XNYS:ESC Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________________________
FORM 10-Q
________________________________

x
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
 
  THE SECURITIES EXCHANGE ACT 1934

For the quarterly period ended June 30, 2012

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
 
THE SECURITIES EXCHANGE ACT OF 1934

Commission file number   1-14012
LOGO
EMERITUS CORPORATION
(Exact name of registrant as specified in its charter)
WASHINGTON
91-1605464
(State or other jurisdiction
(I.R.S Employer
of incorporation or organization)
Identification No.)

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.


 
 

 

EMERITUS CORPORATION
       
 
   
Page No.
       
       
   
       
   
       
   
       
   
       
   
       
   
       
       
       
Note:
Items 2, 3, 4, and 5 of Part II have been omitted because they are not applicable.
       
     
     
   
 
     
 



 
 

 
Table of Contents

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements (unaudited)


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1

 
Table of Contents

EMERITUS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
 (In thousands, except share data)


ASSETS
 
             
   
June 30,
   
December 31,
 
   
2012
   
2011
 
Current Assets:
           
Cash and cash equivalents
  $ 74,792     $ 43,670  
Short-term investments
    4,322       3,585  
Trade accounts receivable, net of allowance of $3,620 and $2,294
    24,429       26,195  
Other receivables
    16,226       16,117  
Tax, insurance, and maintenance escrows
    21,423       20,501  
Prepaid insurance expense
    35,867       36,020  
Deferred tax asset
    22,072       19,934  
Other prepaid expenses and current assets
    6,213       8,140  
Property held for sale
    7,857        
          Total current assets
    213,201       174,162  
Investments in unconsolidated joint ventures
    15,679       15,428  
Property and equipment, net of accumulated depreciation of $465,592 and $407,952
    2,301,824       2,355,425  
Restricted deposits
    18,166       16,427  
Goodwill
    118,590       118,725  
Other intangible assets, net of accumulated amortization of $57,420 and $48,722
    91,761       100,873  
Other assets, net
    26,801       29,288  
          Total assets
  $ 2,786,022     $ 2,810,328  
                 
LIABILITIES, SHAREHOLDERS' EQUITY AND NONCONTROLLING INTEREST
       
                 
Current Liabilities:
               
Current portion of long-term debt
  $ 63,689     $ 74,175  
Current portion of capital lease and financing obligations
    21,471       17,004  
Trade accounts payable
    19,091       7,959  
Accrued employee compensation and benefits
    71,777       70,936  
Accrued interest
    8,120       9,061  
Accrued real estate taxes
    11,872       11,791  
Accrued professional and general liability
    32,091       24,525  
Other accrued expenses
    21,095       19,477  
Deferred revenue
    15,402       16,348  
Unearned rental income
    21,639       22,965  
          Total current liabilities
    286,247       274,241  
Long-term debt obligations, less current portion
    1,521,920       1,528,710  
Capital lease and financing obligations, less current portion
    621,398       619,088  
Deferred gain on sale of communities
    4,256       4,789  
Deferred straight-line rent
    62,449       61,481  
Other long-term liabilities
    41,843       39,283  
          Total liabilities
    2,538,113       2,527,592  
Commitments and contingencies
               
Shareholders' Equity and Noncontrolling Interest:
               
Preferred stock, $0.0001 par value.  Authorized 20,000,000 shares, none issued
           
Common stock, $0.0001 par value.  Authorized 100,000,000 shares, issued and
               
outstanding 45,061,359 and 44,989,861 shares
    4       4  
Additional paid-in capital
    828,666       822,345  
Accumulated deficit
    (584,349 )     (543,249 )
Total Emeritus Corporation shareholders' equity
    244,321       279,100  
Noncontrolling interest-related party
    3,588       3,636  
Total shareholders' equity
    247,909       282,736  
Total liabilities, shareholders' equity, and noncontrolling interest
  $ 2,786,022     $ 2,810,328  
                 


See accompanying Notes to Condensed Consolidated Financial Statements

 
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Table of Contents

EMERITUS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(In thousands, except per share data)

   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Revenues:
                       
Community revenue
  $ 318,628     $ 301,722     $ 636,551     $ 596,442  
Management fees
    5,141       5,485       10,197       10,946  
Reimbursed costs incurred on behalf of managed communities
    51,033       56,480       102,645       114,604  
Total operating revenues
    374,802       363,687       749,393       721,992  
                                 
