XNYS:ESC Emeritus Corporation Quarterly Report 10-Q Filing - 6/30/2012
Effective Date 6/30/2012
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________________________
FORM 10-Q
________________________________
For the quarterly period ended June 30, 2012
Commission file number 1-14012
 EMERITUS CORPORATION
(Exact name of registrant as specified in its charter)
3131 Elliott Avenue, Suite 500, Seattle, WA 98121
(Address of principal executive offices)
(206) 298-2909
(Registrant’s telephone number, including area code)
____________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:
Large accelerated filer o Accelerated filer þ Non-accelerated filer o Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of July 27, 2012, 45,062,109 shares of the Registrant’s Common Stock were outstanding.
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1
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(In thousands, except share data)
See accompanying Notes to Condensed Consolidated Financial Statements
2
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
See accompanying Notes to Condensed Consolidated Financial Statements
3
See accompanying Notes to Condensed Consolidated Financial Statements
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(In thousands)
See accompanying Notes to Condensed Consolidated Financial Statements
5
EMERITUS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(In thousands)
See accompanying Notes to Condensed Consolidated Financial Statements
6
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
Emeritus Corporation (“Emeritus,” the “Company,” “we,” “us,” or “our”) is an assisted living and Alzheimer’s and dementia care (“memory care”) service provider focused on operating residential style senior living communities with operations throughout the United States. Each of these communities provides a residential housing alternative for senior citizens who need help with the activities of daily living, with an emphasis on assisted living and personal care services. As of June 30, 2012, we owned 186 communities and leased 141 communities. These 327 communities comprise the communities included in the condensed consolidated financial statements.
We also provide management services to independent and related-party owners of senior living communities. As of June 30, 2012, we managed 150 communities, of which 141 are owned by joint ventures in which we have a financial interest. The majority of our management agreements provide for fees of 5.0% of gross collected revenues.
We have one operating segment, which is assisted living and related services. Each community provides similar services, namely assisted living and memory care. The class of residents is relatively homogenous and the manner in which we operate each of our communities is basically the same. Our chief operating decision maker, who is Granger Cobb, our president and chief executive officer, reviews the Company’s results of operations on a consolidated basis.
To prepare financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”), management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to resident move-in fees, bad debts, investments, intangible assets, impairment of long-lived assets and goodwill, income taxes, contingencies, self-insured retention, insurance deductibles, health insurance, inputs to the Black-Scholes option pricing model, and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We have adopted certain significant accounting policies that are critical to the judgments and estimates used in the preparation of our condensed consolidated financial statements. We record revisions to such estimates in the period in which the facts that give rise to the revision become known. A detailed discussion of our significant accounting policies and the use of estimates is contained in our Annual Report on Form 10-K for the year ended December 31, 2011 (“Form 10-K”), which we filed with the Securities and Exchange Commission (“SEC”).
Basis of Presentation
The unaudited condensed consolidated financial statements reflect all adjustments that are, in our opinion, necessary to fairly state our financial position, results of operations, and cash flows as of June 30, 2012 and for all periods presented. Except as otherwise disclosed in these notes to the condensed consolidated financial statements, such adjustments are of a normal, recurring nature. Our results of operations for the period ended June 30, 2012 are not necessarily indicative of the results of operations that we may achieve for the full year ending December 31, 2012. We presume that readers of the interim financial information in this Quarterly Report on Form 10-Q have read or have access to our 2011 audited consolidated financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K for the year ended December 31, 2011. Therefore, we have omitted certain footnotes and other disclosures that are disclosed in our Form 10-K.
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EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
Recent Accounting Pronouncements
In July 2012, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2012-02, Testing Indefinite-Lived Intangible Assets for Impairment. The standard is intended to reduce the cost and complexity of testing indefinite-lived intangible assets other than goodwill for impairment. It allows companies to perform a "qualitative" assessment to determine whether further impairment testing of indefinite-lived intangible assets is necessary. The standard allows an entity the option to first assess qualitatively whether it is more likely than not (that is, a likelihood of more than 50%) that an indefinite-lived intangible asset is impaired, thus necessitating that it perform the quantitative impairment test. An entity is not required to calculate the fair value of an indefinite-lived intangible asset and perform the quantitative impairment test unless the entity determines that it is more likely than not that the asset is impaired. We will be required to adopt ASU 2012-02 effective January 1, 2013 and do not expect that it will have a material impact on our financial statements.
