AlerisLife Inc. - Quarter Report: 2014 September (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON,  DC 20549 

FORM 10-Q

 

☒ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2014

 

or

 

☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 001-16817

FIVE STAR QUALITY CARE, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

400 Centre Street, Newton, Massachusetts 02458

(Address of Principal Executive Offices) (Zip Code)

 

 

(Registrant’s Telephone Number, Including Area Code):  617-796-8387

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ☒  No ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ☒  No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐  No ☒

 

Number of registrant’s shares of common stock, $.01 par value, outstanding as of December 12, 2014:  48,661,042.

 

 

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FIVE STAR QUALITY CARE, INC.

 

FORM 10-Q

 

SEPTEMBER 30, 2014

 

INDEX

 

 

As used herein the terms “we”, “us” or “our” mean Five Star Quality Care, Inc. and its consolidated subsidiaries unless the context otherwise requires.

 

 

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Part I.   Financial Information

Item 1.  Condensed Consolidated Financial Statements

 

FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

See accompanying notes.

 

 

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(unaudited)

 

See accompanying notes.

 

 

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes.

 

 

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Note 1.  Basis of Presentation and Organization

General

The accompanying condensed consolidated financial statements of Five Star Quality Care, Inc. and its subsidiaries, which we refer to as we, us or our, are unaudited.  Certain information and disclosures required by U.S. generally accepted accounting principles for complete financial statements have been condensed or omitted.  We believe the disclosures made are adequate to make the information presented not misleading.  However, the accompanying financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2013, or our Annual Report.  In the opinion of our management, all adjustments, which include only normal recurring adjustments, considered necessary for a fair presentation have been included.  All intercompany transactions and balances with or among our consolidated subsidiaries have been eliminated.  Our operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.  Reclassifications have been made to the prior year’s condensed consolidated financial statements to conform to the current year’s presentation.

 

We operate senior living communities, including independent living communities, assisted living communities and skilled nursing facilities, or SNFs.  As of September 30, 2014, we operated 256 senior living communities located in 31 states containing 30,114 living units, including 225 primarily independent and assisted living communities with 27,292 living units and 31 SNFs with 2,822 living units.  As of September 30, 2014, we owned and operated 31 communities (3,061 living units), we leased and operated 181 communities (20,002 living units) and we managed 44 communities (7,051 living units).  These 256 senior living communities included 10,464 independent living apartments, 14,440 assisted living suites and 5,210 skilled nursing units.  The foregoing numbers exclude: (i) 38 living units in one assisted living community that has been temporarily closed for a major renovation; (ii) one assisted living community with 32 living units that we own which is being offered for sale and is classified as a discontinued operation; and (iii) four SNFs and three assisted living communities with a total of 480 living units that we lease from Senior Housing Properties Trust or its subsidiaries, or SNH, that are being offered for sale and are classified as discontinued operations.

 

Revisions to Prior Period Financial Statements 

 

As discussed further in the notes to our financial statements contained in our Annual Report, we identified errors related to our accounts payable and certain other matters that affected previously reported interim periods in 2013. We have revised the prior year’s condensed consolidated financial statements to correct for these errors in the periods in which they occurred.

Segment Information

We have two operating segments: senior living communities and rehabilitation and wellness. In the senior living community segment, we operate for our own account or manage for the account of SNH independent living communities, assisted living communities and SNFs that are subject to centralized oversight and provide housing and services to elderly residents. Our rehabilitation and wellness operating segment does not meet any of the quantitative thresholds for a reportable segment as prescribed under Financial Accounting Standards Board, or FASB, Accounting Standards Codification TM, or ASC, Topic 280 and therefore we have determined that our business is comprised of one reportable segment, senior living. All of our operations and assets are located in the United States, except for the operations of our captive insurance company subsidiary, which participates in our workers’ compensation, professional liability and automobile insurance programs, that is organized in the Cayman Islands.

Note 2. Recent Accounting Pronouncements

In August 2014, the FASB issued Accounting Standards Update 2014-15, Presentation of Financial Statements – Going Concern: Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.  The update requires an entity to evaluate whether there are conditions or events that raise substantial doubt about the entity’s ability to continue

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as a going concern within one year after the date that the financial statements are issued (or within one year after the financial statements are available to be issued when applicable) and to provide related footnote disclosures in certain circumstances.  The update is effective for the annual period ending after December 15, 2016, and for annual and interim periods thereafter with early adoption permitted.  The implementation of this update is not expected to cause any significant changes to our condensed consolidated financial statements.