Expenses:
                               
Community operations (exclusive of depreciation and amortization
                               
    and community leases shown separately below)
    213,571       205,358       427,044       404,389  
General and administrative
    22,987       21,721       46,410       44,934  
Transaction costs
    882       1,844       1,188       8,593  
Impairments of long-lived assets
                2,135        
Depreciation and amortization
    32,993       29,438       65,563       57,525  
Community leases
    31,016       31,202       62,187       62,198  
Costs incurred on behalf of managed communities (see Note2)
    51,033       56,480       102,645       114,604  
Total operating expenses
    352,482       346,043       707,172       692,243  
Operating income from continuing operations
    22,320       17,644       42,221       29,749  
                                 
Other income (expense):
                               
Interest income
    98       123       202       234  
Interest expense
    (38,587 )     (37,975 )     (77,632 )     (74,239 )
Change in fair value of derivative financial instruments
    (534 )     509       (745 )     509  
Net equity losses for unconsolidated joint ventures
    (80 )     (61 )     (472 )     (435 )
Acquisition gain
          42,110             42,110  
Other, net
    361       437       881       2,462  
Net other income (expense)
    (38,742 )     5,143       (77,766 )     (29,359 )
                                 
Income (loss) from continuing operations before income taxes
    (16,422 )     22,787       (35,545 )     390  
Provision for income taxes
    (324 )     (294 )     (596 )     (575 )
Income (loss) from continuing operations
    (16,746 )     22,493       (36,141 )     (185 )
Loss from discontinued operations
    (5,007 )     (397 )     (5,007 )     (397 )
Net income (loss)
    (21,753 )     22,096       (41,148 )     (582 )
Net loss attributable to the noncontrolling interests
    34       101       48       218  
Net income (loss) attributable to Emeritus Corporation
                               
   common shareholders
  $ (21,719 )   $ 22,197     $ (41,100 )   $ (364 )
                                 
Basic income (loss) per common share attributable to
                               
    Emeritus Corporation common shareholders:
                               
Continuing operations
  $ (0.38 )   $ 0.51     $ (0.81 )   $  
Discontinued operations
    (0.11 )     (0.01 )     (0.11 )     (0.01 )
    $ (0.49 )   $ 0.50     $ (0.92 )   $ (0.01 )
                                 
Weighted average common shares outstanding
    44,612       44,283       44,597       44,247  
                                 
Diluted income (loss) per common share attributable to
                               
   Emeritus Corporation common shareholders:
                               
   Continuing operations
  $ (0.38 )   $ 0.50     $ (0.81 )   $  
   Discontinued operations
    (0.11 )     (0.01 )     (0.11 )     (0.01 )
    $ (0.49 )   $ 0.49     $ (0.92 )   $ (0.01 )
                                 
Weighted average diluted common shares outstanding
    44,612       44,874       44,597       44,247  

See accompanying Notes to Condensed Consolidated Financial Statements

 
3

 


 
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
 
(unaudited)
 
(In thousands)
 
                         
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Net income (loss)
  $ (21,753 )   $ 22,096     $ (41,148 )   $ (582 )
Other comprehensive income (loss) net of tax:
                               
Realized gain on sale of investment securities
          (1,569 )           (1,569 )
Unrealized holding gains on
                               
available-for-sale investment securities
          97             97  
Other comprehensive loss net of tax:
          (1,472 )           (1,472 )
Comprehensive income (loss)
    (21,753 )     20,624       (41,148 )     (2,054 )
Comprehensive loss attributable to the noncontrolling interests
    34       101       48       218  
Comprehensive income (loss) attributable to Emeritus Corporation
                               
   common shareholders
  $ (21,719 )   $ 20,725     $ (41,100 )   $ (1,836 )


See accompanying Notes to Condensed Consolidated Financial Statements


 
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Table of Contents


EMERITUS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(In thousands)

   
Six Months Ended June 30,
 
   
2012
   
2011
 
Cash flows from operating activities:
           
Net loss
  $ (41,148 )   $ (582 )
Adjustments to reconcile net loss to net cash provided by (used in)
               
operating activities:
               