In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income. This standard eliminates the current option to report other comprehensive income and its components in the statement of shareholders’ equity. We can elect to present items of net income and other comprehensive income in one continuous statement—referred to as the statement of comprehensive income—or in two separate, but consecutive, statements. The statement(s) need to be presented with equal prominence as the other primary financial statements and prior period statement(s) are required to be recast to conform to the new presentation. On December 23, 2011, the FASB decided to defer the new requirement to present reclassifications of other comprehensive income on the face of the income statement. Companies are still required to adopt the other requirements contained in ASU 2011-05 for the presentation of comprehensive income. We adopted ASU 2011-05 in the first quarter of 2012 and chose two separate, but consecutive statements.
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The new guidance results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between generally accepted accounting principles in the United States (“GAAP”) and International Financial Reporting Standards. We adopted ASU 2011-04 in the first quarter of 2012, and it did not have a material impact on our financial statements or related disclosures.
Revision of Prior Period Financial Statements
We manage certain communities under contracts that provide for payment to the Company of a monthly management fee plus reimbursement of certain operating expenses. 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. The Company does not consider such revisions to be material to any previously issued financial statements.
Reimbursed Costs
Costs incurred on behalf of managed communities are comprised entirely of community operating expenses and include items such as employee compensation and benefits, insurance, and costs incurred under national vendor contracts.
8
EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
We have three equity incentive plans: the Amended and Restated 2006 Equity Incentive Plan (the “2006 Plan”), the Amended and Restated Stock Option Plan for Non-employee Directors (the “Directors Plan”) and the 1995 Stock Incentive Plan (the “1995 Plan”). Employees may also participate in our 2009 Employee Stock Purchase Plan (the “2009 ESP Plan”). We record compensation expense based on the fair value for all stock-based awards, which amounted to $2.8 million and $2.4 million for the three months ended June 30, 2012 and 2011, respectively, and $5.7 million and $4.7 million for the six months ended June 30, 2012 and 2011, respectively.
Stock Incentive Plans
The following table summarizes our stock option activity for the six months ended June 30, 2012:
We did not grant any restricted shares during the current period.
9
EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
From time to time, we make acquisitions and dispositions of certain businesses that we believe align with our strategic intent with respect to, among other factors, maximizing our revenues, operating income, and cash flows.
Community Sale
In April 2012, we sold a 66-unit assisted living and memory care community located in Indiana. Net proceeds from the sale of approximately $3.7 million were used in part to pay off the related mortgage debt in the amount of $2.2 million. We recorded a gain on the sale of $215,000 and expense of $680,000 for a prepayment penalty and write-off of deferred loan fees.
2011 Blackstone JV Acquisition
On June 1, 2011, Emeritus and an affiliate of Blackstone Real Estate Advisors (“Blackstone”) completed the transactions whereby we acquired Blackstone’s equity interest in a joint venture (the “Blackstone JV”) that owned 24 assisted living communities (the “Blackstone JV Communities”) comprised of approximately 1,897 units. Blackstone owned an 81.0% interest and we owned a 19.0% interest in such joint venture. We previously accounted for our 19.0% interest in the Blackstone JV as an equity method investment.
The following table sets forth the effect on our results of operations had the acquisition of the Blackstone JV Communities occurred as of January 1, 2011, excluding a related $42.1 million gain on acquisition (in thousands, except per share):
We previously operated the Blackstone JV Communities on behalf of the Blackstone JV under management agreements between us and each of the Blackstone JV Communities (the “Blackstone JV Management Agreements”). As a result of the completion of the acquisition of the Blackstone JV Communities, each of the Blackstone JV Management Agreements was terminated. The Blackstone JV Management Agreements provided for management fees equal to 5.0% of gross collected revenues. We earned management fees of approximately $602,000 and $1.5 million in the three and six months ended June 30, 2011, respectively. The Blackstone JV Communities incurred no management fee expense from us subsequent to June 1, 2011, and our management fee revenue and the Blackstone JV management fee expense have been eliminated in the pro forma operating results above.