Note 3. Property and Equipment

Property and equipment consists of the following:

 

We recorded depreciation expense of $7,504 and $6,442 for the three months ended September 30, 2014 and 2013, respectively, and $21,787 and $18,824 for the nine months ended September 30, 2014 and 2013, respectively, relating to our property and equipment.

 

We review the carrying value of intangibles and long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If there is an indication that the carrying value of an asset is not recoverable, we determine the amount of impairment loss, if any, by comparing the historical carrying value of the asset to its estimated fair value.  As a result of our intangibles and long-lived assets impairment review, we recorded $589 and $186 of impairment charges to our long-lived assets in continuing operations as of September 30, 2014 and December 31, 2013, respectively.

 

As of September 30, 2014, we had $5,595 of assets included in our property and equipment associated with certain senior living communities that we lease from SNH that we typically request that SNH purchase from us for an increase in future rent; however, we are not obligated to make these sales and SNH is not obligated to fund such amounts.  See Note 10.

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Note 4. Accumulated Other Comprehensive Income

The following table details the changes in accumulated other comprehensive income, net of tax, for the nine months ended September 30, 2014:

 

Accumulated other comprehensive income represents the unrealized appreciation of our investments, net of tax, and our share of other comprehensive income of Affiliates Insurance Company, or AIC.

Note 5.  Income Taxes

For the nine months ended September 30, 2014, we recognized a net tax benefit from continuing operations of $4,558.  We also recognized a tax benefit from discontinued operations of $1,426.  As of December 31, 2013, our federal net operating loss carry forward, which begins to expire in 2026 if unused, was approximately $81,583. This includes $278 of federal net operating losses that are attributable to unvested stock grants which will be recorded as an increase to additional paid in capital once they are realized in accordance with FASB ASC Topic 718. As of December 31, 2013, our tax credit carry forward, which begins to expire in 2022 if unused, was approximately $15,235.  Our net operating loss carry forwards and tax credit carry forwards are subject to possible audit and adjustments by the Internal Revenue Service.

 

We maintain a partial valuation allowance against certain deferred tax assets related to impaired investments and certain state net operating loss carry forwards.  When we believe that we will more likely than not realize the benefit of these deferred tax assets, we will record deferred tax assets as an income tax benefit in our condensed consolidated statement of operations, which will affect our results of operations.

Note 6.  Earnings Per Share

We computed basic earnings per common share, or EPS, for the three and nine months ended September 30, 2014 and 2013 using the weighted average number of shares of our common stock, $.01 par value per share, or our common shares, outstanding during the periods.  Diluted EPS reflects the more dilutive earnings per common share amount calculated using the two-class method or the treasury stock method.  For the three and nine months ended September 30, 2013, respectively, 145 and 1,318 potentially dilutive common shares related to our former convertible senior notes due in 2026, or the Notes,  were not included in the computation of diluted EPS because to do so would have been antidilutive.

 

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The following table provides a reconciliation of income (loss) from continuing operations and loss from discontinued operations and the number of common shares used in the calculations of diluted EPS:

 

 

 

 

Note 7.  Fair Values of Assets and Liabilities

Our assets recorded at fair value have been categorized based upon a fair value hierarchy in accordance with FASB ASC Topic 820. We apply the following fair value hierarchy, which prioritizes the inputs used to measure fair value into three levels.

 

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access at the measurement date.

 

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets and quoted prices in inactive markets.

 

Level 3 inputs are unobservable inputs for the asset or liability in which there is little, if any, market activity for the asset or liability at the measurement date.

 

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Recurring Fair Value Measures

The tables below present the assets measured at fair value at September 30, 2014 and December 31, 2013 categorized by the level of inputs used in the valuation of each asset.

 

 

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During the nine months ended September 30, 2014, we did not change the type of inputs used to determine the fair value of any of our assets and liabilities that we measure at fair value.  Accordingly, there were no transfers of assets or liabilities between levels of the fair value hierarchy during the nine months ended September 30, 2014.

