Betting on Act Two in Life and the Markets

By Michael Brush
April 27, 2006

Sometimes, the market gives you second chance. Today, we are going to take it.

Let’s start with a few true confessions. Over the past eight months, I missed two big opportunities signaled by compelling insider buying at senior assisted living centers.

One was an initial public offering (IPO) called Brookdale Senior Living (BKD) which came public last November. Insiders bought heavily on the IPO. And within just four months Brookdale Senior Living rose 40% to above $39, from $27.

The other big miss was a company called Emeritus (ESC). The insider buy signal here hit my screens last September and by early March Emeritus had risen 39% to nearly $25.

I never wrote about these two in this column. I never bought them. And frankly, missing these big movers after obvious insider signals in a sector with such powerful demographic trends was, well, a kick in the backside.

Act Two

Now, though, we’ve been given a second chance. Let’s take it. Emeritus shares dropped 25% to under $20 from $25 in the middle of March after the company put out its fourth quarter results.

On the pullback in late March, Emeritus co-founder, chairman and chief executive Daniel Baty bought $522,000 worth of stock for between $20.56 and $21, according to Thomson Financial. This is the same insider who was a smart buyer all the way up over the past five years as the stock rose to $21.50 in late 2005 from $2 five years back.

His latest purchase – that half-million dollar buy in late March -- was by far the biggest since a $1.1 million purchase at the end of 2002, except for a $750,000 purchase last December, according to Thomson Financial. That’s called conviction and it is worth following.

The big picture

I don’t need to run through all the demographic trends that favor this sector, since by now we’ve all been beaten over the head with the “aging baby boomer” investing theme.

But a few other positives for Emeritus are worth noting.

* Medicaid – which covers elder care for people who can’t afford it -- is cracking down on the tricks families use to hide assets like houses or savings transferred to offspring. This may reduce the number of middle class elders who can lean on Medicaid for nursing care. Realizing they will be paying their own way anyway, many may opt for assisted living centers, where costs are lower and conditions aren’t as dire as in many nursing homes.

* Emeritus is a big company with $387.7 million in revenue last year (up 22% over the prior year). It operates 184 “communities.” As a large company, its better able to handle the costs of everything from food, equipment, insurance and employee benefits, to debt. Emeritus went through its big acquisition binge in the 1990s. That’s over, but its sheer size means it can continue to afford to buy smaller operators struggling with the higher costs of insurance and greater regulation.

* Emeritus is spread out in 35 states across the country. This reduces the risk of exposure to bad economic, regulatory or competitive conditions in one region.

Some risks

As a business that offers shelter to the elderly, Emeritus is essentially a real estate company. This means it carries a huge amount of debt. That’s a risk all by itself, since missing payments can lead to default and bankruptcy, which usually wipes out shareholders. But it also means profits could be diminished as interest rates go up. Emeritus restructured debt last year, bringing interest costs down considerably. This will help with cash flow.

Next, the company’s chairman and chief executive, Baty, has a hand in many real estate businesses which do a lot of transactions with Emeritus. Such “related party transactions” are often a concern among investors, who suspect that someone pulling the strings on both sides of a transaction may not be working in the best interest of Emeritus shareholders. But Baty himself has beneficial ownership of over 30% of Emeritus shares – making it less likely he will pull any pranks that hurt the value of Emeritus stock.

But partly because of all these transactions, Emeritus has one of the largest annual reports out there – a hefty 545 pages summarizing various deals, leasebacks, debt instruments and accounting policies. This not only makes it tough to fully understand all the moving parts. Some studies have shown that companies with voluminous financial reports are more likely to wind up with accounting issues – which makes sense intuitively, given all the explaining they have to do.

The bottom line: These are all valid warning signs. But Baty’s continued purchases on pullbacks even though he already has big exposure – plus those demographic trends – make Emeritus a stock to own. I’d buy it right here.

Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.

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