increased in 2005 by $484,000 over 2004. However, general and administrative expenses include $350,000 of HealthSouth's litigation costs in 2005. The third quarter of 2004 had only $75,000 of costs related to the HealthSouth litigation. General and administrative expenses exclusive of litigation costs increased in 2005 by only $209,000 or 7.7%, primarily due to acquisitions since July 1, 2004.

Net income was $14.1 million or $0.21 per share for the third quarter compared to $12.9 million or $0.20 per share for the same quarter last year. This 9% year-over-year increase in net income was attributable to the changes in revenues and expenses described earlier.

The weighted average number of common shares outstanding totaled 68.5 million in this quarter as compared with 63.5 million for the third quarter 2004. At September 30, 2005, the outstanding shares were 68,562,227. On October 6, 2005, we declared a dividend of $0.32 per share, which represents 84% of our FFO for the quarter.

On the asset side of the balance sheet, all of our investments are fee interest in senior living properties. Real estate investments increased by a net $31 million since 2004 year end, which represents the acquisition of four properties plus improvement financing since the beginning of the year, less the sale of one nursing home in Maine.

During the third quarter of 2005, we made $3.8 million of improvement financings at a 10% yield. In August, Five Star prepaid a $24 million mortgage loan. During the quarter, we committed to enter a sale leaseback transaction with Five Star for six assisted living facilities for $58 million, which is closing today. The average lease term remaining on the portfolio is 11.9 years. Only 1% of our revenues come up for renewal in the next 5 years.

On the liability side, our real estate investments are partially funded with $552 million of debt as of September 30, 2005. Our debt is comprised of two Senior Notes issuances due in 2012 and 2015 for $395 million, junior subordinated debentures totaling $28 million due in 2041, mortgages in capital leases due mostly in 2012 and 2013 for a total of $71 million and our revolving credit facility. The junior subordinated debentures have a coupon of 10.8% and can be prepaid at par beginning in June 2006. Only 5% of our total capital is secured debt.

The weighted average interest rate on our security fixed-rate debt is 6.7%. The weighted average interest rate on our fixed-rate unsecured debt was 7.8%. While the overall weighted average interest rate including our unsecured revolver is 7.3%.

On a book basis, we are at approximately 39% debt-to-capital, which falls within our stated target range of 35 to 40%. As discussed on our last conference call, we amended and extended our unsecured revolving credit facility, increasing the amount to $550 million of availability with the term extended to November 2009. We also lowered our all-in borrowing costs on the revolver by about 50 basis points. At September 30, 2005, we had $59 million outstanding in our credit facility. As of today with the close of the $58 million sale leaseback with Five Star, we have $109 million outstanding in our revolver, which leaves us with $440 million of available capacity.

In the third quarter of 2005, our EBITDA of interest coverage ratio was 3.2 times, which is consistent with our trends for the last several years. We're also currently comfortably within the requirements of our public debt covenants.

To sum up, the positive trends that we've seen with tenant metrics throughout 2005 have continued. Five Star has taken additional steps in its development as a leader in the senior healthcare industry, and we're pleased with the positive developments with the HealthSouth litigation. Overall, we believe that SNH's long-term leases with strong tenants, its solid balance sheet, attractive dividend yield and low payout ratio are appealing to long-term investors.

That concludes our prepared remarks. Operator, we are now ready to take questions.

(OPERATOR INSTRUCTIONS). Steve Swett, Wachovia Securities.

Dave, on the litigation expenses -- I know you guys can't say a whole lot -- but is it your feeling that the expense level that you had in the third quarter is a reasonable run rate that sort of continues until these issues are taken care of?

That would be my expectation. The third quarter was probably the most intense. And it has the highest level of litigation expense we have incurred to date per quarter. So I would think that would be a conservative position to take.

And then on the Five Star/Sunrise contracts that you guys are exercising your termination, what is the trigger in those 12 versus the other 18? Are the other 18, do they have triggers at some point in the future?

And then a final question on the coverage, when you say the coverage goes from 1.11 to 1.3, is that just on the 12 or is that on the entire pool?

Okay, I'll start off with the end of your question and then work back with the sum. The 1.3 times is for the whole lease. But that's assuming those 12 properties end up with the management fees taken out of the calculation.

