ITEM 1. DESCRIPTION OF BUSINESS
OVERVIEW AND BACKGROUND
Emeritus Assisted Living - Emeritus Corporation ("Emeritus" or the "Company") is a nationally integrated assisted living organization focused on operating residential style communities. Emeritus is one of the largest and most experienced providers of assisted living communities. Assisted living communities provide a residential housing alternative for senior citizens who need help with the activities of daily living, with an emphasis on assisted living and personal care services.
The Company was founded in July 1993 to become a nationwide operator of assisted living communities. During the 16 years prior to 1987, Daniel R. Baty, the Company's Chairman of the Board and Chief Executive Officer, served as the chief executive officer of The Hillhaven Corporation ("Hillhaven"), one of the largest operators of skilled nursing facilities in the United States. Mr. Baty left Hillhaven to pursue opportunities in the independent living market. In 1987, he became the chairman of the board and a principal shareholder of Holiday Retirement Corp. ("Holiday"), one of the largest operators of independent living communities in the United States, and served as its chief executive officer from 1991 through September 1997.
As of March 23, 1999 the Company held ownership, leasehold or management interests in 117 assisted living communities (the "Operating Communities") consisting of approximately 10,400 units with a capacity for 12,000 residents, located in 29 states. As of March 23, 1999, the Company leased 53 of its assisted living communities, owned 15 communities, managed or provided administrative services for 41 communities and had a partnership interest or joint venture in eight communities. Additionally, the Company holds a 31.3% minority interest in Alert Care Corporation ("Alert"), an Ontario, Canada based owner and operator of 21 assisted living communities consisting of approximately 1,200 units with a capacity for approximately 1,300 residents. See "Strategic Relationships --Alert Relationship".
Of the 117 current Operating Communities, the Company has developed 48 and acquired 69 since its inception in 1993. Of the newly developed communities, 20 and 11 (six of which are managed) were opened during 1997 and 1998, respectively. As of March 23, 1999 the Company completed development on four additional communities and owned, had a leasehold interest in, management interest in or had acquired an option to purchase development sites for 17 new assisted living communities (the "Development Communities"). Of the Development Communities, 13 and four are scheduled to open during the remainder of 1999 and in 2000, respectively. The Development Communities contain capacity for 1,800 additional residents. After completion of the 1999 Development Communities and including Alert, the Company will have an interest in 151 communities with a total capacity for over 14,500 residents.
Effective December 31, 1998, the Company completed a transaction whereby a related entity acquired 22 assisted living communities previously leased by the Company from Meditrust and three communities previously owned by the Company for a combined purchase price of approximately $168 million (the "Emeritrust transaction"). The Company is continuing to operate all 25 communities pursuant to a three year management agreement and will receive management fees equal to 5% of revenues, as well as an additional 2% of revenues contingent on such communities achieving positive cash flows. In addition, the Company has an option and a right of first refusal to purchase the 22 previously leased communities and the three previously owned communities, respectively, during the three year period at a purchase price equal to the original cost to the entity plus an amount calculated to provide the entity with a specified rate of return on its invested capital. The combined transaction will accomplish several strategic objectives for the Company including: (i) expected management fee income of $2.5 million in 1999 versus 1998 losses from operations from these communities of $11.0 million and (ii) an immediate improvement of approximately $800,000 in monthly cash flow from operations. Daniel R. Baty, the Company's Chairman and Chief Executive Officer, and William E. Colson, a director, have financial interests in the entity that is a party to this arrangement.
THE ASSISTED LIVING INDUSTRY
The Company believes the assisted living industry is steadily becoming a preferred alternative for meeting the growing needs of senior citizens who do not require the intensive medical attention provided by a skilled nursing facility, but cannot live independently due to physical and/or cognitive frailties. The assisted living industry is one of the fastest growing niche markets in the United States, projected to grow 150 percent by the year 2005, according to the U.S. Small Business Administration. The Company believes an assisted living environment is:
- a residential setting that provides or coordinates personal services, 24-hour supervision and personalized assistance (scheduled and unscheduled), health-related services and activities in a professionally managed group environment; - designed to accommodate individual residents' changing needs and preferences; - intended to maximize resident's dignity, quality of life, autonomy, privacy, independence, choice and safety; - designed to minimize the need to move by providing a comprehensive range of assisted living services, including Alzheimer's care and other services allowing residents to "age in place" within the facility as they develop further physical and cognitive frailties; and - designed to encourage family and community involvement.
The Company believes that assisted living has become the preferred approach to long-term care for seniors due to: (i) increased emphasis by both federal and state governments to contain long-term care costs; (ii) limitations imposed in many states on construction of additional skilled nursing facilities; and (iii) the relative affluence of the elderly segment of the population and the decreasing availability of family care. The Company believes that its communities are attractive to those seniors who do not require 24-hour skilled nursing care but do desire supervision and assistance with the activities of daily living. Also, the limited availability of governmental payment programs has created a strong and growing market demand for non-institutional long-term care services designed to fill the gap between independent living facilities and skilled nursing facilities.
OPERATING PHILOSOPHY
The Company's operating philosophy is to provide a wide variety of assisted living services in a professionally managed environment while allowing its residents to maintain their dignity and independence. In addition, the Company continuously seeks to refine and improve the care and services it offers. Residents of the Company's communities are typically unable to live alone, but do not require the intensive care provided in skilled nursing facilities. Under the Company's operating approach, seniors reside in a private or semi-private residential unit for a monthly fee based on each resident's individual service needs. The Company believes its focus on residential assisted living communities allows seniors to maintain a more independent lifestyle than is possible in the institutionalized environment of skilled nursing facilities. In addition, the Company believes its services, such as assisting residents with their activities of daily living (including medication management, bathing, dressing, personal hygiene, and grooming) are attractive to seniors who are inadequately served by independent living facilities.
RESIDENT SERVICES
The Company's assisted living communities offer residents a full range of services based upon individual resident needs in a supportive "home-like" environment. By offering a full range of services, including FlexAssist programs and Alzheimer's Care, the Company can accommodate residents with a broad range of service needs and therefore enable residents to "age in place". Services provided by the Company to its residents are designed to respond to their individual needs and to improve their quality of life.
BASIC CARE
The Company's basic care program is provided to all residents and includes: three meals per day served in a common dining room; social and recreational activities; weekly housekeeping and linen service; building maintenance and grounds keeping; 24-hour emergency response and security; licensed nurses on staff to monitor and coordinate care needs; and transportation to appointments, etc.
FLEXASSIST
The Company's FlexAssist programs allow residents who require more frequent or intensive assistance or increased care or supervision to receive additional services. The FlexAssist program allows the Company, through consultation with the resident, the resident's physician and the resident's family, to create an individualized care program for residents who might otherwise be forced to move to a more medically-intensive facility. An individual resident's level of care is determined by the degree of assistance he/she requires in each of several categories. The categories of care include, but are not limited to: medication management and supervision; reminders for dining and recreational activities; assistance with bathing, dressing and grooming; incontinence; behavior management; dietary assistance; and miscellaneous (which consists of diabetic management, PRN medication, transfer, simple treatment, oxygen set up/maintenance and prosthesis). The Company charges an additional fee for these services based on the level of care provided.
ALZHEIMER'S CARE
Alzheimer's is a debilitating disease and persons afflicted with it require special care. The Company believes its Alzheimer's Care program distinguishes it from other assisted living providers who do not provide such specialized care.
SERVICE REVENUE SOURCES
The Company currently and for the foreseeable future expects to rely primarily on its residents' ability to pay the Company's charges from their own or familial resources. Although care in an assisted living community is typically less expensive than in a skilled nursing facility, the Company believes generally only seniors with income or assets meeting or exceeding the regional median can afford to reside in the Company's communities. Inflation or other circumstances that adversely affect seniors' ability to pay for services such as those provided by the Company could have an adverse effect on the Company's business or operations. For example, if the Company were unable to attract residents able to pay for its services, it would have to modify its business strategy of relying primarily on the private-pay market and be forced to rely more on the limited number of governmental reimbursement programs. Furthermore, the federal government provides limited reimbursement for the type of assisted living services provided by the Company.
The Company currently serves a limited number of residents who receive aid from various states' (Washington, Florida, Texas and Massachusetts) financial assistance programs, some of which are an extension of federal recipient assistance programs, as well as from alternate sources, such as private insurance. Qualifications are generally similar to those of Medicaid, and the Company is subject to various regulatory and governmental reimbursement policies. Net revenues from state reimbursement programs for the years 1997 and 1998 accounted for less than 10% of the Company's operating revenues for such years. Payments to the Company under state reimbursement programs in which the Company participates are currently sufficient to cover virtually all the operating (but not financing) costs allocable to the Company's participating residents. As third party reimbursement programs and other alternative forms of payment continue to grow, the Company will pursue reimbursement from the third party, if appropriate, given the level of care provided to its residents. However, there can be no assurance that the Company will continue to improve its private-pay mix or that it will not in the future become more dependent on governmental or other reimbursement programs.
COMPANY OPERATIONS
OPERATING STRATEGY
The Company believes there is a significant demand for alternative long-term care services that are well-positioned between the limited services offered by independent living facilities and the more medical and institutional care offered by skilled nursing facilities. The Company seeks to provide high-quality services in its assisted living communities while increasing operating margins primarily by: (i) increasing its focus on occupancy levels throughout the Company's portfolio; (ii) maintaining residents longer by providing programs that offer residents a full range of service options, enabling residents to "age in place" as their needs change; (iii) increasing revenues through modifications in rate structures; and (iv) identifying opportunities to create operating efficiencies and reduce costs. The Company believes its emphasis on quality and continuity of service will enable it to increase its communities' occupancy levels, thereby enhancing revenues. The Company also believes that the physical configuration of its facilities, combined with its diversified levels of service, contributes to resident satisfaction and allows seniors residing at the Company's communities to maintain their dignity and independence.
During 1998 the Company: (i) increased its focus on community operations; (ii) slowed its development and acquisition activities in order to shift its focus from growth to operations; and (iii) disposed of select communities previously
operated at a loss. The Company's increased focus on community operations is primarily the result of continued losses throughout the Company's portfolio and initially lower levels of occupancy than expected at the Company's communities. Since the focus shift to operations, the Company has generated substantial occupancy gains in its communities. Occupancy at December 31, 1998 was 81% compared to 72% at December 31, 1997. In addition, average occupancy for 1998 was 77% compared to 73% for 1997.
The Company's slowed development and acquisition activities in 1998 decreased the Company's financial obligations thereby releasing its resources for other purposes. These additional resources enabled the Company to refine and improve community operations. The Company opened five newly developed communities in 1998 compared to 20 in 1997 and 11 in 1996. In addition, the Company acquired only two communities in 1998, compared to seven in 1997 and 35 in 1996.
In an effort to reduce the impact of start-up losses from acquired and newly developed communities on its current portfolio, the Company began a major restructuring of its portfolio during 1998. This restructuring included an evaluation by the Company of the financial performance of its communities. For those communities with significant losses, the Company negotiated their sale of with buyers focused on the real estate component while the Company retained its focus on the operations through management agreements.
To that end, in 1998 the Company disposed of interests in three assisted living communities to related parties, but has retained management agreements with respect to each community. These dispositions will generate expected management fees of $450,000 in 1999 versus 1998 net losses of $5.0 million. The Company retains a 20% interest in one community and holds notes that are convertible into a 20% interest in one other community.
In addition, effective December 31, 1998, the Company completed a transaction whereby a related entity acquired 22 assisted living communities previously leased by the Company from Meditrust and three communities previously owned by the Company for a combined purchase price of approximately $168 million (the "Emeritrust transaction"). The Company is continuing to operate all 25 communities pursuant to a three year management agreement and will receive management fees equal to 5% of revenues, as well as an additional 2% of revenues contingent on such communities achieving positive cash flows. In addition, the Company has an option and a right of first refusal to purchase the 22 previously leased communities and the three previously owned communities, respectively, during the three year period at a purchase price equal to the original cost to the entity plus an amount calculated to provide the entity with a specified rate of return on its invested capital. The combined transaction will accomplish several strategic objectives for the Company including: (i) expected management fee income of $2.5 million in 1999 versus 1998 losses from operations from these communities of $11.0 million and (ii) an immediate improvement of approximately $800,000 in monthly cash flow from operations. Daniel R. Baty, the Company's Chairman and Chief Executive Officer, and William E. Colson, a director, have financial interests in the entity that is a party to this arrangement.