 

The carrying values of accounts receivable and accounts payable approximate fair value as of September 30, 2014 and December 31, 2013.  The carrying value and fair value of our mortgage notes payable were $52,074 and $55,551, respectively, as of September 30, 2014 and $37,620 and $41,113, respectively, as of December 31, 2013, and are categorized in Level 3 of the fair value hierarchy in their entirety.  We estimate the fair values of our mortgage notes payable by using discounted cash flow analyses and currently prevailing market terms as of the measurement date.  Because these Level 3 inputs are unobservable, our estimated fair value may differ materially from the actual fair value.  We measured the fair value of our equity investment in AIC, an Indiana insurance company that we owned at September 30, 2014 in equal proportion with each of the other six shareholders of that company (see Note 10), categorized in Level 2 of the fair value hierarchy in its entirety, by considering, among other things, the individual assets and liabilities held by AIC, AIC’s overall financial condition and earning trends, and the financial condition and prospects for the insurance industry generally.

 

Non-Recurring Fair Value Measures

 

We evaluate the recoverability of goodwill assets in the fourth quarter of each fiscal year, or more frequently if events or changes in circumstances indicate that goodwill or other intangible assets may be impaired.  As of October 1, 2013, we evaluated our goodwill for impairment and determined that the fair value of our reporting units exceeded their carrying values on that date.  As of September 30, 2014, no events or changes in circumstances had occurred that would trigger the need for an additional impairment review.

 

Goodwill was valued primarily using discounted cash flow models that incorporate assumptions for each reporting unit’s short and long term revenue growth rates, operating margins, and discount rates, which represent our best estimates of current and forecasted market conditions, current cost structure, and the implied rate of return that management believes a market participant would require for an investment in a company having similar risks and business characteristics to the reporting unit being assessed.

 

We review the carrying value of intangibles and long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If there is an indication that the carrying value of an asset is not recoverable, we determine the amount of impairment loss, if any, by comparing the

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historical carrying value of the asset to its estimated fair value.  As a result of our intangibles and long-lived assets impairment review, we recorded $589 and $186 of impairment charges to our long-lived assets in continuing operations as of September 30, 2014 and December 31, 2013, respectively.  We determine estimated fair value based on input from market participants, our experience selling similar assets, market conditions and internally developed cash flow models that our asset or asset groups are expected to generate.  The fair values of the impaired assets were $478 and $137 as of September 30, 2014 and December 31, 2013, respectively, and are considered to be a Level 3 fair value measurement.

  

The fair value of assets held for sale is determined based on the use of appraisals, input from market participants, our experience selling similar assets and/or internally developed cash flow models, all of which are considered to be Level 3 fair value measurements.

 

See Note 11 for discussion of fair value measurements related to an acquisition that occurred during the second quarter of 2014.

Note 8.  Indebtedness

We have a $25,000 revolving secured line of credit, or our Credit Agreement, that is available for general business purposes, including acquisitions.  The maturity date of our Credit Agreement is March 18, 2016.  Borrowings under our Credit Agreement typically bear interest at LIBOR plus a premium of 250 basis points, or 2.65% as of September 30, 2014.  We are also required to pay a quarterly commitment fee of 0.35% per annum on the unused part of our borrowing availability under our Credit Agreement. We may draw, repay and redraw funds under our Credit Agreement until maturity, and no principal repayment is due until maturity.  We made no borrowings under our Credit Agreement during the nine months ended September 30, 2014 and 2013.  As of September 30, 2014, we had no amounts outstanding under our Credit Agreement.  We incurred interest expense and other associated costs related to our Credit Agreement of $48 and $35 for the three months ended September 30, 2014 and 2013, respectively, and $144 and $277 for the nine months ended September 30, 2014 and 2013, respectively.

 

We are the borrower under our Credit Agreement and certain of our subsidiaries guarantee our obligations under our Credit Agreement, which is secured by our and our guarantor subsidiaries’ accounts receivable and certain related collateral. Our Credit Agreement provides for acceleration of payment of all amounts outstanding upon the occurrence and continuation of certain events of default, such as a change of control of us, which includes termination of our business management and shared services agreement, or our business management agreement, with Reit Management & Research LLC, or RMR.

