What HCP's Upcoming Spin Off Means For Dividend Investors

| About: HCP, Inc. (HCP)

HCP Inc.'s (NYSE:HCP) 30-year dividend growth streak has long made it the darling of high-yield dividend growth investors.

HCP is also the only real estate investment trust (REIT) in the S&P Dividend Aristocrats Index. Investors can view analysis on all of the dividend aristocrats here.

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Source: Simply Safe Dividends

However, as covered originally back in March (you can read the original investment thesis here), the company has hit some major rough patches in the last few years.

Now management has announced that it will spin off its troubled ManorCare skilled nursing facilities, or SNFs, into a separate REIT, which will greatly change the nature of HCP's business model going forward.

Find out why management is making this game-changing decision, what it means for the company's future growth prospects, and most importantly what it means for HCP's legendary dividend growth streak.

The spinoff will cause HCP to reduce its dividend, but that's not the entire story. Let's start with a look at why HCP has decided to spin off some of its operations.

HCP's Trouble with ManorCare

Back in 2011, HCP acquired 338 of ManorCare's properties as well as a 9.4% equity stake in the company for $6.1 billion. Unfortunately, while this resulted in absolute growth in revenue and funds available for distribution, or FAD (what pays the dividend), it has created major headaches for HCP since then.

In 2015, the Justice Department launched an investigation of ManorCare over accusations of fraudulent Medicare and Tricare (the private military medical insurer) reimbursement claims. In addition, ongoing changes in Medicare reimbursement from fee for service to managed care plans resulted in shorter stays at its facilities and a sharp decline in cash flow.

In fact, in late 2015, ManorCare's occupancy dropped 1.75% to 82.6%, and its tenants' fixed-fee coverage ratio, or FFCR, a measure of cash flows versus liabilities, declined to 0.97 for the last half of the year. So far in 2016, ManorCare's customer's FFCR has risen to 1.07, a nice improvement, but still dangerously close to the limits of sustainability.

All told, ManorCare's turmoil has resulted in falling profits that have served as a major drag on HCP's overall profitability and returns on shareholder capital.

REIT Operating Margin Net Margin Return On Assets Return On Equity Return On Invested Capital
HCP -4.3% -2.6% -0.3% -0.7% 0.8%
Welltower 18.2 16.0% 2.3% 4.9% 4.19%
Ventas 14.5% 13.1% 1.9% 4.3% 3.72%
Industry Average 28.8% 14.2% 2.1% 4.6% NA
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Source: Morningstar

Potentially even more troubling is that the ManorCare acquisition resulted in HCP taking on a lot of debt, resulting in a far more leveraged balance sheet than its major rivals Welltower (NYSE:HCN) and Ventas (NYSE:VTR).

In fact, as you can see below, HCP's current balance sheet is among the ugliest in its industry, with a low interest coverage ratio and a current ratio that is far below the industry average.

REIT Debt / EBITDA EBITDA / Interest Debt / Capital Current Ratio S&P Credit Rating
HCP 10.18 2.17 52% 0.23 BBB
Welltower 6.16 4.07 44% 2.28 BBB
Ventas 6.27 4.26 52% 1.78 BBB+
Industry Average 6.73 NA 52% 0.80 NA
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Sources: Morningstar, Fastgraphs

HCP's Turnaround Plan: The Good News

HCP management has announced that it plans to spin off its ManorCare assets into a separate REIT called Quality Care Properties (QCP) by the end of the year.

This REIT will own: 274 SNFs and post-acute properties, 62 memory care/assisted living properties, a surgical hospital, and HCP's 9.4% stake in ManorCare.

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Source: HCP Investor Presentation

There are three main reasons for the spin off. First, it should help HCP to pay down a lot of its debt. Specifically, this is because QCP will pay HCP for the assets it gets from the parent company. And when combined with ongoing asset sales and divestitures of the RIDEA II assets (a joint venture with Brookdale Senior Living (NYSE:BKD)), HCP management expects to raise a total of $3.8 billion; $3.3 billion of which will go to paying down debt.