In March 1999, the Company also completed the disposition of its leasehold interest in an additional 19 communities, consisting of 14 currently operational communities and five development communities (the "Emeritrust II communities") to a related entity in a similar transaction. The Company will continue to operate the Emeritrust II communities pursuant to a three year management contract and will receive management fees equal to 5% of revenues, as well as an additional 2% of revenues contingent on such communities achieving positive cash flows. In addition, the Company has an option to purchase the 19 communities during the three year period at a purchase price equal to the original cost to the entity plus an amount calculated to provide the entity with a specified rate of return on its invested capital. Management fee income of $1.8 million is expected to be generated from the 19 Emeritrust II communities in 1999 compared to 1998 net losses from these communities of approximately $300,000.
ACQUISITIONS
The Company has previously acquired, and will consider acquiring, if attractive opportunities are made available, existing assisted living communities. In evaluating possible acquisitions, the Company considers, among other factors: (i) location, construction quality, condition and design of the facility, (ii) the ability to generate revenue and cash flow and increase occupancy; (iii) costs of repositioning the community; and (iv) the extent to which the acquisition will complement the Company's existing portfolio of communities.
In certain circumstances the Company has acquired, and may continue to acquire, independent living and skilled nursing facilities that, for various reasons, it does not reposition as assisted living communities. The Company leases one Medicare Certified skilled nursing facility (Heritage Health) pursuant to a multi-facility acquisition completed in February 1996. Due to the nature of sub-acute care services required in this skilled nursing facility, the Company has engaged third party managers who have the expertise and systems to operate a facility in this line of business. These acquisitions will, however, generally be incidental to the Company's overall focus on assisted living communities, and the Company will typically seek over time to divest itself of the ownership or operation of properties that are inconsistent with its assisted living focus. There can be no assurance however, that the Company will successfully operate such independent living or skilled nursing facilities in the interim, that it will be able to locate qualified purchasers or operators of such facilities or that the terms on which it transfers ownership or operation of such facilities will be advantageous to the Company.
DEVELOPMENT
In 1998, the Company slowed its development activities in order to increase its focus on operations. In 1998 and 1997, the Company began operating five and 20 newly developed communities in which it has leasehold or ownership interests, respectively. The Company currently anticipates opening five additional developments in 1999, all of which will be disposed as part of the Emeritrust II transaction . See "Factors Affecting Future Results and Regarding Forward-Looking Statements --Ability to Develop Additional Assisted living Communities" and "--Need for Additional Capital" for a description of factors that could affect the Company's rate of development.
MANAGEMENT AGREEMENTS
The Company has entered into agreements whereby it manages or provides administrative services for assisted living communities and independent living communities owned or leased by others. The Company currently provides management services for a total of 42 communities, representing 1999 annualized income of approximately $2.8 million. Eight of these communities are owned by Columbia House I, Limited Partnership ("Columbia House"), which is partially owned indirectly by the Company's Chairman and Chief Executive Officer. See "Strategic Relationships --Columbia House Relationship."
In conjunction with the closing of the Emeritrust transaction, the Company also operates 25 communities pursuant to a three year management agreement and will receive management fees equal to 5% of revenues, as well as an additional 2% of revenue contingent on such communities achieving positive cash flows. See "--Operating Strategy."
ADMINISTRATION
The Company employs an integrated structure of management, financial systems and controls to maximize operating efficiency and contain costs. In addition, the Company has developed the internal procedures, policies and standards it believes are necessary for effective operation and management of its assisted living communities. The Company has recruited experienced key employees from several established operators in the long-term-care services field and believes it has assembled the administrative, operational and financial personnel that will enable it to continue to manage its operating strategies effectively.
The Company has established Central, Eastern and Western Operational Divisions. Each division is headed by a divisional director who reports to the Company's Vice President of Operations. Each division is comprised of several operating regions headed by a regional director who provides management support services for each of the communities in his/her respective region. Day to day community operations are supervised by an on-site community director who, in certain jurisdictions, must satisfy certain licensing requirements. The Company provides management support services to each of its residential communities, including establishing operating standards, recruiting, training, and financial and accounting services.
The Company has centralized finance and other operational functions at its headquarters in Seattle, Washington in order to allow community-based personnel to focus on resident care. The Seattle office as a whole is responsible for: establishing Company-wide policies and procedures; financial and marketing functions; management of the Company's acquisition and development activities; and providing overall strategic direction to the Company.
INFORMATION TECHNOLOGY
The Company utilizes a blend of centralized and decentralized accounting and computer systems that link each community with the Company's headquarters. These systems enables the Company to closely monitor operating costs and quickly distribute financial and operating information to appropriate levels of management in a cost efficient manner. Management believes that its current data systems are adequate for current operations and provide the flexibility to meet the continued growth of its operations without disruption or significant modification to existing systems through fiscal year 1999. The Company uses high quality hardware and operating systems from current and proven technologies to support its current technology infrastructure. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Year 2000".
INTERNATIONAL EXPANSION
Demographic trends in Japan suggest a tremendous future need for assisted living services as part of the health care system. The percentage of Japanese citizens over the age of 65 is expected to increase from 7.1% in 1970 to 23.3% by 2010. In April 1998 the Company entered into a joint venture, Sanyo Emeritus Corporation, with Sanyo Electric Company, Ltd. ("Sanyo") of Osaka, Japan to provide assisted living services in Japan. The Company's first assisted living community in Japan is under construction and is anticipated to open in December 1999. The community will be among the first assisted living communities in Japan to offer private apartments on a month-to-month rental. See "Strategic Relationships--Sanyo Relationship".
BRANDING
In 1998, the Company developed a brand concept for the Company's communities. The Company adopted the "Loyalton" name for its newly developed communities as well as selected existing communities. The Company believes that this branding will allow its residents, shareholders and employees to develop some brand loyalty and recognition of the Emeritus and Loyalton name throughout the Company's markets.
MARKETING AND REFERRAL RELATIONSHIPS
The Company's operating strategy is designed to integrate its assisted living communities into the continuum of healthcare providers in the geographic markets in which it operates. One objective of this strategy is to enable residents who require additional healthcare services to benefit from the Company's relationships with local hospitals, home healthcare agencies and skilled nursing facilities in order to obtain the most appropriate level of care. Thus, the Company seeks to establish relationships with local hospitals (including through joint marketing efforts, where appropriate) and home healthcare agencies, alliances with visiting nurses associations and, on a more limited basis, priority transfer agreements with local, high-quality skilled nursing facilities. In addition to benefiting residents, the implementation of this operating strategy has strengthened and expanded the company's network of referral sources.
Of the Company's 117 Operating Communities and 17 Development Communities, 29 are located in markets or proposed markets in which Holiday also operates its independent living facilities. The Company believes that its assisted living communities will offer an attractive alternative for Holiday residents as they age and require more extensive services. The Company and Holiday do not have any formal understanding or written agreement regarding joint marketing programs. As a result, there can be no assurance that joint marketing programs envisioned with Holiday will be effected. Furthermore, there can be no assurance that, if effected, such joint marketing programs will be successful in attracting additional residents to the Company's assisted living communities or that the Company's and Holiday's interest will be compatible in the future. See "Strategic Relationships --Holiday Relationship".
STRATEGIC RELATIONSHIPS
ALERT RELATIONSHIP
In November 1996, the Company agreed to purchase up to 6,888,466 shares of convertible preferred stock of Alert Care Corporation ("Alert"), an Ontario, Canada based owner and operator of assisted living communities at prices ranging from $0.67 to $0.74 per share (Cdn). In addition, the Company acquired an option to purchase an additional 4,000,000 shares of convertible preferred stock at an exercise price of $1.00 per share (Cdn), as well as an option to purchase from Eclipse Capital Management ("Eclipse"), the majority shareholder of Alert, and certain other shareholders of Alert, 9,050,000 issued and outstanding shares of common stock of Alert and 950,000 issued and outstanding shares of Class A non-voting stock of Alert both at an exercise price of $3.25 per share (Cdn). If all options were exercised, the Company would own 60.0% of Alert.
Each Preferred Share is convertible into one common share or one Class A nonvoting share, at the holder's election; the Preferred Shares are immediately convertible into Class A nonvoting shares but are not immediately convertible into common shares and are so convertible only after the controlling persons of Alert have transferred to others (which could include the Company) not less than 10 million shares of common or Class A nonvoting shares (as of March 23, 1999 there are approximately 23.9 million such shares outstanding) and such controlling persons are relieved of certain guarantees of indebtedness.
As of December 31, 1996, the Company had purchased and held 2,577,692 shares of preferred stock for a total investment of $1,800,000 (Cdn) or $1,331,000 (US). In 1997, the Company purchased an additional 5,010,774 shares of preferred stock increasing its ownership to 7,588,466 shares or $4,111,000 (US). As of December 31, 1997, the Company's total investment in Alert represented on an as-converted basis approximately 24.2% of the outstanding common and Class A nonvoting shares combined. In 1998, the Company purchased an additional 3,300,000 shares of preferred stock resulting in an ownership interest of 31.3% or 10,888,466 shares.
Alert has entered into an exclusive management agreement to manage the Company's future assisted living communities in Ontario. Eclipse, through its wholly-owned subsidiary, Eclipse Construction Inc., develops and constructs retirement homes for Alert on a contract basis. Under the agreement, Eclipse has entered into an exclusive development agreement with the Company and Alert to develop their future construction projects in Ontario. No communities have been developed under these agreements as of March 23, 1999.
COLUMBIA HOUSE RELATIONSHIP
Columbia House I, Limited Partnership ("Columbia House"), a Washington limited partnership in which Mr. Baty, the Company's Chairman and Chief Executive Officer indirectly controls the general partner and in which Mr. Baty holds an indirect 60% interest, develops, owns and leases low income senior housing projects. The Company has entered into agreements with Columbia House to provide certain administrative support, due diligence and financial support services to Columbia House with respect to the acquisition, development and administration of Columbia House communities. The Company currently manages eight communities owned by Columbia House consisting of approximately 720 units and provides administrative services for another community consisting of approximately 100 units.
HOLIDAY RELATIONSHIP
Twenty-nine of the Company's Operating Communities are located near existing or proposed independent living facilities operated by Holiday. The Company believes that its focus on expanding in locations near Holiday facilities will often enable it to gauge the need for its services in a particular market by evaluating Holiday's operating performance, and that successful Holiday facilities will generally reflect the combination of criteria required for a successful assisted living community. In addition, the Company believes that, as a result of Mr. Baty's close relationship with Holiday, opportunities may arise for (i) development of assisted living communities on sites near existing or proposed Holiday independent living facilities and (ii) joint marketing programs for attracting residents to the Company's assisted living communities and Holiday's independent living facilities, depending on the level of services required. The Company and Holiday have no written agreement or formal understanding concerning their relationship, and there can be no assurance that opportunities for such development or joint marketing programs will arise and that the Company's and Holiday's interests will be compatible in the future. In February 1998, the Company and a Holiday affiliate entered into four management agreements whereby a Holiday affiliate will provide management services relating to four assisted living communities located in Texas and developed by the Company. The Company sold interests in three of these communities in conjunction with the Emeritrust transaction, but Holiday will continue to manage all four properties in accordance with the original management agreements. The agreements consist of initial terms of two years six months and management fees based on 6% of gross revenues payable monthly. Mr. Baty and Mr. Colson, a director of the Company are the principal shareholders, directors and senior executive officers of Holiday, and substantially all the independent living facilities operated by Holiday are owned by partnerships controlled by Messrs. Baty and Colson and in which they have varying financial interests.
NORTHSTAR RELATIONSHIP
In October 1997, NorthStar Capital Partners LLC ("NorthStar"), a private investment group with financial backing from a Union Bank of Switzerland Securities affiliate and Quantum Realty Partners, a fund advised by Soros Fund Management LLC, invested $25.0 million in the Company through the purchase of 25,000 shares of Series A Convertible Exchangeable Redeemable Preferred Stock (the "Series A Preferred Stock"), representing approximately 10% ownership in the Company. Each share of Series A Preferred Stock is convertible into that number of shares of the Company's Common Stock equal to the liquidation value of a share of Series A Preferred Stock ($1,000) divided by the conversion price of $18.20 per share. Currently the Series A Preferred Stock is convertible into an aggregate of 1,373,626 shares of Common Stock. The Series A Preferred Stock is also exchangeable into convertible debt at the option of the Company. The conversion price is subject to adjustment in the event of stock dividends, stock subdivisions and combinations, and extraordinary distributions. The Series A Preferred Stock provides for cumulative quarterly
dividend payments of 9% and has a mandatory redemption date of October 24, 2004.
PAINTED POST PARTNERS RELATIONSHIP
During 1995, the Company's two most senior executive officers, CEO and then current President, formed a New York general partnership (the "Partnership") to facilitate the operation of assisted living communities in the state of New York, which generally requires that natural persons be designated as the licensed operators of assisted living communities. The Company and the Partnership have entered into Administrative Services Agreements that extend for the term of the underlying leases. The fees payable to the Company under the Administrative Services Agreements have been established at a level that would equal or exceed the profit of the community operated efficiently at full occupancy and, unless reset by agreement of the parties, will rise automatically on an annual basis in accordance with changes in the Consumer Price Index. In addition, the Company has agreed to indemnify the partners against losses, and in exchange, the partners have agreed to assign any profits to the Company. As a part of the general non-competition agreements of the CEO and former President, each has agreed that in the event he were to cease as a senior executive of the Company, he would transfer his interest in the Partnership for a nominal charge to his successor at the Company or other person designated by the Company.
SANYO RELATIONSHIP
In April 1998, the Company entered into a joint venture with Sanyo to provide assisted living services in Japan. The joint venture, Sanyo Emeritus Corporation ("Sanyo Emeritus"), has been formed to provide a residential based health care alternative for Japan's growing elderly population. Sanyo Emeritus was initially capitalized with Y50 million ($384,000 US), with the Company and Sanyo each providing half the funds. The joint venture's first assisted living community in Japan is under construction and is anticipated to open in late 1999. Similar to the United States, the elderly population in Japan is experiencing dramatic growth. The percentage of Japan's citizens over 65 years of age is expected to increase from 7.1% in 1970 to 23.3% by 2010. In 1999, the Japanese Government is changing the current reimbursement system and the Company expects that assisted living services will be an integral part of this new system thereby offering Japan's elderly greater flexibility in choosing their health care.
COMPETITION
The number of assisted living communities in the United States, the ownership of which is fragmented, is increasing rapidly. As the assisted living industry continues to grow, fewer attractive development sights may be available. This market saturation could have an adverse effect on the Company's newly developed communities and their ability to reach stabilized occupancy levels. Moreover, the senior housing services industry has been subject to pressures that have resulted in the consolidation of many small local operations into larger regional and national multi-facility operations. While there are several national and regional companies that provide senior living alternatives, the Company anticipates that its primary source of competition will originate from local and regional assisted living companies that operate, manage and develop residences within the same geographic area as the Company, as well as retirement facilities and communities, home healthcare agencies, not-for-profit or charitable operators and, to a lesser extent, skilled nursing facilities and convalescent centers. The Company believes that quality of service, reputation, a facility's location, physical appearance and price will be significant competitive factors. Some of the Company's competitors have significantly greater resources, experience and recognition within the healthcare community than does the Company.
EMPLOYEES
As of December 31, 1998, the Company had 5,108 employees, including 3,627 full time employees, of which 92 were employed at the Company's headquarters. None of the Company's employees are currently represented by a labor union, and the Company is not aware of any union-organizing activity among its employees. The Company believes that its relationship with its employees is good.
Although the Company believes it is able to employ sufficiently skilled personnel to staff the communities it operates or manages, a shortage of skilled personnel in any of the geographic areas in which it operates could adversely affect the Company's ability to recruit and retain qualified employees and control its operating expenses.
TRADEMARKS
The Registration of the Company's FlexAssist service mark was granted in February 1997.
FACTORS AFFECTING FUTURE RESULTS AND REGARDING FORWARD-LOOKING STATEMENTS
The Company's business, results of operations and financial condition are subject to many risks, including, but not limited to, those set forth below. In addition, the following important factors, among others, could cause the Company's actual results to differ materially from those expressed in the Company's forward-looking statements in this report and presented elsewhere by management from time to time. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. A number of the matters and subject areas discussed in this report are not historical or current facts and refer to potential future circumstances, operations, and prospects. The discussion of such matters and subject areas is qualified by the inherent risks and uncertainties surrounding future expectations generally, and also may materially differ from the Company's actual future experience involving any one or more of such matters and subject areas relating to demand, pricing, competition, construction, licensing, construction delays on new developments contractual and licensure, and other delays on the disposition of assisted living communities in the Company's portfolio, and the ability of the Company to continue managing its costs while maintaining high occupancy rates and market rate assisted living charges in its assisted living communities. The Company has attempted to identify, in context, certain of the factors that they currently believe may cause actual future experience and results to differ from the Company's current expectations regarding the relevant matter or subject area. The Company undertakes no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.
RECENT ORGANIZATION; HISTORY OF LOSSES
The Company was organized and began operations in July 1993 and has operated at a loss since its inception. For 1997 and 1998, the Company recorded a net loss of $28.2 million and $31.0 million, respectively. These historical losses are attributable to the growth in the size of the Company's portfolio fueled by both acquisitions and developments. The majority of the acquired Operating Communities operate at a loss following acquisition and the Company expects such facilities to continue to operate at a loss for at least 12 to 18 months after the date of acquisition. Although the Company has slowed its development activities, it continues to develop new assisted living communities, all of which are expected to incur start-up losses for at least 12 months after commencing operations. As a result, the Company expects to continue to incur losses at least through the end of 1999. In an effort to reduce the impact of start-up losses from acquired and newly developed communities on its current portfolio, the Company began a major restructuring of its portfolio during 1998, selling its ownership and lease interests in 28 communities which represented net losses of $12.7 million and $16.5 million or 45% and 54% of the Company's 1997 and 1998 net losses, respectively. Continuing with this trend, in March 1999, the Company completed a disposition of an additional 19 communities with aggregate 1998 net losses of $300,000. See "Company Operations - Operating Strategy". There can be no assurance, however, that the Company's operations will become profitable at the rate currently expected by the Company, or at all. The Company's inability to achieve profitability on a timely basis could have an adverse effect on the Company's business, operating results, financial condition and the market price of its Common Stock.
DIFFICULTIES INCREASING AND STABILIZING OCCUPANCY RATES; DIFFICULTIES CONTAINING COSTS
Prior to the second quarter of 1998 the Company had experienced challenges regarding its ability to increase occupancy levels as well as its ability to match variable cost levels with occupancy. The Company's losses are partially the result of lower than expected occupancy levels at the Company's newly developed and acquired communities. In addition, the Company incurred higher than expected variable costs as it established staffing and other costs configurations to fluctuate effectively with occupancy. The Company has increased occupancy levels significantly in the last three quarters of 1998, filling more than 1,500 units. The Company has also improved and streamlined a cost containment program geared at matching costs with occupancy levels. However, there is no assurance that occupancy levels will continue to increase at the rate currently expected by the Company, or at all or that cost levels will continue to vary according to occupancy levels. The Company's inability to increase occupancy levels or to control costs throughout its portfolio could have an adverse effect on the Company's business, financial condition and operating results.
SUBSTANTIAL DEBT AND LEASE OBLIGATIONS OF THE COMPANY
At December 31, 1998, the Company had mortgage indebtedness in an aggregate amount of $125.4 million, with minimum principal payments estimated to be approximately $12.6 million in 1999. As of December 31, 1998, approximately $108.4 million principal amount of the Company's indebtedness bore interest at fluctuating rates; therefore, increases in prevailing interest rates would increase the Company's interest payment obligations and could have an adverse effect on the Company's operating results and financial condition. At December 31, 1998, the Company was also a party to long-term operating leases for 52 of its residential communities, which require minimum annual lease payments estimated to be approximately $29.8 million in 1999. In addition, the Company will have approximately $13.3 and $75.1 million in principal amount of debt repayment obligations that become due in 2000 and 2001, respectively. The Company intends to continue to finance its properties through a combination of mortgage financing and operating leases, including leases arising through sale/leaseback transactions. As a result of such mortgages and leases, a substantial portion of the Company's cash flow will be devoted to debt service and lease payments. There can be no assurance that the Company will generate sufficient cash flow from operations to cover required interest, principal and lease payments. Furthermore, from time to time the Company has not been in compliance with certain covenants in its financing agreements. While to date the Company has been able to obtain waivers for such noncompliance, there can be no assurance that in the future it will be able to comply with such covenants, which generally relate to matters such as cash flow and debt coverage ratios. If the Company were unable to meet interest, principal or lease payments, it could be required to re-negotiate such payments or obtain additional equity or debt financing. There can be no assurance, however, that such efforts would be successful or timely or that the terms of any such financing or refinancing would be acceptable to the Company. Furthermore, because of cross-default and cross-collateralization provisions in certain of the Company's mortgage and sale/leaseback agreements, a default by the Company on one of its payment obligations could adversely affect a significant number of the Company's properties. The Company's leverage may also adversely affect the Company's ability to respond to changing business and economic conditions or continue its development and acquisition program.
NEED FOR ADDITIONAL CAPITAL; NEGATIVE CASH FLOW AND FINANCING REQUIREMENTS
The Company has experienced negative operating cash flow due to its significant developments and acquisitions of assisted living communities since its inception. The Company expects its newly developed assisted living communities to generate positive cash flow nine to twelve months after commencing operations. In addition, the Company expects that the properties it acquires for repositioning as assisted living communities will typically require at least 12 months to 18 months after acquisition to begin to generate positive cash flows. In an effort to reduce the impact of start-up losses from acquired and newly developed communities on its current cash flow, the Company began a major restructuring of its portfolio during 1998, selling its ownership and lease interests in 28 communities. See "Company Operations - Operating Strategy". There can be no assurance that any newly developed or repositioned community will achieve a stabilized occupancy rate and resident mix that meets the Company's expectations, generate positive cash flow or operating results sufficient to allow the Company to refinance outstanding indebtedness secured by the community through sale/leaseback transactions. The Company's future success depends in part on arranging sale/leaseback financing or mortgage refinancing for assisted living communities that have achieved stabilized occupancy rates, resident mix and operating margins after initial development or repositioning. The Company will from time to time seek additional funding through public or private financing, including equity financing. If additional funds are raised by issuing equity securities, the Company's shareholders may experience dilution. There can be no assurance, however, that adequate equity, debt or sale/leaseback financing will be available as needed or on terms acceptable to the Company. A lack of available funds may require the Company to delay, scale back or eliminate all or some of its development and acquisition projects.
CONFLICTS OF INTEREST WITH HOLIDAY
Mr. Baty, the Company's Chief Executive Officer, and Mr. Colson, a director of the Company, are the principal shareholders, directors and senior executive officers of Holiday, and substantially all the independent living facilities operated by Holiday are owned by partnerships controlled by Messrs. Baty and Colson and in which they have varying financial interests. Messrs. Baty's and Colson's responsibilities to Holiday and its affiliates include overseeing the management of independent living facilities, the acquisition, financing and refinancing of existing facilities and the
development and construction of, and capital-raising activities to finance new facilities. Although the Company believes that its relationship with Holiday is beneficial, the financial interests and management and financing responsibilities of Messrs. Baty and Colson, with respect to Holiday and its affiliated partnerships could present conflicts of interest, including conflicts relating to the selection of future development or acquisition sites, competition for potential residents in markets where both companies operate and the allocation of time and efforts of Mr. Baty. Because Mr. Baty is the Chief Executive Officer of the Company and a principal executive officer of Holiday, circumstances could arise that would distract him from the Company's operations, which distractions could have an adverse effect on the Company's business, operating results and financial condition. Moreover, there can be no assurance that the Company's and Holiday's interests will remain compatible.
DEPENDENCE ON SENIOR MANAGEMENT AND SKILLED PERSONNEL
The Company depends, and will continue to depend, on the services of Daniel R. Baty, its Chairman of the Board and Chief Executive Officer. The loss of the services of Mr. Baty could have a material adverse effect on the Company's operating results and financial condition. Mr. Baty has financial interests in and management responsibilities with respect to Holiday and its related partnerships. And, as a result, he will not be devoting his full time and efforts to the Company. Under certain circumstances, Mr. Baty could have conflicts of interest in allocating his time and efforts between the Company and Holiday. The Company has entered into a noncompetition agreement with Mr. Baty but this noncompetition agreement does not limit Mr. Baty's current role with Holiday, or the related partnerships which own or lease properties currently operated by Holiday, so long as assisted living is an incidental component to Holiday's operation or management of independent-living facilities. The Company has obtained a key employee insurance policy covering the life of of Mr. Baty in the amount of $10.0 million. The Company also depends on its ability to attract and retain management personnel who will be responsible for the day-to-day operations of each of its residential communities. If the Company is unable to hire qualified management to operate its assisted living communities, the Company's business, operating results and financial condition could be adversely affected. In March 1999, Raymond R. Brandstrom and Frank A. Ruffo retired from their offices of President and Executive Vice President of the Company, respectively, and will continue consulting on behalf of the Company. Mr. Brandstrom will maintain his involvement in the Company's Board of Directors as Vice Chairman.
POSSIBLE ENVIRONMENTAL LIABILITIES
Under various federal, state and local environmental laws, ordinances and regulations, a current or previous owner or operator of real property may be held liable for the costs of removal or remediation of certain hazardous or toxic substances, including, without limitation, asbestos-containing materials, that could be located on, in or under such property. Such laws and regulations often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of the hazardous or toxic substances. The costs of any required remediation or removal of these substances could be substantial and the liability of an owner or operator as to any property is generally not limited under such laws and regulations, and could exceed the property's value and the aggregate assets of the owner or operator. The presence of these substances or failure to remediate such substances properly may also adversely affect the owner's ability to sell or rent the property, or to borrow using the property as collateral. Under these laws and regulations, an owner, operator or any entity who arranges for the disposal of hazardous or toxic substances such as asbestos-containing materials, at a disposal site may also be liable for the costs of any required remediation or removal of the hazardous or toxic substances at the disposal site. In connection with the ownership or operation of its properties, the Company could be liable for these costs, as well as certain other costs, including governmental fines and injuries to persons or properties. As a result, the presence, with or without the Company's knowledge, of hazardous or toxic substances at any property held or operated by the Company could have an adverse effect on the Company's business, operating results and financial condition.
DEPENDENCE ON ATTRACTING SENIORS WITH SUFFICIENT RESOURCES TO PAY
The Company currently, and for the foreseeable future, expects to rely primarily on its residents' ability to pay the Company's fees from their own or familial financial resources. Generally only seniors with income or assets meeting or exceeding the comparable median in the region where the Company's assisted living communities are located can afford the Company's fees. Inflation or other circumstances that adversely affect the ability of seniors to pay for the Company's services could have an adverse effect on the Company. If the Company encounters difficulty in attracting seniors with adequate resources to pay for its services, its business, operating results and financial condition could be adversely affected.
GOVERNMENTAL REGULATION
Healthcare is heavily regulated at the federal, state and local levels and represents an area of expensive and frequent regulatory change. A number of legislative and regulatory initiatives relating to long-term care are proposed or under study at both the federal and state levels that, if enacted or adopted, could have an adverse effect on the Company's business and operating results. The Company cannot predict whether and to what extent any such legislative or regulatory initiatives will be enacted or adopted, and therefore cannot assess what effect any current or future initiative would have on the Company's business and operating results. Changes in applicable laws and new interpretations of existing laws can significantly affect the Company's operations, as well as its revenues (particularly those from governmental sources) and expenses. The Company's residential communities are subject to varying degrees of regulation and licensing by local and state health and social service agencies and other regulatory authorities specific to their location. While regulations and licensing requirements often vary significantly from state to state, they typically relate to fire safety, sanitation, staff training, staffing levels and living accommodations such as room size, number of bathrooms and ventilation, as well as regulatory requirements relating specifically to certain of the Company's health-related services. The Company's success will depend in part of its ability to satisfy such regulations and requirements and to acquire and maintain any required licenses. In addition, with respect to its residents who receive financial assistance from governmental sources for their assisted living services, the Company is subject to certain federal and state regulations that prohibit certain business practices and relationships that might affect healthcare services reimbursable under Medicaid or similar state reimbursements programs. The Company's failure to comply with such regulations could jeopardize its reimbursement payments for any affected residents and, if excessive, could result in fines and the suspension or failure to renew the Company's operating licenses. Federal, state and local governments occasionally conduct unannounced investigations, audits and reviews to determine whether violations of applicable rules and regulations exist. Devoting management and staff time and legal resources to such investigations, as well as any material violation by the Company that is discovered in any such investigation, audit or review, could have a material adverse effect on the Company's business and operating results. There can be no assurance that regulatory oversight of construction efforts associated with repositionings will not result in loss of residents and disruption of community operations.
LIABILITY AND INSURANCE
The Company's business entails an inherent risk of liability. In recent years, participants in the long-term-care industry have become subject to an increasing number of lawsuits alleging malpractice or related legal theories, many of which involve large claims and significant legal costs. The Company expects that from time to time it will be subject to such suits as a result of the nature of its business. The Company currently maintains insurance policies in amounts and with such coverage and deductibles as it deems appropriate, based on the nature and risks of its business, historical experience and industry standards. There can be no assurance, however, that claims in excess of the Company's insurance coverage or claims not covered by the Company's insurance coverage will not arise. A successful claim against the Company not covered by, or in excess of, the Company's insurance could have a material adverse effect on the Company's operating results and financial condition. Claims against the Company, regardless of their merit or eventual outcome, may also have a material adverse effect on the Company's ability to attract residents or expand its business and would require management to devote time to matters unrelated to the operation of the Company's business. In addition, the Company's insurance policies must be renewed annually, and there can be no assurance that the Company will be able to obtain liability insurance coverage in the future or, if available, that such coverage will be on acceptable terms.
POSSIBLE VOLATILITY OF STOCK PRICE
The market price of the Company's Common Stock could be subject to significant fluctuations in response to various factors and events, including, but not limited to, the liquidity of the market for the Common Stock, variations in the Company's operating results, variations from analysts expectations, new statutes or regulations or changes in the interpretation of existing statutes or regulations affecting the healthcare industry generally or the assisted living residence business in particular. In addition, the stock market in recent years has experienced broad price and volume fluctuations that often have been unrelated to the operating performance of particular companies. These market fluctuations also may adversely affect the market price of the Common Stock.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
PROPERTIES
The Company's assisted living communities generally consist of one- to three-story buildings and include common dining and social areas. Twenty-two of the Company's Operating Communities offer independent living services and four are operating as skilled nursing facilities.
The table below summarizes certain information regarding the Operating Communities.
* Near an existing or proposed Holiday facility.
+ Currently offers independent living services.
# Currently operates as a skilled nursing facility.
(a) A unit is a single- or double-occupancy residential living space, typically an apartment or studio.
(b) "Beds" reflects the actual number of beds, which in no event is greater than the maximum number of licensed beds allowed under the community's license.
(1) The Company provides administrative services to the community which is operated by Painted Post Partnership through a lease agreement with an independent third party. See "Strategic Relationships - Painted Post Partners Relationship".
(2) The interest in this community has been sold effective 12/31/98, but Emeritus will manage the buildings pursuant to a three year management contract.
(3) The interest in this community has been sold pursuant to the consummation of Emeritrust II. See "Company Operations - Operating Strategy".
DEVELOPMENTS
The following table summarizes certain information regarding the Development Communities under construction, which are communities where construction activities, such as ground-breaking activities, exterior construction or interior build-out have commenced.
* Near an existing or proposed Holiday facility.
(a) A unit is a single- or double-occupancy residential living space, typically an apartment or studio.
(b) "Beds" reflects the actual number of beds, which in no event is greater than the maximum number of licensed beds allowed under the community's license.
(1) The interest in this community has been sold pursuant to the consummation of Emeritrust II.
The Company's executive offices are located in Seattle, Washington, where the Company leases approximately 26,500 square feet of space. The agreement includes a lease term of 10 years with two five-year renewal options.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On April 24, 1998, the Company commenced a lawsuit against ARV Assisted Living Inc. ("ARV") in Superior Court of the State of California for the County of Orange alleging that share purchases on January 16, 1998 by Prometheus Assisted Living LLC ("Prometheus") triggered the so-called flip-in feature of ARV's poison pill.
The effect of the flip-in feature having been triggered by Prometheus is to require ARV to distribute to all shareholders (other than Prometheus) certificates for one Right per share owned on January 16, 1998. The Company believes that each Right would be exercisable for approximately 9.56 shares at a purchase price of $7.32 per share. The Rights are exercisable until August 8, 2007 and are transferable separate from the ARV common stock.
In connection with Prometheus' initial investment in ARV in July 1997, ARV adopted a Rights Agreement (commonly referred to as a poison pill) which provides that the flip-in feature is triggered if Prometheus acquires "beneficial ownership" of 50% or more of ARV's outstanding common stock. The flip-in is a defensive feature intended to discourage accumulation of control of stock in excess of a specified level by allowing all shareholders other than the acquiror to purchase additional common stock at a 50% discount to the average closing market price of ARV's stock for the 30 trading days prior to the flip-in being triggered.
In a Schedule 13D filing on January 20, 1998, Prometheus disclosed that on January 16th it had acquired additional shares of ARV common stock, increasing Prometheus' direct share ownership to 45% of the outstanding ARV common stock. Previous Schedule 13D filings by Prometheus disclose that Prometheus also then beneficially owned another 9% of ARV's common stock as a result of the Stockholders' Voting Agreement dated October 29, 1997, between Prometheus and certain management stockholders of ARV (collectively, the "Management Stockholders"). Under the Stockholders' Voting Agreement, each Management Stockholder agreed with Prometheus to vote its shares of ARV common stock in support of Prometheus' nominees to ARV's Board of Directors.
The Company' complaint alleges that the Stockholders' Voting Agreement increases Prometheus' beneficial ownership from its 45% direct ownership to 54%, thereby triggering the flip-in feature of the poison pill. For purposes of determining Prometheus' beneficial ownership, the Rights Agreement treats Prometheus as beneficially owning shares held by "any other person with which Prometheus has any agreement, arrangement or understanding whether or not in writing, for the purpose of acquiring, holding, voting or disposing of any securities of ARV."
The Company' complaint seeks the following injunctive and declaratory relief: (i) an order directing ARV to distribute Right Certificates to all holders of common stock of ARV (other than Prometheus) as of January 16, 1998; and (ii) an order declaring that a "Trigger Event" (as defined in the Rights Agreement) occurred on January 16, 1998 when Prometheus acquired beneficial ownership of more than 50% of ARV's common stock.
Prometheus is an investment vehicle controlled by Lazard Freres Real Estate Investors L.L.C. ("Lazard"). Lazard's activities consist principally of acting as general partner of several real estate investment partnerships affiliated with Lazard Freres & Co. LLC.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not submit any matter to a vote of its security holders during the fourth quarter of its fiscal year ended December 31, 1998.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information about the executive officers of the Company. There are no family relationships between any of the directors or executive officers of the Company.
Daniel R. Baty, one of the Company's founders, has served as its Chief Executive Officer and as a director since inception in 1993 and became Chairman of the Board in April 1995. Mr. Baty has served as the chairman of the board of Holiday since 1987 and as its chief executive officer from 1991 through September 1997. Since 1984, Mr. Baty has served as chairman of the board of Columbia-Pacific Group Inc. ("Columbia Pacific") and, since 1986, chairman of the board of Columbia Pacific Management, Inc. ("Columbia Management"), both of which companies are wholly owned by Mr. Baty and engaged in developing independent-living facilities and providing consulting services regarding that market.
Gary D. Witte, joined the Company as Vice President, Operations in November 1996. From 1985 to June 1996, he was Vice President of Operations, Southern Region of Hillhaven/Vencor Corporation. Mr. Witte held a variety of operating positions at that company for 20 years.
Kelly J. Price has served as the Company's Vice President since February 1997, as Chief Financial Officer and Secretary since September 1995 and as Principal Accounting Officer since February 1998. Prior to that, from January 1995 he was the Company's Director of Finance. From September 1991 until joining the Company, Mr. Price was employed at Deloitte & Touche LLP in both the Management Consulting and Accounting practice, last serving as a senior consultant in the real estate and healthcare industries.
Sarah J. Curtis, jointed the Company as Vice President of Sales and Marketing in March 1997. Prior to that, from March 1996 she was National Director of Sales for Beverly Enterprises, Inc. From July 1991 until February 1996 Ms. Curtis was Regional Director of Sales and Marketing of Hillhaven/Vencor Corporation.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the American Stock Exchange, Inc. ("AMEX") under the symbol "ESC". The Common Stock has been listed on the AMEX since November 21, 1995, the date of the Company's initial public offering.
The following table sets forth, for the periods indicated, the high and low closing prices for the Common Stock as reported on AMEX.
As of March 26, 1999, the number of record holders of the Company's Common Stock was 160.
The Company has never declared or paid any dividends on its Common Stock, and expects to retain any future earnings to finance the operation and expansion of its business. Future dividend payments will depend on the results or operations, financial condition, capital expenditure plans and other obligations of the Company and will be at the sole discretion of the Company's Board of Directors. Certain of the Company's existing leases and lending arrangements contain provisions that restrict the Company's ability to pay dividends, and it is anticipated that the terms of future leases and the debt financings may contain similar restrictions. Therefore, the Company does not anticipate paying any cash dividends on its Common Stock in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data have been derived from the audited consolidated financial statements of the Company and subsidiaries for the years ended December 31, 1994, 1995, 1996, 1997 and 1998. The data set forth below should be read in conjunction with the consolidated financial statements and related notes thereto included elsewhere in the Form 10-K and "Management's Discussion and Analysis of Financial Condition and Results of Operations.
(1) The weighted average shares outstanding were retroactively adjusted for the 9,200-for-1 split on April 14,1995.
(2) Information is as of the end of the period and excludes the Operating Communities and units therein that are managed by others.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Emeritus is a nationally integrated senior housing services organization focused on operating residential-style assisted living communities. The Company is one of the largest and most experienced providers of assisted living communities in the United States. These communities provide a residential housing alternative for senior citizens who need help with the activities of daily living, with an emphasis on assisted living and personal care services.
The Company's revenues are derived primarily from rents and service fees charged to its residents. For 1996, 1997 and 1998, the Company generated total operating revenues of $68.9 million, $117.8 million and $151.8 million, respectively. As of December 31, 1998, the Company's accumulated deficit was $80.5 million and its total shareholders' deficit was $46.0 million. For 1996, 1997 and 1998, the Company incurred losses of $8.2 million, $28.6 million and $28.8 million (excluding the extraordinary item and a charge related to the cumulative effect of a change in accounting principle in 1998), respectively.
The Company's losses to date result from a number of factors. These factors include, but are not limited to: the development of 48 and acquisition of 69 assisted living communities since inception that incurred operating losses during the initial 12 to 24 month rent-up phase; initially lower levels of occupancy at the Company's communities than originally anticipated; financing costs arising from sale/leaseback transactions and mortgage financing; refinancing transactions at proportionately higher levels of debt; and increased administrative and corporate expenses to facilitate the Company's growth.
During 1998 the Company adopted an operating strategy focused on: 1) increasing occupancy throughout the Company's portfolio, 2) reducing acquisition and development activities and 3) disposing of select communities operating at a loss. Occupancy at December 31, 1998 increased 9% to 81% compared to 72% at December 31, 1997. In addition, average occupancy increased 4% to 77% for 1998 compared to 73% for 1997. The Company has significantly reduced its acquisition and development activities during 1998. The Company acquired 36 and 10 communities in 1996 and 1997, respectively, and two communities during 1998. In addition, the Company opened 11, 20 and five development communities in 1996, 1997 and 1998 respectively. Slowing its acquisition and development activities has enabled the Company to utilize its resources more efficiently and increase its focus on community operations. During 1998 the Company disposed of its interests in 28 communities, 22 of which were leased from Meditrust. The Company retains a management interest in all 28 facilities through three year management contracts and has an option and a right of first refusal to purchase 22 and three of these facilities, respectively, during this three year period. In addition, the Company has disposed of its leasehold interests in an additional 19 communities during the first quarter of 1999.
As of March 23, 1999, the Company held ownership, leasehold or management interests in 117 residential communities (the "Operating Communities") consisting of approximately 10,400 units with the capacity for 12,000 residents, located in 29 states. Of the 117 Operating Communities, 20 and 11 newly developed communities were opened during 1997 and 1998, respectively. The Company owns, has a leasehold interest in, management interest in or has acquired an option to purchase development sites for 17 new assisted living communities (the "Development Communities"). Of the Development Communities, 13 are scheduled to open during 1999, the remainder in 2000. The Company leases 53 of its residential communities, typically from a financial institution such as a Real Estate Investment Trust ("REIT"), owns 15 communities, manages or provides administrative services for 41 communities and has a partnership interest or joint venture in seven communities. Additionally, the Company holds a minority interest in Alert Care Corporation ("Alert"), an Ontario, Canada based owner and operator of 21 assisted living communities consisting of approximately 1,200 units with a capacity of approximately 1,300 residents. See "--Strategic Relationships - Alert Relationship". Assuming completion of the Development Communities scheduled to open throughout 1999 and including the minority interest in Alert, the Company will own, lease, have an ownership or partnership interest in, joint venture or manage 151 properties in 29 states, Canada and Japan, containing an aggregate of approximately 12,900 units with capacity of over 14,500 residents. There can be no assurance, however, that the Development Communities will be completed on schedule and will not be affected by construction delays, the effects of government regulation or other factors beyond the Company's control." The Company's management of assisted living communities owned or leased by others has not been material to the Company's business or revenue.
The following table sets forth a summary of the Company's property interests.
RESULTS OF OPERATIONS
The following table sets forth, for the years indicated, certain items of the Company's Consolidated Statements of Operations as a percentage of total revenues and the percentage change of the dollar amounts from year to year.
COMPARISON OF THE YEARS ENDED DECEMBER 31, 1998 AND 1997
REVENUES. Total operating revenues for 1998 were $151.8 million, reflecting a $34.0 million increase, or 29% compared to $117.8 million for 1997. The increase is primarily due increased occupancy throughout the Company's portfolio. Occupancy at December 31, 1998 increased 9% to 81% compared to 72% as of December 31, 1997. Furthermore, average occupancy for 1998 was 77% compared to 73% for 1997, an increase of 4%. In addition to the increase in occupancy, the Company opened five newly developed communities in 1998 which accounted for a $3.0 million increase in revenue.
COMMUNITY OPERATIONS. Community operating expenses increased to $110.6 million for 1998 from $82.8 for 1997, an increase of $27.8 million, or 34%. As a percentage of total revenues, community operations increased to 73% for 1998 compared to 70% for 1997. These increases are the result of 1) increased labor costs due to the overall census increase throughout the Company's portfolio, 2) the opening of five newly developed communities during 1998, 3) increased sales and marketing costs and 4) the recording of start-up and organization costs as operating expenses in accordance with SOP 98-5, which would previously have been deferred and amortized.
GENERAL AND ADMINISTRATIVE. General and Administrative ("G&A") costs have increased $2.8 million, or 26% to $13.6 million for 1998 compared to $10.8 million for 1997. As a percentage of revenues, G&A costs have stayed relatively constant at 9% for 1998 and 1997. The overall increase of $2.8 million is primarily attributable to greater personnel costs due to the growth of the Company.
DEPRECIATION AND AMORTIZATION. For 1998 depreciation and amortization expense decreased 14% to $5.7 million from $6.6 million for 1997. As a percentage of total revenue, depreciation and amortization expense decreased to 4% for 1998 compared to 6% for 1997. The decrease is the result of expensing previously deferred start-up in accordance with SOP 98-5.
RENT. Rent expense for 1998 increased 20% or $6.8 million to $41.5 million from $34.7 million for 1997. This increase is primarily attributable to the opening of five newly developed communities in 1998 and 20 in 1997. In addition, the increase is partly the result of lease provisions providing for additional payments based on a percentage of revenue in the 1998 period. As a percentage of total revenue, rent expense decreased 2% to 27% for the year ended December 31, 1998 compared to 29% for the year ended December 31, 1997.
OTHER. As compared to 1997 where the Company incurred $4.4 million of charges related to the termination of the Company's tender offer for ARV and changes in the Company's operating structure, the Company incurred no such operating costs in 1998.
INTEREST EXPENSE. Interest expense increased $5.8 million or 69% to $14.2 million for 1998 compared to $8.4 million for 1997, As a percentage of revenue, interest expense increased 3% to 9% for 1998 compared to 6% for 1997. This increase is primarily the result of an increase in mortgage interest expense due to the refinancing of several properties during the second quarter of 1998. In addition, total debt increased approximately $11 million to $132 million as of December 31, 1998 compared to $121 million as of December 31, 1997.
OTHER, NET. For 1998, other, net increased $3.2 million to $3.8 million from approximately $600,000, a 531% increase. The increase is a result of gains realized on the sale of investment securities and the dispositions of communities.
EXTRAORDINARY ITEM. The Company recognized an extraordinary loss of approximately $937,000 for 1998, representing the write-off of loan fees and other related costs of the Company's early extinguishment of debt when it refinanced 10 communities.
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE. In 1998, the Company incurred a cumulative effect of a change in accounting principle of $1.3 million related to the early adoption of SOP 98-5, which requires that costs of start-up activities and organization costs be expensed as incurred.
COMPARISON OF THE YEARS ENDED DECEMBER 31, 1997 AND 1996
REVENUES. Total operating revenues for 1997 were $117.8 million, representing a $48.8 million, or 71%, increase over revenues of $68.9 million for 1996. The increase resulted from the opening of new developments and the related fill-up of units and the acquisition of communities during 1997. The Company ended with 71 and 100 communities representing approximately 5,900 and 8,700 units as of December 31, 1996 and 1997, respectively, an increase of 41%. For 1997, there was a decline in average occupancy to 71% from 74% for 1996, primarily attributable to the opening of 20 new communities during 1997. The impact on revenue from the decline in occupancy was offset by an increase in the rate per occupied unit.
COMMUNITY OPERATIONS. Expenses for community operations for 1997 were $82.8 million, representing a $33.9 million, or 69%, increase over $48.9 million for 1996, primarily due to the Company's opening of new developments and the acquisition of communities during 1997. As a percentage of total operating revenues, expenses for community operations decreased to 70% for 1997, from 71% for 1996.
GENERAL AND ADMINISTRATIVE. G&A expenses for 1997 were $10.8 million, representing an increase of $4.7 million, or 76%, from $6.2 million for 1996. As a percentage of total operating revenues, G&A expenses remained unchanged at 9% for 1996 and 1997 while the number of employees located at the corporate office was 83 and 90 at December 31, 1996 and 1997, respectively. The dollar increase in G&A expenses was attributable to salaries and associated costs relating to additional employment in conjunction with new business, increased accounting costs and higher travel and other costs relating to the Company's larger number of communities. G&A costs are expected to continue to increase proportionally with revenues and community operations at least through 1998 as the Company acquires additional existing communities and develops new communities.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization for 1997 was $6.6 million, or 6%, of total operating revenues, compared to $2.9 million or 4%, of total operating revenues, for 1996. The increase was due to a combination of an increase in pre-opening amortization expense from the opening of 20 developments in 1997 and the addition of four owned communities, net of communities sold in sale/leaseback transactions in 1997. The Company owned 19%, or 19 of its 100 communities representing approximately 2,100 units at December 31, 1997 compared to 21%, or 15 of its 71 communities representing approximately 1,500 units at December 31, 1996.
RENT. Rent expense for 1997 was $34.6 million, representing an increase of $18.5 million, or 115%, from rent expense of $16.1 million for 1996. As a percentage of total operating revenues, rent expense increased to 29% for 1997, from 23% for 1996. The dollar increases were due to additional lease financing or sale/leaseback transactions. The Company leased 76%, or 76 out of 100 of its residential communities representing approximately 6,100 units as of December 31, 1997 compared to 75%, or 53 out of 71 communities representing approximately 4,200 units as of December 31, 1996. The increase in rent expense as a percentage of revenue is attributable to the opening of newly developed communities, in their fill-up stage, operated by the Company under lease agreements. The Company expects an occupancy fill-up period of 12 to 24 months for a newly developed community. As the fill-up of newly developed communities continues, rent expense as a percentage of revenue is expected to decrease.
OTHER. The Company incurred other expense of $4.4 million for 1997 which represents charges related to the termination of the Company's tender offer for ARV and changes in the Company's operating structure. In 1997, the Company wrote-off certain capitalized pre-opening and marketing expenses related to newly opened developed communities prior to July 1997. This write-off was a result of changes in senior operating personnel and the Company's marketing approach.
INTEREST EXPENSE. Interest expense for 1997 was $8.4 million compared to $4.3 million for 1996, increasing as a percentage of total operating revenue to 7% for 1997 from 6% for 1996. The increase was primarily due to the acquisition of four communities through mortgage financing bearing interest at rates between 8% and 18%, construction financings bearing interest at fixed rates between 9.0% and 9.25% and the opening of four developments owned by the Company, all partially offset by sale/leaseback refinancings, as well as, interest costs related to the Company's investment in ARV common stock.
SAME COMMUNITY COMPARISON
The Company operated 86 communities ("Same Community") on a comparable basis during both the three months ended December 31, 1997 and 1998. The following table sets forth a comparison of Same Community results of operations for the three months ended December 31, 1997 and 1998.
The Same Communities represented $36.8 million or 90% of the Company's total operating revenue for the quarter ended December 31, 1998. Same Community revenues increased $5.5 million or 17% to $36.8 million for the three months ended December 31, 1998 compared to $31.4 million for the comparable period in 1997. This increase in revenue is the result of increased occupancy at the Same Communities and monthly rate increases due to an expanded range of services offered at the communities. For the quarter ended December 31, 1998 occupancy increased 11% to 85% from 74% for the quarter ended December 31, 1997. In addition, revenue per occupied unit increased to $2,016 for the quarter ended December 31, 1998 compared to $1,972 for the quarter ended December 31, 1997. For the quarter ended December 31, 1998 the Company generated operating income of $1.6 million compared to an operating loss of $2.6 million for the comparable period in 1997, an improvement of $4.2 million or 162%.
The Company operated 63 communities ("Same Community") on a comparable basis during both the year ended December 31, 1997 and 1998. The following table sets forth a comparison of Same Community results of operations for the year ended December 31, 1997 and 1998.
The Same Communities represented $100.4 million or 66% of the Company's total operating revenue for 1998. Same Community revenues increased $5.6 million or 6% to $100.4 million for 1998 compared to $94.8 million for 1997. This increase in revenue is the result of increased occupancy at the Same Communities and monthly rate increases due to an expanded range of services offered at the communities. For 1998 occupancy increased 3% to 84% from 81% for 1997. In addition, revenue per occupied unit increased to $2,033 for 1998 compared to $1,965 for 1997. For 1998 the Company generated both operating and net income of $3.7 million and $1.3 million, respectively, compared to operating income and a net loss of $1.4 million and $0.9 million, respectively, for 1997, an improvement of over $2 million and in excess of 100% for both figures.
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 1998. For 1998, net cash used in operating activities was $21.8 million, primarily due to losses incurred on newly acquired and developed communities. The Company obtained $20.4 million in proceeds from the sale of communities in sales transactions and repaid related mortgage indebtedness of $12.7 million as well as $56.6 million of unrelated mortgage indebtedness which primarily relates to the refinancing of 10 assisted living communities. The Company obtained $5.4 million in proceeds from the sale of investment securities. The Company also incurred additional long-term debt of $105.2 million related to the aforementioned refinancing and purchased additional property and equipment and property held for development of $30.4 million. As a result of these acquisition and financing transactions the Company decreased its cash position by approximately $6.0 million. As of December 31, 1998, the Company had a working capital deficiency of $977,000.
In 1997 and 1998, the Company purchased 517,200 shares of its common stock at an aggregate cost of $5.7 million.
In April 1998, the Company entered into a lending arrangement with Deutsche Bank North America ("Deutsche"). The loan terms specify a three year loan not to exceed $77.9 million with a 30-day LIBOR rate plus 2.95%. The Company used the proceeds to refinance 10 of its Operating Communities. At December 31, 1998, the Company has $73.2 million outstanding with Deutsche under this arrangement.
During 1998, the Company disposed of 28 of its buildings through the Emeritrust transaction and through sales to related parties. These dispositions netted proceeds of $33.2 million after repayment of outstanding debt of $12.8 million. In addition, the Emeritrust transaction will reduce operating lease payments of the Company by $11.3 million. See "--Company Operations--Operating Strategy."
The Company was committed to enter into long-term operating leases with a REIT for communities currently under development. In March 1999, the Company completed a disposition of its leasehold interest in these development communities. See "--Company Operations--Operating Strategy."
The Company has been, and expects to continue to be, dependent on third-party financing for its cash needs in connection with operating losses as well as with its acquisition and development of communities. There can be no assurance that financing for these requirements will be available to the Company on acceptable terms. Moreover, to the extent the Company acquires communities that do not generate positive cash flow, the Company may be required to seek additional capital or borrowings for working capital and liquidity purposes.
YEAR 2000
GENERAL The Company has developed a plan (the "Plan") to modify its information technology to address "Year 2000" problems. The concerns surrounding the Year 2000 are the result of computer programs being written using two digits rather than four to define the applicable year. Programs that employ time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could cause system errors or failures.
PLAN The Plan is comprised of three components including assessment of: a) the IT infrastructure (hardware and systems software other than application software); b) application software; and b) third party suppliers/vendors. The Company commenced work on the Plan in the fourth quarter of 1998 by taking inventory of Year 2000 problems in the areas of IT infrastructure as well as application software. In addition, the Company has determined the priority of the items based on their materiality to the Company's operations. No material items have been noted to date. For each component, the Company will address Year 2000 problems in six phases: 1) taking inventory of Year 2000 problems; 2) assigning priorities to identified items; 3) assessing materiality of items to the Company's operations; 4) replacing/repairing material non-compliant items; 5) testing material items; and 6) designing and implementing business continuation plans. Material items are those believed by the Company to have a risk that may affect revenue or may cause a discontinuation of operations. The Company estimates a completion date of June 30, 1999.
COSTS The project is not expected to be material to the Company's operations or financial position. The total cost is not expected to exceed $50,000 of which approximately $2,500 have been incurred to date.
RISKS The failure to correct a material Year 2000 problem could result in an interruption in, or a failure of, normal business activities or operations. Such failures could materially affect the Company's results of operations, liquidity, and financial condition. The Company is unable to determine at this time whether the consequences of Year 2000 failures will have a material impact on its results of operations, liquidity or financial condition due, in part, to uncertainty regarding compliance by third parties. The Plan is expected to significantly reduce the Company's level of uncertainty regarding the Year 2000 problem, however, particularly compliance and readiness of its third-party suppliers/vendors. The Company believes that, with the completion of the Plan as scheduled, the possibility of significant interruptions of normal operations will be reduced and, therefore, a contingency plan has not been deemed necessary to date.
IMPACT OF INFLATION
To date, inflation has not had a significant impact on the Company. Inflation could, however, affect the Company's future revenues and operating income due to the Company's dependence on its senior resident population, most of whom rely on relatively fixed incomes to pay for the Company's services. As a result, the Company's ability to increase revenues in proportion to increased operating expenses may be limited. The Company typically does not rely to a significant extent on governmental reimbursement programs. In pricing its services, the Company attempts to anticipate inflation levels, but there can be no assurance that the Company will be able to respond to inflationary pressures in the future.
FORWARD-LOOKING STATEMENTS
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995: A number of the matters and subject areas discussed in this report that are not historical or current facts deal with potential future circumstances, operations, and prospects. The discussion of such matters and subject areas is qualified by the inherent risks and uncertainties surrounding future expectations generally, and also may materially differ from the Company's actual future experience involving any one or more of such matters and subject areas relating to demand, pricing, competition, construction, licensing, permitting, construction delays on new developments contractual and licensure, and other delays on the disposition of assisted living communities in the Company's portfolio, and the ability of the Company to continue managing its costs while maintaining high occupancy rates and market rate assisted living charges in its assisted living communities. The Company has attempted to identify, in context, certain of the factors that they currently believe may cause actual future experience and results to differ from the Company's current expectations regarding the relevant matter or subject area. These and other risks and uncertainties are detailed in the Company's reports filed with the Securities and Exchange Commission, including the Company's Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's earnings are affected by changes in interest rates as a result of its short and long term borrowings. The Company manages this risk by obtaining fixed rate borrowings when possible. At December 31, 1998, the Company's variable rate borrowings totaled $97.3 million. If market interest rates average 2% more in 1999 than they did in 1998, the Company's interest expense would increase and income before taxes would decrease by $1.9 million. These amounts are determined by considering the impact of hypothetical interest rates on the Company's outstanding variable rate borrowings as of December 31, 1998 and does not consider changes in the actual level of borrowings which may occur subsequent to December 31, 1998. This analysis also does not consider the effects of the reduced level of overall economic activity that could exist in such an environment nor does it consider likely actions that management could take with respect to the Company's financial structure to mitigate the exposure to such a change.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and the Independent Auditors report are listed at Item 14 and are included beginning on Page.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information under the caption "Executive Officers of the Registrant" in Part I of this Form 10-K and under the captions "Election of Directors -- Nominees for Election" and "Compliance with Section 16(a) of the Exchange Act of 1934" in the Company's Proxy Statement relating to its 1998 annual meeting of shareholders (the "Proxy Statement") is hereby incorporated by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information under the captions "Executive Compensation" and "Election of Directors -- Director Compensation" in the Company's Proxy Statement is hereby incorporated by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement is hereby incorporated by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information under the caption "Certain Transactions" in the Company's Proxy Statement is hereby incorporated by reference.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of the report:
(1) FINANCIAL STATEMENTS. The following financial statements of the Registrant and the Report of Independent Public Accountants therein are filed as part of this Report on Form 10-K:
(2) FINANCIAL STATEMENT SCHEDULES. Schedule II Valuation and Qualifying Accounts (contained on page) Other financial statement schedules have been omitted because the information required to be set forth therein is not applicable, is immaterial or is shown in the consolidated financial statements or notes thereto.
(b) REPORTS ON FORM 8-K. No reports on Form 8-K were filed by the Registrant during the quarter ended December 31, 1998.
(c) EXHIBITS: The following exhibits are filed as a part of, or incorporated by reference into, this Report on Form 10-K:
(1) Incorporated by reference to the indicated exhibit filed with the Company's Registration Statement on Form S-1 (File No. 33-97508) declared effective on November 21, 1995.
(2) Incorporated by reference to the indicated exhibit filed with the Company's Annual Report on Form 10-K (File No. 1-14012) on March 29, 1996.
(3) Incorporated by reference to the indicated exhibit filed with the Company's Second Quarter Report on Form 10-Q (File No. 1-14012) on August 14, 1996.
(4) Incorporated by reference to the indicated exhibit filed with the Company's Third Quarter Report on Form 10-Q (File No. 1-14012) on November 14, 1996.
(5) Incorporated by reference to the indicated exhibit filed with the Company's Annual Report on Form 10-K (File No. 1-14012) on March 31, 1997.
(6) Incorporated by reference to the indicated exhibit filed with the Company's First Quarter Report on Form 10-Q (File No. 1-14012) on May 15, 1997.
(7) Incorporated by reference to the indicated exhibit filed with the Company's Current Report on Form 8-K (File No. 1-14012) on May 16, 1997.
(8) Incorporated by reference to the indicated exhibit filed with the Company's Current Report on Form 8-K Amendment No. 1 (File No. 1-14012) on July 14, 1997.
(9) Incorporated by reference to the indicated exhibit filed with the Company's Second Quarter Report on Form 10-Q (File No. 1-14012) on August 14, 1997.
(10) Incorporated by reference to the indicated exhibit filed with the Company's Registration Statement on Form S-3 Amendment No. 2 (File No. 333-20805) on August 14, 1997.
(11) Incorporated by reference to the indicated exhibit filed with the Company's Registration Statement on Form S-3 Amendment No. 3 (File No. 333-20805) on October 29, 1997.
(12) Incorporated by reference to the indicated exhibit filed with the Company's Third Quarter Report on Form 10-Q (File No. 1-14012) on November 14, 1997.
(13) Incorporated by reference to the indicated exhibit filed with the Company's Annual Report on Form 10-K (File No. 1-14012) on March 30, 1998.
(14) Incorporated by reference to the indicated exhibit filed with the Company's Registration Statement on Form S-8 (File No. 333-60323) on July 31, 1998.
(15) Incorporated by reference to the indicated exhibit filed with the Company's Second Quarter Report on Form 10-Q (File No. 1-14012) on August 14, 1998
(16) Filed herewith.
SIGNATURES
Pursuant to the requirements of 13 of 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: March 29, 1999 EMERITUS CORPORATION (Registrant)
/s/ Daniel R. Baty ---------------------------------------------------- Daniel R. Baty, Chief Executive Officer and Director
/s/ Kelly J. Price ---------------------------------------------------- Kelly J. Price, Chief Financial Officer, Vice President, Finance and Principal Accounting Officer
/s/ Tom A. Alberg ---------------------------------------------------- Tom A. Alberg, Director
/s/ Patrick Carter ---------------------------------------------------- Patrick Carter, Director
/s/ William E. Colson ---------------------------------------------------- William E. Colson, Director
/s/ David Hamamoto ---------------------------------------------------- David Hamamoto, Director
/s/ Motoharu Iue ---------------------------------------------------- Motoharu Iue, Director
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders Emeritus Corporation:
We have audited the accompanying consolidated balance sheets of Emeritus Corporation and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, comprehensive operations, shareholders' equity (deficit) and cash flows for each of the years in the three-year period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Emeritus Corporation and subsidiaries as of December 31, 1998 and 1997 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1998 in conformity with generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for start-up costs and organization costs.
/s/ KPMG LLP
Seattle, Washington February 26, 1999, except as to Note 20, which is as of March 29, 1999
INDEPENDENT AUDITORS' REPORT ON SCHEDULE
The Board of Directors Emeritus Corporation
Under date of February 26, 1999, except as to Note 20, which is as of March 29, 1999, we reported on the consolidated balance sheets of Emeritus Corporation and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of operations, comprehensive operations, shareholders' equity (deficit), and cash flows for each of the years in the three year period ended December 31, 1998, as contained in the 1998 annual report on Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedule of valuation and qualifying accounts. This consolidated financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this consolidated financial statement schedule based on our audits.
In our opinion, such consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respect, the information set forth therein.
/s/ KPMG LLP
Seattle, Washington February 26, 1999
EMERITUS CORPORATION CONSOLIDATED BALANCE SHEETS (In thousands, except share data)
ASSETS
See accompanying notes to consolidated financial statements.
EMERITUS CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data)
See accompanying notes to consolidated financial statements.
EMERITUS CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS (In thousands)
See accompanying notes to consolidated financial statements.
EMERITUS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
See accompanying notes to consolidated financial statements.
EMERITUS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS - (Continued) (In thousands)
See accompanying notes to consolidated financial statements.
EMERITUS CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT) (In thousands, except share data)
See accompanying notes to consolidated financial statements.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Emeritus Assisted Living - Emeritus Corporation ("Emeritus" or the "Company") is a nationally integrated assisted living organization focused on operating residential style communities. These communities provide a residential housing alternative for senior citizens who need help with the activities of daily living, with an emphasis on assisted living and personal care services. The Company also provides management services to third-party owners of assisted living communities.
BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. In addition, the accounts of limited liability companies and partnerships ("LLCs") have been consolidated where the Company maintains effective control over the LLCs' assets and operations, not withstanding a lack of technical majority ownership of the LLCs. All significant intercompany balances and transactions have been eliminated in consolidation.
REVENUE RECOGNITION
Operating revenue consists of resident fee revenue and management services revenue. Resident units are rented on a month-to-month basis and rent is recognized in the month the unit is occupied. Service fees paid by residents for assisted-living and other related services and management fees are recognized in the period services are rendered. Management services revenue is comprised of revenue from management contracts and is recognized in the month in which it is earned in accordance with the terms of the management contract.
CASH AND CASH EQUIVALENTS
All short-term investments, consisting primarily of commercial paper and certificates of deposit, with a maturity at date of purchase of three months or less are considered to be cash equivalents.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets as follows: buildings and improvements, 25 to 40 years; furniture, equipment and vehicles, five to seven years; leasehold improvements, over the lesser of the estimated useful life or the lease term.
For long-lived assets, including property and equipment, the Company evaluates the carrying value of the assets by comparing the estimated future cash flows generated from the use of the assets and their eventual disposition with the assets' reported net book values. The carrying values of assets are evaluated for impairment when events or changes in circumstances occur which may indicate the carrying amount of the assets may not be recoverable.
INVESTMENTS
Investment securities are classified as available-for-sale and are recorded at fair value. Unrealized holding gains and losses, net of any related tax effect, are excluded from results of operations and are reported as a component of other comprehensive income (loss).
Investments in 20% to 50% owned affiliates are accounted for under the equity method except where lack of voting power exists. Investments in less than 20% owned entities are accounted for under the cost method.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
INTANGIBLE ASSETS
Intangible assets, which are comprised of deferred financing costs, (included in other assets) as well as lease acquisition costs are amortized on the straight-line method over the term of the related debt or lease agreement.
INCOME TAXES
Deferred income taxes are provided based on the estimated future tax effects of temporary differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that are expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded for deferred tax assets when it is more likely than not that such deferred tax assets will not be realized.
DEFERRED RENT
Deferred rent primarily represents lease incentives which are deferred and amortized using the straight-line method over the lives of the associated leases.
DEFERRED GAINS ON SALE OF COMMUNITIES
Deferred gains on sale/leasebacks of communities are deferred and amortized using the straight-line method over the lives of the associated leases. The Company has no continuing involvement in communities which it has sold and leased back outside of operating the communities.
COMMUNITY OPERATIONS
Community operations represent direct costs incurred to operate the communities and include costs such as resident activities, marketing, housekeeping, food service, payroll and benefits, facility maintenance, utilities, taxes and licenses.
STOCK-BASED COMPENSATION
The Company applies APB Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES and related Interpretations in measuring compensation costs for its stock option plans. The Company discloses pro forma net income (loss) and net income (loss) per share as if compensation cost had been determined consistent with Statement of Financial Accounting Standards (SFAS) No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION.
NET LOSS PER SHARE
Basic net income (loss) per share is computed based on weighted average shares outstanding and excludes any potential dilution. Diluted net income (loss) per share is computed on the basis of the weighted average number of shares outstanding plus dilutive potential common shares using the treasury stock method. The capital structure of the Company includes convertible debentures, redeemable convertible preferred stock, as well as stock options. The assumed conversion and exercise of these securities have been excluded from the calculation of diluted net loss per share as their effect is anti-dilutive.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
FOREIGN CURRENCY TRANSLATION
Foreign currency amounts attributable to foreign operations have been translated into U.S. dollars using year-end exchange rates for assets and liabilities, historical rates for equity, and average annual rates for revenues and expenses. Unrealized gains and losses arising from fluctuations in the year-end exchange rates are recorded as a component of other comprehensive income (loss).
RECLASSIFICATIONS
Certain reclassifications of the 1996 and 1997 amounts have been made to conform to the 1998 presentation.
(2) CHANGES IN ACCOUNTING PRINCIPLES
In April 1997, the Accounting Standards Executive Committee issued Statement of Position 98-5 (SOP 98-5), REPORTING ON THE COSTS OF START-UP ACTIVITIES. This statement provides guidance on financial reporting for start-up costs and organization costs and requires such costs to be expensed as incurred. The Company elected early adoption of this statement effective January 1, 1998 and has reported a charge of $1,320,000 for the cumulative effect of this change in accounting principle. The adoption of SOP 98-5 on January 1, 1998 resulted in the Company expensing approximately $967,000 of start-up costs incurred in 1998.
In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards 130 (SFAS 130), REPORTING COMPREHENSIVE INCOME. This statement establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The purpose of reporting comprehensive income is to report a measure of all changes in equity of an enterprise that result from recognized transactions and other economic events of the period other than transactions with owners in their capacity as owners. The Company adopted SFAS 130 effective January 1, 1998.
(3) RESTRICTED DEPOSITS
Restricted deposits consist of funds required by various Real Estate Investment Trusts ("REITs") to be placed on deposit until the Company's communities meet certain debt coverage and/or cash flow coverage ratios, at which time the funds will be released to the Company. As of December 31, 1997 and 1998, the Company had $10.8 million and $8.4 million in restricted deposits, respectively.
(4) PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(5) PROPERTY HELD FOR DEVELOPMENT
Property held for development is recorded at cost. Interest costs capitalized on property held for development and construction in progress was $1.4 million, $2.7 million and $0.1 million for 1996, 1997 and 1998, respectively.
At December 31, 1998, the Company was committed to enter into long-term operating leases with a REIT for communities currently under development. In March 1999, the Company completed a disposition of its leasehold interests in these development communities (note 20).
(6) INVESTMENT SECURITIES
During 1997, the Company purchased common stock of ARV Assisted Living, Inc. ("ARV") in market transactions and at December 31, 1997, the Company held 1,077,200 shares of ARV common stock. Also in 1997, the Company initiated a tender offer which was terminated in January 1998, for all of the remaining outstanding common stock of ARV. The Company incurred costs of $3,418,000 associated with this activity in 1997.
During 1998, the Company sold a portion of the ARV common stock in market transactions realizing gains approximating $450,000 which are included in other income, net. Details regarding the ARV investment as of December 31, follow:
(7) FINANCIAL INSTRUMENTS
The Company has financial instruments other than investment securities consisting of cash and cash equivalents, trade accounts receivable, notes receivable from and investments in affiliates, short-term borrowings, accounts payable, convertible debentures, redeemable preferred stock and long-term debt. The fair value of the Company's financial instruments based on their short-term nature or current market indicators such as prevailing interest rates approximate their carrying value with the exception of the convertible debentures which had a fair value of $28.6 million versus a book value of $32.0 million at December 31, 1998.
(8) NOTES RECEIVABLE FROM AND INVESTMENTS IN AFFILIATED COMPANIES
In November 1996, the Company agreed to purchase up to 6,888,466 shares of convertible preferred stock of Alert Care Corporation ("Alert"), an Ontario, Canada-based owner and operator of assisted-living communities at prices ranging from $0.67 to $0.74 per share (Cdn). In addition, the Company acquired an option to purchase an additional 4,000,000 shares of convertible preferred stock at an exercise price of $1.00 per share (Cdn), as well as an option to purchase from Eclipse Capital Management ("Eclipse"), the majority shareholder of Alert, and certain other shareholders of Alert, 9,050,000 issued and outstanding shares of common stock of Alert and 950,000 issued and outstanding shares of Class A non-voting stock of Alert both at an exercise price of $3.25 per share (Cdn). There was no cost in acquiring the option to purchase additional shares from Alert and no value was assigned to the option by the Company.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The investment in Alert is accounted for under the cost method, as the Company's equity ownership consists of non-voting preferred stock. Details regarding the Alert holdings as of December 31 are as follows:
Alert has entered into an exclusive management agreement to manage the Company's future assisted-living communities in Ontario. Eclipse, through its wholly-owned subsidiary, Eclipse Construction Inc., develops and constructs retirement homes for Alert on a contract basis. Under the agreement, Eclipse has entered into an exclusive development agreement with the Company to develop its future construction projects in Ontario. No communities have been developed under these agreements as of December 31, 1998.
During 1998, the Company sold its interest in a community located in Texas to a partnership in which the principal shareholder of the Company is a partner. Pursuant to the purchase and sale agreement, the Company advanced funds to the partnership of $1.0 million and $800,000 subject to promissory notes bearing interest at 9% and payable in 10 years and on demand, respectively. The $1.0 million note contains additional funding provisions whereby the Company funds 20% of the losses generated by the community up to $500,000, of which $350,000 is outstanding at December 31, 1998. The Company at its option can then convert its $1.5 million investment into a 20% interest in the partnership. In addition, the Company has advanced the partnership $450,000 under a repair note bearing interest at 9% and due June 2008. At December 31, 1998, the Partnership's obligations to the Company total $2.6 million.
In 1998, the Company entered into a $5.0 million credit agreement with Aurora Bay Investments, L.L.C. ("Aurora Bay"), a limited liability company that acquires, develops and operates Alzheimer's special care facilities. In September 1998, the credit agreement was assumed by a related party for $4.2 million which equaled the total advances made under the facility.
(9) CONVERTIBLE DEBENTURES
The Company has $32.0 million of 6.25% convertible subordinated debentures (the "Debentures") which are due in 2006. The Debentures are convertible into common stock at the rate of $22 per share, which equates to an aggregate of approximately 1,454,545 shares of the Company's common stock and bear interest payable semiannually on January 1 and July 1 of each year. The Debentures are unsecured and subordinated to all other indebtedness of the Company.
The Debentures are subject to redemption, as a whole or in part, at any time or from time to time commencing after July 1, 1999 at the Company's option on at least 30 days' and not more than 60 days' prior notice.
The redemption prices (expressed as a percentage of principal amount) are as follows for the 12-month period beginning after July 1 of the following years:
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(10) LONG-TERM DEBT
Long-term debt consists of the following:
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Substantially all long-term debt is secured by the Company's property and equipment.
During 1998, the Company consolidated approximately $60.3 million of outstanding debt through a refinancing with a single lender and wrote off $937,000 of related deferred costs as an extraordinary item.
Certain of the Company's indebtedness includes restrictive provisions related to cash dividends, investments and borrowings, and require maintenance of specified operating ratios, levels of working capital and net worth. As of December 31, 1998, the Company was in compliance with such covenants or obtained waivers for noncompliance.
Principal maturities of long-term debt at December 31, 1998 are as follows:
(11) SHORT-TERM BORROWINGS
The Company maintains a $5,000,000 unsecured revolving account from U.S. Bank which bears interest at the prime rate (7.75% at December 31, 1998) and expires in August 1999. The line of credit is guaranteed by a principal shareholder of the Company.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(12) MARGIN LOAN ON EQUITY SECURITIES
During 1997, the Company opened a margin account to facilitate the acquisition of marketable securities. This account had a loan balance of $9,165,000 and $2,324,000 at December 31, 1997 and 1998, respectively, secured by marketable equity securities with respective market values of $17,235,000 and $4,491,000. This loan is due upon the sale of the securities and bears interest at 0.375% under broker call (6.125% as of December 31, 1998).
(13) INCOME TAXES
Income taxes reported by the Company differ from the amount computed by applying the statutory rate primarily due to limitations on utilizing net operating losses.
The tax effect of temporary differences and carryforwards that give rise to significant portions of deferred tax assets and liabilities are comprised of the following:
The net increase in the total valuation allowance was $9,380,000 and $11,856,000 for 1997 and 1998, respectively. The increases were primarily due to the increase in deferred gains on sale/leasebacks and the amount of net operating loss carryforwards, for which management does not believe that it is more likely than not that realization is assured.
For federal income tax purposes, the Company has net operating loss carryforwards at December 31, 1998, available to offset future federal taxable income, if any, of approximately $57,539,000 expiring beginning in 2011.
(14) RELATED-PARTY MANAGEMENT AGREEMENTS
During 1995, the Company's two most senior executive officers, CEO and now former President, formed a New York general partnership (the "Partnership") to facilitate the operation of assisted-living communities in the state of New York, which generally requires that natural persons be designated as the licensed operators of assisted-living communities. The Partnership operates ten leased communities in New York. The Company has agreements with the Partnership and the partners under which all of the Partnership's profits have been assigned to the Company and the Company has indemnified the partners against losses. In February 1999, the President of the Company ceased to be an officer of the Company and has agreed to transfer his ownership in the Partnership to his successor at a nominal value. As the Company has unilateral and perpetual control over the Partnership's assets and operations, the results of operations of the Partnership are consolidated with those of the Company.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A number of limited partnerships which are partly owned indirectly by Mr. Baty, the Company's Chairman and Chief Executive Officer, develop, own and lease senior housing projects, some of which cater to low income seniors. The Company has agreements with these partnerships to provide certain administrative support, due diligence and financial support services with respect to the acquisition, development and administration of these communities. The agreements have terms ranging from two to four years, with options to renew, and provide for management fees ranging from 4% to 7% of gross operating revenues and fixed administrative fees. Management fee revenue earned under these agreements was approximately $103,000 and $535,000 in 1997 and 1998, respectively.
In 1998, the Company and XL Management Company L.L.C., ("XL Management"), an affiliate of Holiday Retirement Corp., an owner and operator of independent-living communities, entered into four management agreements whereby XL Management will provide management services relating to four newly developed assisted-living communities located in Texas. The agreements have initial terms of two years six months with management fees based on 6% of gross revenues payable monthly. Total fees in 1998 amounted to $187,000. The Company will pay a bonus fee per community to XL Management based on occupancy; one year after managing the communities, if occupancy is between 75% and 89%, XL Management will receive a bonus fee of $25,000 and if occupancy is 90% or greater the bonus fee will be $50,000. The Company's Chairman and Chief Executive Officer and another member of the Company's board of directors are principal shareholders and officers of Holiday.
In addition to the foregoing, the Company entered into 25 management agreements with a related party for properties previously leased and owned (note 18).
(15) SHAREHOLDERS' EQUITY
In December 1997, the Company purchased 25,600 shares of its common stock at an aggregate cost of $341,000. In January 1998, the Company's board of directors authorized a stock repurchase program to acquire up to an additional 500,000 shares of the Company's common stock. At December 31, 1998, the Company had acquired a total of 517,200 shares of its common stock at an aggregate cost of $5.7 million.
1995 STOCK INCENTIVE PLAN
The Company has a 1995 stock incentive plan ("1995 Plan") which combines the features of an incentive and nonqualified stock option plan, stock appreciation rights and a stock award plan (including restricted stock). The 1995 Plan is a long-term incentive compensation plan and is designed to provide a competitive and balanced incentive and reward program for participants.
The Company has authorized 1,600,000 shares of common stock to be reserved for grants under the 1995 Plan of which 155,384 remained available for future awards at December 31, 1998. Options generally vest between three-year to five-year periods, at the discretion of the Compensation Committee of the Board of Directors, in cumulative increments beginning one year after the date of the grant and expire not later than ten years from the date of grant. The options are granted at an exercise price equal to the fair market value of the common stock on the date of the grant.
In November 1998, the Company offered, at the election of individual employees, a repricing of options granted to date at an exercise price of $9.8125 which was equal to the fair market value of the stock on the grant date. A total of 1,005,166 shares were forfeited and reissued under the repricing transaction.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Had compensation cost for the Company's stock option plan been determined pursuant to SFAS 123, the Company's pro forma net loss and pro forma net loss per share, including the effect of the repricing, would have been as follows:
The fair value of each option grant has been estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 1996, 1997 and 1998: dividend yield of 0.0% for all periods; expected volatility of 55% for 1996, 49.1% for 1997 and 48.9% for 1998; risk-free interest rates of 5.47% to 6.39% for 1996, 5.45% to 5.50% for 1997, and 4.51% to 4.70% for 1998; and an expected option term of 4.5 years and 5 years for 1996 and 1997, respectively, and for 1998 of 2 to 5 years, giving effect to the option repricing.
A summary of the activity in the Company's stock option plans follows:
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following is a summary of stock options outstanding at December 31, 1998:
EMPLOYEE STOCK PURCHASE PLAN
In July 1998, the Company adopted an Employee Stock Purchase Plan (the Plan) to provide substantially all employees who have completed six months of service an opportunity to purchase shares of its common stock through payroll deductions, up to 15% of eligible compensation. A total of 200,000 shares are available for purchase under the Plan. Monthly, participant account balances are used to purchase shares of stock on the open market at the lesser of the fair market value of shares on the first or last day of the participation period. Employees may not exceed $25,000 in annual purchases. The Employee Stock Purchase Plan expires in May 2008. At December 31, 1998, 900 shares have been purchased by employees under the Plan.
(16) REDEEMABLE PREFERRED STOCK
The Company has authorized 5,000,000 shares of preferred stock, $0.0001 par value. Pursuant to such authority, in October 1997, the Company issued and sold 25,000 shares of Series A cumulative convertible, exchangeable, redeemable preferred stock for $25,000,000. Cumulative dividends of 9% are payable quarterly. The preferred stock has a mandatory redemption date of October 24, 2004 at a price equal to $1,000 per share plus any accrued but unpaid dividends. Each share of preferred stock may be converted, at the option of the holder, into 55 shares of common stock. The preferred stock is also exchangeable in whole only, at the option of the Company, to 9% subordinated convertible notes due October 24, 2004. The 9% subordinated notes would contain the same conversion rights, restrictions and other terms as the preferred stock.
The Company may redeem the preferred stock, in whole or in part, after October 24, 2001 for $1,050 per share plus accrued dividends, provided that the market price of common stock is at least 130% of the conversion price for the preferred stock. In the event of liquidation of the Company, the holders of outstanding preferred stock shall be entitled to receive a distribution of $1,000 per share plus accrued dividends.
(17) LEASES
At December 31, 1998, the Company leases office space and 54 assisted-living communities . The office lease expires in 2006 and contains two five-year renewal options. The community leases expire from 2004 to 2017 and contain two to six five-year renewal options.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Minimum lease payments under noncancelable operating leases at December 31, 1997 are as follows:
Rent expense under noncancelable operating leases was approximately $16,114,000, $34,651,000 and $42,217,000 for 1996, 1997 and 1998, respectively. A number of operating leases provide for additional lease payments, computed as 5% of gross community revenues, beginning 24 months after the inception of the lease. In 1998, such additional rents were not significant.
(18) SALES AND ACQUISITIONS
During 1997, the Company completed several acquisitions of assisted-living, independent-living and skilled nursing communities. These acquisitions have been accounted for as purchases and, accordingly, the assets and liabilities of the acquired communities were recorded at their estimated fair values at the dates of acquisitions. No goodwill or other identifiable intangibles were recorded with respect to any of the acquisitions. The results of operations of the communities acquired have been included in the Company's consolidated financial statements from the dates of the acquisition. Summary information concerning the acquisitions is as follows:
The foregoing acquisitions were generally financed through borrowings.
During 1997, the Company completed three acquisitions of communities through operating lease transactions. The results of operations of the communities have been included in the Company's consolidated financial statements from the dates the leases commenced.
During 1997, the Company entered into sale/leaseback transactions with a REIT, pursuant to which the REIT acquired one new community developed by the Company and two existing communities and leased the communities back to the Company. The Company has no continuing involvement outside of operating the communities.
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following summary, prepared on a pro forma basis, combines the results of operations of the acquired businesses with those of the Company as if the acquisitions through lease financings and sale/leaseback financings had been consummated as of January 1, 1997.
During 1998, the Company entered into a sale/leaseback transactions with a REIT, pursuant to which the REIT acquired a community previously owned by the Company and leased it back to the Company. The Company has no continuing involvement outside of operating the community.
In 1998, the Company acquired two communities which it previously leased from a REIT for an aggregate purchase price of $13.5 million. These acquisitions were financed through borrowings.
In 1998 the Company sold interests in three assisted living communities for an aggregate sales price of $25 million, including the assumption of a $14.8 million mortgage obligation and $1.8 million in notes receivable, to partnerships in which the Company's principal shareholder is a partner and realized cumulative gains of $475,000 which are included in other income, net. The Company retains a management interest in each community through management contracts and a residual economic interest in two of the communities.
In December 1998 the Company disposed of its leasehold interest in 22 leased communities and three owned communities (the "Emeritrust communities"). The Emeritrust communities were sold to an entity in which a principal shareholder and a Board member of the Company are investors. Pursuant to the transaction, the Company will manage all 25 communities in accordance with a three year management contract and will receive management fees of 5% of revenues currently payable as well as 2% of revenues which is contingent upon the communities achieving positive cash flows. The management agreement provides the Company an option to purchase the 22 previously leased communities at a formula price and a right of first refusal on the three previously owned communities. The management agreement further stipulates a cash shortfall funding requirement by the Company to the extent the Emeritrust communities generate cash deficiencies in excess of $4.5 million. Previously deferred gains and the gain on this transaction collectively totaling approximately $13 million have been deferred given the continuing financial involvement of the Company stipulated in the management agreement.
(19) CONTINGENCIES
The Company is involved in legal proceedings, claims and litigation arising in the ordinary course of business. In the opinion of management, the outcome of these matters will not have a material effect on the Company's results of operations or financial position.
The Company is self insured for certain employee health benefits. The Company's policy is to accrue amounts equal to the actuarial liabilities which are based on historical information along with certain assumptions about future events. Changes in assumptions for such matters as health care costs and actual experience could cause these estimates to change.
(20) SUBSEQUENT EVENT
In March 1999, the Company completed a disposition of its leasehold interests in 19 additional communities, consisting of 14 currently operational communities and five development communities (the "Emeritrust II communities"). The Emeritrust II communities were sold to an entity in which a principal shareholder and a Board member of the Company are investors. Pursuant to the transaction, the Company will manage all 19 communities in accordance with a three year management contract and will receive management fees of 5% of revenues currently payable as well as 2% of revenues which is contingent upon the communities achieving positive cash flows. The management agreement provides the Company an option to purchase the 19 previously leased communities at a formula price. The management agreement further stipulates a cash shortfall funding requirement by the Company to the extent the development communities generate cash deficiencies in excess of $2.3 million.
EMERITUS CORPORATION VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1998, 1997 and 1996 (in thousands)
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(1) Represents amounts written off