Omega Healthcare: The Dividend Is At Risk

Co-produced with Rida Morwa of High Dividend Opportunities

It has been over a year and a half since I first wrote about Omega Healthcare Investors (OHI), determining that it was a value trap. In that article, I predicted that the company would slow or stop its dividend raises, but had confidence that it would not be reduced. Two quarters later, OHI froze its dividend increases.

Since then, its AFFO has dropped. The company missed its guidance of $3.42 in 2017, which came in at only $3.30/share. Then, in 2018, AFFO dropped to $3.04. For 2019, guidance is for AFFO of $3.00-3.12; if met, that would make the REIT’s AFFO/share equivalent to its 2015 results.

Despite the drop in AFFO, OHI common shares have rebounded strongly.

Chart

Data by YCharts

Despite AFFO dropping almost 10%, the share price has increased by over 20%. It did take a dive initially when Orianna filed bankruptcy, but the bulls have been in control and are pushing the pedal to the metal. OHI is trading at 12x projected 2019 AFFO.

(Source: Company Filings, Chart Authors)

Looking at P/Guided AFFO on March 31st, we can see that OHI has consistently traded from 9x to 12x at this time of year. The current price is towards the upper end of that range.

This tells me that the market is confident that OHI’s troubles are behind it, and that the company will beat guidance or, at the minimum, provide better growth next year. Neither one is a safe bet.

Ignoring The Fundamentals

One of my consistent warnings about OHI has been that the tenants are suffering from declining fundamentals. The REIT has had problems with several of its top ten tenants.

(Source)

In addition to Orianna (formerly known as Ark) filing bankruptcy, OHI has reduced Signature’s rent by over $10 million, plus gave it a $10 million loan to pay for operating expenses. It has extended over $71 million in loans to Genesis Healthcare (GEN), with a substantial portion of the interest being paid-in-kind (PIK), which means that OHI is receiving warrants for GEN common shares.

Additionally, according to the 10-K, Signature and Daybreak combined are $18.3 million behind in rent, which has been deferred by agreement, while another unnamed operator has $5.4 million outstanding with no current deferral agreement. Per the 10-K:

Additionally, $5.4 million of the $33.8 million of contractual receivables outstanding – net of allowances as of December 31, 2018, relates to one operator that continues to pay, although at times less than the monthly contractual rent due. We continue to monitor this operator, including their contractual payments and their operational performance to determine if it will impact our revenue recognition in future periods.

These cracks are being completely ignored by the market.

Other REITs

The bullishness in OHI is especially surprising when other similar REITs have been rocked by tenant defaults. Sabra Health Care REIT (SBRA) dropped in November when Senior Care Centers defaulted.

Senior Housing Properties Trust (SNH) plummeted when it had to restructure its arrangement with Five Star Senior Living (FVE). SNH is taking much greater control of the properties and becoming a majority shareholder of the tenant. Blurring the line between landlord and tenant, SNH is now much more exposed to market fluctuations.

MedEquities Realty Trust (MRT) dropped when OnPointe Health, one of its major tenants, went bankrupt, and the new tenant pays substantially lower rent. OHI is in the process of acquiring MRT now, which will add struggling operator Fundamental Healthcare to its roster.

OHI bulls seem convinced that it won’t happen to the company (again).

Genesis

Perhaps the single biggest warning sign for OHI investors ought to be GEN.

Chart

Data by YCharts

The market sees the risk of GEN as a company with shares trading at penny stock levels. GEN accounts for 7.5% of OHI’s revenues, making it even larger than Orianna was. The market is flashing a big red warning sign about GEN – a sign that is completely being ignored.

More critical for OHI is that GEN’s coverage ratio has continued to decline.

(Source: Company SEC Filings, Chart Author’s)

The decline since 2016 was steady, interrupted by substantial rent reductions, only to resume declining through 2018.

