Five Star Senior Living: Reorg with Spin Dynamics

*This one ran away from me a little bit today but still likely cheap, wrote most of this last night after @valuewacatalyst (probably my favorite follow) tweeted on the idea and reminded me that the distribution had just happened, but below is the thesis -- interesting situation that's worth keeping an eye on or looking for something similar in the future*

Five Star Senior Living (FVE) is an RMR Group (RMR) controlled operator of primarily independent and assisted living communities for Diversified Healthcare Trust (DHC), which is RMR Group's externally managed senior housing and medical office REIT that was formerly known as Senior Housing Properties Trust (old ticker: SNH).  RMR manages a series of REITs and doesn't have the best reputation with investors, there's an obvious conflict of interest present in most external REITs, we last ran into RMR when they purchased the net-lease retail assets of SMTA for RMR's hotel REIT, Hospitality Properties Trust (HPT), their incentive is growth regardless of price or fit.  Their agreement with FVE is similarly structured, RMR gets a 0.6% cut of revenues without paying attention to profit.  Everyone knows the demographic tailwinds that should support the senior housing sector, the population of those 75 or older is growing at 2-3x the rate of the overall population in the United States.  Developers got excited, overbuilt in recent years into this well telegraphed demographic trend and senior housing operators have struggled due to the oversupply of rooms.  However the trend might be improving, construction is a little more rationale now and each year we move forward the demographic wave of seniors gets closer to being realized.

Five Star has been on the brink of collapse a few times (it was originally a spin of DHC 15+ years ago), they've been hampered with a poor business model of both high operating leverage (labor is expensive and often semi-fixed regardless of occupancy levels, insurance premiums, private vs public pay, etc) and high financial leverage via leasing their properties on a triple net basis from big brother Diversified Healthcare Trust.  They couldn't survive the oversupplied market and their troubles have bled into DHC's share price as well.  Through a restructuring with their largest creditor DHC, which is akin to a pre-packaged bankruptcy reorganization, Five Star will now be primarily an asset-lite operator of senior housing and the capital requirements will be DHC's responsibility.  The new structure is very similar to what is used in the hotel REIT industry where the REIT owns the property but in order to qualify as a REIT, the REIT needs to hire a third party management company, that's going to be Five Star going forward, switching from being DHC's tenant to their hired hand.  The primary difference, in the hotel industry the best revenue stream is the brand/franchise royalty, the Five Star brand isn't Marriott, so its just the less attractive but still a decent enough business of managing the property component in this situation.  In return, DHC received about 85% of FVE equity and distributed about 51% of the proforma shares outstanding to DHC's shareholders via a taxable special dividend, keeping the rest on DHC's balance sheet.

Five Star's new management agreement is for 5% of gross revenues plus the opportunity to earn another 1.5% of revenues in incentive payments if certain property level EBITDA targets are met.  FVE management is guiding to $20-30MM in EBITDA this year, even putting a 4-5x multiple on that and the stock could be a double from here.  The company has essentially no significant conventional debt following the restructuring, they will have a few remaining owned properties that carry mortgages but its pretty minor, a few non-DHC leases and a self insurance liability that is backed by their marketable securities portfolio.  Following the share issuance and sale of fixed assets to DHC, Five Star has approximately $100MM in proforma cash (this will likely not be all cash but a receivable from DHC for working capital liabilities, but eventually will be cash **EDIT: apparently this is wrong, being told that cash will be ~$35-40MM**), not far off from the proforma market cap of $112MM (31.1 million shares using a $3.60 share price).  Even at a 4x multiple of $25MM in the mid-point EBITDA range, the business is worth $100MM plus the $100MM in cash, FVE could be a $6+ stock without a demanding valuation.

Why does this exist?  DHC's shareholders are primarily retail investors who are hungry for yield or REIT index funds, few fundamental institutions would continually want to suffer the abuse of owning an RMR externally managed REIT.  The distribution of FVE shares was especially small, on 1/2/20 for each share of DHC, DHC shareholders received 0.07 shares of FVE, meaning it's likely an automatic sell due to its insignificant size and its 0% dividend yield (or if it's a REIT index fund holder, it would no longer be in the index).  Five Star has plenty of red flags, but the combination of a reorg to a better business model and the spin like dynamics of placing the new shares in disinterested holders makes it an interesting near-to-medium term opportunity.

Disclosure: I own shares of FVE