After a 58% drop in market value since April, the publicly traded assisted-living sector is no longer the rising star of the long-term-care industry.
Part of the problem, experts say, is that publicly traded assisted-living companies have commonly used an accounting practice that boosts earnings. In recent months one company has abandoned the approach. At many other companies, the expectations the practice helped fuel have begun backfiring.
Here's how it works: An assisted-living company creates a private joint venture that's called a "black box" because its financial insides are hidden. The venture owns and operates new developments and usually pays management fees to the public company, which markets to prospective residents and manages the building as the units are filled.
With a black box, public companies can record income from management fees but omit start-up losses from their balance sheets. The joint venture, which owns the buildings under development, absorbs the losses.
Public companies usually can buy the buildings from the joint venture once the facilities are profitably full of residents.
For several years black box financing has helped assisted-living companies grow much faster than otherwise would have been possible (March 2, 1998, p. 76).
The mechanism became popular in the mid-1990s, when several private companies went public.
"Companies were under a lot of pressure to meet or exceed growth expectations," says Frank Morgan, a Nashville-based analyst at J.C. Bradford & Co.
To grow quickly, assisted-living companies needed to build and expand, but they also needed to show profits or risk losing investor interest, Morgan says. Black boxes allowed companies to build and show profits.
But lately black boxes have become a liability for the industry, because they unleashed rapid growth and spurred overbuilding in some parts of Florida and Texas.
"The sector grew very quickly because of pent-up demand," says Howard Capek, a New York-based healthcare analyst at Warberg Dillon Read. "But facilities are not leasing up as quickly as before, and there is no longer the easy access to capital there used to be."
That makes it more difficult for the companies to buy filled residences at prices they can afford.
Investors have fled the sector, frightened by the specter of overbuilding. They were also concerned about a possible increase in regulatory oversight of the industry because of a General Accounting Office report released in April. But that concern turned out to be largely unfounded.
A run of earnings misses at several companies has further shaken investor confidence.
Investors also have gained a more sophisticated understanding of black boxes and have begun to look beyond companies' reported earnings.
Most sector analysts, in fact, have developed complicated mathematical models to get past the black boxes and estimate companies' "real" earnings.
In a recently published review of the sector, the Assisted Living Federation of America sounded a note of caution on black boxes, concluding that "it would appear that publicly traded assisted-living providers that owned the majority of their assets and financed the majority of growth with traditional bank debt achieved higher valuations."
Assisted Living Concepts, a Portland, Ore.-based company, has already restored its joint venture financing on its balance sheet, but not because it wanted to. In a ruling that applied to only ALC but that the rest of the sector has watched closely, the company's auditors disallowed its joint ventures because its partner didn't share the risk. The accounting change, announced in February, led to the cancellation of a merger with Nashville-based American Retirement Corp.
Shortly thereafter, trading on the company's stock was halted as ALC recalculated its earnings. Late last month ALC told investors the unsurprising news: Without the black box, the company had never made a profit. Further, occupancy rates at its 175 facilities had fallen to an average of 74.3%, and positive earnings were not on the horizon.
"We have shifted our orientation away from development to operations and will not begin any new developments until we have achieved stabilization at our facilities," said Keren Brown Wilson, ALC president and chief executive officer. The industry defines a stabilized residence as one that is 95% occupied.
A different kind of black box problem has surfaced at other companies. Fairfax, Va.-based Sunrise Assisted Living said it expected lower earnings at its 128 facilities because of lower occupancy and higher costs. Sunrise also said its management fees would dip because its joint ventures were having trouble obtaining construction financing.
Analysts point to Brookfield, Wis.-based Alterra Healthcare Corp, which operates or manages 389 facilities, as a company that seems to be doing less off-balance-sheet financing. That move may be part of a growing trend.
With investor interest in the sector at a low ebb, analysts say companies may not be under as much pressure to produce high earnings.
"My view is, going forward there won't be as much of a need for (black boxes)," Morgan says.