 

We also have a $150,000 secured revolving credit facility, or our Credit Facility, that is available for general business purposes, including acquisitions.  The maturity date of our Credit Facility is April 13, 2015, and, subject to the payment of extension fees and meeting certain other conditions, our Credit Facility includes options for us to extend its stated maturity date for two consecutive one-year periods.  Borrowings under our Credit Facility typically bear interest at LIBOR plus a premium of 250 basis points, or 2.65% as of September 30, 2014.  We are also required to pay a quarterly commitment fee of 0.35% per annum on the unused part of our borrowing availability under our Credit Facility.  We may draw, repay and redraw funds under our Credit Facility until maturity, and no principal repayment is due until maturity.  The weighted average interest rate for borrowings under our Credit Facility was 2.76% and 3.15% for the nine months ended September 30, 2014 and 2013, respectively.  As of September 30, 2014, we had $25,000 outstanding under our Credit Facility.  We incurred interest expense and other associated costs related to our Credit Facility of $552 and $542 for the three months ended September 30, 2014 and 2013, respectively, and $1,687 and $1,442 for the nine months ended September 30, 2014 and 2013, respectively.

 

We are the borrower under our Credit Facility, and certain of our subsidiaries guarantee our obligations under our Credit Facility, which is secured by real estate mortgages on 15 senior living communities with 1,549 living units owned by our guarantor subsidiaries and our guarantor subsidiaries’ accounts receivable and certain related collateral.  Our Credit

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Facility provides for acceleration of payment of all amounts outstanding upon the occurrence and continuation of certain events of default, such as a change of control of us.

 

Our Credit Agreement and our Credit Facility contain a number of financial and other covenants, including covenants that restrict our ability to incur indebtedness or to pay dividends or make other distributions under certain circumstances and require us to maintain financial ratios and a minimum net worth.  Our Credit Agreement and Credit Facility require that we deliver quarterly and annual financial statements within the time periods specified within those agreements.  The lenders under each of our Credit Agreement and Credit Facility have waived until December 31, 2014 any default resulting from our not timely delivering our financial statements for the quarters ended March 31, 2014, June 30, 2014, and September 30, 2014 as required under those agreements.  Our condensed consolidated financial statements for the quarters ended March 31, 2014, June 30, 2014, and September 30, 2014, are being delivered to our lenders contemporaneously with the filing of this Quarterly Report on Form 10-Q and the filing of our Quarterly Reports on Forms 10-Q for the quarters ended March 31, 2014, and June 30, 2014, which are being filed substantially concurrently with this Quarterly Report.

 

In October 2006, we issued $126,500 principal amount of the Notes.  Our net proceeds from this issuance were approximately $122,600.  The Notes bore interest at a rate of 3.75% per annum and were convertible into our common shares at any time.  The conversion rate, which was subject to adjustment, was 76.9231 common shares per $1 principal amount of the Notes, which represented a conversion price of $13.00 per share.  The Notes were guaranteed by certain of our wholly owned subsidiaries.  The Notes were scheduled to mature on October 15, 2026.  We were entitled to prepay the Notes at any time and the holders were entitled to require us to purchase all or a portion of these Notes on each of October 15, 2013, 2016 and 2021 at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus any accrued and unpaid interest.  We periodically repurchased Notes in open market transactions or in privately negotiated transactions, and, on July 8, 2013, we redeemed all of the $24,872 principal amount of the Notes then outstanding at a redemption price equal to the principal amount, plus accrued and unpaid interest.  We incurred interest expense and other associated costs related to the Notes of $21 and $511 for the three and nine months ended September 30, 2013, respectively.

