Secular Trends Pulling Welltower In Different Directions

| About: Welltower Inc. (WELL)
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Summary

Welltower benefits from a portfolio full of relatively new assets with low capital expenditure needs in markets with high barriers to entry.

Welltower maintains investment grade credit ratings, and it has delivered over 180 consecutive quarterly dividends.

Though its yield is certainly appealing (~5.5%), REIT investors should pay close attention to changes in Treasury rates.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Welltower (HCN), formerly called Health Care REIT, is a real estate investment trust that has been at the forefront of seniors housing and health care real estate since the company was founded in 1970. Welltower benefits from a portfolio full of relatively new assets with low capital expenditure needs in markets with high barriers to entry. It expects to continue to benefit from attractive demographic tailwinds as the 85+ age group continues to outgrow the general population (nearly two-thirds of its portfolio is senior housing).

Image source: Welltower

Image source: Welltower

The firm maintains investment grade credit ratings, and it has delivered over 180 consecutive quarterly dividends. Normalized funds from operations have averaged nearly $1.3 billion from 2013-2015, slightly above annual runrate cash dividend obligations of just over $1.2 billion, though the metric has been sufficient in covering dividend obligations in each individual year in the period. Though its yield is certainly appealing (~5.5%), REIT investors should pay close attention to changes in Treasury rates, which have been profound in recent weeks.

The risks to Welltower's business do not stop with rising Treasury yields. Real estate investment trusts pay out 90% of annual taxable income and therefore are unable to meaningfully reinvest internally-generated funds, resulting in external capital market dependence. The weak internal cash-flow retention of most REITs translates into poor raw, unadjusted Dividend Cushion ratios, which could become severe during the depths of the real estate cycle. Even though a REIT's operating cash flow may be robust, the lack of cash accumulation on the balance sheet and the massive debt needed to purchase/develop new properties can become restrictive.

The adjusted Dividend Cushion ratio, accounts for expectations of continued access to the capital markets, which while "normal," cannot be guaranteed in times of tight credit. Be sure to watch our podcasts on REITs here.

Welltower's Investment Considerations

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Investment Highlights

• Welltower's portfolio continues to generate nice same store NOI growth, and occupancy and retention rates also remain solid. Health Care REIT's portfolio should experience low-to-mid single-digit average same store NOI growth going forward. We like the experience of the management team.

• The REIT's long-term customer relationships would be difficult to replicate. Recurring investments with existing customers are 75%+ of the REIT's total investments, for example. Health Care REIT's relationship-investment philosophy continues to create opportunities for remarkable growth. The credit agencies rate its debt Baa1/BBB+/BBB+.

• We like Welltower's portfolio concentration in affluent, high-barrier-to-entry markets and affiliation with market-dominant operators and health systems. Its pipeline across the US, UK and Canada is robust. Major, high growth metro markets in the US, Canada and the UK will continue to provide opportunities. The company has a nice dividend payout as well.

• No matter how much we may like Welltower's fundamentals, the company's share price will be sensitive to changes in interest rates. The current environment reveals a 10-year Treasury rate that is significantly less than that offered by Welltower's yield, but it is rising quickly. Should that relationship continue change, investors may switch to fixed income in a big way.

• We expect the REIT to build on the ~$4.30 per diluted share in funds from operations in 2015 in coming years. Mid-to-high single-digit annual FFO expansion is a reasonable expectation, even in the face of potentially rising interest rates.

Business Quality

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Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Welltower's free cash flow margin has averaged about 23.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Welltower, cash flow from operations increased about 39% from levels registered two years ago, while capital expenditures expanded about 13% over the same time period.

Valuation Analysis

We think Welltower is worth $62 per share with a fair value range of $50-$74.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 5.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 28.8%.

Our model reflects a 5-year projected average operating margin of 33.1%, which is above Welltower's trailing 3- year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0.9% for the next 15 years and 3% in perpetuity. For Welltower, we use a 7.7% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Image source: Valuentum

Margin of Safety Analysis

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $62 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Welltower. We think the firm is attractive below $50 per share (the green line), but quite expensive above $74 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

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We estimate Welltower's fair value at this point in time to be about $62 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Welltower's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $68 per share in Year 3 represents our existing fair value per share of $62 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.