Omega's 9.7% Yield: Despite 5 Huge Risks, It's Worth Considering

Summary

• Do not confuse Omega’s sell-off as just another REIT facing macroeconomic headwinds. There is a lot more going on here.
• For starters, this Skilled Nursing Facilities REIT is considering draconian rent concessions for many of its operators, including Orianna, Signature, Daybreak, Preferred Care, and arguably Genesis and others.
• And beyond the dire operator environment, Omega faces huge risks from regulations, the market cycle/demographics, macroeconomics, and a shrinking dividend coverage ratio.
• Finally, this article considers a few things that could actually go right for Omega, before concluding with our views on who might actually want to consider owning this big-dividend REIT.
• We are long Omega Healthcare Investors. This article was originally shared within our Marketplace Service, The Value & Income Forum on March 3rd.

Many of Omega Healthcare Investors' (NYSE:OHI) operators (including Orianna, Signature, Daybreak, Preferred Care, and arguably Genesis and others) are increasingly unable to pay their rent, thereby forcing Omega to consider draconian rent concessions. And that's just one of the five huge risks Omega is currently dealing with. The others include a terrible regulatory environment, an over-hyped demographic wave and market cycle, massive macroeconomic headwinds, and a dividend coverage ratio (as compared to FAD, AFFO and shrinking cap rates) that is a flashing red flag. After reviewing these five huge risks, we consider a few things that could actually go right for Omega, and then conclude with some ideas about who might want to consider investing in this big-dividend REIT.

Note: We are long Omega Healthcare Investors. This article was originally shared within our Marketplace Service, The Value & Income Forum on March 3rd.

About Omega:

Omega Healthcare is a big dividend (+10% yield) real estate investment trust ("REIT") that maintains a portfolio of long-term healthcare facilities in the United States and the United Kingdom. As of 12/31/17, 83% of its investments were in Skilled Nursing Facilities ("SNF") and 17% in Senior Housing.

Omega has an impressive track record of raising its dividend every quarter. However, the company recently announced that future dividend increases have essentially been put on hold.

According to CEO Taylor Pickett during the latest earnings call:

"We're proud of our unprecedented streak of 22 straight quarterly dividend increases, wherein we increased the dividend from $0.43 per share to $0.66 per share, 53% over five and a half years. Our quarterly dividend growth was predicated on and driven by our consistent FFO and FAD growth. As a result of our strategic repositioning activities, 2018 will not be a growth year and therefore we do not expect to increase the dividend during 2018."

In addition to dividend increases being essentially put on hold, Omega's share price has not been performing well, as shown in the following chart.

5 Huge Risks Facing Omega

1. Draconian Rent Concessions for Operators

Struggling property operators are a huge risk that Omega is dealing with. For example, in the quarterly call, Omega described multiple large operators that are facing significant challenges (Orianna, Signature, Daybreak, Preferred Care and arguably Genesis), and three of them are among the company's top 5 biggest operators, as shown in the following table.

Here's what Omega had to say about (1) Orianna during the quarterly call:

"We are in active confidential negotiations with Orianna and remain confident that our post transition restructuring rent or rent equivalent in the event of asset sales, will be in our previously stated range of between $32 million and $38 million."

And comparing those figures ($32 million to $38 million), that's a very significant reduction compared to the contractual rent amount as listed in the above table.

Similarly, (2) Daybreak is another challenged operator. Both Orianna and Daybreak were put on a cash basis in the third quarter and, therefore, Omega recorded no Orianna or Daybreak revenue in the fourth quarter. Per the quarterly call:

"for Daybreak… as Dan mentioned they maintained their payment plan. So, once they're caught up on the passed to AR, which is going to happen at or around at the end of this quarter. We'll begin to book Daybreak on a - it's contractual basis which is $7 million quarter run rate."

If Omega has to renegotiate (i.e. lower) Daybreak's contractual payments, that could be another big hit to Omega's cash flow and ultimately its ability to raise and support the dividend.

Next, (3) Signature, Omega's third biggest operator. Here's what management had to say:

"Moving on to Signature Healthcare, since our last earnings call, considerable progress has been made toward finalizing a comprehensive agreement among Signature and Signature's three primary landlords, which will effectively bifurcate each of the three portfolios into three distinct legal silos and separate virtually all legal obligations.

As part of those agreements, Omega has agreed to defer certain rent payment obligations and provide for a working capital loan. While we remain cautiously optimistic that a satisfactory global restructuring with all constituents will be finalized in the near future, such restructuring remains contingent upon Signature's successful resolution of its material PL/GL claims."

Depending on the outcome to the Signature restructuring, that could be another big hit to Omega's cash flow, and ultimately its ability to raise and support the dividend.