 

At September 30, 2014, five of our senior living communities were encumbered by mortgage notes with an aggregate outstanding principal balance of $52,074 :  (1) two of our communities were encumbered by a Federal National Mortgage Association, or FNMA, mortgage note and (2) three of our communities were encumbered by Federal Home Loan Mortgage Corporation, or FMCC, mortgage notes.  These mortgages contain FNMA and FMCC, respectively, standard mortgage covenants.  We recorded mortgage premiums in connection with our assumption of the FNMA and FMCC mortgage notes at the time of our acquisitions of the encumbered communities in order to record the assumed mortgage notes at their estimated fair value.  We are amortizing the mortgage premiums as a reduction of interest expense until the maturity of the respective mortgage notes.  The weighted average interest rate on these five notes was 6.77% as of September 30, 2014.  Payments of principal and interest are due monthly under these mortgage notes until maturities at varying dates ranging from June 2018 to September 2032.  We incurred mortgage interest expense, including premium amortization, of $709 and $581 for the three months ended September 30, 2014 and 2013, respectively, and $1,957 and $2,425 for the nine months ended September 30, 2014 and 2013, respectively, and including some interest expense recorded in discontinued operations.  Our mortgages require monthly payments into escrows for taxes, insurance and property replacement funds; withdrawals from these escrows require applicable lender approvals.  As of September 30, 2014, we believe we were in compliance with all applicable covenants under these mortgages.

Note 9. Off Balance Sheet Arrangements 

We have pledged certain of our assets, including our accounts receivable with a carrying value, as of September 30, 2014, of $13,767, arising from our operation of 26 properties owned by SNH and leased to us to secure SNH’s borrowings from its lender, FNMA.  As of September 30, 2014, we had no other off balance sheet arrangements that have had or that we expect would be reasonably likely to have a future material effect on our financial condition,

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changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Note 10. Related Person Transactions

We were formerly a 100% owned subsidiary of SNH, SNH is our largest landlord and our largest stockholder and we manage senior living communities for SNH.  In 2001, SNH distributed substantially all of our then outstanding common shares to its shareholders.  As of September 30, 2014, SNH owned 4,235 of our common shares, or approximately 8.7% of our outstanding common shares.  One of our Managing Directors, Mr. Barry Portnoy, is a managing trustee of SNH.  Mr. Barry Portnoy’s son, Mr. Adam Portnoy, also serves as a managing trustee of SNH.

 

As of September 30, 2014, we leased 184 senior living communities (including seven that we have classified as discontinued operations) from SNH.  Under our leases with SNH, we pay SNH minimum rent plus percentage rent based on increases in gross revenues at certain properties.  Our total minimum annual rent payable to SNH as of September 30, 2014 was $191,375, excluding percentage rent.  Our total rent expense (which includes rent for all properties we lease from SNH, including properties that we have classified as discontinued operations) under all of our leases with SNH, net of lease inducement amortization, was $49,030 and $50,622 for the three months ended September 30, 2014 and 2013, respectively, and $146,611 and $152,089 for the nine months ended September 30, 2014 and 2013, respectively. As of September 30, 2014 and 2013, we had outstanding rent due and payable to SNH of $17,405 and $17,863, respectively.  During the nine months ended September 30, 2014, pursuant to the terms of our leases with SNH, we sold $23,776 of improvements made to properties leased from SNH, and, as a result, our annual rent payable to SNH increased by approximately $1,903.  As of September 30, 2014, our property and equipment included $5,595 for similar improvements we have made to properties we lease from SNH that we typically request that SNH purchase from us for an increase in future rent; however, we are not obligated to make these sales and SNH is not obligated to fund such amounts.

 

We and SNH previously agreed that SNH would offer for sale 11 senior living communities we lease from SNH, which we have classified as discontinued operations.  Our rent payable to SNH is reduced as these sales occur pursuant to terms set in our leases with SNH.  In August 2013, we and SNH sold one of these communities, a SNF located in Missouri with 112 living units, for a sale price of $2,550, and as a result of this sale, our annual minimum rent payable to SNH decreased by $255 in accordance with the terms of the applicable lease.  In January 2014, we and SNH sold one of these communities, an assisted living community located in Texas with 48 assisted living units, for a sale price of $2,400, and as a result of this sale, our annual minimum rent payable to SNH decreased by $210 in accordance with the terms of the applicable lease. In June 2014, we and SNH sold two of these communities, both of which are SNFs located in Wisconsin, with a combined total of 139 living units, for a sale price of $4,500, and as a result of this sale, our annual minimum rent payable to SNH decreased by $450 in accordance with the terms of the applicable lease. In October 2014, we and SNH sold one of these communities, an assisted living community in Virginia with 55 assisted living units, for a sale price of $2,850, and as a result of this sale, our annual minimum rent payable to SNH decreased by $285 in accordance with the terms of the applicable lease. Also in October 2014, we and SNH sold one assisted living community and one SNF located in Arizona with a combined total of 160 living units, for a sale price of $5,900, and as a result of this sale, our annual minimum rent payable to SNH decreased by $590 in accordance with the terms of the applicable lease. We can provide no assurance that the remaining four senior living communities that we and SNH have agreed to offer for sale will be sold or what the terms of any such sales may provide.

 

Concurrent and in connection with entering into the Villa Valencia Agreement, described below, we and SNH entered into the Fifth Amendment to the Amended and Restated Master Lease Agreement (Lease No. 4), or Lease No. 4. Under this Lease No. 4 amendment, we exercised the first of our existing options under Lease No. 4, extending the term from April 30, 2017 to April 30, 2032, and a third option for us to extend the term of Lease No. 4 from May 1, 2047 to April 30, 2062, was added.

 

As of September 30, 2014, we managed 44 senior living communities for the account of SNH.  In connection with these management agreements, we and SNH have entered into four combination agreements, or pooling agreements: three 

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pooling agreements combine our management agreements with SNH for communities that include assisted living units, or the AL Pooling Agreements, and a fourth pooling agreement combines our management agreements with SNH for communities that include only independent living units, or the IL Pooling Agreement.    The management agreements that are included in each of our pooling agreements are on substantially similar terms.  Our first AL Pooling Agreement includes 20 identified communities and our second AL Pooling Agreement includes 19 identified communities.  The third AL Pooling Agreement currently includes the management agreement for a community we began managing in November 2013 and two communities we began managing in December 2014.  The IL Pooling Agreement currently includes management agreements for two communities that have only independent living units.  A senior living community in New York and one senior living community in California described below that we manage for SNH are not included in any of our pooling agreements.  Each of the AL Pooling Agreements and the IL Pooling Agreement aggregates the determination of fees and expenses of the various communities that are subject to such pooling agreement, including determinations of our incentive fees and SNH’s return on its invested capital.  We earned management fees from SNH of $2,438 and $2,290 for the three months ended September 30, 2014 and 2013, respectively, and $7,295 and $6,866 for the nine months ended September 30, 2014 and 2013, respectively.  

 

Our second AL Pooling Agreement previously included the management agreement for the assisted living community known as Villa Valencia, which is located in California.  On July 10, 2014, we entered into an agreement with SNH, pursuant to which the management agreement for Villa Valencia was removed from the second AL Pooling Agreement as of July 1, 2014. We expect that the management agreement affecting the Villa Valencia community will not be included in any pooling agreement until after extensive renovations planned at that community are completed.

 

Also on July 10, 2014, we entered into an amendment to the management agreements with SNH that include assisted living units to (i) extend the term of each of the management agreements between us and SNH for Villa Valencia and the 19 assisted living communities currently included in the second AL Pooling Agreement from December 31, 2031 to December 31, 2033 and (ii) extend the term of the management agreement between us and SNH for the senior living community known as Willow Pointe, which is currently included in the third AL Pooling Agreement, from December 31, 2031 to December 31, 2035. On July 10, 2014, we also entered into an amendment to our management agreements with SNH that include only independent living units to extend the term of the management agreements between us and SNH for two independent living communities from December 31, 2031 to December 31, 2032. The term of the 20 management agreements included in the first AL Pooling Agreement were not affected by these amendments and those management agreements expire on December 31, 2031.

 

We manage a portion of a senior living community in New York that is not subject to the requirements of New York healthcare licensing laws, consisting of 199 living units, pursuant to a long term management agreement with SNH.  In order to accommodate certain requirements of New York healthcare licensing laws, SNH subleases another portion of this senior living community that is subject to those requirements, consisting of 111 living units, to an entity, D&R Yonkers LLC, which is owned by SNH’s President and Chief Operating Officer and its Treasurer and Chief Financial Officer.  We manage this portion of the community pursuant to a long term management agreement with D&R Yonkers LLC.

 

We may enter into additional management arrangements with SNH for us to manage senior living communities that SNH may acquire in the future.  We expect that these management arrangements will be pursuant to long term management agreements on terms similar to our existing management agreements and that those agreements may be added to our existing pooling agreements or that we may enter into additional pooling agreements with SNH with respect to these management agreements.

 

RMR provides business management and shared services to us pursuant to our business management agreement.  RMR also provides management services to SNH.  One of our Managing Directors, Mr. Barry Portnoy, is Chairman, majority owner and an employee of RMR.  Mr. Barry Portnoy’s son, Mr. Adam Portnoy, is an owner of RMR and serves as President, Chief Executive Officer and a director of RMR.  Our other Managing Director, Mr. Gerard Martin, is a

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director of RMR.  Mr. Bruce Mackey, our President and Chief Executive Officer, and Mr. Paul Hoagland, our Treasurer and Chief Financial Officer, are officers of RMR.  RMR provides management services to SNH, SNH’s officers are executive officers of RMR and SNH’s President and Chief Operating Officer serves as a director of RMR.  Our Independent Directors also serve as independent directors or independent trustees of other public companies (but not SNH) to which RMR or its affiliates provide management services.  Mr. Barry Portnoy serves as a managing director or managing trustee of those companies and Mr. Adam Portnoy serves as a managing trustee of a majority of those companies.  In addition, officers of RMR serve as officers of those companies.

 

Pursuant to our business management agreement with RMR, we recognized aggregate business management, administrative and information system service fees of $3,390 and $3,014 for the three months ended September 30, 2014 and 2013, respectively, and $10,433 and $10,175 for the nine months ended September 30, 2014 and 2013, respectively.  These amounts are included in general and administrative expenses in our condensed consolidated statements of operations.  We also lease our headquarters from an affiliate of RMR for annual rent of approximately $785, which amount is subject to fixed increases.  Our rent expense for our headquarters, which included our utilities and real estate taxes that we are required to pay as additional rent, under this lease, was $371 and $355 for the three months ended September 30, 2014 and 2013, respectively, and $1,043 and $1,049 for the nine months ended September 30, 2014 and 2013, respectively.

 

We, RMR, SNH, and four other companies to which RMR provides management services currently own AIC, an Indiana insurance company.  All of our Directors and most of the trustees and directors of the other AIC shareholders currently serve on the board of directors of AIC.  RMR provides management and administrative services to AIC pursuant to a management and administrative services agreement with AIC.

 

On March 25, 2014, as a result of the removal, without cause, of all of the trustees of Equity Commonwealth (formerly known as CommonWealth REIT), or EQC, EQC underwent a change in control, as defined in the shareholders agreement among us, the other shareholders of AIC and AIC. As a result of that change in control and in accordance with the terms of the shareholders agreement, on May 9, 2014, we and those other shareholders purchased pro rata the AIC shares EQC owned.  Pursuant to that purchase, we purchased 2,857 AIC shares from EQC for $825.  Following these purchases, we and the other remaining six shareholders each owned approximately 14.3% of AIC.

 

In June 2014, we and the other shareholders of AIC renewed our participation in an insurance program arranged by AIC. In connection with that renewal, we purchased a one-year property insurance policy providing $500,000 of coverage with respect to which AIC is a reinsurer of certain coverage amounts.  We paid AIC a premium, including taxes and fees, of approximately $3,901 in connection with that policy, which amount may be adjusted from time to time as we acquire or dispose of properties that are included in the policy.

 

As of September 30, 2014, we have invested $6,034 in AIC since its formation in 2008.  Although we own less than 20% of AIC, we use the equity method to account for this investment because we believe that we have significant influence over AIC because all of our Directors are also directors of AIC.  Our investment in AIC had a carrying value of $6,806 and $5,913 as of September 30, 2014 and December 31, 2013, respectively.  We recognized income of $38 and $64 for the three months ended September 30, 2014 and 2013, respectively, and $59 and $219 for the nine months ended September 30, 2014 and 2013, respectively, related to our investment in AIC.

 

In June 2014, we, RMR, SNH and three other companies to which RMR provides management services extended our and their combined directors’ and officers’ liability insurance policy through August 31, 2014.  In September 2014, we purchased a two year combined directors’ and officers’ insurance policy with RMR and five other companies managed by RMR that provides $10,000 in aggregate primary coverage, including certain errors and omission coverage.  At that time, we also purchased separate additional one year directors’ and officers’ liability insurance policies that provide $20,000 of aggregate excess coverage plus $5,000 of excess non-indemnifiable coverage.  The total premium payable by us for these policies purchased in September 2014 was approximately $357. 