If management can in fact raise these funds, then it could decrease HCP's debt from $10.8 billion to $7.5 billion. However, in the short term, while HCP's debt load may decrease in absolute terms, its leverage ratio will actually increase due to the estimated $500 million in decreased cash flow that is currently coming from the REIT's ManorCare assets.

In fact, HCP's leverage ratio is likely to rise, potentially as high as 14.8. This has led both Fitch, and Moody's to recently downgrade HCP's credit rating. And with HCP's CEO, Lauralee Martin, resigning on July 11th, and the company having yet to name a permanent replacement, it's clear that this spin off is just the start of HCP's turnaround effort. The turnaround will likely take several years and require a continued strong emphasis on paying down debt, potentially at the expense of dividend growth.

The second reason for the spinoff is that it will help to decrease HCP's reliance on Medicare and Medicaid funding by increasing the percentage of its cash flow coming from private payers from 80% to 95%.

In addition, the smaller HCP will own younger, more in demand properties focused on the senior housing, life sciences, and medical office buildings, or MOBs.

Thanks to America's rapidly aging population, these are all industries that are expected to be in high demand and will help the new HCP achieve faster growth going forward.

HCP Dividend QCP Spinoff

Specifically, HCP expects its leaner, post spin off form to achieve 0.8% faster net interest income growth. This should help the company eventually achieve faster dividend growth in the future, once the balance sheet is returned to a safer level; one more in line with industry standards.

HCP Dividend Cut QCP Spinoff

Source: HCP Earnings Release

The final reason for the spinoff is a bit more nebulous. According to Mark Ordan, who HCP has chosen to be the new CEO of Quality Care Properties, "With a singular focus on SNF and assisted living assets and a flexible capital structure, we believe SpinCo (former name of QCP) will have the tools and flexibility to unlock value in the HCR ManorCare portfolio, as we own, manage, sell or transition assets as desired over time."

Now, personally this claim is one that I am skeptical of, as it's a classic example of non-specific corporate speak that usually follows poor execution, and a pledge to turn things around.

Which brings me to the most troubling aspect of this corporate restructuring; the impact it will potentially have on HCP's dividend.

Here's the Bad News for HCP Dividend Investors

Since 2014, as ManorCare started becoming a larger and larger drain on HCP's overall profitability, dividend investors have seen only token increases in the payout. In other words, $0.01 per quarter hikes are just large enough to keep the dividend growth streak alive, but really only big enough to offset inflation.

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Source: Simply Safe Dividends

Well, things are about to get worse after the Quality Care spinoff is completed on October 31, 2016. HCP will likely reduce its dividend by 20-40% as a result of the spinoff.

That's because HCP is expecting its FAD to decline by about $500 million once QCP becomes a standalone REIT. In addition, HCP is still divesting other assets to try to bring its debt down, which means that 2017's FAD per share is likely to look even weaker due to its far smaller and still shrinking property portfolio.

Over the last 12 months, HCP's FAD payout ratio sits near 82%. However, if we back out the $250 million in FAD that ManorCare provided in the first half of 2016, then HCP's existing dividend FAD payout ratio becomes an unsustainable 134.6%.

In other words, without QCP, HCP's current dividend is unsustainable after the spinoff. A 20-40% dividend reduction would bring the FAD payout ratio back to 80-90%, which is in line with peers and more sustainable.

HCP is going to lose its dividend aristocrat status unless you hold onto the shares of QCP that you'll get once the deal goes through on October 31. That's because QCP, as a REIT, will be legally obligated to pay out 90% of taxable income as unqualified dividends (click here for a basic guide to REIT investing).

Which means that the combined HCP and QCP shares might be able to maintain the current payout, and potentially even offer a tiny bit of growth. However, there are two main reasons that I still consider this a loss for long-term HCP investors.

First, Quality Care Properties is essentially a collection of distressed assets that the parent company is trying to wash its hands of. After all, its properties will be mainly run by ManorCare and Brookdale, both of which have struggled immensely in recent years.

What's more its cash flow just barely covers its existing liabilities, and its cost of capital is likely to be very high, which is largely why I am skeptical of management's claim that QCP on its own will be better off.

