Source: HCP Inc.
America's aging population means that healthcare spending is likely to rise dramatically in the coming decades. However, over the past few years dividend investors hoping to cash in on this mega-trend by investing in HCP Inc. (NYSE:HCP), haven't had the best luck.
HCP Total Return Price data by YCharts
HCP has badly underperformed both the broader market, and its major rivals: Welltower (NYSE:HCN), Ventas (NYSE:VTR), Omega Healthcare Investors (NYSE:OHI), Medical Properties Trust (NYSE:MPW), and Healthcare Trust of America (NYSE:HTA).
While some value focused high-yield investors may be drawn to HCP under the assumption that it's potentially the most undervalued major medical REIT, there are four major reasons I advise against buying HCP at this time. Instead read on to find out what two high-yielding medical REITs have the potential to offer far better long-term total returns over the next decade and beyond.
Dividend security ALWAYS needs to be your top priority
|REIT||Yield||Q1 2016 AFFO Payout Ratio||10-Year Analyst Dividend Growth Projection||10-Year Total Annual Return Projection|
|Medical Properties Trust||6.2%||68.8%||4.8%||11.0%|
|Healthcare Trust of America||3.8%||79.7%||4.0%||7.8%|
HCP is the highest yielding dividend aristocrat, having grown its payout every year since 1986. However, not only does it have the highest payout ratio of its peers, but that ratio is soon likely to rise to an unsustainable level. That's because management plans to spin-off its senior nursing facility or SNF, business into a separate REIT called ManorCare.
The reason for the spin-off is because HCP's growth has slowed in recent years. By getting rid of the post-acute/nursing business, (which is expected to see same property NOI growth of -0.6% in 2016), management believes 2016's NOI growth will rise from 2% to 2.8%
Source: HCP investor presentation
In addition, the new HCP's customers will receive almost all of their cash flow from private parties, rather than Medicare or Medicaid. That will greatly reduce HCP's future cash flow risk from changes in government healthcare spending. However, in the short term it also means the loss of significant cash flow.
In fact, HCP is likely to see a $500 million decrease in funds available for distribution or FAD, which is what pays the dividend. Since the ManorCare spin-off isn't expected to be completed until the second half of the year, management is projecting $2.68 per share in FAD this year.
With 467.1 million shares outstanding that means that next year's FAD is likely to fall from $1.25 billion to $752 million, or $1.61 per share. With the current annual dividend at $2.3 per share HCP's payout ratio will soar to 143%. In order to preserve the current payout HCP would need to make up a $322.2 million shortfall yet it only has $95 million in cash on its balance sheet. Which means the only way HCP will be able to avoid a drastic dividend cut will be either to take on debt or sell off assets. The problem with that is that the company has been selling off numerous assets already in order to pay down its large debt burden.
Meanwhile, both Omega Healthcare and Medical Properties Trust have very solid and attractive dividends. What's more both Omega and Medical Properties are still growing at enviably rates, having reported Q1 year-over-year AFFO per share growth of 16.9%, and 18.5% respectively
Strong balance sheet is also a priority
|REIT||Debt/EBITDA||Interest Coverage Ratio||Debt/Assets||S&P Credit Rating||Average Debt Cost|
|Medical Properties Trust||9.1||2.6||59.8%||BB+||3.94%|
|Healthcare Trust of America||6.6||1.9||50.3%||BBB||3.54%|
As you can see HCP is the most leveraged REIT of its peer group. And while its debt service costs have been low up till now, that might be about to change. Fitch and Moody's (NYSE:MCO) both recently downgraded HCP's credit rating over concerns over the execution of the spinoff.
Specifically, Fitch "expects HCP's leverage will increase markedly at the time of the spin due to the loss of HCR's sizable, albeit thinly covered, rent." In addition should ManorCare not be able to obtain the needed financing to buy HCP's SNF assets, the company's liquidity will be hurt significantly, threatening its growth prospects.
Combined with the risk that in a potentially rising interest rate environment, a credit downgrade and increased leverage ratio could mean higher debt refinancing costs, and you can see why I'm recommending against buying HCP right now. Unless the spinoff goes well, HCP faces the threat of higher interest costs threatening its already poor profitability.
Meanwhile Omega and Medical Properties Trust both have leverage ratios more inline with the industry average of 7.23. Add in the strongest interest coverage ratios of the group and I'm confident that Omega Healthcare and Medical Properties will have ongoing access to cheap debt to fund their growth plans.
Worst profitability of the bunch means management has a lot to prove
|REIT||Operating Margin||Net Margin||Return on Assets||Return on Equity||TTM Return on Invested Capital||4-Year Annual NAV/Share Growth|
|Medical Properties Trust||62.8%||33.6%||3.4%||8.2%||3.79%||4.2%|
|Healthcare Trust of America||23.7%||8.7%||1.1%||2.5%||3.15%||17.1%|
Not only are HCP's margins the worst of any major health care REIT but over the past 4 years its net asset value per share, (the best metric for a REIT's intrinsic value), has been shrinking. This means that HCP has actually been destroying shareholder wealth. Should HCP fail to execute its spinoff plan correctly, potentially higher future debt service costs going could make its current abysmal profitability metrics even worse.
In comparison Omega's net asset per share growth has been stupendous. And while Medical Properties' nav/share hasn't grown nearly as fast, it makes up for it with the highest margins of the group.
HCP's valuation doesn't make it attractive relative to its problems
|REIT||Yield||5 Year Average Yield||P/AFFO||Historic P/AFFO||P/NAV||10-Year Median P/NAV|
|Medical Properties Trust||6.2%||6.8%||12.7||13.4||1.66||1.40|
|Healthcare Trust of America||3.8%||na||21.6||19.0||3.05||na|
Given its worst-in-class profitability, slow growth, and uncertainty surrounding the ManorCare spin-off, you'd think that HCP would at least be trading at a steep discount to its peers. On a historical yield and price/AFFO ratio basis that is true. However, the fact that Omega and Medical Properties Trust are selling for an equivalent or even lower price/NAV is unjustifiable given their superior growth, balance sheets, and profitability.
Don't get me wrong, HCP management is confident that it can turn things around after the merger is complete. That means paying down its debt and bringing its margins closer to the industry average. However, with Omega and Medical Properties Trust offering clearly superior long-term dividend growth opportunities, I just can't see why investors should accept HCP's current risks before management can prove its ability to successfully execute its turnaround plans.
Bottom line: HCP's turnaround efforts MIGHT work out, but for now there are far better alternatives to invest in
HCP's track record of 30 consecutive years of dividend growth is indeed impressive. However, after the ManorCare spin-off, it's highly likely that HCP will be forced to slash its dividend dramatically. In addition, while the new HCP might become a more profitable company EVENTUALLY, in the short term it faces the risk of making its already highly leveraged balance sheet even worse.
Which is why I recommend long-term dividend investors buy Omega Healthcare and Medical Properties Trust instead. These two medical REITs offer: far better valuations, secure, generous, and growing dividends, and much stronger balance sheets. This combination of positive factors should allow Omega and Medical Properties to continue rewarding investors with market beating returns for many years to come.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in OHI over the next 72 hours.
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.