10
EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
Other acquisitions in the year ended December 31, 2011, as discussed below, were not material to our condensed consolidated financial statements. Therefore, we have not disclosed pro forma financial information related to these acquisitions.
2011 Contract Buyout Agreement
In February 2011, we entered into an agreement with Mr. Daniel R. Baty, the chairman of our board of directors and one of the Company’s founders, to purchase his rights related to six of 18 communities included in the cash flow sharing agreement (“CFSA”) between Emeritus and Mr. Baty (the “Buyout”). Mr. Baty was originally granted these rights in exchange for guaranteeing our obligations under a lease agreement. Three of the six communities in the Buyout were owned by our 50/50 consolidated joint venture with Mr. Baty (the “Batus JV”), and the Buyout also included our purchase of Mr. Baty’s equity interest in these three communities. We paid to Mr. Baty a total of $10.3 million in cash under the terms of the Buyout, which was based on predetermined formulas in the joint venture agreement and the CFSA. Of the $10.3 million payment, we recorded $6.2 million to transaction costs and decreased total shareholders’ equity by $4.1 million; this allocation approximated the relative fair value of the two elements in the transaction, which were the CFSA and the equity interest in the 50/50 joint venture, respectively.
In November 2011, we exercised our option to buy three additional communities included in the CFSA. Two of the three communities were owned by the Batus JV, and we purchased Mr. Baty’s equity interest in these communities. We paid to Mr. Baty a total of $4.2 million in cash, of which we recorded $1.6 million to transaction costs and decreased total shareholders’ equity by $2.6 million.
Other 2011 Acquisitions and Dispositions
During 2011, we purchased six assisted living communities with a total of 536 units. The aggregate purchase price was $83.0 million and we financed these purchases with mortgage debt totaling $62.4 million and cash on hand. We accounted for these acquisitions as business combinations.
During 2011, we sold eight communities with a total of 825 units and used the net proceeds to retire the related mortgage debt.
On June 19, 2012, we refinanced $11.1 million of mortgage debt, which was due to mature in November 2012, with Fannie Mae financing in the amount of $10.6 million. Monthly payments of principal and interest are based on a 25-year amortization with a fixed interest rate of 4.58%, with principal due at maturity in July 2022.
Debt Covenants
Our lease and loan agreements generally include customary provisions related to: (i) restrictions on cash dividends, investments, and borrowings; (ii) cash held in escrow for real estate taxes, insurance, and building maintenance; (iii) financial reporting requirements; and (iv) events of default. Certain loan agreements require the maintenance of debt service coverage or other financial ratios and specify minimum required annual capital expenditures at the corresponding communities. Many of our lease and debt instruments contain “cross-default” provisions pursuant to which a default under one obligation can cause a default under one or more other obligations to the same lender or property owner. Such cross-default provisions affect the majority of our properties. Accordingly, an event of default could cause a material adverse effect on our financial condition if such debts/leases are cross-defaulted. 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.
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EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
In connection with the acquisition of the Blackstone JV Communities described in Note 4, 2011 Blackstone JV Acquisition, we refinanced the debt that was assumed in the transaction to a total of $220.0 million pursuant to a credit agreement (“Credit Agreement”) with General Electric Capital Corporation (“GECC”). Under the terms of the Credit Agreement, the loan bears interest at a floating rate equal to 4.05%, plus the greater of: (i) the 90-day London Interbank Offered Rate (“LIBOR”) or (ii) 1.0% per annum, or a minimum floor of 5.05%, reset each month. Pursuant to the terms of the Credit Agreement, in October 2011 we purchased an interest rate cap for a cash payment of $1.6 million. This contract effectively caps the LIBOR on a notional amount of $132.0 million at 2.50% over the term of the loan. As of June 30, 2012, the fair value of the interest rate cap was $368,000, which is included in other assets, net, in the condensed consolidated balance sheet (see Note 10).