For example, without the larger scale and investment-grade credit rating of HCP, QCP is looking at much higher borrowing costs. In fact, here are the most recent debt terms that it just obtained.

  • $750 million in 7-year senior secured bonds at 8.125%
  • $1 billion, 6-year term loan at LIBOR + 5.25% (with a 1% minimum LIBOR floor)
  • $100 million, 5-year revolving credit facility, or RCF, at LIBOR + 5.25%

LIBOR, or the London Interbank Offered Rate, is the interest rate banks charge other banks to borrow from them. Currently, US 1-year LIBOR is 1.59%, which means that, assuming QCP borrows all $100 million from its RCF, its weighted average cost of debt would be an unfortunately high 7.36%. The only reason for such high interest rates is because Quality Care Properties is essentially a collection of high risk (i.e. "junk bond") assets.

Worse yet, these high rates were obtained while interest rates are currently at their lowest point in history.

Unless QCP management can turn around its troubled properties in a hurry (and obtain an investment-grade credit rating), Quality Care Properties is going to face the prospect of interest rates rising over the coming years. This would only raise its debt costs all the more, further reducing profitability and making a successful turnaround less likely.

In other words, HCP is basically telling dividend investors, some of whom have owned shares for decades, that in order to avoid a dividend cut, they must hold onto shares of QCP.

Since Quality Care Partners is going to start out as an unproven, junk bond bearing REIT whose largest tenants can barely pay their bills, I don't consider this spin off a benefit for dividend investors. Sure, QCP can get more attention as a standalone company, but its weakness will also be all the more glaring to capital providers.

After all, conservative investors bought HCP because it was a highly diversified medical REIT with a secure and generous yield, a great dividend growth record, and an investment grade balance sheet. QCP will have none of those things, making it a riskier and more speculative holding for investors' portfolios. I imagine its Dividend Safety Score will be below average once data is available.

Meanwhile, HCP's yield is likely to drop drastically without the added benefit of ManorCare's cash flow. In fact, I calculate that, assuming an 80% to 90% FAD payout ratio, HCP's quarterly dividend will need to be cut from $0.57 per share to $0.34 to $0.3825, resulting in a yield of 3.8% to 4.2%.

That's lower than both Welltower and Ventas, which offer better yields, proven management teams, high profitability, much stronger balance sheets, and superior long-term dividend growth prospects.

That's especially true given that HCP's poor track record on execution over the past few years means that it has a lot to prove when it comes to growing the dividend post-spinoff, especially with a balance sheet that is going to get only more leveraged and likely take many years to fix.

Conclusion

While in the long run HCP's spin off of Quality Care Properties will likely make it more profitable and increase its cash flow security, the short-term effects on dividend investors could be painful. I'm not interested in adding HCP to our Conservative Retirees dividend portfolio for these reasons.

With such high uncertainty regarding HCP's future management, its ongoing turnaround efforts, and the likely large cut that is coming to its dividend, I can't recommend this troubled medical REIT. Especially not when REITs such as Welltower and Ventas are far higher quality, and soon to be higher-yielding, choices at this time.

QCP could see a good deal of selling pressure when the spinoff completes, which isn't unusual for unwanted business units. Even if the combined dividends from QCP and the "new" HCP equal HCP's current dividend, owning a business like QCP is too risky for me. I'll stick to some of my favorite blue-chip dividend stocks here.

From a Dividend Safety Score perspective, it's a tough judgment call on how to handle these unique situations. Yes, HCP's headline dividend figure will be cut, but in reality part or all of it is being "converted" into shares of QCP instead. We don't yet know QCP's payout plans (total dividends could remain unchanged or even slightly increase), but it is clearly a riskier business.

No one knows how the market might respond if there is a moderate reduction (e.g. 10-15%) in total dividends paid by HCP and QCP combined. In the long run, I don't think it will matter. However, current HCP investors, especially those using dividends to supplement their retirement income, must decide if they want to wait around through the transition or move on to other investments with more certain dividend payouts.