Lenders have been paying attention: GEN’s asset-based lending revolving facility is at LIBOR +600 bps, additionally the agreement comes with several protective features such as a “springing maturity” that makes it due 90 days prior if its Term Loan Agreements, Welltower Real Estate Loans or Midcap Real Estate Loans fail to be extended or refinanced. In other words, the ABL has to be paid first (before OHI gets its own).

The ABL also has a “swinging lockbox clause” which ensures cash goes through the lender:

The revolving credit facility includes a swinging lockbox arrangement whereby we transfer all funds deposited within designated lockboxes to MidCap on a daily basis and then draw from the revolving credit facility as needed.

These types of arrangements come from lenders who believe there is a strong possibility that GEN is going to default. As of December 31st, GEN only had a borrowing base of $436.9 million and $430.6 million in borrowings under the credit facility, leaving it with only $6.3 million in borrowing capacity and only $20.8 million in unrestricted cash. The bulk of GEN’s cash ($121 million) has been put in restricted accounts. Some of that cash is limited to paying insurance claims through its self-insurance program. Per the 10-K, the company’s total liquidity is only $93.8 million.

Any interruption of its operations, revenues or an increase in expenses could be catastrophic for GEN.

PDPM

There is a big change headed towards senior healthcare known as the “Patient Driven Payment Model,” or PDPM. This changes the model for Medicare reimbursements. The motivation for the government is to move away from a system which incentivizes volume to a system which is (theoretically) more centered on the needs of the patient.

There is a raging debate over what it means for skilled nursing facility (NYSE:SNF) operators. It is not really known what the impact is going to be when it is put into practice, and the impacts will likely vary from operator to operator depending on the particular mix of patients.

What is clear is that PDPM is going to force a shift in how SNFs do business. On its Q4 2018 conference call, GEN has quantified one expected impact:

We currently estimate that PDPM will reduce the top line of our rehab segment between 10% to 12%. This revenue contraction is related to the expected use of more cost-effective methods of delivery such as group and concurrent therapy. And will come with a corresponding reduction in operating costs that will substantially mitigate the impact of lower revenues.

The company’s rehab segment accounted for $889 million in revenue in 2018 and has one of the best EBITDA margins at 11.4%. The reduction might be offset by decreasing expenses slightly improving the margin, but the rehab segment was already trending down with a 9.2% decrease from 2017.

Additionally, the government has implemented the SNF-Value Based Purchasing program, which withholds 2% of Medicare payments and distributes it based on an SNF’s score (based on hospital “potentially preventable readmissions” within 30 days) relative to its peers. In its 10-K, GEN is predicting that it is a net loser in this program.

The FY 2019 SNF PPS Rules reiterate the SNF-VBP program instructions and affirm that effective October 1, 2018, skilled nursing facilities now experience a 2.0% withholding to fund the incentive payment pool. Simultaneously, based upon performance, skilled nursing facilities have an opportunity to have their reimbursement rates adjusted for incentive payments based on their performance under the SNF-VBP Program. Of the 2.0% withheld under the SNF-VBP Program, we expect to retain 1.3% based on performance.

This provides an opportunity for improvement, but it also introduces a risk of greater losses.

(Source: GEN Investor Presentation)

GEN’s average daily census has increased slightly and was up YoY from November 2018 through February 2019. This only tells part of the story – to really understand the issue, we also need to consider the “skill mix,” which is how many patients are being paid for with Medicare versus the much lower-paying Medicaid.

(Source: 10-K)

Along with the decline in admissions, the percentage of Medicaid days has increased. Medicaid only reimburses less than half of what Medicare reimburses. Management has been very vocal about the increase in occupancy in Q4, but it turns out that the increase in occupancy is driven by Medicaid patients. Per GEN’s CFO and Senior Vice President Tom DiVittortio on the conference call:

On the census, with respect to patient mix and occupancy, skilled days mix in 4Q, 2018 of 18.1% decline 60 basis points from the prior year quarter.

