The widely held assumption that debt is bad (and a high debt load even worse) causes many investors to overlook companies such as Brookdale Senior Living (BKD -2.28%) that have otherwise strong fundamentals. The high debt load must be viewed in context of the industry environment and company-specific factors, however.
The well-known favorable demographic growth drivers for the company include a senior population that is estimated to grow three times faster than the overall population, according to the U.S. Census Bureau. On the supply side, there are currently only 1.9 million units to serve a population of 12 million seniors. Moreover, the low amount of new construction (2.5% of inventory) is significantly lower than the 7% demographic growth. Meanwhile, the vast majority of that demographic is not even within the company's markets (a five mile radius of existing communities.)
From a company-specific standpoint, Brookdale is one of the best positioned to benefit from this trend as the largest operator of senior living communities. The company has a broad geographic footprint (550 communities serving 52,000 residents) and a wide range of offerings including retirement centers, assisted living communities, and continuing care retirement centers. Add-on ancillary services such as home health and hospice, as well as therapy services, provide incremental revenue from existing residents. Moreover, there is less risk from recent Medicare cuts given that private pay accounts for 80% of the overall payor mix.
Internal growth is largely driven by redeveloping existing communities to better align with customer needs (known as "Program Max"), a factor that should drive higher occupancy and pricing. This investment generates superior risk-adjusted returns (12%-15%) compared to acquisitions and is the primary use of free cash flow. Brookdale completed 12 Program Max projects this year and has 21 under construction.
While acquisition-fueled growth is less attractive due to the lower returns and increased debt, it is still attractive on an absolute basis (approximately 11% since 2009). The fragmented nature of the market provides an opportunity to make accretive acquisitions of smaller operators while the significant economies of scale drive margin expansion and cash flow growth.
These bullish tailwinds are reflected in another excellent quarterly performance driven largely by higher revenue per unit (up 2.8%) and occupancy (up 100 basis points to 89%), as well as slower expense growth (only up 1.7%). The high operating leverage drove an 8.1% increase in same-community operating income while the margin rose 140 basis points to 33.9%. As a result of the strong performance, management raised the low end of full-year cash from facility operations (CFFO) guidance to $2.40-$2.45 per share.
The elephant in the room
The approximately $2.7 billion worth of debt that the company holds should not be viewed in isolation, as this would fail to account for three important factors. First, as shown in the chart below, the steady growth in revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization) means Brookdale has more than sufficient debt coverage. Moreover, there is more than $230 million of available liquidity between cash and the line of credit while only 12% of its debt is variable rate not subject to caps or swap agreements.
Second, having a large debt load (with a leverage ratio of 6.2) is not unusual for the industry given the inherent operating and growth requirements.
Third, Brookdale has many levers to pull in order to manage this debt. For example, in March 2013 its lender agreed to extend the maturity date for the credit facility to 2018, increased the company's borrowing capacity, and lowered its interest rate. Moreover, it refinanced debt, which reduced the amount of near-term debt maturities.
While its two closest competitors are both benefiting from the same industry growth drivers, employ a similar operating model, and continue to deliver consistent revenue and CFFO growth, there are key distinctions that make Brookdale the better overall investment.
Capital Senior Living (CSU 0.00%) deserves a higher multiple given that 95% of its revenue is from private pay sources and it owns 49% of its communities (compared to 34% for Brookdale). This is offset by the lower occupancy of 86.4% and higher leverage ratio of 7.1, however As a result, the P/CFFO of 14.7 seems high compared to 11.4 for Brookdale.
While Emeritus (NYSE: ESC) appears to be more fairly valued with a P/CFFO of 11.5, this is offset by its lower occupancy of 87.3%, significantly higher leverage ratio of 10.7, and slower revenue per unit growth of 1.8%.
The bottom line is that Brookdale has the best combination of reasonable valuation, strong performance, and a lower leverage ratio.
There is no such thing as a perfect investment. Each one has its own unique risks and rewards. The job of investors is to determine if the latter sufficiently outweighs the former. In the case of Brookdale, the answer to my mind is clearly yes.