Depreciation and amortization
    65,563       57,525  
Amortization of above/below market rents
    3,378       3,933  
Amortization of deferred gains
    (533 )     (572 )
Acquisition gain
          (42,110 )
Loss on early extinguishment of debt
    625        
Impairments of long-lived assets
    6,678        
Gain on sale of investments
          (1,569 )
Gain (loss) on sale of asset
    (205 )     384  
Amortization of loan fees
    1,680       1,474  
Allowance for doubtful receivables
    5,225       4,507  
Equity investment losses
    472       435  
Stock-based compensation
    5,679       4,709  
Change in fair value of derivative financial instruments
    745       (509 )
Deferred straight-line rent
    2,298       4,932  
Deferred revenue
    (450 )     1,140  
Other
    1,236       3,566  
Change in other operating assets and liabilities
    17,273       (19,793 )
Net cash provided by operating activities
    68,516       17,470  
                 
Cash flows from investing activities:
               
Acquisition of property and equipment
    (11,399 )     (14,390 )
Community acquisitions, net of cash acquired
          (139,568 )
Proceeds from the sale of assets
    3,725       10,557  
Other assets
    (179 )     (304 )
Advances from (to) affiliates and other managed communities, net
    481       (450 )
Distributions from (contributions to) unconsolidated joint ventures, net
    (637 )     1,351  
Net cash used in investing activities
    (8,009 )     (142,804 )
                 
Cash flows from financing activities:
               
Sale of stock, net
    623       1,281  
Distribution to noncontrolling interest
          (4,078 )
Increase in restricted deposits
    (1,655 )     (2,342 )
Debt issuance and other financing costs
    (1,118 )     (3,510 )
Proceeds from long-term borrowings and financings
    10,553       108,316  
Repayment of long-term borrowings and financings
    (29,711 )     (40,880 )
Repayment of capital lease and financing obligations
    (8,077 )     (6,898 )
Net cash provided by (used in) financing activities
    (29,385 )     51,889  
                 
Net increase (decrease) in cash and cash equivalents
    31,122       (73,445 )
Cash and cash equivalents at the beginning of the period
    43,670       110,124  
Cash and cash equivalents at the end of the period
  $ 74,792     $ 36,679  

See accompanying Notes to Condensed Consolidated Financial Statements

 
5

 
Table of Contents


EMERITUS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(In thousands)

   
Six Months Ended June 30,
 
   
2012
   
2011
 
             
Supplemental disclosure of cash flow information:
           
Cash paid during the period for interest
  $ 75,574     $ 68,252  
Cash paid during the period for income taxes
    1,016       1,037  
Cash received during the period for income tax refunds
    46       13  
Non-cash financing and investing activities:
               
Capital contribution to Sunwest JV
    (2,036 )      
Distribution from Sunwest JV
    2,036        
Net cash
           
Capital lease and financing obligations
          280  
Unrealized gain on investment in marketable equity securities
          97  
Receivable from exercise of stock options
    19       42  




See accompanying Notes to Condensed Consolidated Financial Statements

 
6

 

EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011

Note 1.  
Description of Business

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.

Note 2.  
Summary of Significant Accounting Policies and Use of Estimates

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


Table of Contents

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


Table of Contents


Note 3.  
Stock-Based Compensation

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:

         
Weighted
   
Aggregate
 
   
Shares
   
Average
   
Intrinsic
 
   
Underlying
   
Exercise
   
Value
 
   
Options
   
Price
    $(000)  
Outstanding at beginning of period
    4,470,939     $ 18.52     $ 6,825  
Granted
    60,000       16.01          
Exercised
    (42,675 )     5.25       573  
Forfeited/expired
    (116,175 )     17.44          
Outstanding at end of period
    4,372,089       18.64       5,087  
                         
Options exercisable
    2,383,238       20.21       3,287  
                         
Weighted average grant date fair value
            9.11          
                         
Options exercisable in the money
    704,143               3,287  
Options exercisable out of the money
    1,679,095                

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


Table of Contents


Note 4.  
Acquisitions and Other Significant Transactions

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):

   
Pro Forma Combined
 
   
(unaudited)
 
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
                         
Total operating revenues
  $ 374,802     $ 377,044     $ 749,393     $ 755,315  
Operating income from continuing operations
    22,320       18,572       42,221       31,767  
Loss from continuing operations before income taxes
    (16,422 )     (19,281 )     (35,545 )     (41,769 )
Net loss attributable to Emeritus Corporation common shareholders
    (21,719 )     (19,872 )     (41,100 )     (42,524 )
                                 
Basic and diluted loss per common share attributable to Emeritus Corporation common shareholders
  $ (0.49 )   $ (0.45 )   $ (0.92 )   $ (0.96 )
                                 
Basic and diluted weighted average common shares outstanding
    44,612       44,283       44,597       44,247  

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.