Right. So those 12 properties actually the move and coverage is much more substantial than the 1.11 to 1.3?

Yes. Now as far as all of these contracts have the same provision in the contract that allows Five Star at periods in time to exercise the purchase option out of these contracts. And the 12 that were selected in this particular instance, they were a number of factors that went into which ones were selected. A good part of it had to do with where Five Star currently has operations and can absorb these facilities into its regional operations without incurring a lot of increased management costs as well as the properties where they believe that there is significant potential if certain things were done differently or if certain capital improvements were made at the properties. So they have been strategically chosen by Five Star. And obviously, we have to consent to their --

Would you say this is a first batch? Or is this pretty much the property could fit those requirements, and there'll be no further ones?

I really can't comment because a lot will depend on how the properties perform going forward and capital availability and so on. It's really -- in 2 weeks, Five Star will be having its conference call. And you can ask them if they have any thoughts on it, but I really don't.

Jerry Doctrow, Legg Mason.

Dave, the Five Star guys tend to talk about this as 12 contracts but 11 properties. And you're sort of saying 12 properties in the 30. Could you just clarify that issue for me so that we're doing apples-to-apples math?

Sure. There are two properties located out in Southern California near San Diego that are literally across the street from each other called Remington Club I and II. And those got two separate -- are two distinct properties, and I think it is one operating contract. That's where the confusion comes.

So it's actual 11 -- I was thinking it was the other way around. 12 contracts, 11 properties, but it is actually 11 contracts, 12 properties. Is it?

Correct. Yes.

Are there any negotiations going on with HealthSouth in addition to litigation? Or are you just pursuing the legal action at this point?

Well, I can't comment obviously because we are in the thick of litigation. But HealthSouth has not been too open to discussions. So it is mostly being fought out in the courtrooms.

Do you have just overall coverage for the whole portfolio -- I don't think you mentioned that -- or overall occupancy because we had had those stats in the past. So much detail is helpful.

Yes, I have that. For the whole portfolio, occupancy for the third quarter is about 90%; percentage of private paid was about 81%. And the coverage was about 1.4 times.

You have revenue participation I know on many of the Five Star leases; I am not sure if you did it with others as well. But I was curious if you can just help us think a little bit better as to the growth rate in your earnings as we can go into '06. Because I think a number of those things start kicking in as we go into '06. And should the growth rate be picking up a bit as a result of that?

Just about all the properties that are leased to Five Star fall into the formula of beginning in 2006, where Senior Housing Properties Trust receives 4% of the growth in revenues at the underlying properties over what the revenues were in 2005. So, I can't give you guidance on what exactly that would be, but you can make some assumptions about the growth in revenues at the properties. And we get 4% of that, and that drops straight to our bottom line.

And that is in lieu of any other type of escalators that -- so if I'm thinking of a typical escalator, say 2.5% or whatever, this is a better deal than that? I mean if they are going up say 5% from rate and maybe another percent or so on occupancy, I'm just trying to think through how that works.

It's purely what the revenues go up by. So it can be a function of both the increase in occupancy levels as well as increase in revenues -- rates that are passed on at the facilities.

But I assume that you are hopeful with this formula; that you'll do better then sort of a fixed percentage increase or a CPI kind of increase?

Yes, it's a couple things. One is that my fixed increase is obviously public companies don't want it on the other side of their lease -- don't want to have straight fixed increases because they want to straight line them. So it could be CPI-based, or it could be this formula that we have. We actually go in with a higher base rent, and so I would expect probably maybe marginally this may be a little lower than say 2 to 3% that people expect CPI to be.

Jerry, I was handed a note to make a correction. You were correct. It's 12 contracts, and they describe them as 11 communities. The Remington Club is -- Five Star's calling it one community.

But for account, when we say 184 properties or 31 in that lease, we count those as 2.

And so the amount -- again, if we're doing apples to apples, they are saying 11 communities, how many are really left? Is it 18 19? I guess that's what I'm also trying to understand?

There are 18 last.

18 properties left?

That's correct.

And you both would agree on that number?

Take some properties and eat and drink out of there.

