This Company Has a Four-Star Rating, But It’s Worth Five Stars

Jonathan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I tend to be skeptical about investing in stocks that have enjoyed substantial run-ups that I missed out on. Like Benjamin Graham, I like my cigarette-butt stocks and reject the idea of riding momentum to success. But the more I observe the market, the more I start to realize that value can exist in stocks that are feeling the love from Wall Street.

Today, I'll make my first pick using my new approach. The stock? Five Star Quality Care (NYSE: FVE), which has enjoyed a run-up of more than 60% over the last 52 weeks. It enjoys a four-star CAPS rating, but I think it deserves five stars.

Five Star’s main business is operating 207 assisted living facilities and 38 nursing homes, but it also leases and operates two rehabilitation hospitals along with the 13 clinics associated with them. Senior living provides the bulk of its revenue, and 73% of its senior living revenue comes from residents’ own funds, the remainder from Medicaid and Medicare. More specifically, over three quarters of assisted living revenues, but less than a quarter of nursing home revenues, are from private payors.

As assisted living facilities are Five Star’s bread and butter, this situation reduces the company’s sensitivities to the vagaries of Congress and places it in a strong position, especially given that the majority of nursing home and assisted living revenues nationwide are government-derived. It only helps that the population is aging and that this fragmented industry is ripe for consolidation.

The Curious Life of Five Star Quality Care

Five Star’s birth was inauspicious, to say the least, essentially the product of a large-scale eviction. Parent company Senior Housing Properties Trust (NYSE: SNH), a REIT, had some problem tenants operating senior living facilities in its properties.

The REIT took over, creating its own management company, which was spun off as Five Star in 2002. Ever since, Five Star and SNH have been closely related. To this day, Five Star leases the real estate housing all 38 of its nursing homes and 149 of its assisted living facilities from SNH.

The Value Proposition

To understand the value in Five Star, first take a look at rivals Brookdale Senior Living (NYSE: BKD), with 12 times the market capitalization, Emeritus Corp. (NYSE: ESC), with four times the market capitalization, and self-described “value leader” Capital Senior Living (NYSE: CSU).

Wall Street darlings as of late, all three are very similar to Five Star. For starters, they target seniors with the wherewithal to pay for chef-created meals, daily activities, and comfortable surroundings. They derive around 80% or more of their revenue from residents, instead of Medicare or Medicaid. In 2011, Emeritus and Five Star led the pack at over 87%, whereas Brookdale lagged at 79.5%. 

Like Five Star, none of these three companies pays dividends or is a REIT, although each owns some of its properties while managing others for REIT landlords and has taken steps towards increasing the percentage of its communities that it owns. For example, Emeritus has gone from 6% owned communities in 2006 to 57% in 2011.

Each company faces similar challenges as well, which include increasing labor costs, changing government regulations and bearing substantial debt burdens, especially in the case of Capital Senior Living. The lists of risk factors in their annual reports are almost identical.

Stock

Price/Book Value

Five Star Quality Care (FVE)

0.9

Senior Housing Properties Trust (SNH)

1.6

Brookdale Senior Living (BKD)

3.2

Emeritus Corporation (ESC)

5.3

Capital Senior Living (CSU)

3.4

Knowing that these companies share the same business model, ask why Five Star trades below book value and its fellow non-REITs trade at three to five times book value. (SNH is at 1.6x book value.)

I don’t claim to have all the answers, but I’ll tell you this: at least over the short term, the market is inefficient. And for us Fools, temporary inefficiencies can provide buying opportunities.


Fool blogger Jonathan Lim (whywalkrandomly) has no position in any stocks mentioned, but may initiate a position in FVE two business days after the syndication of this article. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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