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Summary

  • HCP is one of the 3 biggest medical REITS in the country.
  • HCP is set to ride one of the largest mega trends in socio-economic history, the aging of the baby boomer generation.
  • It sports an above average yield and a consistent but slow, dividend growth rate.
  • HCP has been less focused on acquisitions than its competitors but new management might increase the rate of acquisitions and dividend growth.
  • HCP is projected to return 9% CAGR (with dividend reinvestment) over the next 5-10 years. This performance is far below that of competitors Vertias and Omega Health.

As a passionate high yield investor I am always on the hunt for new investing ideas for my experimental real world portfolio. One of my favorite industries is REITs which are traditionally known for high yields and low volatility. Medical REITs in particular pose a unique long-term opportunity as the US population ages and healthcare spending surges for decades to come. In an effort to find the best medical REITs for my portfolio, I began researching some of the bigger players in the industry and came across HCP. My goal in this article is to analyze the company, its strengths, weaknesses, fair value and likely future returns. Finally, I'll compare these likely returns with those of competitors to try to help investors determine whether HCP deserves their investment dollars at this time.

Company Overview:

HCP (NYSE:HCP) is one of the largest medical REITs in the US with $22 billion in assets consisting of 1,153 properties operating in 5 segments of the medical industry:

  • Senior Housing: 36% of assets
  • Post Acute Skilled Care: 29% of assets
  • Life Sciences: 17% of assets
  • Medical Offices: 16% of assets
  • Hospitals: 3% of assets

The company's scale allows it access to cheaper capital than competitors. For example, in 2013 HCP was able to negotiate the interest rate on its revolving credit line down from 180 basis points above LIBOR to just 125. In 2013, the company was able to refinance $800 million in 5.7% interest debt at 4.25%, a result of its BBB+ investment grade rating from S&P.

HCP management has a strong track record of growing same store sales from its properties averaging 3.86% annual growth over the last 4 years. For 2014 it is guiding for 3.5% same store growth.

The company is also known as an aggressive yet disciplined acquirer having spent $9.6 billion in 2011 and 2012 on acquisitions that were immediately accretive to FFO/share and helped to grow the dividend. However, in 2013 new acquisitions declined to just $600 million which is down from $2.6 billion in 2012 and $7 billion in 2011. The company is not threatened by excess debt as its debt/equity ratio is 0.8. This is 20% below the industry average of 1. The massive decline in new investment has resulted in a slowdown in FFO/share and FAD/share (funds available for distribution) which is used to pay the dividend. From 2010 through 2013 the FAD/share grew at a CAGR of 7.2%. However, management is guiding for a slowdown to 3.3% growth in 2014 and the recent decline in acquisitions is likely the cause.

When it comes to the company's dividend HCP is proud of its 29 consecutive year track record of dividend increases and the fact that it is the only REIT in the S&P 500 Dividend Aristocrat Index. To make it into this index requires 25 consecutive years of dividend growth. In addition to its consistent growth, the company emphasizes a decreasing FFO/share payout. Since 2002 the company has lowered its payout ratio from 100% to 73% while growing its dividend by a CAGR of 2.76%.

Catalysts For Growth:

According to the March 2014 investor presentation HCP is riding one of the greatest waves in demographic history. The aging of the baby boomer generation will see the proportion of the US over the age of 65 grow from 10% to 23% from 2010 through 2050. This represents a growth in senior citizens from 45 million to 90 million which includes nearly 10 million additional persons above the age of 85. These are prime candidates for senior assisted living facilities that HCP specializes in. The demographic trend is sure to keep the company's senior assisted living comps growing at its traditional 4.1% rate for decades to come.

Risks:

Despite the decent track record of growth at HCP over the last decade there are some risks to investing in this medical REIT.

Management change:

James Flaherty served as Chairman and CEO of HCP for the last ten years. He deserves credit for most of the company's achievements including its 10 year 8.83% CAGR total return (which includes dividend reinvestment). However, this has underperformed the market's 9.15% CAGR which rises to 9.33% with dividend reinvestment. In addition, it underperformed industry peers such as Healthcare REIT (NYSE:HCN) 10.72% CAGR, Ventas (NYSE:VTR) 13.9% and Omega Healthcare Investors (NYSE:OHI) 19.8%. It did manage to slightly outperform Senior Housing Properties Trust (NYSE:SNH) by 0.1% CAGR.