Potential dilutive shares consist of the incremental common shares issuable upon the exercise of outstanding stock options (both vested and non-vested), using the treasury stock method. Potential dilutive shares are excluded from the computation of earnings per share if their effect is antidilutive. For the three and six months ended June 30, 2012, we had outstanding stock options totaling 4.4 million that were excluded from the computation of net loss per share because they were antidilutive. For the three and six months ended June 30, 2011, we excluded 3.6 million and 4.2 million stock options, respectively, from net income (loss) per share because they were antidilutive.
Performance-based restricted shares, totaling 435,000 shares as of June 30, 2012, are included in total outstanding shares but are excluded from the loss per share calculation until the related performance criteria have been met.
Loss from discontinued operations for the three and six months ended June 30, 2012 represents primarily the impairment losses on two communities that we designated as held for sale in June 2012, based on purchase and sale agreements from prospective purchasers, and the sale of one community in April 2012 (see Note 10). In the second quarter of 2011, we recorded an impairment charge of $397,000.
As of June 30, 2012, we have a working capital deficit of $73.0 million compared to a working capital deficit of $100.1 million at December 31, 2011. We are able to operate in the position of a working capital deficit because we often convert our revenues to cash more quickly than we are required to pay the corresponding obligations incurred to generate those revenues, and we have historically refinanced or extended maturities of debt obligations as they become current liabilities. Our operations result in a low level of current assets to the extent we have used cash for business development expenses or to pay down long-term liabilities. Additionally, the working capital deficit includes the following non-cash items: 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 in excess of normal requirements, except for $30.9 million in final (“balloon”) payments of principal on long-term debt maturing in the next 12 months, which is included in current portion of long-term debt as of June 30, 2012.
Since 2008, we have refinanced and extended the terms of a substantial amount of our existing debt obligations, extending the maturities of such financings to dates in 2012 through 2047. Balloon payments of principal on long-term debt maturing in the next 12 months amount to $30.9 million, which are expected to be repaid, refinanced, or extended. Many of our debt instruments and leases contain “cross-default” provisions pursuant to which a default under one obligation can cause a default under one or more other obligations to the same lender or lessor. Such cross-default provisions affect the majority of our properties. Accordingly, any event of default could cause a material adverse effect on our financial condition if such debt or leases are cross-defaulted.
12
EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
In the six months ended June 30, 2012 and 2011, we reported net cash provided by operating activities of $68.5 million and $17.5 million, respectively, in our condensed consolidated statements of cash flows. Net cash provided by operating activities in the first six months of 2011 included $6.2 million in contract buyout costs treated as transaction expenses (see Note 4). In addition, our net trade accounts receivable increased by $14.7 million from December 31, 2010 to June 30, 2011, due primarily to delays in Medicare reimbursement for certain communities that we began operating under lease agreements in the fourth quarter of 2010, which include skilled nursing beds. Delays are customary when there is a change in providers, and payments were received prior to the end of 2011. Net cash provided by operating activities has not always been sufficient to pay all of our long-term obligations and we have been dependent upon third-party financing or disposition of assets to fund operations. We cannot guarantee that, if necessary in the future, such transactions will be available on a timely basis or at all, or on terms attractive to us.
As discussed above, we expect to refinance or extend our balloon payments due 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.
The following table presents information about our assets and liabilities measured at fair value on a recurring basis as of June 30, 2012 and December 31, 2011 and indicates the fair value hierarchy of the valuation techniques we have utilized to determine such fair value (in thousands):
In general, fair values determined by Level 1 inputs utilize quoted prices in active markets for identical assets or liabilities that we have the ability to access.
Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability.
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EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and we consider many factors specific to the asset or liability.
