ITEM 1. DESCRIPTION OF BUSINESS
Overview
Emeritus is one of the largest and most experienced national operators of assisted living residential 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.
At December 31, 2001, we held an interest in 133 assisted living communities, consisting of approximately 12,200 units with a capacity for 14,000 residents, located in 29 states and Japan. Of these, we operate 132 communities, including 16 communities that we own, 42 communities that we lease, and 74 communities that we manage, including four in which we hold joint venture interests. Under three management agreements covering 46 of our 74 managed communities, we have options to purchase 38 communities and rights of first refusal on three communities that expire June 30, 2003, and options to purchase five communities that expire December 31, 2003.
We strive to provide a wide variety of assisted living services in a professionally managed environment that allows our residents to maintain dignity and independence. Our residents are typically unable to live alone, but do not require the intensive care provided in skilled nursing facilities. Under our approach, seniors reside in a private or semi-private residential unit for a monthly fee based on each resident's individual service needs. We believe our residential assisted living communities allow seniors to maintain a more independent lifestyle than is possible in the institutional environment of skilled nursing facilities. In addition, we believe that our services, including assisting residents with activities of daily living, such as medication management, bathing, dressing, personal hygiene and grooming, are attractive to seniors who are inadequately served by independent living facilities.
The Assisted Living Industry
We believe that the assisted living industry is the preferred residential alternative for seniors who cannot live independently due to physical or cognitive frailties but who do not require the more intensive medical attention provided by a skilled nursing facility.
Generally, assisted living provides housing and 24-hour personal support services designed to assist seniors with the activities of daily living, which include bathing, eating, personal hygiene, grooming, medication reminders, ambulating and dressing. Certain assisted living facilities may offer higher levels of personal assistance for residents with Alzheimer's disease or other forms of dementia.
We believe that a number of factors will allow assisted living companies to continue as one of the fastest growing choices for senior care:
* Consumer Preference. We believe that assisted living is preferred by prospective residents as well as their families, who are often the decision makers for seniors. Assisted living is a cost-effective alternative to other types of care, offering seniors greater independence while enabling them to reside longer in a more residential environment.
* Cost-Effectiveness. The average annual cost to care for a Medicare or Medicaid patient in a skilled nursing home can exceed $40,000. The average cost to care for a private pay patient in a skilled nursing home can exceed $60,000 per year in certain markets. In contrast, assisting living services generally cost 30% to 50% less than skilled nursing facilities located in the same region. We also believe that the cost of assisted living services compares favorably with home healthcare, particularly when costs associated with housing, meals and personal care assistance are taken into account.
* Demographics. The target market for our services is generally persons 75 years and older who represent the fastest growing segments of the U.S. population. According to the U.S. Census Bureau, the portion of the U.S. population age 75 and older is expected to increase by 11.5% from approximately 16.6 million in 2000 to approximately 18.6 million by the year 2010. The number of persons age 85 and older, as a segment of the U.S. population, is expected to increase by 33.2% from approximately 4.3 million in 2000 to over 5.7 million by the year 2010. Furthermore, the number of persons afflicted with Alzheimer's disease is also expected to grow in the coming years. According to data published by the Alzheimer's Association, this population will increase 127% from the current 4.4 million to 10.0 million people by the year 2010. Because Alzheimer's disease and other forms of dementia are more likely to occur as a person ages, we expect the increasing life expectancy of seniors to result in a greater number of persons afflicted with Alzheimer's disease and other forms of dementia in future years, absent breakthroughs in medical research.
* Changing Family Dynamics. According to the U.S. Census Bureau, the median income of the elderly population is increasing. Currently, more that 60 percent of the population over the age of 75 have incomes over $15,000 per year and slightly more than 35 percent have annual incomes of at least $25,000. Accordingly, we believe that the number of seniors and their families who are able to afford high-quality senior residential services, such as those we offer, has also increased. In addition, the number of two-income households has increased over the last decade and the geographical separation of senior family members from their adult children has risen with the geographic mobility of the U.S. population. As a result, many families that traditionally would have provided the type of care and services we offer to senior family members are less able to do so.
* Supply/Demand Imbalance. While the senior population is growing significantly, the supply of skilled nursing beds per thousand is declining. We attribute this imbalance to a number of factors in addition to the aging of the population. Many states, in an effort to maintain control of Medicaid expenditures on long-term care, have implemented more restrictive Certificate of Need regulations or similar legislation that restricts the supply of licensed skilled nursing facility beds. Additionally, acuity-based reimbursement systems have encouraged skilled nursing facilities to focus on higher acuity patients. We also believe that high construction costs and limits on government reimbursement for construction and start-up expenses also have constrained the growth and supply of traditional skilled nursing beds. We believe that these factors, taken in combination, result in relatively fewer skilled nursing beds available for the increasing number of seniors who require assistance with the activities of daily living but do not require 24-hour medical attention.
Competitive Strengths
We compete with other assisted living communities located in the areas where we operate. These communities are operated by individuals, local and regional businesses and larger operators of regional and national groups of communities, including public companies similar to us. We believe that we have the following competitive strengths:
* State-of-the-Art Communities. Of our 132 operating communities, 65 communities have been built and opened since January 1, 1996 and reflect state-of-the-art design and equipment. In addition, we have significantly upgraded 48 of our older communities to improve their appearance and operating efficiency. These upgrades include the finished appearance of the communities, as well as various improvements to kitchens, nurse call systems and electronic systems, including those for data transmission, data sharing and e-mail.
* Large Operating Scale. We believe that our size gives us significant advantages over smaller operators. Given the scale of our operations, we have the opportunity to select the best operating systems and service alternatives and to develop a set of best practices for implementation on a national scale. We also believe that, because of our size, we are able to purchase such items as food, equipment, insurance and employee benefits at lower costs, and to negotiate more favorable financing arrangements.
* Lower Cost of Communities. As of December 31, 2001, the average cost per unit of our communities was approximately $64,700. We believe that these costs are less than the current replacement costs of these communities and below the average costs incurred by many other public companies operating in the industry. We also believe that these lower capital costs give us opportunities to enhance margins and greater flexibility in designing our rate structure and responding to varying regional economic and regulatory changes.
* Geographic Diversification and Regional Focus. We operate our communities in 29 states in all regions of the United States. We believe that because of this geographic diversification we are less vulnerable to adverse economic developments and industry factors, such as overbuilding and regulatory changes, that are limited to a particular region. We believe that this also moderates the effects of regional employment and competitive conditions. Within each region, we have focused on establishing a critical mass of communities in secondary markets, which enables us to maximize operating efficiencies.
* Experienced Management with Industry Relationships. Daniel R. Baty, our Chief Executive Officer, has more than 30 years of experience in the long-term care industry, ranging from independent living to skilled nursing care. We believe that his experience and the relationships that he has developed with owners, operators and sources of capital have helped us and will continue to help us develop operating efficiencies, investment and joint venture relationships, as well as obtain sources of debt and equity capital. Mr. Baty also has a significant financial and management interest in Holiday Retirement Corporation, an operator of independent living facilities, which we believe provides us with an informal but important relationship with a complementary business. In addition, our senior operating vice presidents have an average of 19 years of experience with major companies in the long-term care industry. We believe that this strong senior leadership, with proven
management skills, will allow us to take advantage of the opportunities present in the assisted living industry.
Business Strategy
We believe that 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 higher-level medical and institutional care offered by skilled nursing facilities. Our goal is to become the national leader in the assisted living segment of the long-term care industry through the following strategy:
* Focus on Operations and Occupancy. Through 1998, we focused on rapidly expanding our operations in order to assemble a portfolio of assisted living communities with a critical mass of capacity. We pursued an aggressive acquisition and development strategy during that time. Having achieved our growth objective, in 1999 and continuing through 2001, we have substantially reduced our pace of acquisition and development activities to concentrate on improving community performance through both increased occupancy and revenue per occupied unit. Initially, we focused most of our efforts on increasing occupancy across our portfolio. Having achieved a portion of our total goal by late 1999, we then shifted our efforts toward enhancing our rates, particularly in facilities that were substantially below industry averages. This rate strategy has led to increased rates across most of our portfolio. We believe that continued focus on both rates and occupancy will continue to generate the incremental growth in margins we are striving to achieve.
* Expand Business through Third Party Management Agreements. With the current changes in the capital markets, we may be presented with, or look for, opportunities for revenue growth through the use of third party management agreements. We will take advantage of these opportunities if the managed communities fit into our existing areas of operational strength and appropriate geological proximity to the communities that we currently own or manage, and, therefore require minimal incremental cost. We intend to manage these new communities for a fee based on a percentage of their gross revenue.
* Acquire Communities Selectively. In 1998, we reduced our acquisition activity in part to concentrate on the need to improve operations through occupancy and rate enhancement. As we achieve these objectives, we expect to be more receptive to acquisition opportunities that meet designated criteria. We particularly expect to favor the acquisition of communities that provide more complete coverage of our existing markets and intend to focus on acquisitions of communities that have been originally designed as assisted living facilities and that will have positive cash flow opportunities. We intend to be more selective and measured in our acquisition strategy in the future.
* Appeal to the Middle Market. The market segment most attractive to us is middle to upper-middle income seniors in smaller cities and suburbs with populations of 50,000 to 150,000 persons. We believe that this "value-sensitive" segment of the senior community is the largest, broadest and most stable. We think that these markets are receptive to the development of new assisted living communities and the expansion of existing communities.
Resident Services
Our assisted living communities offer residents a full range of services based on individual resident needs in a supportive "home-like" environment. By offering a full range of services, we can accommodate residents with a broad range of service needs. The services that we provide to our residents are designed to respond to their individual needs and to improve their quality of life.
Service Revenue Sources
We rely primarily on our residents' ability to pay our charges for services from their own or familial resources and expect that we will do so for the foreseeable future. Although care in an assisted living community is typically less expensive than in a skilled nursing facility, we believe generally that only seniors with income or assets meeting or exceeding the regional median can afford to reside in our communities. Inflation or other circumstances that adversely affect seniors' ability to pay for assisted living services could therefore have an adverse effect on our business.
As third party reimbursement programs and other forms of payment continue to grow, we intend to pursue these alternative forms of payment, depending on the level of reimbursement provided in relation to the level of care provided. We also believe that private long-term care insurance will increasingly become a revenue source in the future, although it is currently small. All sources of revenue other than residents' private resources constitute less than 10% of our total revenues.
Management Activities
At December 31, 2001, we managed and provided administrative services to 74 assisted living communities under management agreements that typically provide for management fees ranging from 3% to 7% of gross revenues. Management fees were approximately $8.7 million in 2001. These management agreements have terms ranging from two to five years, and may be renewed or renegotiated at the expiration of the term. We have various categories of management agreements, including:
* management agreements covering 46 communities in connection with the Emeritrust transactions, which we will refer to extensively throughout this document are summarized as follows:
* EMERITRUST I: 25 communities that we began managing in December 1998. Until December 31, 2001, we received a base management fee of 5% of gross revenues, but were entitled to receive up to 7% depending on the cash flow performance of the communities managed. As of January 1, 2002, however, we will receive a base management fee of 3% of gross revenues, but may receive up to 7% depending on the cash flow performance of the communities managed. Additionally, we are required by our management contracts to fund cash operating deficits.
* EMERITRUST II: 21 communities that we began managing in March 1999, consisting of:
* EMERITRUST II OPERATING: 16 communities for which we have no obligation to fund cash operating deficits. We receive a base management fee of 5% of gross revenues, but may receive up to 7% depending on the cash flow performance of the communities managed.
* EMERITRUST II DEVELOPMENT: 5 communities for which we are required to fund cash operating deficits. We receive a base management fee of 5% of gross revenues, but may receive up to 7% depending on the cash flow performance of the communities managed.
* management agreements covering 8 communities owned by Columbia House, a limited partnership, and 10 additional communities, all owned by entities controlled by Mr. Baty. We provide management services and administrative services in connection with acquisition, development and financing activities and generally receive fees ranging from 4% to 6% of the gross revenues generated by the communities.