Company

Yield

Dividend CAGR (10 year)

Dividend CAGR (5 year)

Dividend Growth 1 year

Projected 10 year CAGR, (without dividend reinvestment)

Avg 5 yr yield

Projected Total Long-Term Return CAGR

Beta

Total Returns CAGR (10 year historical)

3 year revenue growth rate

3 year EPS growth rate

ROE

ROA

Operating Margins

Net Margins

Debt/Equity

OHI

6.07%

12.57%

10.31%

10.10%

18.64%

7

19.94%

1.06

19.84

17.5

45.5

5.4

14.9

63.5

41.2

1.6

VTR

4.79%

10.46%

7.16%

10.28%

15.25%

4.4

15.92%

0.46

13.90%

40.1

22.6

2.3

5.1

16.8

16.5

1.1

SNH

7.07%

2.32%

2.19%

1.30%

9.39%

6.7

10.02%

0.51

8.73%

30.8

9.1

34.7

19.9

3.2

5.6

0.7

HCN

5.46%

3.11%

3.17%

3.92

8.57%

5.5

9.04%

0.5

10.72%

70.8

4.1

0.4

0.8

3.7

2.7

1

HCP

5.79%

2.76

3.45%

3.81

8.54%

5.2

8.98%

0.42

8.83%

19.2

43.2

4.9

9.1

39.7

46.2

0.8

IND AVG

28.3

29.9

2.7

5.7

34.7

19.9

1

The board of HCP has refused to comment on the reasons for Mr. Flaherty's departure other than stating that it had nothing to do with financial or operational performance. The company review website glassdoor.com has 6 reviews from HCP employees and the average rating is 2/5 stars. Apparently many workers at the company felt that: "The culture is cancerous with continuous turnover. There is limited opportunity to contribute and heavy micromanagement." The fact that HCP has had 4 CFOs during Mr. Flaherty's tenure does give credence to the notion that there was something amiss in the offices of HCP. Perhaps an overly political environment - one not conducive to independent operations is what finally forced the board to act and bring on Mr. Flaherty's replacement.

It is possible the new CEO, Lauralee Martin, will usher in a more aggressive style of management. She could focus on increasing investment and the pace of dividend growth. Her background at the REIT Jones Lang Lesalle was as head of its America division. This means she oversaw general REIT investing and management which included some medically related properties. During her tenure as CEO of the Americas division (and COO of the company at large) the stock increased 300%. This indicates that Mrs. Martin is a very capable executive. She has served on the board of HCP for several years, however, has no specific experience with running one of the largest and most diversified medical REITs in the country. Investors in HCP are taking a risk that she will be able to learn quickly and make the necessary changes to return the company to growth.

Sharply decreased growth:

The recent decline in new investments cannot be explained through lack of liquidity nor of opportunity because competitor Ventas had $2 billion in investments in 2013. This is more than 3 times the investment that HCP closed. Meanwhile, Omega Healthcare Investors had $569 million in new investments in just the 4th quarter of 2013. Management has not explained the decreased investment activity. Investors are left to hope that whatever reasons that resulted in Mr. Flaherty's departure were responsible for the slow down in growth and that a new CEO will bring renewed emphasis on investments and growth.

According to the Q4 earnings call FFO/share and FAD/share increased 6% and 9% respectively when adjusted for the one time beneficial charges. However, for 2014 management is guiding for just 1.7% and 3.3% growth in FFO and FAD/share, respectively. FFO and FAD are what fuels the dividend. If there is a rapid decline in the growth rate of these metrics that means the growth rate of the dividend must slow proportionally. This is especially concerning since Mrs. Martin made clear in the last earnings call that she intends to continue making a decrease in the payout ratio a priority. Thus the future rate dividend growth is 1-2% below the growth rate in FAD. For certain, HCP investors can expect an increase in the dividend as the company will not allow its status as a Dividend Growth Aristocrat to be threatened. However, the growth may only be 1-2% annually. Perhaps Mrs. Martin will be more aggressive with acquisitions and investment and return the company to strong FAD/share and dividend growth. Only time will tell.