We have financial instruments other than investment securities consisting of cash equivalents, other receivables, tax and maintenance escrows, workers’ compensation collateral accounts, and long-term debt. As of June 30, 2012 and December 31, 2011, the fair values of other receivables, tax and maintenance escrows, and workers’ compensation collateral accounts approximate their carrying values based on their short-term nature as well as current market indicators, such as prevailing interest rates (Level 2 inputs). The fair value of our long-term debt is as follows as of the periods indicated (in thousands):
We estimated the fair value of debt obligations using discounted cash flows based on our assumed incremental borrowing rate of 8.5% for unsecured borrowings and 5.4% for secured borrowings (Level 2 inputs).
Impairments of Long-Lived Assets
In the second quarter of 2012, we recorded impairment charges of $4.3 million related to two communities that we have classified as held for sale. We determined the fair values based on pending purchase offers, less estimated selling costs (Level 2 input). The impairment charges are included in loss on discontinued operations in the condensed consolidated statement of operations.
In the first quarter of 2012, we recorded impairment charges of $2.1 million related to two parcels of undeveloped land. We determined the fair values of the properties based on comparable land sales in the respective local markets (Level 2 input). The impairment charges are reflected in the condensed consolidated statement of operations as impairments of long-lived assets.
In the second quarter of 2011, we recorded an impairment charge of $397,000 (see Note 8), which was based on the actual selling prices of two communities, net of selling costs.
Our income tax accruals include liabilities for unrecognized tax benefits, including penalties and interest, which we recorded in connection with our acquisition of Summerville Senior Living in 2007. These liabilities, which total $416,000 as of June 30, 2012, are included in other long-term liabilities and are the result of uncertainty surrounding the deductibility of certain items included in the Summerville tax returns for periods prior to the merger.
We record deferred income taxes based on the estimated future tax effects of loss carryforwards and temporary differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We record a valuation allowance to reduce the Company’s deferred tax assets to the amount that is more likely than not to be realized, which as of June 30, 2012 and December 31, 2011, reflects a net asset value of zero. Deferred tax assets are recorded as current assets in the condensed consolidated balance sheets and amounted to $22.1 million and $19.9 million as of June 30, 2012 and December 31, 2011, respectively. Deferred tax liabilities amounted to $22.1 million and $19.9 million as of June 30, 2012 and December 31, 2011, respectively, which are included in other long-term liabilities in the condensed consolidated balance sheets.
Because the Company fully reserves its deferred tax assets, no net tax effects were allocated to the components of other comprehensive loss.
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EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011
The Company has been and is currently involved in litigation and claims incidental to the conduct of its business that are comparable to other companies in the senior living industry, including professional and general liability claims. Certain claims and lawsuits allege large damage amounts and may require significant costs to defend and resolve. As a result, we maintain a combination of self-insurance reserves and commercial insurance policies in amounts and with coverage and deductibles that we believe are adequate, based on the nature and risks of our business, historical experience, and industry standards.
As of June 30, 2012, we have recorded a liability related to self-insured professional and general claims, including known claims and incurred but not yet reported claims, of $23.2 million. We believe that the range of reasonably possible losses as of June 30, 2012, based on sensitivity testing of the various underlying actuarial assumptions, is approximately $22.0 million to $31.1 million. The high end of the range reflects the potential for high-severity losses.
Debt refinancing
In July 2012, we entered into a mortgage loan agreement in the amount of $6.8 million. The loan requires monthly payments of $50,000 with an adjustable interest rate equal to LIBOR plus 5.85%. The loan matures in July 2015 with a one-year extension option. Proceeds from the loan were used to repay an existing mortgage loan with KeyBank with an outstanding principal balance of $6.9 million. In accordance with the terms of the loan agreement with KeyBank, which originally covered 16 communities, we are required to reduce the overall principal balance to specified levels during the term of the agreement.
Community disposition
In July 2012, we sold a 52-unit community located in Georgia. Net proceeds from the sale of $3.5 million were used to pay off the related mortgage debt in the amount of $3.4 million. The community’s property and equipment are classified as property held for sale in the condensed consolidated balance sheet as of June 30, 2012 (see Note 8).