 
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EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011


Table of Contents


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.

Note 5.  
Long-Term 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


Table of Contents


Note 6.  
Derivative Financial Instruments

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).

Note 7.  
Income (Loss) Per Share

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.

Note 8.  
Discontinued Operations

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.

Note 9.  
Liquidity

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.

 
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EMERITUS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Six Months Ended June 30, 2012 and 2011


Table of Contents


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.

Note 10.  
  Fair Value Disclosures

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):

   
Quoted Prices in
   
Significant
             
   
Active Markets
   
Other
   
Significant
   
Balance as of
 
   
for Identical
   
Observable
   
Unobservable
   
June 30,
 
   
Assets (Level 1)
   
Inputs (Level 2)
   
Inputs (Level 3)
   
2012
 
Assets
                       
Investment securities - trading
  $ 4,322     $     $     $ 4,322  
Interest rate cap agreement
          368             368  
                                 
                                 
   
Quoted Prices in
   
Significant
                 
   
Active Markets
   
Other
   
Significant
   
Balance as of
 
   
for Identical
   
Observable
   
Unobservable
   
December 31,
 
   
Assets (Level 1)
   
Inputs (Level 2)
   
Inputs (Level 3)
      2011  
Assets
                               
Investment securities - trading
  $ 3,585     $     $     $ 3,585  
Interest rate cap agreement
          1,146             1,146  
Liabilities
                               
Interest rate swap agreement
          33             33  

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.
 
 
13

 
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):

   
June 30, 2012
   
December 31, 2011
 
   
Carrying
         
Carrying
       
   
Amount
   
Fair Value
   
Amount
   
Fair Value
 
Long-term debt
  $ 1,585,609     $ 1,638,841     $ 1,602,885     $ 1,660,451  

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.

Note 11.  
  Income Taxes

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


Table of Contents



Note 12.  
  Litigation

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.

Note 13.  
  Subsequent Events

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).



Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

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:

·  
Total operating revenues increased $27.4 million, or 3.8%, to $749.4 million from $722.0 million for the prior-year period.
·  
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.
·  
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.
·  
Average rate per occupied unit increased 1.9% to $4,136 from $4,058 for the prior-year period.
·  
Net cash provided by operating activities was $68.5 million compared to $17.5 million for 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



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:

 
June 30, 2012
 
December 31, 2011
 
June 30, 2011
 
Community Count
 
Unit
Count (b)
 
Community Count
 
Unit
Count (b)
 
Community Count
 
Unit
Count (b)
Owned
186
 
15,243
 
187
 
15,309
 
190
 
15,732
Leased(a)
141
 
14,596
 
141
 
14,596
 
141
 
14,594
Consolidated Portfolio
327
 
29,839
 
328
 
29,905
 
331
 
30,326
Managed
9
 
933
 
9
 
933
 
11
 
1,121
Managed - Joint Ventures
141
 
11,809
 
141
 
11,809
 
140
 
11,728
Operated Portfolio
477
 
42,581
 
478
 
42,647
 
482
 
43,175
                       
(a)  We account for 80 of the 141 leased communities as operating leases, 58 as capital leases, and three as financing leases.  We do not include the assets and
       liabilities of the 80 operating lease communities on our condensed consolidated balance sheets.
(b)  Total units reflect skilled nursing units in terms of beds.
                       
 
Our Total Operated Portfolio as of June 30, 2012 consisted of the following unit types:

 
Units by Type of Service
 
AL (a)
MC (b)
IL (c)
SN (d)
Other (e)
Total
Owned
          11,278
            2,941
              698
              148
              178
          15,243
Leased
          10,792
            2,253
              673
              826
                52
          14,596
Consolidated Portfolio
          22,070
            5,194
            1,371
              974
              230
          29,839
Managed
              569
              183
              161
            –
                20
              933
Managed - Joint Ventures
            6,926
            1,372
            3,026
              195
              290
          11,809
Operated Portfolio
          29,565
            6,749
            4,558
            1,169
              540
          42,581
             
(a) Assisted living
           
(b) Memory care
           
(c) Independent living
           
(d) Skilled nursing beds
           
(e) Units taken out of service
           

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.