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Note 11.  Acquisition

 

In May 2014, we acquired a senior living community with 116 living units located in Alabama for approximately $19,914, including the assumption of approximately $13,920 of mortgage debt and the assumption of approximately $68 of net working capital liabilities,  but excluding closing costs. This community primarily offers independent and assisted living services that are currently 100% paid by residents from their private resources. We funded this acquisition with cash on hand and borrowings under our Credit Facility.  We incurred acquisition related costs of $81 during the second quarter of 2014.  These costs include transaction costs, professional fees and other acquisition related expenses.  The preliminary allocation of the purchase price was based on management’s judgment after evaluating several factors, including valuation assessments of tangible and intangible assets, and estimates of the fair value of liabilities assumed. The definite lived intangible assets were valued using the income approach and are categorized in Level 3 of the fair value hierarchy.  The valuation of certain tangible assets and liabilities acquired was determined using the cost approach.  For personal property, we primarily used the cost approach to estimate reproduction or replacement cost.  The fair value of these assets and liabilities are also categorized in Level 3 of the fair value hierarchy.  The following table summarizes the preliminary allocation of the purchase price to the estimated fair values of the assets acquired and liabilities assumed:

 

 

 

Note 12.  Discontinued Operations

 

In September 2012, we completed the sale of our pharmacy business to Omnicare, Inc., or Omnicare. In connection with the sale, Omnicare did not acquire the real estate we own associated with one pharmacy located in South Carolina.  In July 2014, we sold this real estate for a sale price of $205.

 

In June 2013, we decided to offer for sale one assisted living community we own with 32 living units.  We are in the process of offering this community for sale.

 

Please see Note 10 above for a discussion of 11 senior living communities that we lease or had leased from SNH which are included in discontinued operations for all of the periods presented in these condensed consolidated financial statements; four of which had been sold as of September 30, 2014 and three additional of which were sold in October 2014.

 

We can provide no assurance that we will be able to sell the senior living community that we are offering for sale, or that we and SNH will be able to sell the senior living communities we lease from SNH that are being offered for sale, or what the terms or timing of any such sales may be.

 

We have reclassified our condensed consolidated balance sheets and condensed consolidated statements of operations for all periods presented to show the financial position and results of operations of our senior living communities, pharmacies and rehabilitation hospitals which have been sold or are expected to be sold as discontinued.  Below is a

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summary of the operating results of these discontinued operations included in the condensed consolidated financial statements for the three and nine months ended September 30, 2014 and 2013:

 

 

 

Note 13.  Legal Proceedings and Claims

We have been, are currently, and expect in the future to be involved in claims, lawsuits, and regulatory and other governmental audits, investigations and proceedings arising in the ordinary course of our business, some of which may involve material amounts.  Also, the defense and resolution of these claims, lawsuits, and regulatory and other governmental audits, investigations and proceedings may require us to incur significant expense.  We account for claims and litigation losses in accordance with ASC Topic 450, Contingencies, or ASC 450. Under ASC 450, loss contingency provisions are recorded for probable and estimable losses at our best estimate of a loss or, when a best estimate cannot be made, at our estimate of the minimum loss. These estimates are often developed prior to knowing the amount of the ultimate loss, require the application of considerable judgment, and are refined as additional information becomes known. Accordingly, we are often initially unable to develop a best estimate of loss and therefore the estimated minimum loss amount, which could be zero, is recorded; then, as information becomes known, the minimum loss amount is updated, as appropriate. Occasionally, a minimum or best estimate amount may be increased or decreased when events result in a changed expectation.

 

In August 2014, in connection with an ongoing and routine compliance audit of medical records, we became aware of certain potential inadequate medical record documentation and other possible failures to comply with appropriate policies at one of our SNFs.  We have commenced an in depth review of these matters that is ongoing.  We have determined that a loss in connection with this matter is reasonably possible, but cannot be reasonably estimated at this time; accordingly, we have not recorded any loss for this matter at this time.  However, such loss could have a material adverse impact on our business, financial condition, and results of operations.