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
The disclosure and analysis in this Quarterly Report on Form 10-Q contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, as amended. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. They often include words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “predict,” “seek,” “should,” “will,” or the negative of those terms, or comparable terminology. These forward-looking statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Our actual future results and trends may differ materially depending on a variety of factors, including, but not limited to, the risks and uncertainties discussed under Risk Factors and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.
Any or all of our forward-looking statements in this report may turn out to be inaccurate. Incorrect assumptions we might make and known or unknown risks and uncertainties may affect the accuracy of our forward-looking statements. Forward-looking statements reflect our current expectations or forecasts of future events or results and are inherently uncertain. Accordingly, you should not place undue reliance on our forward-looking statements.
Although we believe that the expectations and forecasts reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance, or achievements. Consequently, no forward-looking statement can be guaranteed, and future events and actual or suggested results may differ materially. We are including this cautionary note to make applicable and take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 for forward-looking statements. We expressly disclaim any obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise. You are advised, however, to consult any further disclosures we make in our quarterly reports on Form 10-Q and current reports on Form 8-K.
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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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 2011
Our Portfolios
As of June 30, 2012, our Consolidated Portfolio had a capacity of 34,945 beds in 37 states, and our Operated Portfolio had a capacity of 49,601 beds in 44 states. The following table sets forth a comparison of our Consolidated and Operated Portfolios:
Our Total Operated Portfolio as of June 30, 2012 consisted of the following unit types:
The units taken out of service represent rooms that we have converted to alternative uses, such as additional office space, and are not available for immediate occupancy. We exclude the units taken out of service from the calculation of the average occupancy rate. We place these units back into service as demand dictates.
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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 2011
Significant Transactions
In recent periods, we entered into a number of transactions that affected the number of communities we operate, our financing arrangements, and our capital structure. These transactions are summarized below.
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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 2011
Results of Operations
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.
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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 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.
Selected data from our Same Community Portfolio is as follows:
Revenues from our Same Community Portfolio represented 91.2% of our total community revenue for the second quarter of 2012, compared to 95.3% for the second quarter of 2011.
Of the $2.9 million increase in same community revenues, $447,000 was due to improved occupancy and $2.5 million was due to an increase in average revenue per occupied unit.
As a result of ongoing expense control and efficiency measures, operating expense from the Same Community Portfolio was held to an increase of 0.3%, or $630,000. This increase was primarily due to increases in health insurance, raw food, maintenance and repairs, and professional liability insurance, partially offset by decreases in a variety of other expenses.
Comparison of the Three Months Ended June 30, 2012 and 2011
Net Loss Attributable to Emeritus Corporation Common Shareholders
We reported a net loss attributable to Emeritus common shareholders of $21.7 million for the three months ended June 30, 2012, compared to net income of $22.2 million in the prior-year period. The prior period results include a $42.1 million gain on the acquisition of the Blackstone JV Communities. As further described in the section Liquidity and Capital Resources below, the Company has incurred significant losses since its inception, but has generated annual positive cash flow from operating activities since 2001.
The details of each of the components of net loss are set forth below.
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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 2011
(a) Comprised primarily of deferred move-in fees.
Revenues from communities not in our Same Community Portfolio increased by $13.2 million due to acquisitions during 2011, including the 24 Blackstone JV Communities, and net of certain dispositions. The change in unallocated community revenue of $803,000 resulted primarily from an overall decrease in the recognition of revenue for resident move-in fees, which we recognize over the average resident stay.
As of June 30, 2012, we managed 139 communities for the Sunwest JV, a joint venture with an affiliate of Blackstone and an entity controlled by Mr. Baty, two communities in joint ventures with an affiliate of The Wegman Companies, Inc. (“Wegman”), and nine other communities for third parties. The Sunwest JV, which commenced operations in August 2010, contributed $4.7 million and $4.5 million to management fee revenues in the three-month periods ended June 30, 2012 and 2011, respectively. The Blackstone JV contributed $602,000 to management fee revenues in the three-month period ended June 30, 2011. As described in Note 4, Acquisitions and Other Significant Transactions—2011 Blackstone JV Acquisition, we acquired the 24 communities that we previously managed for the Blackstone JV and have included them in our Consolidated Portfolio effective on the June 1, 2011 acquisition date. In connection with this acquisition, our management agreements with the Blackstone JV were terminated.