* management agreements covering four communities owned by joint ventures in which we have a financial interest. We receive management fees ranging from 4% to 7% of gross revenues.
* management agreements covering six communities owned by independent third parties. We receive management fees ranging from 4% to 7% of gross revenues, or similar arrangement based on occupied capacity.
Prior to 1999, we did not have material revenue from management agreements. If we exercise our options to purchase the Emeritrust communities prior to June 10, 2003 (December 10, 2003, for the five Emeritrust II Development communities), or if the management agreements expire on those dates and are not renewed, our revenue from management fees will diminish substantially.
Marketing and Referral Relationships
Our operating strategy is designed to integrate our assisted living communities into the continuum of healthcare providers in the geographic markets in which we operate. One objective of this strategy is to enable residents who require additional healthcare services to benefit from our relationships with local hospitals, physicians, home healthcare agencies, and skilled nursing facilities in order to obtain the most appropriate level of care. Thus, we seek to establish relationships with local hospitals, 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 our network of referral sources.
Administration
We employ an integrated structure of management, financial systems and controls to maximize operating efficiency and contain costs. In addition, we have developed the internal procedures, policies and standards we believe are necessary for effective operation and management of our assisted living communities. We have recruited experienced key employees from several established operators in the long-term care services field and believe we have assembled the administrative, operational and financial personnel who will enable us to continue to manage our operating strategies effectively.
We have established Central, Eastern and Western Operational Divisions. A division vice president heads each division. Each division consists of several operating regions headed by a regional director of operations who provides management support services for each of the communities in his/her respective region. An on-site community director who, in certain jurisdictions, must satisfy certain licensing requirements supervises day-to-day community operations. We provide management support services to each of our residential communities, including establishing operating standards, recruiting, training, and financial and accounting services.
We have centralized finance and other operational functions at our headquarters in Seattle, Washington, in order to allow community-based personnel to focus on resident care. The Seattle office establishes certain policies and procedures applicable to the entire company, oversees our financial and marketing functions, manages our acquisition and development activities and provides our overall strategic direction.
We use a blend of centralized and decentralized accounting and computer systems that link each community with our headquarters. Through these systems, we are able to monitor operating costs and distribute financial and operating information to appropriate levels of management in a cost efficient manner. We believe that our current data systems are adequate for current operating needs and provide the flexibility to meet the requirements of our operations without disruption or significant modification to existing systems beyond 2002. We use high quality hardware and operating systems from current and proven technologies to support our current technology infrastructure.
Competition
The number of assisted living communities continues to grow in the United States. We believe that market saturation has had, and could continue to have, an adverse effect on our communities and their ability to reach and maintain 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. We anticipate that our source of competition will come from local, regional and national assisted living companies that operate, manage and develop residences within the geographic area in which we operate, 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. We believe that quality of service, reputation, community location, physical appearance and price will be significant competitive factors. Some of our competitors have significantly greater resources, experience and recognition within the healthcare community than we do.
Employees
At December 31, 2001, we had 6,005 employees, including 4,409 full-time employees, of which approximately 150 were employed at our headquarters. None of our employees are currently represented by a labor union, and we are not aware of any union-organizing activities among our employees. We believe that our relationship with our employees is satisfactory.
Although we believe that we are able to employ sufficiently skilled personnel to staff the communities we operate or manage, a shortage of skilled personnel in any of the geographic areas in which we operate could adversely affect our ability to recruit and retain qualified employees and to control our operating expenses.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
Communities
Our assisted living communities generally consist of one-story to three-story buildings and include common dining and social areas. Twenty-two of our operating communities offer some independent living services and three are operated as skilled nursing facilities. The table below summarizes information regarding our currently operating communities as of December 31, 2001.
* 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) We provide administrative services to the community that is operated by Painted Post Partners through a lease agreement with an independent third party. (2) On December 31, 1998, an investor group acquired these communities ("Emeritrust I") from Meditrust. We hold an option or a right of first refusal to purchase the communities, expiring on June 10, 2003, at a formula price based on a specified return to the investor group. We manage the communities during the option term. (3) On March 31, 1999, an investor group acquired these communities ("Emeritrust II") from Meditrust. We hold an option to purchase the communities, expiring on June 10, 2003, or December 10, 2003, for the five development communities, at a formula price based on a specified return to the investor group. We manage the communities during the option term.
Executive Offices
Our executive offices are located in Seattle, Washington, where we lease approximately 26,500 square feet of space. Our lease agreement includes a term of 10 years, expiring July 2006, with two five-year renewal options.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In August 2000, Emeritus began arbitration proceedings with Corio Inc. ("Corio") in connection with a contract dispute. In 1999, we entered into an agreement with Corio, pursuant to which Corio would plan, implement, and finalize our new accounting software program. In March 2000, Emeritus canceled the implementation of the program prior to its completion. Corio asserted a claim for breach of contract for $1.4 million, requesting payment of the full contract value. Both parties contacted AAA Arbitration as specified in the leasing and service contract, and the dispute was settled in February 2001 for $500,000, representing reimbursement for actual expenditures incurred by Corio. Payment of $300,000 was made in 2001. The remaining payments are to be remitted over a two-year term as follows: $150,000 in 2002 and $50,000 in 2003. This balance has been accrued and is included in the consolidated financial statements for the year ended December 31, 2001.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Emeritus did not submit any matter to a vote of its security holders during the fourth quarter of its fiscal year ended December 31, 2001.
EXECUTIVE OFFICERS OF EMERITUS
The following table presents certain information about our executive officers. There are no family relationships between any of the directors or executive officers.
Daniel R. Baty, one of Emeritus' founders, has served as its Chief Executive Officer and as a director since its inception in 1993 and became Chairman of the Board in April 1995. Mr. Baty also has served as the Chairman of the Board of Holiday Retirement Corporation since 1987 and served as its Chief Executive Officer from 1991 through September 1997. Since 1984, Mr. Baty has also served as Chairman of the Board of Columbia Pacific Group, Inc. and, since 1986, as Chairman of the Board of Columbia Management, Inc. Both of these companies are wholly owned by Mr. Baty and are engaged in developing independent living facilities and providing consulting services for that market.
Raymond R. Brandstrom, one of Emeritus' founders, has served as a director since its inception in 1993 and as Vice Chairman of the Board since March 1999. From 1993 to March 1999, Mr. Brandstrom also served as Emeritus' President and Chief Operating Officer. In March 2000, Mr. Brandstrom was elected Vice President of Finance, Chief Financial Officer and Secretary of Emeritus. From May 1992 to May 1997, Mr. Brandstrom served as Vice President and Treasurer of Columbia Winery, a company affiliated with Mr. Baty that is engaged in the production and sale of table wines.
Gary S. Becker joined Emeritus as Western Division Director in January 1997, was promoted to Vice President, Operations-Western Division in September 1999, and then promoted to Senior Vice President of Operations in March 2000. Mr. Becker has 28 years of health care management experience. From October 1993 to December 1996 he was Vice President of Operations for the Western Division of Sunrise Healthcare Corp. From 1982 to October 1993 he was Vice President of Operations for the Mid-West division of the Hillhaven Corporation.
Martin D. Roffe joined Emeritus as Director of Financial Planning in March 1998, and was promoted to Vice President of Financial Planning in October 1999. Mr. Roffe has 29 years experience in the acute care, long-term care, and senior housing industries. Prior to joining Emeritus, from May 1987 until February 1996, Mr. Roffe served as Vice President of Financial Planning for the Hillhaven Corporation, at which he also held the previous positions of Sr. Application Analyst and Director of Financial Planning, from January 1983 to April 1987. Prior to 1983, Mr. Roffe served in a Budget Director capacity for Acute Care Facilities.
Suzette McCanless joined Emeritus as Eastern Division Director of Operations in March 1997 and was promoted to Vice President of Operations-Eastern Division, in September 1999. Ms. McCanless has 21 years of health care management experience. Prior to joining Emeritus, from July 1996 to February 1997, she was Group Vice President for Beverly Enterprises, Inc., at which she also held the previous positions of Administrator and Regional Director of Operations from June 1983 to March 1994. In the interim, Ms. McCanless worked for Delta Health Group, from April 1994 to August 1995, as Regional Director of Operations, and at Hillhaven/Vencor Corporation as the Director of Operations from September 1995 to June 1996.
Russell G. Kubik joined Emeritus as Central Division Director of Operations in April 1997 and was promoted to Vice President, Operations - Central Division, in September 1999. Mr. Kubik has 17 years of health care management experience. Prior to joining Emeritus, from 1994 to 1997, Mr. Kubik served as Regional Director of Operations for Sun Healthcare Group in the Seattle/Puget Sound area. From May 1992 to March 1994, Mr. Kubik worked as Regional Director of Operations for Beverly Enterprises, Inc. in Washington and Idaho.
Peter Kacy Kang joined Emeritus as Regional Director of Operations in June 1997 and was promoted to Senior Director of Operations - Western Division, in February 2001. Mr. Kang was then promoted to Vice President of Operations - Western Division in August 2001. Prior to joining Emeritus, Mr. Kang operated nursing and rehabilitation facilities for Beverly Enterprises from 1991 to 1994 and Sun Health Care from 1994 through 1997. He also holds a Master of Science degree from Columbia University in Administration.
Kellie S. Murray joined Emeritus as Director of Human Resources in September 1999. Ms. Murray was promoted to Vice President of Human Resources in April 2001. Ms. Murray has 17 years of health care and human resources management experience. From January 1995 to September 1999 she was Vice President of Human Resources for the Western Group of Sunrise Healthcare Corporation. From 1985 to December 1994 she was Human Resources Manager for Virginia Mason Medical Center.
Susan A. Scherr joined Emeritus as a Regional Support Specialist in October 1999 and was promoted to Director of Signature Services and a member of the Emeritus Senior Management team in December 1999. In April 2001 Susan became Vice President of Signature Services, providing leadership and direction to Emeritus through Sales and Marketing, Education and Training, Dining Services, and Wellness and Activities Programming. Susan brings to Emeritus more than 17 years in the assisted living, acute and skilled care, and hospice/home health industries.
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock has been traded on the American Stock Exchange under the symbol "ESC" since November 21, 1995, the date of our initial public offering. The following table sets forth for the periods indicated the high and low closing prices for our common stock as reported on AMEX.
As of February 28, 2002, the number of record holders of our Common Stock was 138.
We have never declared or paid any dividends on our Common Stock, and expect to retain any future earnings to finance the operation and expansion of our business. Future dividend payments will depend on our results of operations, financial condition, capital expenditure plans and other obligations and will be at the sole discretion of our Board of Directors. Certain of our existing leases and lending arrangements contain provisions that restrict our ability to pay dividends, and it is anticipated that the terms of future leases and debt financing arrangements may contain similar restrictions. Therefore, we do not anticipate paying any cash dividends on our Common Stock in the foreseeable future.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected data presented below under the captions "Consolidated Statements of Operations Data" and "Consolidated Balance Sheet Data" for, and as of the end of, each of the years in the five-year period ended December 31, 2001, are derived from the consolidated financial statements of Emeritus Corporation, which financial statements have been audited by KPMG LLP, independent auditors. The consolidated financial statements as of December 31, 2001 and 2000, and for each of the years in the three-year period ended December 31, 2001, are included elsewhere in this document.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
Emeritus is a Washington corporation organized by Daniel R. Baty and two other founders in 1993. In November 1995, we completed our initial public offering and began our expansion strategy.
Through 1998, we focused on rapidly expanding our operations in order to assemble a portfolio of assisted living communities with a critical mass of capacity. We pursued an aggressive acquisition and development strategy during that time, acquiring 35 and developing 10 communities in 1996, acquiring 7 and developing 20 communities in 1997, and developing 5 communities in 1998. During 1999 and continuing through 2001, we have substantially reduced our pace of acquisition and development activities to concentrate on improving our operations and increasing occupancy and our average revenue per unit.