As a result, a 2% increase in occupancy would only result in approximately a 1% increase in gross revenues. By the time you factor in the much lower (sometimes negative) margins of Medicaid, an increase in occupancy could actually drive lower EBITDA.

Conclusion

OHI bulls have been in control of the share price. They have driven it up to historically high levels in terms of price/AFFO. This is occurring despite management guiding for lower AFFO in 2019, and despite OHI already making concessions for several of its top 10 tenants and three significant tenants that are behind in rent.

The fundamentals of the SNF industry are terrible. Operators are being pressured by long-term occupancy declines and a substantial shift from Medicare to the lower-paying Managed Medicare and Medicaid.

These pressures have caused several operators to go into bankruptcy, which rocked several of OHI’s competitors. There are several potential weaknesses in OHI’s portfolio, including Signature, Daybreak and, when it closes the MRT transaction, Fundamental Healthcare.

Perhaps one of the biggest potential hits would be GEN. With its ABL lender having a lockbox, a GEN default would mean an immediate loss of cash flow from its $71 million in outstanding loans. It would also risk the $59 million in annual rent – which, if history is any guide, could be expected to be reduced 30-40% upon transitioning to a new operator.

With OHI projecting to pay out nearly 100% of FAD in 2019, any disruption of cash flows puts the dividend at risk. A default from GEN would almost certainly necessitate a dividend cut. GEN accounts for more rent than Orianna did in 2016.

Looking at GEN’s finances, investors cannot be comfortable with the health of the company. There is a lot of risk, and PDPM or any other disruption might be the last straw. GEN is in a position where its liquidity is limited, and its revolver has tightened the leash. A continued decline of SNF fundamentals in an industry that has been declining since 2014 will render the company insolvent. GEN needs improvement now – it cannot afford to wait for the “Silver Tsunami.”

OHI is a very high-risk investment right now. What investors can see of GEN’s finances should terrify them, and it is likely that the financials of private companies like Signature and Daybreak are similar. It is impossible to say exactly when, but it is only a matter of time before OHI announces the restructuring of another major tenant.

OHI stock should be avoided, and at current prices, it is a great time to take profits.

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Disclosure: I am/we are short OHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Beyond Saving is short OHI via January 2020 Put Options. HDO does not have a position.

Three 7% To 10% Yielders Beating The Market In 2019, But Still Selling At Discounts – No K-1s

Want to “have your cake and eat it too”?

With the market on a roll in 2019, is it possible to find outperforming income vehicles which are still selling at a discount?

As a matter of fact, it is. You just have to look in the nooks and crannies of the market. In this case, we visited the world of closed-end funds – CEFs, which can sell for a premium or a discount to their net asset values, or NAV.

Our journey took a few twists and turns – we began by looking for utilities which might be undervalued, being inspired by the resurgence of this sector in 2019, thanks to the Fed becoming increasingly dovish in its rate hike stance.

But rather than stake a claim on just three individual utility stocks, we checked out CEFs to see if we could find some undervalued proxies for that sector.

The three we came up with are: Duff & Phelps Global Utility Income Fund (DPG), the not very succinctly named Macquarie/First Trust Global Infrastructure Utilities Dividend & Income Fund (MFD), and the Macquarie Global Infrastructure Total Return Fund (MGU).

DPG is the largest of the three funds, with ~$900M in net assets. It also has the highest concentration of US equities, at 55.5%, but the lowest concentration of utilities, at 38.8%. Like the other funds, DPG’s second highest sector concentration is energy-related.

DPG also uses leverage, of 30.92%, to goose its returns, and its expense percent is at 2.97%, very close to MFD’s 3.04% ratio.

MFD is the smallest of the group, with $137M in net assets, but it has the highest concentration of utilities, at 44.09%, with oil and gas being its second highest sector, at 29.14%.