Another potential big hit to Omega's cash flows are related to operator (4) Preferred Care. Here's what management had to say:

"In addition to the three operators just mentioned, another one of our top ten operators, Preferred Care, a Texas based operator and certain of its affiliated operators in the states of Kentucky and New Mexico filed for Chapter 11 bankruptcy as a result of the $28 million jury award in the state of Kentucky and the overwhelming number of personal injury suits initiated against such operators in those states. While Omega has no exposure to Preferred Care in Kentucky, we currently lease 16 facilities to Preferred Care in New Mexico, Texas, Arizona and Oklahoma."

Preferred Care is another big threat against Omega's future revenues.

Finally, (5) Genesis, Omega's second biggest operator, continues to perform (according to management anyway), but investors are worried. Here's what management had to say about Genesis during the quarterly call:

"Yeah, the Genesis - our portfolio performances continue to do well, it has been and continued to be about the mean. I can't really comment on why it does better than other portfolio's, other than obviously there's different assets in different states. A lot of our assets are legacy fund facilities. We continue to support the management team, we think they are doing a good job, they have done a good job and we will remain supported. But, on our portfolio once again it's been consistent and it continues to perform."

Management seems somewhat optimistic about Genesis, but here's what the Genesis CEO had to say during his last quarterly call:

"Clearly, this has been the most protracted and complex down cycle in our history. More recently, as these pressures had continued to mount, we have begun to see operators of all sizes forced into receivership or other formal restructuring proceedings."

And if Omega management is being overly optimistic about Genesis, it begs the question: what else is it being overly optimistic about? (for example, how many more operators are in trouble).

2. Terrible Regulatory Environment:

Omega's operators are facing extreme challenges largely because of continued regulatory pressures on Skilled Nursing Facilities, in particular. For example, according to the Genesis CEO:

"Government-sponsored reimbursement rate growth is not keeping pace with inflation and cost, particularly nursing labor costs amid a strengthening labor market. And unfortunately, unlike other industries, with the majority of our revenue coming from government-sponsored payment plans, skilled nursing operators have no ability to pass these incremental costs along to our customers."

Additionally, according to Omega's quarterly call:

"Medicare Part B therapy caps were permanently repealed, [but] partially paid for with a small reduction in the Medicare per day annual market basket rate increase."

Further, the industry is under constant threat of regulatory changes. For example, according to Omega, in 2017,

"The industry elevated further threats to federal Medicaid funding, as tax reform took the focus of Medicaid reform in congress."

and

"Looking ahead to 2018, the concern for SNFs is the potential that a cut to Medicaid provider tax funding could be used as an offset to any ACA modification legislation."

It has clearly been a challenging regulatory environment for skilled nursing facilities.

3. Over-Hyped Demographic Wave and Market Cycle

Another huge risk for Omega is the current market cycle and the anticipated demographic wave that may not arrive soon enough. For starters, management believes the SNF industry is at the lower end of the market cycle, and there simply are not a lot of attractive merger and acquisition opportunities that Omega needs for growth. Here's what CEO Taylor Pickett had to say when asked about M&A activities:

"The assets that are out in the market place for us generally aren't that attractive, but I think as this cycle begins to end, what we typically see is an uptick in real estate sale activity and I would expect that to occur again backend of '18 into'19."

It seems he is corroborating the idea that the market environment is terrible, and he is hoping things will improve within the next year or two.

Next, here is a look at the demographic wave Omega is hoping for.

This graphic suggests that there will eventually be an undersupply of skilled nursing facilities, but that's not coming until 2025. Also, the graphic is based on assumptions that there will be no efforts to reduce the lengths of stay and increased utilization of alternative care sites. Yet, the government regulators continue to put pressure on operators to do exactly that (i.e. reduce lengths of stay and increase use of alternative care sites). It seems Omega management may be again overly optimistic about the current environment.

Another example of Omega pinning its hopes on market cycle improvements is this quote from CEO Taylor Pickett:

"The labor market has been difficult and direct care wages within the Omega portfolio have increased 2.9% year-over-year. Fortunately, although wage growth puts pressure on tenant coverage's, the level of wage growth is generally manageable and other related MediCare and MediCaid rate increases generally lag behind, eventually reimbursement rates catch up for labor inflation."

Omega is basically waiting/hoping for highly uncertain market conditions to improve.

4. Massive Macroeconomic Headwinds

In addition to struggling operators and unfavorable regulations (plus an over-hyped demographic wave), there are a variety of broader macroeconomic headwinds that are plaguing Omega. For example, interest rates, recent tax law changes, increasing alternative yield opportunities, and "risk on" market conditions, as described in our recent article: 100+ Big-Dividend REITs, The Mass Exodus Continues are also creating big challenges for Omega. Also worth mentioning, a lot of investors are betting against Omega as short-interest was recently more than 18%.