Opportunity Costs:

HCP investors can expect stability and consistency from the company. Dividends are well covered and are certain to grow each year even if it is very slowly. However, investing is not done in a vacuum. HCP has strong competitors that are equally well positioned to take advantage of the mega trend that is the aging of the US population. Ventas and Omega Healthcare Investors are two of HCP's competitors and are likely to return far better total returns than HCP. This is because when it comes to high yield investments a good rule of thumb for total returns are yield+CAGR of the dividend. Multiplying the sum by the average five-year dividend yield models the effect of dividend reinvestment and you get a reasonable approximation for future returns.

Proof of this can be seen in the table below which compares the 10-year actual total return to the predicted return.

Company

Predicted CAGR

Actual CAGR

Difference

OHI

20.94

19.84

-5.5%

VTR

15.51

13.9

-11.6%

SNH

9.62

8.73

-10.2%

HCN

9.08

10.72

15.3%

HCP

8.38

8.83

5.1%

AVG

12.706

12.404

-1.38%

Accuracy

88.84%

Investors need to keep in mind that the long-term market return (from 1871-2013) when adjusted for dividends is 11.1%. Thus, any stock with predicted returns that are under this threshold is less efficient than simply parking one's funds in a cheap S&P 500 index fund and dripping the dividends. What are the current long-term (5-10 year) projections for the returns of these 5 medical REITs?

Company

Projected Total Long-Term Return CAGR

OHI

19.94%

VTR

15.92%

SNH

10.02%

HCN

9.04%

HCP

8.98%

As can be seen in the table, HCP is projected to perform the worst among its peers and under perform the market's long-term total return by 18.1%.

Valuation:

To determine the fair price I take the projected 10-year returns and discount it by the 11.1% CAGR market return (assuming dividend reinvestment). This gives a fair value at which investors purchasing HCP could expect an equal return to the general market.

11.1% annual growth will return 187% over 10 years. 8.54% will return 127%. Dividing HCP's expected return by the market's discount factor yields 0.81 which indicates that HCP is currently 19% overvalued based on its projected yield and future dividend growth. In order to ensure a market beating return an investor should purchase a stock at a discount to fair value (what is known as a margin of safety). Given that HCP is a high quality company with many valuable cash flow producing assets, I believe that a 15% margin of safety is appropriate. I would apply this 15% to any high quality dividend paying stock as the probability of long-term capital destruction is very low.

HCP Fair Value: $31.12

Buy At: $26.41 or below

At the price shown, HCP's 10-year projected total return increases to 12.9%. Please don't misunderstand me. I believe HCP to be a fine company and at the right price it is a solid long-term investment. If the company can refocus itself on growth and double the growth rate of the dividend then the investment thesis becomes far more compelling.

Conclusion:

HCP is a wonderful company that has many positive attributes about it. Its yield is above average in the REIT industry and its dedication to consistent dividend growth is admirable. Its size and investment grade debt rating allow it access to large amounts of cheap capital with which to invest and grow shareholder wealth. The industry in which it operates is part of a mega trend that is sure to see healthcare spending soar and will likely make HCP and its competitors vast fortunes. However, when one considers the unique risks inherent in HCP that its competitors such as Veritas and Omega Healthcare Investors do not face, HCP's potential as a market beating long-term investment is called into question. These risks include a sudden and unexplained CEO turnover and decreased investment in the face of ample liquidity and market opportunities. When one considers its slow rate of dividend growth and strong decrease in the FFO and FAD/share growth rate expected in 2014, investors need to ask what, if anything, can bring a recovery to dividend growth rate. In the long-term only an acceleration in the dividend growth rate can improve HCP's total returns.

Perhaps Mrs. Martin, the new CEO, can refocus the company on FAD/share accretive acquisitions and investments, bringing a return to strong FAD/share growth and the potential for faster dividend growth in the future. With this being said I feel that investing in HCP, as opposed to its stronger competitors such as Veritas and Omega Healthcare, is speculating on Mrs. Martin's yet unproven leadership abilities. With yields nearly as high as HCP (in the case of Omega Healthcare it is higher) and faster dividend growth, income investors have little reason to choose HCP over its stronger peers which are likely to outperform it in the long run.

Source: HCP: Can This Medical REIT Big Dog Still Compete?