Is Omega Healthcare's Risk In Government-Based Income Overstated?

| About: Omega Healthcare (OHI)

Omega Healthcare Investors (NYSE:OHI) has become a "go to" REIT for many DGI investors. Over the years the $5.9 billion (Total Cap) Health Care REIT has evolved from a sleep little nursing home landlord into a well-recognized dividend model of repeatability.

One of the primary attractions to Omega and one of the reasons that I own the stock is because of the steady and reliable track record of dividend performance. Omega has managed to pay and increase dividends for over 11 years in a row - earning the company a spot in my 3D portfolio (see my newsletter HERE).

One of the best things about Omega is the fact that this REIT has increased its dividend more than many of the other Health Care REIT peers. Over the last 3 years, Omega's average dividend increase has been 12% and over the last 5 years, the company has increased its dividend by over 9%.

Of course a reliable dividend history is important but it's equally essential to buy stocks with an adequate "margin of safety." As I referenced in a previous article, my BUY Target for Omega is $30.50 a share and the most recent close price was $31.80. The current dividend yield is 6.1%.

As part of my continued effort to connect investors with management, I recently interviewed Taylor Pickett, the CEO of Omega Healthcare.

Pickett has served in the CEO capacity since 2001 and he is also a Director and has served in this capacity since 2002. Pickett's term as Director expires in 2014. From 1998 to 2001 Pickett served as the Executive Vice President and Chief Financial Officer of Integrated Health Services, Inc. (IHS), a public company specializing in post-acute healthcare services. Pickett served in a variety of executive roles at IHS from 1993 through 1998. From 1991 to 1993, Pickett was Vice President of Taxes for PHH Corporation and from 1984 to 1991, he worked for KPMG, an international accounting and consulting firm.

As I referenced in a previous article, investors deserve to understand "the business behind the business." That's why I asked Taylor Pickett to answer a few questions exclusively for Seeking Alpha.

Thomas: OHI recently acquired a portfolio of 56 facilities in a sale/leaseback from Ark Holding Company. The $529 million deal will make Ark the largest tenant (based on revenue concentration), surpassing Genesis, Inc. What can you tell me about Ark Holdings (from a credit perspective) and how does this large acquisition add value to Omega's business model?

Pickett: Ark is a new tenant for Omega. The quality of the facilities is high. In addition, Ark is concentrated in key southeastern states. We now have a presence in Virginia and South Carolina and we will look to grow in both states.

The Ark portfolio reflects our continued focus on high quality regional operators with the infrastructure and management team that allows for additional growth through acquisitions.

Thomas: OHI has been a public REIT for over 21 years and the company has had a remarkable record of growing its dividend. However, in 2000, Omega was forced to cut its dividend. What caused that cut and what has the company learned from that experience?

Pickett: The current senior management team joined the Company in 2001. However, we were all in the industry in the 1990s when the Federal government changed the reimbursement system from a cost reimbursed based system to a prospective payment (fee based) system. This change rewarded operators who had efficient operating models while those operators who were not efficient or who were over levered experienced significant financial difficulty.

Our focus has always been on quality, highly efficient operators with little or no debt. We have been able to partner with our tenants to acquire over $3 billion in new assets over the last 10 years. As a result, we have had REIT industry leading (number 1) total shareholder return for the ten-year periods ended December 31, 2012 and December 31, 2013.

Thomas: A few days ago OHI announced an increase in its quarterly common dividend to $.49 per share. This is a 2.1% increase from the last quarter and a 9% increase from the fourth quarter of 2012. OHI has now increased the dividend six consecutive quarters. What can you tell us about your dividend policy and the capacity for future increases?

Pickett: In addition to the track record you just mentioned, we have raised our dividend by at least $.01 27 times in the last 40 quarters. We have designed our business model with the goal of continuing to increase dividends on a regular basis. Our dividend policy remains the same. We pay out between 75% - 85% of adjusted FFO and less than 90% of funds available for distribution.

Thomas: OHI has a very risk-averse capital stack with only 14% secured debt. What can you tell us about your company's balance sheet and do you expect to see future credit upgrades as a result of your healthy investment policies?

Pickett: We also have maintained debt to adjusted EBITDA below 5x and our fixed charge coverage is over 4x. Our credit metrics are among the strongest in the health care REIT sector. Our bonds are currently investment grade rated by S&P and Fitch and a notch below investment grade by Moody's. We continue to focus on improving our credit rating with all three agencies.

Thomas: In late December, OHI closed on a $200 million term loan priced at LIBOR plus 175 basis points, which is short liquidity for potential new investments. Is this how you intend to acquire assets in 2014 and what is your guidance for the year (for new investments)?

Pickett: We expect to continue to finance new deals with 50% equity and 50% debt. We will look at opportunities to replace the $200 million term loan with longer term bond debt and/or equity.

We have not provided acquisition guidance for 2014, but our pipeline of deals remains active.

Thomas: OHI's occupancy has been stable - reported 83.4 percent during the latest earnings period. What can you tell us about the occupancy and do you expect to increase that over time?

Pickett: Both industry occupancy and Omega occupancy have been fairly stable over the last decade. We expect this trend to continue in the near term. It is quite possible we will see occupancy improve over the long term.

Thomas: The majority of OHI's revenue is from government resources (private pay is 10%). What can you tell us about the mix of revenue sources and also is there a way that you mitigate risk in the highly government relied upon model?

Pickett: Medicare and Medicaid have been and will continue to be our operators' principal source of revenue. Over the last ten years within Omega's portfolio, both Medicare and Medicaid per day revenue have increased slightly more than inflation. Based on history, we believe the "risk" is more of a misperception regarding rate setting.

Thomas: On that same line, OHI was one of the lowest P/FFO multiples in the Health Care sector. Do you think that is because of the government-based income and what can you tell us about your valuation today and whether or not OHI is valued fairly?

Pickett: We continue to believe that the focus on government-based operator revenue as a major risk factor has been overstated. When you consider our very strong operator cash flow to rent coverage and our consistent FFO and dividend growth, we personally believe our multiple should be closer to the peer group average.

Thomas: Finally, can you go out 5 or 10 years and let me know what you think US health care will look like? Will there be more or less reliance on the government? Also, what is the supply and demand for your sub-sector?

Pickett: The supply in the skilled nursing facility sector is steady while the demand for the services provided in SNFs continues to climb. As for U.S. health care, it certainly seems like the government's role will continue to expand. Ultimately the most efficient low cost providers will attract the most capital.

Thomas: Thank you for your time.

Source: SNL Financial and FAST Graphs.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I am long O, DLR, VTR, HTA, STAG, UMH, CSG, GPT, ARCP, ROIC, MPW, HCN, OHI, LXP, KIM. 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.