5. Dividend Coverage is a Red Flag

For starters, here is a look at Omega's historical quarterly Funds Available for Distribution ("FAD"), Adjusted Funds from Operation ("AFFO") and dividends, and the trend is going in the wrong direction (i.e. FAD and AFFO are shrinking, and dividend increases have been put on hold).

Specifically, the dividend payout ratios have been trending higher (this is not good for dividend safety), and things are projected to get worse in 2018. For example, AFFO was $3.30 per share in 2017, but management has provided 2018 guidance of only $2.96-3.06.

Another way to think about Omega's earnings power is "cap rate" (cap rate is basically the income of an asset divided by the cost of the asset). All else equal, higher cap rates are better. However, Omega's investment cap rates are shrinking thereby making it increasingly challenging to continue raising and supporting the dividend. For example, CFO Robert Stephenson noted cap rate slippage, although slight, on the last quarterly call when asked about sales. He said recent property sales result in "very little slippage in terms of run rate," but slippage nonetheless.

Here is a look at Omega's investment assets and revenues in 2017.

This amounts to a cap rate of around 10.5%. However, recall Omega is evaluating over $300 million of asset sales in 2018, and combining those sales with the fact that it is having trouble finding assets to buy (remember CEO Taylor Pickett claims "the assets that are out in the market place for us generally aren't that attractive"), Omega is going to end up with a smaller pie with lower cap rates. Not exactly what dividend investors want to hear, especially considering all the unfavorable operator renegotiations currently underway, and the fact that there is very little cushion between the dividend Omega is currently paying. These challenging headwinds are a big part of the reason short interest on Omega is currently high.

What Could Actually Go Right for Omega:

Despite all the challenges Omega is faced with, management remains optimistic, and recently highlighted a variety of things that could actually go write for the company. For example,

1. 2019 Acquisitions: Omega is faced with an unattractive acquisition market right now, but it may improve by 2019. According to Omega's earnings call:

"The acquisition market remains choppy and to date is not particularly robust. However, as we've seen through several cycles in the SNF industry, there tends to be a significant uptick in mergers and acquisitions as down cycles come to an end. I would expect to see meaningful growth opportunities later in 2018 and moving into 2019."

If Omega does start seeing attractive acquisition opportunities, that could help support the dividend and eventually help the company return to dividend growth.

2. Demographic Wave: As we mentioned previously, Omega is counting on a huge demographic wave that will support its business in the future. And according to the company:

"We have partnered with two leading consulting firms to gather an extremely comprehensive and detailed analysis of the demographics that will drive demand for skilled nursing facilities throughout the next decade. With literally thousands of hours dedicated to this analysis, we believe we'll begin to feel the demographic demand wave going into 2019. And finally we have unique business attributes that set us apart from our competitors. We had the most SNF operator relationships."

If the SNF demographic wave does come, Omega's business will be well-positioned for it.

3. Improving Regulatory Environment: Despite the challenging regulatory environment as described earlier, Omega believes the environment is actually "neutral to favorable." To support this more positive outlook, Omega explains:

"Fortunately, although wage growth puts pressure on tenant coverage's, the level of wage growth is generally manageable and other related MediCare and MediCaid rate increases generally lag behind, eventually reimbursement rates catch up for labor inflation. On the reimbursement and regulatory front, the environment is generally neutral to favorable."

Further, Omega believes the Trump administration has more friendly regulatory policies. For example:

"On January 24, the senate confirmed the appointment of Alex Azar to lead the Health and Human Services Department with oversight of CMS. Azar's confirmation provides assurance that the SNF friendly regulatory policies to date under the Trump administration are likely to continue, especially with the continued leadership of CMS by Seema Verma."

Also:

"In congress the risk to SNF fundings through Medicaid reform has lessened with the reduction in the Republican senate majority from the Alabama election."

4. Subsiding Dividend Headwinds: According to CEO Taylor Pickett:

"However, I want to be very clear that we are very confident in the payout percentage coverage and the sustainability of our current dividend of $0.66 per share per quarter. With the current yield of 10% and our strong beliefs with the headwinds we've been battling are beginning to subside. We believe we're well positioned to deliver substantial shareholder returns over the next five years."

"We expect that our quarterly AFFO results will trend upwards throughout 2018, providing us with a solid baseline run rate as we head into 2019."

It's true that Omega's dividend coverage ratios are moving in the wrong direction (as shown in our earlier table). However, there is still some cushion left over. For example, even if Omega meets the low-end ($2.96) of its dramatically reduced 2018 AFFO guidance (it was $3.30 in 2017), that's still more than its 2018 expected dividend payout of $2.64 (assuming no dividend increases). Dividend-focused REIT investors don't like to see big declines in AFFO, but if 2018 truly is a new base year from which Omega can grow, then an AFFO payout ratio of below 1 (in this case approximately 89%) isn't the worst thing in the world. It's manageable.