The decrease in reimbursed costs incurred on behalf of managed communities is due primarily to the conversion of the Blackstone JV Communities from managed to owned on June 1, 2011.
Community operating expense represents direct costs incurred to operate the communities and includes costs such as payroll and benefits, resident activities, marketing, housekeeping, food service, facility maintenance, utilities, taxes, and licenses. The increase from 2011 to 2012 is due primarily to a net increase in the number of communities in our
21
EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 2011
Consolidated Portfolio due to acquisitions. Of the $8.3 million increase in expense due to acquisitions, the largest contributor was an increase in total labor and benefits of $5.4 million, as well as increases in other categories required to provide services to residents, including skilled nursing residents.
Community operating expense in our Same Community Portfolio increased slightly, as described above under Same Community Portfolio. We focus on providing the appropriate level of care at our communities, while also pursuing overall expense efficiencies. For example, in the first half of 2011, we implemented an improved labor hours tracking system.
The increase in general and administrative expenses reflects increases in incentive compensation, including noncash stock compensation expense, and professional and consulting fees.
General and administrative expense as a percentage of community operating revenues for all managed and consolidated communities increased to 5.4% for the three months ended June 30, 2012 from 5.2% for the same quarter for 2011.
We focus on overhead expense efficiencies, while ensuring adequate infrastructure to support our operational needs. For example, in the first half of 2011 we eliminated certain processes and related positions that were deemed to duplicate or be less efficient than similar processes performed elsewhere within the organization. As a result, salaries and wages and related taxes and benefits were unchanged from the prior-year period.
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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 2011
Transaction costs represent professional and consulting fees incurred related to community purchases and other acquisition activity.
The increase in depreciation and amortization expense represents an increase in depreciation expense of $2.2 million and an increase in amortization expense of $1.3 million. The increased depreciation expense is due to communities acquired in 2011, including the 24 Blackstone JV Communities, as well as depreciation on improvements to our existing communities. The increase in amortization expense is the result of resident contract intangible assets acquired in business combinations, including the Blackstone JV Communities (see Note 4, Acquisitions and Other Significant Transactions—2011 Blackstone JV Acquisition).
The decrease in total community lease expense reflects an increase in operating lease expense due to rent escalators, which was partially offset by a lower level of deferred straight-line rent amortization. We leased 80 communities under operating leases both as of June 30, 2012 and 2011.
Costs Incurred on Behalf of Managed Communities:
The decrease in costs incurred on behalf of managed communities is due primarily to the conversion of the Blackstone JV Communities from managed to owned on June 1, 2011 (see Note 4, Acquisitions and Other Significant Transactions—2011 Blackstone JV Acquisition).
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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
Three and Six Months Ended June 30, 2012 and 2011
The Company earns interest income on invested cash balances and on restricted deposits.
The increase in interest expense was due primarily to communities acquired in 2011, including the 24 Blackstone JV Communities.
The amount in the 2012 period represents noncash expense resulting from changes in the fair value of our interest rate cap. The amount in the 2011 period represents noncash income resulting from changes in the fair value of an interest rate swap that expired on January 2, 2012. See Note 6, Derivative Financial Instruments.
The equity losses in the three months ended June 30, 2012 were comprised primarily of equity losses from the Sunwest JV. As described in Note 4, Acquisitions and Other Significant Transactions—2011 Blackstone JV Acquisition, we acquired the 24 communities that we previously managed for the Blackstone JV and have included them in our Consolidated Portfolio effective on the June 1, 2011 acquisition date. The equity losses in the three months ended June 30, 2011 were comprised of equity losses of $530,000 from the Sunwest JV, equity earnings of $489,000 from the Blackstone JV, and equity losses of $20,000 from joint ventures with Wegman.
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EMERITUS CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS - CONTINUED
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