In our consolidated portfolio, our rate enhancement program brought about an increase in average monthly revenue per occupied unit to $2,405 for 2001 from $2,213 for 2000. This represents an average revenue increase of $192 per month per occupied unit, or 8.7%. The average occupancy rate decreased slightly to 84.1% in 2001 from 85.8% during 2000.
In our total operated portfolio, which includes managed communities, our rate enhancement program brought about an increase in average monthly revenue per occupied unit to $2,294 for 2001 from $2,109 for 2000. This represents an average revenue increase of $185 per month per occupied unit, or 8.8% . The average occupancy rate decreased slightly to 81.6% in 2001 from 81.7% during 2000.
We intend to continue a selective growth strategy through acquiring and developing new communities with operating characteristics consistent with our current emphasis on stabilizing occupancy and enhancing our operating model and service offerings.
The following table sets forth a summary of our property interests.
- -------- (1) Included in our consolidated portfolio of communities. (2) The percentage increase (decrease) indicates the change from the prior period. (3) The communities under development at December 31, 2000, were developed by third parties, but are currently managed by Emeritus.
We rely primarily on our residents' ability to pay our charges for services from their own or familial resources and expect that we will do so for the foreseeable future. Although care in an assisted living community is typically less expensive than in a skilled nursing facility, we believe that generally only seniors with income or assets meeting or exceeding the regional median can afford to reside in our communities. Inflation or other circumstances that adversely affect seniors' ability to pay for assisted living services could therefore have an adverse effect on our business. All sources of revenue other than residents' private resources constitute less than 10% of our total revenues.
We have incurred net operating losses since our inception. As of December 31, 2001, we had an accumulated deficit of approximately $141.7 million. These losses resulted from a number of factors, including:
* occupancy levels at our communities that were lower for longer periods than we originally anticipated;
* financing costs that we incurred as a result of multiple financing and refinancing transactions; and
* administrative and corporate expenses that we increased to facilitate our growth and maintain operations.
During 1998, we decided to reduce acquisition and development activities and dispose of select communities that had been operating at a loss. We believe that slowing our acquisition and development activities has enabled us to use our resources more efficiently and increase our focus on enhancing community operations.
EMERITRUST TRANSACTIONS
In two separate transactions during the fall of 1998 and the spring of 1999, we arranged for two investor groups to purchase an aggregate of 41 of our operating communities and five communities under development for a total purchase price of approximately $292.2 million. Of the 46 communities involved, 43 had been, or were proposed to be, leased to us by Meditrust Company LLC under sale/leaseback financing arrangements, and three had been owned by us. The first purchase, consisting of 25 communities, which we will call the Emeritrust I communities, was completed in December 1998 and the second purchase, consisting of 21 communities, 16 of which we will call the Emeritrust II Operating communities and five of which we call the Emeritrust II Development communities, was completed in March 1999.
Of the $168.0 million purchase price for the Emeritrust I communities, $138.0 million was financed through a three-year first mortgage loan with an independent third party and $30.0 million was financed through subordinated debt and equity investments from the investor group, which includes Daniel R. Baty, our Chief Executive Officer, who is also a director and a principal shareholder. Of the $124.2 million purchase price for the Emeritrust II Operating communities and Emeritrust II Development communities, approximately $99.6 million was financed through three-year first mortgage loans with independent third parties and $24.6 million was financed through subordinated debt and equity investments from the investor group, which includes Mr. Baty.
The investor groups retained us to manage all of the communities through December 31, 2001, and granted us options to purchase the communities during this period. During 2000, the Emeritrust I communities failed to comply with covenants under the $138 million mortgage loan and in 2001 it became clear that we would not be able to purchase the communities under the options. As a result, in January 2002, the mortgage loans were restructured and the management agreements and options to purchase were extended to June 30, 2003 (to December 31, 2003 in the case of the five Emeritrust II Development communities). The discussion below reflects the terms of these arrangements as modified.
From January 1, 2002, through June 30, 2003, we will receive for the Emeritrust I communities a base management fee of 3% of gross revenues generated by the communities and an additional management fee of 4%, payable out of 50% of cash flow. The availability of cash flow to pay management fees is subject to prior payment of expenses and fees related to the restructuring of the mortgage loan in 2001. For the Emeritrust II Operating communities and the Emeritrust II Development communities, we have received and continue to receive a base management fee of 5% of gross revenues and an additional management fee of 2%, payable to the extent that the communities meet certain cash flow standards. Prior to January 1, 2001, the management fees for the Emeritrust I communities were also computed in this fashion.
Under the management agreements, we are obligated to reimburse the investor groups for cumulative cash operating losses greater than $4.5 million in the case of the Emeritrust I communities and $500, 000 in the case of each of the five Emeritrust II Development communities. Since these thresholds have been exceeded, we are currently responsible for most cash operating losses generated by these communities if they occur. There is no such funding arrangement with respect to the Emeritrust II Operating communities. Our funding obligations for the Emeritrust I communities have been $1.3 million, $4.9 million and $1.9 million for 2001, 2000 and 1999, respectively. Our funding obligations for the Emeritrust II Development communities have been $310,000 and $1.6 million in 2001 and 2000, respectively.
2000 and 1999, respectively. Our funding obligations for the Emeritrust II Development communities have been $310,000 and $1.6 million in 2001 and 2000, respectively.
Although the amounts of our funding obligation each year include management fees earned by us under the management agreements, we do not recognize these management fees as revenue in our financial statements to the extent that we are funding the cash operating losses that include them. Correspondingly, we recognize the funding obligation under the agreement, less the applicable management fees, as an expense in our financial statements under the category "Other, net." Conversely, if the applicable management fees exceed our funding obligation, we recognize the management fees less the funding obligation as management fee revenue in our consolidated financial statements. Management fees earned for the Emeritrust I communities have been $4.0 million, $2.1 million and $1.9 million in 2001, 2000 and 1999, respectively, of which $2.8 million have been recognized in 2001. Management fees earned for the Emeritrust II Development communities have been $766,000 and $360,000, of which $673,000 and $174,000 have been recognized in 2001 and 2000, respectively. Management fees earned for the Emeritrust II Operating communities have been $1.9 million earned and recognized in both 2001 and 2000.
We have an option to purchase 43 of the 46 Emeritrust Communities and a right of first refusal with respect to the remaining three communities, both of which expire June 30, 2003 (December 31, 2003 in the case of the five Emeritrust II Development communities). The option must be exercised with respect to all communities or may not be exercised at all. If investor groups require Mr. Baty to purchase certain of the communities, upon the conditions described below, we have the right to exercise our option within 60 days of receiving notice of this action. The option price for the 43 Emeritrust communities is equal to the original cost of the communities of approximately $292 million, plus an amount that would provide the investor groups with an 18% rate of return, compounded annually, on their original investment of $54.6 million (less any cash distributions received). In connection with the exercise of the option, we are also obligated to pay certain costs and fees.
The management agreements, including the options to purchase the related communities, are subject to various termination provisions, including cross-default provisions among all three groups of communities. The management agreement for the Emeritrust I communities may be terminated if cash distributions to the investor group do not meet certain levels or if the communities fail to meet certain coverage requirements under the mortgage loan. In addition, certain of the communities have been refinanced and, accordingly, our ability to exercise the option will depend on whether we can assume or refinance the debt secured by these communities. Termination of the management agreements or failure to exercise the options could result in the loss of management fees and the substantial decrease in the number of communities we operate.
Under related agreements, the investor groups may require Mr. Baty to purchase between ten and twelve of the Emeritrust communities, depending on the occurrence of any one of the following events: (a) we do not exercise our option to purchase the communities before the option expires, (b) we default under the management agreements, (c) Mr. Baty's net worth falls below a certain threshold, (d) we experience a change of control or (e) Mr. Baty ceases to be our chief executive officer. If Mr. Baty is required to purchase some of the communities, he will also have the option to purchase all of the Emeritrust communities on the same terms under which we are entitled purchase the communities, subject to our prior right to do so within a specified time period.
RESULTS OF OPERATIONS
Critical Accounting Policies and Estimates.
Emeritus's discussion and analysis of its financial condition and results of Operations are based upon Emeritus's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires Emeritus to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, Emeritus evaluates its estimates, including those related to resident programs and incentives, bad debts, investments, intangible assets, income taxes, financing operations, restructuring, long-term service contracts, contingencies, and litigation. Emeritus bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Emeritus believes the following critical accounting policies are more significant to the judgments and estimates used in the preparation of its consolidated financial statements. Revisions in such estimates are charged to income in the period in which the facts that give rise to the revision become known. Emeritus maintains allowances for doubtful accounts for estimated losses resulting from the inability of its residents to make required payments. If the financial condition of Emeritus's residents were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Emeritus holds shares in ARV Assisted Living, Inc. amounting to less than 5% of its shares. ARV is publicly traded and has a volatile share price. Emeritus records an investment impairment charge when it believes this investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results underlying this investment could result in losses or an inability to recover the carrying value of the investment that may not be reflected in this investment's current carrying value, thereby possibly requiring an impairment charge in the future. Emeritus records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized, which at this time shows a net asset valuation of zero. While Emeritus has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance, in the event Emeritus were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.
The following table sets forth, for the periods indicated, certain items from our Condensed Consolidated Statements of Operations as a percentage of total revenues and the percentage change of the dollar amounts from period to period.
Comparison of the Years Ended December 31, 2001 and 2000 - -----------------------------------------------------------------
Total Operating Revenues: Total operating revenues for the year ended December 31, 2001, increased by $15.4 million to $140.6 million from $125.2 million in 2000, or 12.3%. Approximately $4.1 million of the increase reflects revenue from four communities that we first leased in late 2000, reduced by revenues from leased communities we disposed of in late 2001. The balance of the change in revenue is primarily the result of increases in the average monthly revenue per unit due to our rate enhancement program. Average monthly revenue per unit was $2,405 for 2001 compared to $2,213 for 2000, an increase of approximately 8.7%. These increases were partially offset by a small decrease in the occupancy rate of 1.7 percentage points to 84.1% for 2001 from 85.8% for 2000. An increase in management fee revenue of $4.2 million contributed significantly to increased revenue. Improved performance of managed communities allowed us to recognize base management fees and performance-driven contingent management fees. Concurrently, our net funding obligation for the Emeritrust communities was greatly reduced (see Other, net below).
Community Operations: Community operating expenses for the year ended December 31, 2001, increased $4.0 million to $80.8 million from $76.8 million for 2000, or 5.2%. Approximately $1.8 million of the increase reflects operating expense from four communities that we first leased in late 2000, reduced by operating expense from leased communities we disposed of in late 2001. The balance of this change was due to increases in personnel costs and above average increases in utility costs and liability insurance
premiums. Community operating expenses as a percentage of total operating revenue decreased to 57.5% in 2001 from 61.4% in 2000, primarily as a result of increased revenues.
General and Administrative: General and administrative (G&A) expenses for the year ended December 31, 2001, increased $561,000 to $18.0 million from $17.4 million for 2000, or 3.2%. This comparison reflects the effect of abnormally high expenses in 2000 for professional consulting fees and for certain employee benefits. Excluding these items, we experienced increases of approximately $1.5 million in personnel costs, liability insurance and utilities. As a percentage of total operating revenues, G&A expenses decreased to 12.8% for 2001, compared to 13.9% for 2000, primarily as a result of increased revenues. Since more than half of the communities we operate are managed, G&A expense as a percentage of operating revenues for all communities, including managed communities, may be more meaningful for industry wide comparisons. These percentages were 6.6% and 7.2% for 2001 and 2000, respectively.
Depreciation and Amortization: Depreciation and amortization for the year ended December 31, 2001 and 2000, were approximately $7.3 million and $7.4 million, respectively. In 2001, this represents 5.2% of total operating revenues, compared to 5.9% for 2000. The decrease as a percentage of revenues is due to increased revenues.
Facility Lease Expense: Facility lease expense for the year ended December 31, 2001, was $27.1 million compared to $24.3 million for the year ended December 31, 2000, representing an increase of $2.8 million, or 11.5%. Approximately $1.8 million of the increase reflects rental from four communities that we first leased in late 2000, reduced by rental from leased communities we disposed of in late 2001. The balance of the increase is primarily attributable to rental increases based on community performance under certain of our leases and to higher rental on two leased communities that were refinanced through sale/leaseback transactions. We leased 42 communities as of December 31, 2001, compared to 45 communities as of December 31, 2000. Facility lease expense as a percentage of revenues decreased to 19.3% from 19.4% for the years ended December 31, 2001 and 2000, respectively.
Interest Income: Interest income for the year ended December 31, 2001, was $980,000 versus $990,000 for the year ended December 31, 2000. The decrease is primarily attributable to declining interest rates, offset by higher investment amounts.
Interest Expense: Interest expense for the year ended December 31, 2001, was $13.3 million compared to $15.1 million for the year ended December 31, 2000. This decrease of $1.8 million, or 11.9%, is primarily attributable to lower interest rates on our variable rate debt. As a percentage of total operating revenues, interest expense decreased to 9.4% from 12.0% for the year ended December 31, 2001 and 2000, respectively, reflecting increased revenues in conjunction with lower interest rates.
Other, net: Other, net increased by $7.8 million to $707,000 income for the year ended December 31, 2001, from $7.1 million expense for the year ended December 31, 2000. The amount for the year 2001 included a deficit-funding obligation of $335,000 arising from our management of the Emeritrust communities, losses of $313,000 associated with our investment in Senior Healthcare Partners, LLC, and a gain of $1.2 million on sale of a community. The amount for the year 2000 includes a deficit funding obligation of $3.7 million arising from our management of the Emeritrust communities, write-offs of $1.5 million relating to
receivables and capitalized development transaction costs that do not have future realizable value, losses of $557,000 associated with our investment in Senior Healthcare Partners, LLC, and other items aggregating $1.3 million.
Preferred dividends: For the year ended December 31, 2001 and 2000, the preferred dividends were approximately $6.4 million and $5.3 million, respectively. For the last six quarters we have not paid dividends on our preferred stock but have been accruing such accumulated and unpaid dividends. The terms of our preferred stock provide that accumulated and unpaid dividends accrue at a higher rate than dividends that are paid currently. The amount of dividends attributable to such higher rates is $2.1 million and $600,000 for 2001 and 2000, respectively. In addition, because we have failed to pay the dividends on our Series A Stock for six quarters, effective January 1, 2002, such dividends will be calculated on a compounded cumulative basis, retroactive to our last payment, until they are paid current. Had we been required to compound the dividends for the Series A Stock in prior years, both our preferred dividends and net loss to common shareholders would have increased $275,000 and $20,000 for 2001 and 2000, respectively.
Comparison of the Years Ended December 31, 2000 and 1999 - -----------------------------------------------------------------
Total Operating Revenues. Total operating revenues increased $2.6 million to $125.2 million for 2000 from $122.6 million in 1999, representing a 2.1% increase. Within total operating revenues, community revenue (including other service fees) increased $2.8 million to $120.6 million in 2000 from $117.7 million in 1999. The first quarter of 1999, however, includes approximately $6.3 million of community revenue from 21 communities (known as the Emeritrust II communities, more fully discussed under Other, net) that were transferred at the end of the quarter to a related party investor group under agreements pursuant to which we continue to manage them. Accordingly, the first quarter of 2000 includes only management fees from these communities and no community revenue. Excluding the Emeritrust II communities, revenues increased $9.1 million or 8% from 1999 to 2000, primarily as a result of a 4% increase in revenue per unit (an increase of $79 per unit to $2,213 per unit at December 31, 2000) and the addition of six communities during 2000, partially offset by the disposition of a skilled nursing facility.
Management fee revenue decreased $336,000 to $4.6 million in 2000 from $4.9 million in 1999. In 2000, we were not able to recognize fees earned from our management of 25 communities (known as the Emeritrust I communities, more fully discussed under Other, net) where the management agreements require us to fund cash operating deficits, while in 1999 we recognized $1.4 million in management fee revenue from these communities. This was partially offset by an increase of $500,000 in management fees from the Emeritrust II communities from $1.4 million to $1.9 million, the addition of several new management agreements and the generally improving performance of our portfolio of managed communities.
Community Operations. Community operating expenses decreased $1.4 million to $76.8 million for 2000 from $78.2 for 1999, representing a 1.7% decrease. As a percentage of total operating revenues, community operations decreased to 61.4% for 2000 compared to 63.8% for 1999. The first quarter of 1999, however, includes approximately $3.9 million of community operating expenses from the Emeritrust II communities, with no comparable offset in 2000. Excluding the Emeritrust II communities, community operating expenses increased $2.5 million or 3% from 1999 to 2000, primarily as a result of the addition of six new
buildings to our consolidated portfolio, slightly offset by the disposition of one skilled nursing facility.
General and Administrative. General and administrative expenses increased $1.9 million to $17.4 million for 2000 from $15.5 million for 1999, representing a 12.3% increase. As a percentage of revenues, general and administrative expenses increased to 13.9% for 2000 compared to 12.6% for 1999. The increase of general and administrative costs as a percentage of revenues is due, in part, to transferring our interest in the Emeritrust II communities. The overall increase of $1.9 million is primarily attributable to settlement and legal costs of the Corio mediation (See Item 3. Legal Proceedings) and additional costs associated with increased professional liability insurance deductibles. Since more than half of the communities we operate are managed, G&A expense as a percentage of operating revenues for all communities, including managed communities, may be more meaningful for industry wide comparisons. These percentages were 7.2% and 8.2% for 2000 and 1999, respectively.
Depreciation and Amortization. Depreciation and amortization expense increased $798,000 to $7.4 million for 2000 from $6.6 million for 1999, representing a 12.1% increase. As a percentage of total revenue, depreciation and amortization expenses increased to 5.9% in 2000 from 5.4% in 1999. This marginal increase is principally the result of six community acquisitions in 2000, partially offset by the disposition of one skilled nursing facility.
Facility Lease Expense: Facility lease expense decreased $829,000 to $24.3 million for 2000 from $25.1 million for 1999, representing a decrease of 3.3%. The decrease is primarily attributable to the transfer of the Emeritrust II communities that converted to management agreements as discussed in Total Operating Revenues above. These communities accounted for $1.9 million in rent expense for 1999, partially offset by additional rent generation from six community acquisitions and normal increases in lease expense obligations from our existing portfolio. Facility Lease Expense as a percentage of revenues was 19.4% for 2000 compared to 20.5% for 1999.
Interest Income: Interest income for the year ended December 31, 2000, was $990,000 versus $670,000 for the year ended December 31, 1999. This is primarily attributable to the increase in cash available for earning interest in 2000 as compared to 1999.
Interest Expense: Interest expense for the year ended December 31, 2000, was $15.1 million compared to $13.8 million for the year ended December 31, 1999. This increase is primarily attributable to generally increasing mortgage interest expense associated with our variable rate debt, as well as the addition of six consolidated communities in early 2000. In addition, total debt increased approximately $5 million to $175 million as of December 31, 2000, compared to $170 million as of December 31, 1999. As a percentage of total operating revenues, interest expense increased to 12.0% from 11.2% for the year ended December 31, 2000 and 1999, respectively.
Impairment of Investment Securities. During 2000, we did not have an impairment of investment securities. In 1999, we wrote down $7.4 million on our investment in ARV Assisted Living, Inc., as we concluded the decline in the fair market value of this investment was other than temporary. Other, Net. Other, net was $7.1 million (expense) in 2000 and $2.5 million income in 1999, representing a
net change of $9.6 million. The amount for the year 2000 includes a deficit funding obligation of $3.7 million arising from our management of both the Emeritrust I and Emeritrust II Development communities in which we are responsible for cash operating deficits for such communities, write-offs of $1.5 million relating to receivables and capitalized development transaction costs that do not have future realizable value, losses of $557,000 associated with our investment in Senior Healthcare Partners, LLC, and other items aggregating $1.3 million. The amount for the year 1999 includes gain of $3.2 million arising from a litigation settlement, gain of $762,000 from the sale of a Canadian subsidiary, deficit-funding obligation of $1.4 million arising from our management of the Emeritrust I communities described above, and other items aggregating $600,000.
Extraordinary Item. We recognized extraordinary losses of approximately $333,000 in 1999 and none in 2000. Our 1999 extraordinary loss resulted from the write-off of loan fees and other related costs in conjunction with the refinancing of several of our mortgage-financed communities.
Same Community Comparison
We operated 57 communities on a comparable basis during both the three months ended December 31, 2001 and 2000. The following table sets forth a comparison of same community results of operations, excluding general and administrative expenses, for the three months ended December 31, 2001 and 2000.
The same communities represented $30.1 million or 84.3% of our total revenue of $35.7 million for the fourth quarter of 2001. Same community revenues increased by $1.2 million or 4.1% for the quarter ended December 31, 2001, from the comparable period in 2000. This was primarily due to rate increases, which increased revenue per unit by 7.8%, partially offset by a decrease in average occupancy to 82.6% in the fourth quarter of 2001 from 85.4% in the fourth quarter of 2000. For the quarter ended December 31, 2001, we increased our net income to $2.1 million from $1.4 million for the comparable period of 2000, primarily as a result of decreased interest expense resulting from lower interest rates.
We operated 57 communities on a comparable basis during both 2001 and 2000. The following table sets forth a comparison of same community results of operations, excluding general and administrative expenses, for 2001 and 2000.
The same communities represented $119.8 million or 85.2% of our total revenue of $140.6 million for the year ended December 31, 2001. Same community revenues increased by $7.0 million or 6.2% for the year ended December 31, 2001, from the year ended December 31, 2000. The increase in revenue is attributable to our rate enhancement program, which resulted in same community average monthly revenue per unit increasing to $2,411 for 2001, from $2,201 for 2000. This is an increase of $210 or 9.5%. These results were partially offset by a decrease in occupancy to 83.7% in 2001 from 86.2% in 2000. For the year ended December 31, 2001, we increased our net income to $7.2 million from $2.9 million for 2000, primarily through our rate enhancement program, controlling community level costs and the effects of lower interest rates.
LIQUIDITY AND CAPITAL RESOURCES
For the year ended December 31, 2001, net cash provided by operating activities was $3.6 million compared to $9.2 million of cash used in operating activities for the prior year. The primary component of the operating cash provided in the year ended December 31, 2001, was the decrease of our net loss from $21.9 million in the year ended December 31, 2000 to $4.2 million for the year ended December 31, 2001.
Net cash provided by investing activities amounted to $2.5 million for the year ended December 31, 2001, and was comprised primarily of repayment of advances by third parties and affiliates and proceeds received from the sale of two communities, which was partially offset by the acquisition of property, equipment, and new leases.
For the year ended December 31, 2001, net cash used in financing activities was $3.8 million primarily from short-term and long-term debt repayments. For the year ended December 31, 2000, net cash provided by
financing activities was $118,000 primarily from proceeds of long-term borrowings, partially offset by debt repayment and preferred dividend payments.
In 2001, and as described in Note 21, we refinanced substantially all of our debt obligations, extending such financings through 2003 or thereafter. In addition, we achieved consecutive positive cash flows from operations for the last three quarters and positive earnings before preferred dividends in the fourth quarter of 2001. Including required debt service payments and capital expenditures, management believes we will be able to sustain positive cash flow through at least 2002.
The we have incurred significant operating losses since our inception and have a working capital deficit of $12.1 million, although $7.4 million of preferred dividends is only due if declared by the our board of directors. To date, we have been dependent upon third party financing or disposition of assets to fund operations. While we do not anticipate the need for third party financing or dispositions of assets to fund operations, it cannot be guaranteed that, if necessary, third party financing or disposition of assets will be available timely or at all.
We are currently out of compliance with covenants on debt totaling $1.7 million which will be repaid in June 2002 and is not cross-defaulted with any other debt. In addition, many of our other debt instruments and leases contain "cross-default" provisions pursuant to which a default under one obligation can cause a default under one or more other obligations to the same lender or lessor. Such cross-default provisions affect 14 owned assisted living properties and 36 operated under leases. Accordingly, any event of default could cause a material adverse effect on our financial condition if such debt or leases are cross-defaulted.
The following table summarizes our contractual obligations at December 31, 2001:
IMPACT OF INFLATION
To date, inflation has not had a significant impact on Emeritus. Inflation could, however, affect our future revenues and operating income due to our dependence on the senior resident population, most of whom rely on relatively fixed incomes to pay for our services. The monthly charges for the resident's unit and assisted living services are influenced by the location of the community and local competition. Our ability to increase revenues in proportion to increased operating expenses may be limited. We typically do not rely to a significant extent on governmental reimbursement programs. In pricing our services, we attempt to anticipate inflation levels, but there can be no assurance that we will be able to respond to inflationary pressures in the future.
RISK FACTORS
Our business, results of operations and financial condition are subject to many risks, including, but not limited to, those set forth below.
The following important factors, among others, could cause actual operating results to differ materially from those expressed in forward-looking statements included in this report and presented elsewhere by our
management from time to time. Do not 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 refer to potential future circumstances, operations and prospects, and therefore, are not historical or current facts. The discussion of such matters and subject areas is qualified by the inherent risks and uncertainties surrounding future expectations, and also may materially differ from our actual future experience involving any one or more of such matters and subject areas relating to possible excess assisted living capacity in our market areas affecting our occupancy and pricing levels; uncertainties in increasing occupancy and pricing, generally; effective management of costs and the effects of cost increases beyond our control, such as utilities and insurance; the difficulty in reducing and eliminating continuing operating losses; vulnerability to defaults in our debt and lease financing as a result of noncompliance with various covenants; the effects of cross-default terms; competition; and uncertainties relating to construction, licensing, environmental and other matters that affect acquisition, disposition and development of assisted living communities. We have attempted to identify, in context, certain of the factors that may cause actual future experience and results to differ from our current expectations regarding the relevant matter or subject area. We are not obligated 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. These and other factors are discussed in more detail below.
We have incurred losses since we began doing business and may continue to incur losses for the foreseeable future. We organized and began operations in July 1993 and have operated at a loss since we began doing business. For 2001, 2000 and 1999, we recorded net losses before preferred dividends of $4.2 million, $21.9 million, and $21.0 million, respectively. We believe that the historically aggressive growth of our portfolio through acquisitions and developments and related financing activities were among the causes of these losses. To date, we have been generally unable to stabilize occupancy and rate structures at our communities that result in positive earnings. While we were able to substantially reduce our net losses during 2001, we cannot guarantee that this improvement will continue in 2002.
If we cannot generate sufficient cash flow to cover required interest, principal and lease payments, we risk defaults on our debt agreements and operating leases. At December 31, 2001, we had mortgage debt of $133.8 million, with minimum principal payments of about $4.5 million due in 2002. At December 31, 2001, we were obligated under long-term operating leases requiring minimum annual lease payments of which $25.4 million is payable in 2002. In addition, we will have approximately $61.9 million and $40.7 million in principal amount of debt repayment obligations that become due in 2003 and 2004, respectively. We intend to continue to finance our communities through a combination of mortgage financing and operating leases, including leases arising through sale/leaseback transactions.
Because we are highly leveraged, we may not be able to respond to changing business and economic conditions or continue our development and acquisition program. Further, a substantial portion of our cash flow will be devoted to debt service and lease payments. In the past we have been unable to generate sufficient cash flow from operations to cover required interest, principal and lease payments and we may be unable to do so in the future. If we cannot meet these payments when due, we may need to renegotiate payments or obtain additional equity or debt financing. We may not be successful or timely in doing so, and the terms of any financing or refinancing may not be favorable.
If we fail to obtain alternative financing, a lender could foreclose on our facilities secured by the respective indebtedness or, in the case of an operating lease, could terminate our lease, resulting in loss of income and
asset value. In some cases, our indebtedness is secured by a particular community and a pledge of our interests in a subsidiary entity that owns that community. In the event of a default, a lender could avoid judicial procedures required to foreclose on real property by foreclosing on our pledge instead, thus accelerating its acquisition of that community. Furthermore, because of cross-default and cross-collateralization provisions in certain of our mortgage and sale/leaseback agreements, if we default on one of our payment obligations, we could adversely affect a significant number of our communities.
We may be unable to increase or stabilize our occupancy rates that would result in positive earnings. In previous years we had difficulty increasing our occupancy levels. Our historical losses have resulted, in part, from lower than expected occupancy levels at our newly developed and acquired communities. Although we have reduced our acquisition and development activity substantially, we have been unable to increase occupancy levels as we had anticipated and, during the last year, occupancy levels declined slightly. We cannot guarantee that our occupancy levels will increase.
We will occasionally seek additional funding through public or private financing, including equity financing. We may not find adequate equity, debt or sale/leaseback financing when we need it or on terms acceptable to us. This could affect our ability to finance our operations or refinance our properties to avoid the consequences of default and foreclosure under our existing financing as described above. In addition, if we raise additional funds by issuing equity securities, our shareholders may experience dilution of their investment.
We may be unable to obtain the additional capital we will need to retain important segments of our operating communities. We manage 46 of our operating communities under short-term management agreements expiring December 31, 2003, for the five Emeritrust II Development communities, and June 30, 2003, for the remaining 41 communities, which we have referred to throughout this document as the Emeritrust I and Emeritrust II Operating communities. We also have options to purchase 43 communities, and a right of first refusal to purchase three of these communities prior to December 31, 2003, for the five Emeritrust II Development communities, and June 30, 2003, for the remaining 41 communities. Based on formulas in the options, the purchase prices of the communities would be substantially greater than the original purchase prices paid by the investor groups that currently own them, depending on when the purchase occurs and the performance of the communities. If we are unable to obtain the capital and related mortgage financing necessary to complete these purchases, we could lose control of these communities and the right to operate them, which represents about 33% of our total operating capacity. The loss of these operating communities would have a material adverse effect on our revenues and results of operations.
If we fail to comply with financial covenants contained in our debt instruments, our lenders may accelerate the related debt. From time to time, we have not complied with certain covenants in our financing agreements. In the future we may not be able to comply with these covenants, which generally relate to matters such as net worth, cash flow and debt coverage ratios. If we fail to comply with any of these requirements, our lenders could accelerate the related indebtedness so that it becomes due and payable prior to its stated due date. We may be unable to pay or refinance this debt if it becomes due.
Our liability insurance may be insufficient to cover the liabilities we face. In recent years, participants in the long-term-care industry have faced an increasing number of lawsuits alleging malpractice or related legal theories. Many of these suits involve large claims and significant legal costs. We expect that we occasionally will face such suits because of the nature of our business. We currently maintain insurance
policies with coverage and deductibles we deem appropriate based on the nature and risks of our business, historical experience and industry standards. We could incur liability in excess of our insurance coverage or claims not covered by our insurance. Claims against us, regardless of their merit or eventual outcome, may also undermine our ability to attract residents or expand our business and would require management to devote time to matters unrelated to the operation of our business. Our liability insurance policies must be renewed annually, and we may not be able to obtain liability insurance coverage in the future or, if available, on acceptable terms. During the past several years, deductible amounts and annual premiums have increased significantly, which have substantially compounded our costs associated with insurance and claims defense.
We face risks associated with selective acquisitions. We intend to continue to seek selective acquisition opportunities. However, we may not succeed in identifying any future acquisition opportunities or completing any identified acquisitions. The acquisition of communities presents a number of risks. Existing residences available for acquisition may frequently serve or target different market segments than those we presently serve. It may be necessary in these cases to re-position and renovate acquired residences or turn over the existing resident population to achieve a resident care level and income profile that is consistent with our objectives. In the past, these obstacles have delayed the achievement of acceptable occupancy levels and increased operating and capital expenditures. As a consequence, we currently plan to target assisted living communities with established operations, which could reduce the number of acquisitions we can complete and increase the expected cost. Even in these acquisitions, however, we may need to make staff and operating management personnel changes to successfully integrate acquired communities into our existing operations. We may not succeed in repositioning acquired communities or in effecting any necessary operational or structural changes and improvements on a timely basis. We also may face unforeseen liabilities attributable to the prior operator of the acquired communities, against whom we may have little or no recourse.
We expect competition in our industry to increase, which could cause our occupancy rates and resident fees to decline. The long-term care industry is highly competitive, and given the relatively low barriers to entry and continuing health care cost containment pressures, we expect that our industry will become increasingly competitive in the future. We believe that the industry is experiencing over-capacity in several of our markets, thereby intensifying competition and adversely affecting occupancy levels and pricing. We compete with other companies providing assisted living services as well as numerous other companies providing similar service and care alternatives, such as home healthcare agencies, independent living facilities, retirement communities and skilled nursing facilities. We expect that competition will increase from new market entrants, as assisted living residences receive increased market awareness and more states decide to include assisted living services in their Medicaid programs. Many of these competitors may have substantially greater financial resources than we do. Increased competition may limit our ability to attract or retain residents or maintain our existing rate structures. This could lead to lower occupancy rates or lower rate structures in our communities.
We also cannot predict the effect of the healthcare industry trend toward managed care on the assisted living marketplace. Managed care, an arrangement whereby service and care providers agree to sell specifically defined services to public or private payers in an effort to achieve more efficiency with respect to utilization and cost, is not currently a significant factor in the assisted living marketplace. However, managed care plans sponsored by insurance companies or HMOs may in the future affect pricing and the range of services provided in the assisted living marketplace.
If development of new assisted living facilities outpaces demand, we may experience decreased occupancy, depressed margins and diminished operating results. We believe that some assisted living markets have become or are on the verge of becoming overbuilt. The barriers to entry in the assisted living industry are not substantial. Consequently, the development of new assisted living facilities could outpace demand. Overbuilding in the markets in which we operate could thus cause us to experience decreased occupancy and depressed margins and could otherwise adversely affect our operating results.
Market forces could undermine our efforts to attract seniors with sufficient resources. We rely on our residents' abilities to pay our 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 our assisted living communities are located can afford our fees. Inflation or other circumstances may undermine the ability of seniors to pay for our services. If we encounter difficulty in attracting seniors with adequate resources to pay for our services, our occupancy rates may decline and we may suffer losses that could cause the value of your investment in our stock to decline.
Our labor costs may increase and may not be matched by corresponding increases in rates we charge to our residents. We compete with other providers of assisted living services and long-term care in attracting and retaining qualified and skilled personnel. We depend on our ability to attract and retain management personnel responsible for the day-to-day operations of each of our residences. If we are unable to attract or retain qualified residence management personnel, our results of operations may suffer. In addition, possible shortages of nurses or trained personnel may require us to enhance our wage and benefits packages to compete in the hiring and retention of personnel. We also depend on the available labor pool of semi-skilled and unskilled employees in each of the markets in which we operate. As a result of these and other factors, our labor costs may increase and may not be matched by corresponding increases in rates we charge to our residents.
We face possible environmental liabilities at each of our properties. 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 asbestos-containing materials, that could be located on, in or under its property. These 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. We could face substantial costs of any required remediation or removal of these substances, and our liability typically is not limited under applicable laws and regulations. Our liability could exceed our properties' value or the value of our assets. We may be unable to sell or rent our properties, or borrow using our properties as collateral, if any of these substances is present or if we fail to remediate them properly. Under these laws and regulations, if we arrange for the disposal of hazardous or toxic substances such as asbestos-containing materials at a disposal site, we also may be liable for the costs of the removal or of the hazardous or toxic substances at the disposal site. In addition to liability for these costs, we could be liable for governmental fines and injuries to persons or properties.
Some of our facilities generate infectious medical waste due to the illness or physical condition of the residents, including, for example, blood-soaked bandages, swabs and other medical waste products and incontinence products of those residents diagnosed with an infectious disease. The management of infectious medical waste, including handling, storage, transportation, treatment and disposal, is subject to regulation under various laws, including federal and state environmental laws. These environmental laws set
forth the management requirements, as well as permit, record-keeping, notice and reporting obligations. Each of our facilities has an agreement with a waste management company for the proper disposal of all infectious medical waste. Any finding that we are not in compliance with these environmental laws could adversely affect our business and financial condition. Because these environmental laws are amended from time to time, we cannot predict when and to what extent liability may arise. In addition, because these environmental laws vary from state to state, expansion of our operations to states where we do not currently operate may subject us to additional restrictions on the manner in which we operate our facilities.
Our chief executive officer has personal interest that may conflict with ours due to his interest in Holiday Retirement Corporation. Mr. Baty, our Chief Executive Officer, is a principal shareholder, director and Chairman of the Board of Holiday Retirement Corporation. Substantially all of the independent living facilities operated by Holiday are owned by partnerships that are controlled by Mr. Baty and Holiday. Mr. Baty's varying financial interests and responsibilities include the acquisition, financing and refinancing of independent living facilities and the development and construction of, and capital raising activities to finance, new facilities. The financial interests and management and financing responsibilities of Mr. Baty with respect to Holiday and its affiliated partnerships could present conflicts of interest with us, including potential competition for residents in markets where both companies operate and competing demands for the time and efforts of Mr. Baty.
Because Mr. Baty is both our Chief Executive Officer as well as Holiday's Chairman of the Board, circumstances could arise that would distract him from our operations. Our interests and Holiday's interests may on some occasions be incompatible. We have entered into a noncompetition agreement with Mr. Baty, but this noncompetition agreement does not limit Mr. Baty's current role with Holiday or its related partnerships, so long as assisted living is only an incidental component of Holiday's operation or management of independent living facilities.
We have entered into agreements with several companies that are owned or controlled by our affiliates, whose interests with respect to these companies occasionally may conflict with ours. We have entered into agreements, including most of our management agreements, with several entities that are owned or controlled by certain of our officers and directors. Under these agreements, we provide management and other services to senior housing communities owned by those companies and we have material agreements relating to the purchase, sale and financing of a number of our operating communities. There is a risk that our dealings with these companies under these and any future arrangements will not be negotiated at arm's length and may be regarded as less advantageous to us than terms that would be negotiated with unrelated third parties. Because of our affiliates' interests and responsibilities with respect to these other companies, these affiliates may occasionally have interests that are not compatible with ours.
We may be unable to attract and retain key management personnel. We depend upon, and will continue to depend upon, the services of Mr. Baty, our Chief Executive Officer. The loss of Mr. Baty's services, in part or in whole, could adversely affect our business and our results of operations. Mr. Baty has financial interests and management responsibilities with respect to Holiday and its related partnerships. As a result, he does not devote his full time and efforts to Emeritus. We may be unable to attract and retain other qualified executive personnel critical to the success of our business.
Our costs of compliance with government regulations may significantly increase in the future. Federal, state and local authorities heavily regulate the healthcare industry. Regulations change frequently, and sometimes
require us to make expensive changes in our operations. 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 adversely affect our business and operating results. We cannot predict to what extent legislative or regulatory initiatives will be enacted or adopted or what effect any initiative would have on our business and operating results. Changes in applicable laws and new interpretations of existing laws can significantly affect our operations, as well as our revenues, particularly those from governmental sources, and our expenses. Our residential communities are subject to varying degrees of regulation and licensing by local and state health and social service agencies and other regulatory authorities. While these regulations and licensing requirements often vary significantly from state to state, they typically address:
* fire safety, * sanitation, * staff training, * staffing levels, * living accommodations such as room size, number of bathrooms, and ventilation, and * health-related services.
We may be unable to satisfy all regulations and requirements or to acquire and maintain any required licenses on a cost-effective basis.
In addition, with respect to our residents who receive financial assistance from governmental sources for their assisted living services, we are subject to federal and state regulations that prohibit certain business practices and relationships. Failure to comply with these regulations could prevent reimbursement for our healthcare services under Medicaid or similar state reimbursement programs. Our failure to comply with such regulations also could result in fines and the suspension or inability to renew our 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 us that is discovered in any such investigation, audit or review, could strain our resources and affect our profitability. In addition, regulatory oversight of construction efforts associated with refurbishment could cause us to lose residents and disrupt community operations.
Our stock price has been highly volatile, and a number of factors may cause our common stock price to decline. The market price of our common stock has fluctuated and could fluctuate significantly in the future in response to various factors and events, including, but not limited to:
* the liquidity of the market for our common stock; * variations in our operating results; * variations from analysts' expectations; and * 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 cause the market price of our common stock to decline.
Our share ownership and certain other factors may impede a proposed takeover of our business. As of February 28, 2002, Mr. Baty, our Chief Executive Officer, controls about 39% of our outstanding common stock. Together, our directors and executive officers own, directly and indirectly, over 68% of the voting power of our outstanding common and preferred stock. Accordingly, Mr. Baty and the other members of our board and management would have significant influence over the outcome of matters submitted to our shareholders for a vote, including matters that would involve a change of control of Emeritus. Further, our Articles of Incorporation require a two-thirds supermajority vote to approve a business combination of
Emeritus with another company that is not approved by the board of directors. Accordingly, the current management group and board of directors could prevent approval of such a business combination. We currently have a staggered board in which only one-third of the board stands for election each year. Thus, absent removals and resignations, a complete change in board membership could not be accomplished in fewer than approximately two calendar years.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The table below provides information about our financial instruments that are sensitive to changes in interest rates. For our debt obligations, the table presents principal repayments in thousands of dollars and current weighted averages of interest rates on these obligations as of December 31, 2001. For our debt obligations with variable interest rates, the rates presented reflect the current rates in effect at the end of 2001. These rates are based on LIBOR plus a margin of either 3.25% or 3.5%, and the prime rate plus 2%.
If market interest rates average 2% more in 2002 than they did in 2001, our interest expense and net loss would increase by $1.5 million. These amounts are determined by considering the impact of hypothetical interest rates on our outstanding variable rate borrowings as of December 31, 2001, and do not consider changes in the actual level of borrowings that may occur subsequent to December 31, 2001. 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 possible actions that management could take with respect to our 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.
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 2002 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.
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 S-1) 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, 2001. (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) 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, 1999. (17) 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 10, 1999. (18) 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 15, 1999. (19) Incorporated by reference to the indicated exhibit filed with the Company's Form 8-K (File No. 1-14012) on January 14, 2000. (20) 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, 2000. (21) Incorporated by reference to the indicated exhibit filed with the Company's Annual Report on Form 10-K (File No. 1-14012) on April 2, 2001. (22) Incorporated by reference to the indicated exhibit filed with the Company's Current Report on Form 8-K (File No. 1-14012) on July 18, 2001. (23) Incorporated by reference to the indicated exhibit filed with the Company's Definitive Proxy Statement on Form DEF 14A on August 17, 2001. (24) 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.
Emeritus Corporation (Registrant)
Dated: March 29, 2002
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders Emeritus Corporation
We have audited the accompanying consolidated balance sheets of Emeritus Corporation and subsidiaries ("the Company") as of December 31, 2001 and 2000, and the related consolidated statements of operations, shareholders' deficit, and cash flows for each of the years in the three-year period ended December 31, 2001. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 a 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, 2001 and 2000, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
/s/KPMG LLP
Seattle, Washington March 8, 2002
EMERITUS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
Emeritus Corporation ("Emeritus" or the "Company") is a nationally integrated assisted living company focused on operating residential style communities. These communities provide a residential housing alternative for senior citizens that 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 and related-party owners of assisted living communities, including management agreements covering 46 communities in connection with the Emeritrust transactions, which are referred to extensively throughout these financial statements, summarized as follows (see Note 17):
* EMERITRUST I: 25 communities that the Company began managing in December 1998. Until December 31, 2001, the Company received a base management fee of 5% of gross revenues, but was entitled to receive up to 7% depending on the cash flow performance of the communities managed. As of January 1, 2002, however, the Company will receive a base management fee of 3% of gross revenues, but may receive up to 7% depending on the cash flow performance of the communities managed. Additionally, the Company is required by its management contracts to fund cash operating deficits.
* EMERITRUST II: 21 communities that the Company began managing in March 1999, consisting of:
* EMERITRUST II OPERATING: 16 communities for which the Company has no obligation to fund cash operating deficits. The Company receives a base management fee of 5% of gross revenues, but may receive up to 7% depending on the cash flow performance of the communities managed.
* EMERITRUST II DEVELOPMENT: 5 communities for which the Company is required to fund cash operating deficits. The Company receives a base management fee of 5% of gross revenues, but may receive up to 7% depending on the cash flow performance of the communities managed.
Critical Accounting Policies and Estimates
The preparation of consolidated financial statements requires Emeritus to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, Emeritus evaluates its estimates, including those related to resident programs and incentives, bad debts, investments, intangible assets, income taxes, financing operations, restructuring, long-term service contracts, contingencies, and litigation. Emeritus bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the
carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Emeritus believes the following critical accounting policies are most significant to the judgments and estimates used in the preparation of its consolidated financial statements. Emeritus maintains allowances for doubtful accounts for estimated losses resulting from the inability of its residents to make required payments. If the financial condition of Emeritus's residents were to deteriorate, resulting in an impairment of their ability to make payments, additional charges may be required. Emeritus holds shares in ARV Assisted Living, Inc. amounting to less than 5% of its shares. ARV is publicly traded and has a volatile share price. Emeritus records an investment impairment charge when it believes this investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results underlying this investment could result in losses or an inability to recover the carrying value of the investment that may not be reflected in this investment's current carrying value, thereby possibly requiring an impairment charge in the future. Emeritus records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized, which at this time shows a net asset valuation of zero. While Emeritus has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event Emeritus were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.
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 are consolidated where the Company maintains effective control over such entities' assets and operations, notwithstanding a lack of technical majority ownership. All significant inter-company balances and transactions are 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 services are performed in accordance with the terms of the management contract.
Cash and Cash Equivalents
Cash and cash equivalents consist primarily of money market investments, commercial paper and certificates of deposit with a maturity date at purchase of three months or less. Cash equivalents at December 31, 2001, were insignificant.
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 to be 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. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed discounted future cash flows expected to be generated by such assets. Assets to be disposed of are reported at the lower of their carrying amount or fair market value less costs to sell.
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 a lack of voting power exists. Investments in less than 20% owned entities are accounted for under the cost method unless the Company exercises significant influence by means other than ownership.
Intangible Assets
Intangible assets, which are comprised of deferred financing costs (included in other assets) and 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 loss carryforwards and 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 carryforwards and 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 that are deferred and amortized using the straight-line method over the terms of the associated leases.
Deferred Gain on Sales of Communities
Deferred gains on sales of communities consist of deferred gains on sale/leaseback transactions and deferred gains on sale transactions. Deferred gains on sale/leaseback transactions are amortized using the straight-line method over the lives of the associated leases where the Company has no continued financial involvement in communities that it has sold and leased back outside the leaseback. Deferred gains on sale/leaseback and sale transactions where the Company has continuing financial involvement, other than the leasebacks, are deferred until such involvement terminates.
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 loss and net 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 loss per share is computed based on weighted average shares outstanding and excludes any potential dilution. Diluted net loss per share is computed on the basis of the weighted average number of shares outstanding plus dilutive potential common shares (if any) using the treasury stock method. The capital structure of the Company includes convertible debentures, redeemable and non-redeemable convertible preferred stock, as well as stock options and common stock warrants. 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.
Comprehensive Income (Loss)
Comprehensive income (loss) consists of net income (loss) and other gains and losses affecting shareholders' equity, which under accounting principles generally accepted in the United States, are excluded from results of operations. For the Company, these consist of unrealized gains and losses on investment securities and foreign currency translation adjustments, net of any related tax effect.
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 1999 and 2000 amounts have been made to conform to the 2001 presentation.
(2) INVESTMENT SECURITIES
In 1999, the Company wrote down its investment in the common stock of ARV Assisted Living, Inc. ("ARV") by $7.4 million as management concluded the decline in the fair market value of this investment was other than temporary. Details regarding the ARV investment as of December 31, as follows:
In September 1999, the Company prevailed in a claim against ARV and settled for $5.0 million. The settlement terms provided for $1.5 million to be paid immediately with the remaining balance of $3.5 million to be paid through 2001, with a discount provision for early payment. As of December 31, 1999, the Company collected $4.3 million as full settlement on this claim. The settlement, net of all related legal costs, is included in other income.
(3) OTHER RECEIVABLES
Other receivables consisted of the following at December 31:
(4) PROPERTY AND EQUIPMENT
Property and equipment consist of the following at December 31:
(5) 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 currently issued and outstanding shares of common stock of Alert and 950,000 currently 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 the Company assigned no value to the option.
In September 1999, the Company sold 38.9% of its holdings in Alert, or 4,235,613 shares, to an entity in which a principal shareholder and a Board member of the Company are investors at a price per share equal to the Company's cost basis of $0.85 per share (Cdn) or $0.59 per share (US). Subsequently, in November 1999, Alert repurchased all of its preferred stock for $1.10 per share (Cdn). The Company realized a gain of $760,000 on this transaction, which is included in other income for 1999. Prior to its disposition, the investment in Alert was accounted for under the cost method, as the Company's equity ownership consisted of non-voting preferred stock.
During 1998, the Company sold an interest in a community located in Texas to a partnership in which the principal shareholder of the Company is a partner, retaining an approximately 12% interest. Pursuant to the purchase and sale agreement, the Company advanced funds to the partnership of $800,000, payable on demand. The purchase and sale agreement contained additional funding provisions whereby the Company funds 20% of the losses generated by the community up to $500,000, of which $500,000 was outstanding at December 31, 2001. This balance bears interest at 9% and is due in June 2008. 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, 2001, the Partnership's obligations to the Company were $2.1 million, including accrued interest. The Company's share of losses in 2001, 2000, and 1999 were $208,000, $321,000, and $551,000, respectively, and the investment balance at December 31, 2001 and 2000 was negative $1,080,000 and $872,000, respectively.
In January 2000, the Company purchased a 30% equity interest in Senior Healthcare Partners, LLC, a pharmaceutical supply limited liability company. The Company has an obligation to contribute up to $1.8 million. At December 31, 2000, the Company had contributed the entire $1.8 million and during 2001 and 2000 recognized its share of partnership losses of $313,000 and $557,000, respectively, which are included in "Other, net".
(6) 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.
(7) SHORT-TERM BORROWINGS
In December 2000, the Company entered into a 9% demand note payable with a related party investor group for $1.65 million. The note was repaid in full on January 3, 2001.
(8) LONG-TERM DEBT
Long-term debt consists of the following at December 31:
- ---------------------
* LIBOR is the London Interbank Offering Rate.
Substantially all long-term debt is secured by the Company's property and equipment.
During 1999, the Company refinanced approximately $15.9 million of outstanding debt and wrote off $333,000 of related deferred costs as extraordinary items. No additional refinancing or write-offs of deferred costs occurred during 2000 or 2001.
Certain of the Company's indebtedness include restrictive provisions related to cash dividends, investments and borrowings, and require maintenance of specific operating ratios, levels of working capital and net worth. As of December 31, 2001, the Company was in compliance with all such covenants with the exception of a 62-unit community in Scottsdale, Arizona, with a principal balance of $1.7 million that is due in June 2002 and presented as short-term borrowings. The Company plans to cure this covenant violation by remitting a reduction of outstanding principal in the amount of $530,000.
Principal maturities of long-term debt at December 31, 2001 are as follows:
(9) CONVERTIBLE DEBENTURES
The Company has $32.0 million of 6.25% convertible subordinated debentures (the "Debentures") that 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 a redemption price of 100% of the principal amount.
(10) 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 sold 25,000 shares of Series A cumulative convertible,
exchangeable, redeemable preferred stock for $25,000,000. The Series A redeemable Preferred Stock is entitled to receive quarterly dividends payable in cash. The dividend rate is 9% of the stated value of $25,000,000. Dividends accumulate, whether or not declared or paid. If cash dividends are not paid quarterly, the dividend rate will increase to 11% ("arrearage rate") until the unpaid cash dividends have been fully paid. 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, at the trading price at the time of conversion. The preferred stock is also exchangeable in whole only, at the option of the Company, into 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. For the year ended December 31, 2000, the Company paid dividends outstanding from 1999 of $2.6 million and two quarterly dividends of $1.1 million at the normal dividend rate of 9% and accumulated two quarterly dividends aggregating $1.4 million at the arrearage dividend rate of 11%. For the year ended December 31, 2001, the Company accumulated dividends aggregating $2.7 million at the arrearage dividend rate of 11%.
At December 31, 2001, the Company has accrued excess dividends of $750,000 to our Series A preferred shareholders related to non-payment of the cash portion of their dividends. Since the Company was unable to pay these dividends for six consecutive quarters, their Series A shareholders became entitled to elect one additional director to their board of directors at each annual shareholders' meeting until such time the Company has paid the accrued dividends. In addition, because the Company has been unable to pay dividends to their Series A shareholders after six consecutive quarters, beginning in 2002, the Series A dividends will be calculated on a compounded cumulative basis, retroactively.
The Company may redeem the preferred stock, in whole or in part, 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 are entitled to receive a distribution of $1,000 per share plus accrued dividends.
(11) 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 at December 31:
The increase in the valuation allowance was $1,633,000, $4,780,000 and $7,122,000 for 2001, 2000 and 1999, respectively. The increases were primarily due to the impairment of investment securities 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, 2001, available to offset future federal taxable income, if any, of approximately $87,983,000 expiring beginning in 2012.
(12) SHAREHOLDERS' DEFICIT
In January 1998 and subsequently in August 1999, the Company's board of directors authorized a stock repurchase program to acquire up to aggregate 1,000,000 shares of the Company's common stock. In March 2000, the stock repurchase plan was discontinued. At December 31, 2000, the Company had acquired and retired a total of 941,100 shares of its common stock at a cumulative cost of $8.3 million. No stock repurchases were made in 2001.
Preferred Stock
In December 1999, the Company entered an agreement to sell 40,000 shares of its Series B preferred stock to Saratoga Partners IV, L.P. ("Saratoga") and certain investors related to Saratoga for a purchase price of $1,000 per share. On December 30, 1999, the Company completed the sale of 30,000 shares of Series B Stock, and agreed to complete the sale of the remaining 10,000 shares during the first half of 2000. Each share of Series B Stock has voting authority, and is convertible into the number of shares of common stock equal to the stated value of $1,000 divided by an initial conversion price of $7.22, to be adjusted for any anti-dilutive transactions. The net proceeds to be received by the Company from the sale of all 40,000 shares of the Series B Stock were to be approximately $38.6 million, after fees and expenses of the transaction estimated at $1.4 million. The purchase agreement and related documents provided that the Company's use of the proceeds would be subject to Saratoga's approval after June 2000 if a substantial portion had not been used for the acquisition of specified properties. Under a letter agreement dated May 15, 2000, the agreements with Saratoga were modified to (i) cancel the sale of the remaining 10,000 shares of Series B Stock, (ii) remove all restrictions and requirements relating to the use of proceeds received from the sale of the original 30,000 shares and (iii) provide that the Company would issue to Saratoga a seven-year warrant ("the Warrant") to purchase one million shares of Common Stock at an exercise price of $4.30 per share or, in the alternative, make a specified cash payment to Saratoga. On August 31, 2000, the Warrant was issued to Saratoga.
The Series B Stock is entitled to receive quarterly dividends payable in a combination of cash and additional shares of Series B Stock. From issuance to January 1, 2004, the dividend rate will be 6% of the stated value of $1,000, of which 2% is payable in cash and 4% is payable in Series B Stock at the rate of one share of Series B Stock for every $1,000 of dividend. After January 1, 2004, the dividend rate will be 7%, of which 3% is payable in cash and 4% is payable in Series B Stock. Dividends accumulate, whether or not declared or paid. Prior to January 1, 2007, however, if the cash portion of the dividend is not paid, the cash dividend rate will increase to 7% ("arrearage rate"), until the unpaid cash dividends have been fully paid or until January 1, 2007, whichever first occurs. Beginning January 10, 2003, the Company can redeem all of the Series B Stock at $1,000 per share plus unpaid dividends, if the closing price for the common stock on the American Stock Exchange is at least 175% of the then conversion price for 30 consecutive trading days. In 2000, the Company accrued $1.3 million in cash dividends, including one quarter at the higher arrearage rate, and $1.2 million equivalent to 1,224 shares of Series B Stock as in-kind dividends, of which $302,000 were paid and 609 shares were issued in 2000. In 2001, the Company accrued $2.4 million in cash dividends at the higher arrearage rate, and $1.3 million equivalent to 1,268 shares of Series B Stock as in-kind dividends, none of which were paid or issued in 2001. Accordingly, the Company had a cumulative commitment to issue 615 shares of Series B Stock at December 31, 2000, and 1,883 shares of Series B Stock at December 31, 2001.
At December 31, 2001, the Company had accrued additional dividends of $2.0 million as a result of the arrearage rate, which is included in the total of $5.1 million of dividends on Series B Stock that the Company has accrued. Since the Company has failed to pay these dividends for six consecutive quarters, the Series B shareholders are entitled to elect one additional director to at each annual shareholders' meeting until such time the Company has paid the accrued dividends.
1995 Stock Incentive Plan
The Company has a 1995 stock incentive plan ("1995 Plan") which combines the features of an incentive and non-qualified 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 2,500,000 shares of common stock to be reserved for grants under the 1995 Plan of which 1,201,098 remained available for future awards at December 31, 2001. 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 May 2001, the Company announced an offer to exchange options under the 1995 Plan held by current employees, including executive officers, for new options to be granted under the 1995 Plan and new option letter agreements. Under the offer, employees were required to tender all or none of their options in exchange for new options subject to the same number of shares of common stock as the options tendered for exchange. Approximately 99% of outstanding options were exchanged. The new options were granted on December 10, 2001, which was the first business day that was at least six months and one day after the date tendered options were accepted for exchange. The new options have an exercise price of $2.11 and will fully vest 2 1/2 years from the date the new options are granted under the following schedule: 33 1/3 percent will vest six months after the date of grant; 33 1/3 percent will vest 18 months after the date of grant; and 33 1/3 percent will vest 30 months after the date of grant. In all other respects, the terms of the new options are the same as the terms of the options tendered for exchange.
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 would have been as follows for the years ended December 31:
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 1999, 2000 and 2001: dividend yield of 0.0% for all periods; expected volatility of 50.2% for 1999, 48.0% to 49.6% for 2000, and 80.7% to 82.1%
for 2001; risk-free interest rates of 6.47% to 6.63% for 1999, 6.06% to 6.69% for 2000, and 4.12% to 4.39% for 2001; and an expected option term of 4 years for 2001, 2000, and 1999.
A summary of the activity in the Company's stock option plans follows:
The following is a summary of stock options outstanding at December 31, 2001:
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, at a price equal to 85% of the fair market value. A total of 200,000 shares are available for purchase under the Plan. Quarterly, 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 or 15% of eligible compensation. The Employee Stock Purchase Plan expires in May 2008. In 2001 and 2000, employees purchased an aggregate of 75,985 and 56,295 common shares, respectively, through the Employee Stock Purchase Plan.
(13) COMPREHENSIVE LOSS
Comprehensive loss consists of the following for the years ended December 31, 2001, 2000, and 1999, respectively:
(14) FINANCIAL INSTRUMENTS
The Company has financial instruments other than investment securities consisting of cash and cash equivalents, trade accounts receivable, other receivables, notes receivable from 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 approximates their carrying value with the exception of the following: long-term debt had an estimated fair value, based on the Company's incremental borrowing rate, of $130.9 million versus a carrying value of $135.6 million; the convertible debentures had an estimated fair value, based on the Company's incremental borrowing rate and the conversion price, of $28.6 million versus a book value of $32.0 million; and the redeemable preferred stock had an estimated fair value, based on the Company's incremental borrowing rate and the conversion price, of $24.9 million versus a book value of $25.0 million at December 31, 2001.
(15) RELATED-PARTY MANAGEMENT AGREEMENTS
During 1995, the Company's two most senior executive officers, its Chief Executive Officer and then former President, and now current Vice President of Finance, Chief Financial Officer, and Secretary, 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. 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.
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, financial and management services with respect to 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 $2,417,000, $1,731,000, and $774,000, in 2001, 2000, and 1999, 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 was to provide management services relating to four newly developed assisted living communities located in Texas. The agreements had initial terms of two years six months with management fees based upon 6% of gross revenues payable monthly. XL Management ceased management of these buildings during 2000. Total fees in 2000 amounted to $150,000 as compared to $316,000 in 1999. The Company's Chairman and Chief Executive Officer and a former member of the Company's board of directors are principal shareholders and officers of Holiday.
(16) LEASES
At December 31, 2001, the Company leases office space and 46 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 extension options, ranging from five to ten years.
Minimum lease payments under noncancelable operating leases at December 31, 2001 are as follows:
Facility lease expense under noncancelable operating leases was approximately $26,796,000, $24,240,000, and $25,135,000 for 2001, 2000, and 1999, respectively. A number of operating leases provide for additional lease payments after 24 months computed at 5% of additional revenues of the community. In 2001, additional facility lease expense under this provision was not significant.
(17) SALES AND ACQUISITIONS
In two separate transactions during the fall of 1998 and the spring of 1999, the Company arranged for two investor groups to purchase an aggregate of 41 of its operating communities and five communities under development for a total purchase price of approximately $292.2 million. Of the 46 communities involved, 43 had been, or were proposed to be, leased to the Company by Meditrust Company LLC under sale/leaseback financing arrangements, and three had been owned by the Company. The first purchase, consisting of 25 communities, which we will call the Emeritrust I communities, was completed in December 1998 and the second purchase, consisting of 21 communities, 16 of which we will call the Emeritrust II Operating communities and five of which we call the Emeritrust II Development communities, was completed in March 1999.
Of the $168.0 million purchase price for the Emeritrust I communities, $138.0 million was financed through a three-year first mortgage loan with an independent third party and $30.0 million was financed through subordinated debt and equity investments from the investor group, which includes Daniel R. Baty, the Company's Chief Executive Officer, who is also a director and a principal shareholder. Of the $124.2 million purchase price for the Emeritrust II Operating communities and Emeritrust II Development communities, approximately $99.6 million was financed through three-year first mortgage loans with independent third parties and $24.6 million was financed through subordinated debt and equity investments from the investor group, which includes Mr. Baty.
The investor groups retained the Company to manage all of the communities through December 31, 2001, and granted the Company options to purchase the communities during this period. During 2000, the Emeritrust I communities failed to comply with covenants under the $138 million mortgage loan and in 2001 it became clear that the Company would not be able to purchase the communities under the options. As a result, the mortgage loans were restructured and the management agreements and options to purchase
were extended to June 30, 2003 (to December 31, 2003 in the case of the five Emeritrust II Development communities). The discussion below reflects the terms of these arrangements as modified.
From January 1, 2002, through June 30, 2003, the Company will receive for the Emeritrust I communities a base management fee of 3% of gross revenues generated by the communities and an additional management fee of 4%, payable out of 50% of cash flow. The availability of cash flow to pay management fees is subject to prior payment of expenses and fees related to the restructuring of the mortgage loan in 2001. For the Emeritrust II Operating communities and the Emeritrust II Development communities, the Company has received and continues to receive a base management fee of 5% of gross revenues and an additional management fee of 2%, payable to the extent that the communities meet certain cash flow standards. Prior to January 1, 2001, the management fees for the Emeritrust I communities were also computed in this fashion.
Under the management agreements, the Company is obligated to reimburse the investor groups for cumulative cash operating losses greater than $4.5 million in the case of the Emeritrust I communities and $500,000 in the case of each of the five Emeritrust II Development communities. Since these thresholds have been exceeded, the Company is currently responsible for most cash operating losses generated by these communities if they occur. There is no such funding arrangement with respect to the Emeritrust II Operating communities. The Company's funding obligations for the Emeritrust I communities have been $1.3 million, $4.9 million and $1.9 million for 2001, 2000 and 1999, respectively. The Company's funding obligations for the Emeritrust II Development communities have been $310,000 and $1.6 million in 2001 and 2000, respectively.
Although the amounts of our funding obligation each year include management fees earned by us under the management agreements, we do not recognize these management fees as revenue in our financial statements to the extent that we are funding the cash operating losses that include them. Correspondingly, we recognize the funding obligation under the agreement, less the applicable management fees, as an expense in our financial statements under the category "Other, net." Conversely, if the applicable management fees exceed our funding obligation, we recognize the management fees less the funding obligation as management fee revenue in our consolidated financial statements. Management fees earned for the Emeritrust I communities have been $4.0 million, $2.1 million and $1.9 million in 2001, 2000 and 1999, respectively, of which $2.8 million have been recognized in 2001. Management fees earned for the Emeritrust II Development communities have been $766,000 and $360,000, of which $673,000 and $174,000 have been recognized in 2001 and 2000, respectively. Management fees earned for the Emeritrust II Operating communities have been $1.9 million earned and recognized in both 2001 and 2000.
The Company has an option to purchase 43 of the 46 Emeritrust communities and a right of first refusal with respect to the remaining three communities, both of which expire June 30, 2003 (December 31, 2003 in the case of the five Emeritrust II Development communities). The option must be exercised with respect to all communities or may not be exercised at all. If investor groups require Mr. Baty to purchase certain of the communities, upon the conditions described below, the Company has the right to exercise its option within 60 days of receiving notice of this action. The option price for the 43 Emeritrust communities is equal to the original cost of the communities of approximately $292 million, plus an amount that would
provide the investor groups with an 18% rate of return, compounded annually, on their original investment of $54.6 million (less any cash distributions received). In connection with the exercise of the option, the Company is also obligated to pay certain costs and fees.
The management agreements, including the options to purchase the related communities, are subject to various termination provisions, including cross-default provisions among all three groups of communities. The management agreement for the Emeritrust I communities may be terminated if cash distributions to the investor group do not meet certain levels or if the communities fail to meet certain coverage requirements under the mortgage loan. In addition, certain of the communities have been refinanced and, accordingly, the Company's ability to exercise the option will depend on whether the Company can assume or refinance the debt secured by these communities. Termination of the management agreements or failure to exercise the options could result in the loss of management fees and the substantial decrease in the number of communities the Company operates.
Under related agreements, the investor groups may require Mr. Baty to purchase between ten and twelve of the Emeritrust communities, depending on the occurrence of any one of the following events: (a) the Company does not exercise its option to purchase the communities before the option expires, (b) the Company defaults under the management agreements, (c) Mr. Baty's net worth falls below a certain threshold, (d) the Company experiences a change of control or (e) Mr. Baty ceases to be the Company's chief executive officer. If Mr. Baty is required to purchase some of the communities, he will also have the option to purchase all of the Emeritrust communities on the same terms under which the Company is entitled purchase the communities, subject to the Company's prior right to do so within a specified time period.
In September 1999, the Company acquired a community that it previously leased for a purchase price of $8.0 million. This acquisition was financed through borrowings.
In January 2001, the Company sold one of its communities to a new operator and various third parties. The sale included terms for the Company to lease and continue to operate the facility for an interim period, which concluded in the third quarter of 2001. The Company recognized a gain on the sale of the facility of $1.3 million.
In April 1998, the Company assigned its economic interest in a 172-unit assisted living community located in Fairfield, California, to a related party investor group for $2.8 million in cash. Its economic interest consisted of a 66 2/3% interest in the profits, losses, and distributions of an operating limited liability company that owns and operates the community, the right to receive payments of principal and interest under a $2.4 million promissory note evidencing a loan by the Company to the operating company, and the obligation to make additional capital contributions under the agreement establishing the operating company. The Company continues to manage the operations of the community pursuant to a management agreement and to manage the affairs of the operating limited liability company. In January 2000, the Company repurchased 25% of its original interest in the community (16 2/3% of the operating limited liability company) for a total of $791,000. During the quarter ended September 30, 2001, the Company entered into an agreement with the related party investor to offset against interest payable any amounts that the Company had previously funded or will fund the assisted living community on their behalf. This agreement
allows for collection of a note receivable in the amount of approximately $477,000 that had previously been fully reserved. Therefore, the Company recorded a recovery of approximately $428,000 in Other, net and approximately $49,000 as a decrease in interest expense. In December 2001, the Company acquired an additional 16 2/3% interest in the community from a third party minority owner for a purchase price of $250,000. The purchase was paid with cash and notes payable due in certain terms ranging from 30 days through January 31, 2005. As of December 31, 2001, the Company's effective economic interest in the community is 33 1/3% in the profits, losses, and distributions.
(18) COMMITMENTS AND 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 that 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.
The following table summarizes the Company's contractual obligations at December 31, 2001:
(19) LIQUIDITY
In 2001, and as described in Note 21, the Company refinanced substantially all of its debt obligations, extending such financings through 2003 or thereafter. In addition, the Company achieved consecutive positive cash flows from operations for the last three quarters and positive earnings before preferred dividends in the fourth quarter of 2001. Including required debt service payments and capital expenditures, management believes the Company will be able to sustain positive cash flow through at least 2002.
The Company has incurred significant operating losses since its inception and has a working capital deficit of $12.1 million, although $7.4 million of preferred dividends is only due if declared by the Company's board of directors. To date, the Company has been dependent upon third party financing or disposition of assets to fund operations. While the Company does not anticipate the need for third party financing or dispositions of assets to fund operations, it cannot be guaranteed that, if necessary, third party financing or disposition of assets will be available timely or at all.
The Company is currently out of compliance with covenants on debt totaling $1.7 million which will be repaid in June 2002 and is not cross-defaulted with any other debt. In addition, many of the Company's other debt instruments and leases contain "cross-default" provisions pursuant to which a default under one obligation can cause a default under one or more other obligations to the same lender or lessor. Such cross-default provisions affect 14 owned assisted living properties and 36 operated under leases. Accordingly, any event of default could cause a material adverse effect on the Company's financial condition if such debt or leases are cross-defaulted.
(20) QUARTERLY RESULTS (UNAUDITED)
The sum of quarterly per share data may not equal the per share total reported for the year.
(21) SUBSEQUENT EVENTS
In February 2002, the Company reached an agreement with Heller Healthcare Finance to refinance three of the properties in our $71.8 million portfolio that previously was financed by Deutsche Bank AG and matured December 14, 2001. The new loan of $25.5 million matures February 2004 and provides for monthly principal payments of approximately $40,000 in addition to interest at LIBOR plus four percent. This refinancing in turn satisfied our extension agreement dated May 31, 2001, with Deutsche Bank AG to extend the maturity date of the remaining debt of $46.3 million secured by seven properties in the original portfolio to May 31, 2003, provided that the Company pays to the lender a fee equal to 1% of the outstanding portfolio balance at May 31, 2002. As a result of this refinancing, the Company has reclassified the entire $71.8 million principal balance on this portfolio to long-term debt from current debt in its December 31, 2001, financial statements.
S-1