Conclusion:

Do not confuse Omega's sell-off as just another REIT facing macroeconomic headwinds - there is a lot more going on here. The big question is whether Omega can get through this SNF mess without cutting the dividend and ultimately return to dividend growth. Management believes it can, but the market is not so confident considering the recent sell-off and the high level of short-interest.

If you have a higher tolerance for risk and a longer horizon, you might want to consider owning Omega. In fact, we've ranked it on our members-only list within The Value & Income Forum: Top 10 Big-Dividend REITs Worth Considering (noting that it is one of the higher risk names on the list). However, if you're looking for only the safest dividends, then you might want to consider other opportunities. We are currently long Omega Healthcare Investors.

Analyst’s Disclosure: I am/we are long OHI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Comments

[jmatson]

What publication would that be? It always helps to provide a link.

[jarco]

Anyone interested in OHI might want to read an article in the leading investment tabloid publication titled “Could Health Care Crash?”

[phamp1973]

What is a good price to buy OHI?

[sa78216dmreit]

Age respects nobody. The oldest segments of the population will EVENTUALLY grow much larger.

There has never been an outbreak of good health.

Try buying 24 hour nursing help on Amazon.

For the patient investor, the experienced management team will navigate these shoals and produced a continued stream of very high dividends and recovery in the share price.

Long OHI.

[jarco]

Agree with your aging assessment. Time marches on. That’s not the issue with OMI. Follow the money. Who will pay for OMI services. Unless it’s all private pay (and we know it’s far from it), the answer is Federal reimbursement tied to Medicare and Medicad. These programs are already underfunded and further reductions are on the horizon. Who will pay the bill?

[28769445]

Possible Tail Winds...
* lower corporate tax rates moving forward
* regulatory concerns lower in this current administration (mentioned in article)

Thanks Blue as I am 15% down and weighing my options!

[sixthspeed]

This aspiring passive income investor sees opportunity to accumulate, much negative sentiment. I acknowledge the risks, however.

[rossellotw]

When this stock was 34.00 it was the great 8% yielder, with increasing there dividends and smooth sailing and now its buyer beware.

[Vandooman]

Good article. I dumped OHI before it crashed. The more the analysts touted the stock the more I became a skeptic. Health care is a lousy business and the screws will continue to be put to providers.

Unfortunately inexperienced investors often go shopping for yields, not realizing that a high yield usually is the result of a low stock price caused by a deteriorating business. They invest in turnarounds, from GE to OHI. But these companies very often don't turn around. I sold IBM at $192 6 years ago and it is now trading at $159. Some turnaround. I sold GE at $35 10 years ago and it is trading at under $15. Try to buy at the bottom and you often find the bottom is flat. If a behemoth like GE or IBM has no moat, why would you assume OHI has one.

When things go against me I take my medicine and move on. Buy companies with the wind at their backs. If you want to gamble intelligently, buy an assortment of Amazon, Facebook, Salesforce, Google etc and do nothing for 5 years.

[zachdellinger1]

A beautiful well-balanced article. Bravo

[alexalekhine]

After this was published, Orianna filed for bnankruptcy.

OHI is providing DIP financing.

Orianna will be paying $1 million a month rent, down from about $4 million prior to their problem period.

OHI will sell 19 facilities and transition the rest to a new operator.

This is a MUCH worse outcome than the cut in revenue to $32-$38 million annually that they previously discussed.

Management's credibility has taken (another) hit, IMHO.

[Blue Harbinger]

Alex- This was announced Wednesday, and Omega reaffirmed Adjusted FFO guidance and Orianna guidance: “We continue to expect that our post-transition restructuring rent for the transition portfolio and rent equivalent for the 19 properties to be sold will ultimately be in our previously-estimated range of $32.0 million - $38.0 million." Here is the press release: http://bit.ly/2D8TMoX Thank you.

[CEFspert]

How many times/ways/years can one rationalize .. "Woof, Woof."
A co, as I have said for years, grows by crummy acquisition, then writes off 20++% of it.

[N93143]

Why would anyone tie themselves to ANY ticker symbol??? If you want 9.7%, you can get it via innumerable funds where the ills of one company are buried in the noise.

[Blue Harbinger]

N93143: I agree with the benefits of diversification. But for grins, would you mind sharing one of the "innumerable funds" offering a 9.7% yield? Thank you.

[CapeHornInvesting]

Won't touch this one with a 10 foot pole until I see 2 quarters of increasing dividend. So many better stocks to invest in.

I'm also stuck with $2K of Welltower. