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For a while now I've been realizing that there is a bubble in dividend-paying stocks. The appeal is huge, as some of these stocks pay dividend yields approaching double digits. But for at least one stock (and trust me, there are others), this dividend payout is a mirage. Health Care REIT, Inc. (HCN) is paying out a huge distribution every quarter. In a vacuum, more distributions are obviously better, of course. But HCN plainly cannot afford the distributions they are paying.

Valuation
A few stats:

  • Payout ratio / earnings: 346%
  • Payout ratio / op cash flow: 102%
  • Payout ratio / FFO: 118%
  • Payout ratio / AFFO: 146%
  • P/FFO - 32.6
  • P/AFFO - 41.5

(I use the company's reported FFO and then subtract their reported maintenance capex. These numbers would be completely irrelevant including all capex.)

Distribution History

Below is a chart of distributions paid and cash from operations. I decided to exclude capex from this analysis so as to remove any effect of maintenance vs. expansion capex. As you can see, the results are quite stunning. HCN pays out almost the entirety of its CFO every year. In some years it's more. And that's before factoring in capex at all! Something is seriously wrong. In case you want to make comparisons to earnings, let me just tell you that the numbers are even worse. For instance in the most recent fiscal year, distributions paid out were $370mm. This was paid out of $84mm of operating income and $106mm of net income. Again, the proper comparison would be Distributions Paid/Free Cash Flow. However, including any capex moves the payout ratio significantly higher.

Year Distributions Paid (thousands) CFO Payout Ratio
2010 $370,223 $364,741 102%
2009 $333,739 $381,259 88%
2008 $276,860 $360,683 77%
2007 $208,099 $271,461 77%
2006 $199,828 $216,319 92%

The company is noticeably opaque about how they decide on their distributions. They merely say that they must pay out "at least 90% of taxable income (excluding 100% of net capital gains)." Note 18 of the financial statements then breaks down the distributions into ordinary income, return of capital, long-term capital gains, and 1250 gains. It doesn't say, however, how the company arrives at these particular numbers.

The problems with HCN originate with their distributions, but that is not where they end.

How Would HCN Get Out of This Jam?

So, what does HCN need to do to fix this (assuming they have any desire to)? None of the answers are particularly palatable.
First, HCN could grow organically, which would require greater rents. But HCN says that most of its properties are leased under long term leases, with terms of 12 to 15 years (occupancy rates are generally around 90%, except for hospitals, which have been between 50 and 60%).
Though the leases have either "fixed or contingent" rent escalating features, presumably this is only to track inflation, and it would take a long time for the company to actually increase rents enough to really affect their payout ratio. Another way to grow cash flows would be to acquire other companies. This could work, but because the company has no cash left over to do this, they would need to issue debt or equity in the market in order to raise the necessary capital. If they issue equity, current shareholders get diluted, obviously, and they will need to pay out more total in the way of distributions in the future just to maintain their current per share distribution (I am operating under the assumption that any cut in the distribution would lead to a huge selloff).
If they issue debt, they will further erode the balance sheet, and will have more fixed costs in the form of interest payments. The last issue with this is that the company has shown quite clearly that they have not been able to turn acquisitions into earnings or extra cash (see below).

The other option for HCN to bring the distribution in line would be to lower it, which would certainly not please the current holders of the stock, leading to my predicted selloff.

Despite "rapid" growth, cash flow has been largely unchanged in the last 4+ years (check prior years). HCN claims to have experienced rapid growth over the last few years. And if you look at the top line, this is true. However, FFO has not followed suit. In fact, despite increases in revenue between 2008 and 2010 of 35% percent, FFO actually fell from $330mm to $313mm, a decrease of 5 percent. Obviously, the reason this is the case is that costs have grown at the same rate, or higher, than revenues. This indicates an inability on management's part to make profitable acquisitions, or to control costs. It doesn't matter how many acquisitions you're making if they don't add to your bottom line.


There is a very simple reason for this: costs are out of control. From 2009 to 2010, revenues increased from $546mm to $680mm, an increase of 25%, but operating expenses increased from $396mm to $602mm, an increase of 52%. $90mm of this (approximately) can be blamed on transaction costs and depreciation; if these costs are excluded the increase was still approximately 29%. Costs and revenues were more stable in prior years. There are obviously still opportunities to realize "synergies" from these acquisitions, but I just don't see how these can be high enough to make these acquisitions look good.

Massive Equity Dilution
The table below shows the share counts in each of the last five years for HCN.

Year 2006 2007 2008 2009 2010
Share Count (mm) 73.5 85.8 110.7 123.7 147.4
% Change - 16.7% 29.0% 11.7% 19.2%

For those counting along at home, shares outstanding have more than doubled since 2006. That is huge dilution. And HCN shows no signs of slowing down. For comparison's sake, Intel (INTC) (a highly regarded, large, stable company) actually decreased their shares outstanding over the same time period.

Debt, Too Much of It
The numbers don't lie. Debt to Equity is 100%. Debt to Assets is around 50%. Most recent fixed charges coverage was 2.22x; interest coverage was 2.75x. We're talking about a company that is spending just under half of its money on fixed charges and just over a third on interest alone! And the worst part is that HCN will have to continue issuing debt (or equity) or be forced to cut the dividend. This is not a company that is in good financial shape.

From the Horse's Mouth
If none of this has convinced you that the company is basically issuing equity and debt and using that to fund its distributions, perhaps this actual quote from the most recent 10-K will convince you otherwise: "The increase in dividends is primarily attributable to an increase in our common shares outstanding." They are admitting it! Why is anyone owning this company? It is akin to a Ponzi scheme. No, it is a Ponzi scheme. If you own HCN, your distributions are being paid by the people who just participated in a secondary offering. Their distributions will be paid by the next offering. This is clearly unsustainable and sooner or later, HCN will be realized for what it is: smoke and mirrors.

One Last Note
By shorting HCN, you will be on the same side of the trade as the HCN insiders. In the last 3 months, insiders have exercised options for and sold tens of thousands of shares worth millions of dollars. Though there are obviously always many reasons for insiders to sell their shares, and I don't worry when 2 or 3 are selling, when it is this widespread, it's worth asking questions.
It should also be mentioned that executives and directors own less than 1% of the shares outstanding collectively. This is probably because they sell their shares as soon as they exercise the options. I have reviewed many, many proxy statements, and this is the first one I have ever seen that does not report the percentage of shares held by insiders, only the absolute number. Perhaps they are embarassed about how little they actually own.
Source: Health Care REIT, Inc.: It's Nothing but Smoke and Mirrors