   
Transaction Period
Unit Count
 
Transaction Type
D in Owned Count
Purchase Price
(000) (a)(b)
Amount Financed
(000) (b)
D in Leased Count
 
D in Managed Count
Count as of December 31, 2010
       
165
   
141
 
173
                       
2011 Activity
                   
Plaza on the River
Jan 2011
64
 
Joint venture (c)
  –
 N/A
 N/A
  –
 
  –
Emeritus at Baywood
Jan 2011
126
 
Acquisition
1
12,855
10,000
  –
 
  –
Emeritus at Steel Lake
Mar 2011
87
 
Managed
  –
N/A
N/A
   
1
Emeritus at Mandeville
Mar 2011
84
 
Acquisition
1
10,400
7,800
  –
 
  –
Palmer Ranch Healthcare
Apr 2011
160
 
Joint venture (c)
  –
 N/A
 N/A
  –
 
1
Emeritus at Spruce Wood
May 2011
90
 
Acquisition
1
19,065
14,115
  –
 
  –
Emeritus at New Port Richey
May 2011
70
 
Disposition
(1)
 N/A
 N/A
  –
 
  –
Emeritus at Venice
May 2011
78
 
Disposition
(1)
 N/A
 N/A
  –
 
  –
Blackstone JV
Jun 2011
1,897
 
Acquisition (d)
24
144,130
58,608
  –
 
(24)
Emeritus at Fillmore Pond
Jul 2011
101
 
Acquisition
1
20,935
15,825
  –
 
  –
Emeritus at Vista Oaks and
                   
Emeritus at Summer Ridge
Jul 2011
135
 
Acquisition
2
19,700
14,700
  –
 
  –
Emeritus at Lakeland Hills
Aug 2011
170
 
Disposition
(1)
N/A
N/A
  –
 
  –
Emeritus at Long Cove Pointe
Sep 2011
81
 
Joint venture
  –
N/A
N/A
  –
 
1
Emeritus at Bayside Terrace
Oct 2011
154
 
Disposition
         
(1)
Colonial Gardens
Oct 2011
47
 
Disposition
         
(1)
Emeritus at Pavillion
Dec 2011
174
 
Disposition
(1)
 N/A
 N/A
  –
 
  –
Emeritus at Cambria
Dec 2011
79
 
Disposition
(1)
 N/A
 N/A
   
  –
Emeritus at Palisades
Dec 2011
158
 
Disposition
(1)
 N/A
 N/A
   
  –
Emeritus at Cielo Vista
Dec 2011
66
 
Disposition
(1)
 N/A
 N/A
   
  –
Emeritus at Desert Springs
Dec 2011
30
 
Disposition
(1)
 N/A
 N/A
   
  –
                       
Count as of December 31, 2011
       
187
   
141
 
150
                       
2012 Activity
                   
Emeritus at Greenwood
Apr 2012
66
 
Disposition
(1)
 N/A
 N/A
  –
 
  –
Count as of June 30, 2012
       
186
   
141
 
150
                       
(a)
Purchase price exclusive of closing costs.
                       
(b)
Purchase price and amount financed are not applicable for new lease and management agreements or expansions and dispositions.
                       
(c)
Management of units previously operated by an unrelated third party.
                       
(d)
Represents the purchase of Blackstone's 81% ownership interest in the joint venture.  See Note 4, Acquisitions and Other Significant Transactions-Blackstone JV Acquisition.


 
18

 
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.

 
19

 
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:

   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D (a) (b)
   
(in thousands, except percentages)
 
                             
Community revenue
  $ 290,479     $ 287,536     $ 2,943       1.0 %
Community operations expense
    (191,838 )     (191,208 )     (630 )     (0.3 )%
Community operating income
  $ 98,641     $ 96,328     $ 2,313       2.4 %
                                 
Average monthly revenue per occupied unit
  $ 4,136     $ 4,101     $ 35       0.9 %
Average occupancy rate
    86.6 %     86.5 %          
0.1 ppt
 

(a) "N/M" indicates percentages that are not meaningful in this analysis.  Applies to all subsequent tables in this section.
(b) "ppt" refers to percentage points.  Applies to all subsequent tables in this section.

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.

 
20

 
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




Total Operating Revenues:

   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Same Community Portfolio
  $ 290,479     $ 287,536     $ 2,943       1.0 %
Acquisitions, development and expansion
    27,999       14,839       13,160       88.7 %
Unallocated community revenue (a)
    150       (653 )     803       N/M  
Community revenue
    318,628       301,722       16,906       5.6 %
Management fees
    5,141       5,485       (344 )     (6.3 %)
Reimbursed costs incurred on behalf of managed communities
    51,033       56,480       (5,447 )     (9.6 %)
Total operating revenues
  $ 374,802     $ 363,687     $ 11,115       3.1 %
                                 
Average monthly revenue per occupied unit
  $ 4,148     $ 4,057     $ 91       2.2 %
Average occupancy rate
    86.4 %     86.0 %          
0.4 ppt
 

  (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:

   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Same Community Portfolio
  $ 191,838     $ 191,208     $ 630       0.3 %
Acquisitions, development, and expansion
    19,283       10,935       8,348       N/M  
Unallocated community expenses
    2,450       3,215       (765 )     (23.8 %)
Community operations
  $ 213,571     $ 205,358     $ 8,213       4.0 %
As a percentage of total operating revenues
    57.0 %     56.5 %          
0.5 ppt
 

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.

General and Administrative Expense:
   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
General and administrative
  $ 22,987     $ 21,721     $ 1,266       5.8 %
As a percentage of total operating revenues
    6.1 %     6.0 %          
0.1 ppt
 

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 computed these percentages as follows:

   
Three Months Ended June 30,
 
   
2012
   
2011
 
   
(in thousands, except percentages)
 
General and administrative expenses
        $ 22,987           $ 21,721  
Sources of revenue:
                           
Owned and leased
  $ 318,628             $ 301,722          
Managed
    104,257               112,416          
Total revenue for all communities
          $ 422,885             $ 414,138  
                                 
General and administrative expenses as a percent of
                               
      all sources of revenue
            5.4 %             5.2 %
General and administrative expenses less stock-based
                               
     compensation as a percent of all sources of revenue
            4.8 %             4.7 %

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.

Transaction Costs:
   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Transaction costs
  $ 882     $ 1,844     $ (962 )     (52.2 %)
As a percentage of total operating revenues
    0.2 %     0.5 %          
(0.3) ppt
 

 
22

 
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.

Depreciation and Amortization Expense:
   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Depreciation and amortization
  $ 32,993     $ 29,438     $ 3,555       12.1 %
As a percentage of total operating revenues
    8.8 %     8.1 %          
0.7 ppt
 

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).

Community Lease Expense:
   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Operating lease expense
  $ 28,296     $ 26,795     $ 1,501       5.6 %
Above/below market rent
    1,624       1,967       (343 )     (17.4 %)
Deferred straight-line rent amortization
    1,096       2,440       (1,344 )     (55.1 %)
Community leases
  $ 31,016     $ 31,202     $ (186 )     (0.6 %)
As a percentage of total operating revenues
    8.3 %     8.6 %          
(0.3) ppt
 

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:

   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Costs incurred on behalf of managed communities (see Note2)
  $ 51,033     $ 56,480     $ (5,447 )     (9.6 %)
As a percentage of total operating revenues
    13.6 %     15.5 %          
(1.9) ppt
 

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).

 
23

 
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




Interest Income:
   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D
   
(in thousands, except percentages)
 
Interest income
  $ 98     $ 123     $ (25 )     (20.3 %)
As a percentage of total operating revenues
                     
– ppt
 

The Company earns interest income on invested cash balances and on restricted deposits.

Interest Expense:
   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Interest expense
  $ 38,587     $ 37,975     $ 612       1.6 %
As a percentage of total operating revenues
    10.3 %     10.4 %          
(0.1) ppt
 

The increase in interest expense was due primarily to communities acquired in 2011, including the 24 Blackstone JV Communities.

Change in Fair Value of Derivative Financial Instruments

   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Change in fair value of derivative financial instruments
  $ (534 )   $ 509     $ (1,043 )     N/M  
As a percentage of total operating revenues
    (0.1 %)     0.1 %          
(0.2) ppt
 

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.

Equity Earnings (Losses) for Unconsolidated Joint Ventures:
   
Three Months Ended June 30,
 
   
2012
   
2011
    $D      % D  
   
(in thousands, except percentages)
 
Net equity losses for unconsolidated joint ventures
  $ (80 )   $ (61 )   $ (19 )     (31.1 %)
As a percentage of total operating revenues
                     
– ppt
 

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. 

 
24