MGU has $465M in net assets, with a 40% concentration in utilities, followed by a ~29% Pipelines concentration. It has a 52% concentration in US equities, and the lowest expense ratio, 2.6% of the group:

Portfolio Holdings:

DPG’s top holdings are spread out into four sectors – utilities, oil and gas storage/transportation, telecoms, and infrastructure. Utility heavyweight NextEra Energy (NEE) is in the top spot, followed by Spanish multi-national Iberdrola Canadian stock Emera (OTCPK:EMRAF) and US-based AEP (AEP) and Evergy (EVRG).

Canada makes up 17% of DPG’s non-US country allocation, followed by Europe, at ~15%, and Australia, at 7%:

Source

MFD has more UK stocks in its mix, 17.72%, with Australia, 16.13%, and Canada, 13.67%, all comprising the bulk of its non-US holdings.

Source

MFD’s top 10 includes UK water utilities Severn Trent (OTCPK:SVTRF) and United Utilities Group (UUGRY) and National Grid (NGG), which also owns US assets. There are also Australian infrastructure companies in the mix, such as Spark, Sidney Airport, and Transurban Group (OTCPK:TRAUF), as well as US midstream giant Enterprise Products Partners LP (EPD):

(Source: MFD site)

MGU has a sizable chunk of infrastructure assets in its mix, with toll roads, 15.4%, and airports, 11.1%, comprising 25.5%. Like DPG, MGU has significant to exposure to Europe, at 17.9% of its country mix:

Source

MGU’s top 10 holdings include some of the same UK and Australian companies as MFD, such as Transurban, National Grid, Sydney Airport, and Severn Trent, but in different percent allocations – Transurban heads the list, followed by US stocks, Cheniere Energy (CQP) and Sempra Energy (SRE):

(Source: MGU site)

Distributions:

MFD has the highest yield of the group, at 10.88%, followed by DPG, at 9.26%, and MGU, at 7.49%. These certainly aren’t big dividend growth plays – five-year dividend growth ranges from -2.86% for MFD, to just 3.86% for MGU. All three funds pay quarterly.

MFD has the next upcoming ex-dividend date, on ~5/22/19, with DPG and MGU both going ex-dividend on ~6/14/19:

Taxes:

MFD had the highest percent of tax deferral in its 2018 payouts, with 21.53% return of capital, followed by MGU, at 12.91%, while DPG had no return of capital. All three funds issue 1099s to investors at tax time.

Valuations:

We’ve often seen CEF’s selling at a discount to NAV in the past, but they’ve also had negative returns on NAV since their inception. This isn’t the case with these three funds, which have returned 6.09% to 7.41% on NAV since their inceptions.

DPC has the highest return on NAV over the past year, at 21.49%, vs. 12.42% for MGU, and 7.63% for MFD.

However, all three funds are currently selling at a discount to NAV – from -3.75% for MFD, to -10.74% for DPG, to a -14.45% discount for MGU, whose current discount to NAV is a bit higher than its one-year average discount of -14.10%:

Performance:

All three funds have outperformed the S&P 500 in 2019 by a wide margin and also outperformed in the past six months, which includes the Q4 2018 pullback, with MGU and DPG up the most during the half year. Over the past month, DPG and MGU have performed the best, while MFD has lagged the market.

Summary:

We rate MGU as a buy, based upon its higher percent of US equities, much larger discount to NAV, (MGU’s discount is slightly higher than its one-year average). MGU also has a positive $.1404 undistributed net investment income – UNII – of $.1404, the highest in the group, vs. a -$1.09 UNII for DPG, and the lowest expense ratio, 2.60%.

But, as you can see from the table below, it’s not a clear case for picking MGU over MFD and DPG – they all have some positive attributes. MFD has a much higher yield, at 10.88%, and positive UNII, but a smaller NAV -3.75% discount. DPG also has a higher yield, the best return on NAV, and the best YTF performance, but negative UNII.

Disclosure: I am/we are long MGU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: CLARIFICATION: Our www.DoubleDividendStocks.com investing site, has been increasing subscribers’ yields via selling options on high dividend stocks for over 10 years.