(OPERATOR INSTRUCTIONS). Sunday Ramakrishna (ph), ING Clarion.

Two quick questions here. First thing, looking at your rent coverage by tenant, I noticed that for Genesis HealthCare, your coverage went from 2.03 times to 1.82 times. Could you just tell me why that was or disclose that?

No, nothing in particular there. The fact that the last -- the third quarter of the year, the new rates kick in effective October 1 for Medicare and some of the operations. I don't think it takes much to make the coverage fluctuate that much.

That equates to about $300,000. I think there was a slight dip in the occupancy too.

And then the next question is more strategy. I noticed that obviously with the sale leaseback, you are increasing your exposure in line with your recent transactions to the Five Star. And as the agencies have said, you're tenant concentration is one of the primary issues that they have in evaluating the credit. So I've been wondering if you have been in recent discussions with the agencies. Is this something that you constantly consult with them with as you do these transactions? And just in general how your relationship has been with them lately?

Well, I think the relationship is good with the agencies. I think we always like to see a lesser percentage of our investments with Five Star just to be more diversified. However, just the reality of the acquisition environment out there is such that it -- we'd love to do more transactions with companies like New Seasons and other significant players that have a good credit worthy guarantee with it. But just the reality is going into the acquisition environment making bids that we can make -- seem to be able to make at least more competitive bids with Five Star putting in some money of their own or changing the way the portfolio is split between the two of us to be most competitive. But it is a balancing act that we would love to do business with others. And just the reality is that there are more opportunities with them. And we are not not going to do a transaction because we've reached some artificial limit or ceiling on how much we can do with them.

So we're trying to balance, and I think the equity interest would -- although I would like more diversification -- we'd like to see more growth too. But the debt side certainly would prefer more diversification.

And then one quick final question. I noticed you said your revolver is going to go from 59 million where it is now to around you said 109 million on the fourth quarter? And that 50 million difference is for the sale leaseback, right?

Correct.

The additional 8 million on the 50 million price?

Just from cash.

Okay, you're going to you use that from cash on the balance sheet. Okay. Great.

Ray Garson, UBS.

You mentioned that there -- one of the opportunities that Five Star saw with respect to the properties that chose to terminate the management contracts on was some capital improvements. Should we expect that SNH will participate in some of those capital investments?

Well, it may. As far as -- under our leases, Five Star can do capital improvements. And it has the ability to ask us if we would fund them, and we would charge an increased rental rate of approximately 10% on the amounts funded. So it is possible that we could participate in those fundings of improvements. One of the things that does come out of this new arrangement where they take back these properties is the fact that each of these properties have various FF&E reserve escrows. And the escrow is spread across the whole group of properties individually. And by taking back these properties, they can take control of those FF&E reserves. Certain properties have plenty of surplus of capital in those reserves, and other properties have already spent most of those reserves and are kind of low on the balances.

And what Five Star will be able to do is pull this together and spend it where they think is more appropriate than where Sunrise would spend it.

But at least at this point, there is no expectation that there'll be some larger CapEx investment upfront that you all will help refinance a portion of?

No, we certainly would not provide any that would not have a return on investment. At some point, they likely could come to us to just take them out after they've developed say a wing like on some major improvements. But we would charge them 10% of the amount funded.

And then just directionally with respect to the acquisitions given the comments regarding the market, is a 9% kind of target yield the right way to think about what you all are trying to achieve?

Well I think the market continues to move down from a cap rate perspective. If you look at some of the recent transactions announced in the last couple of weeks amongst the other healthcare REITs, they have been more in the neighborhood of 8 to 8.5. So I think we would have to adjust our underwriting accordingly to be more competitive. But maybe instead of 9%, we would be trying to achieve something in the 8.5 range.

It appears there are no further questions at this time.

Well, thank you all for joining us this afternoon. We will be at the NAREIT convention in Chicago later this week, and we are scheduled to present at Wachovia's Real Estate Conference in New York in early December. And we look forward to seeing you at one of those events. And if you want to meet with us at any of those conferences, please let us know or let Tim know, and thank you very much. Have a good afternoon.

This does conclude today's conference. We thank you for your participation. Have a good day.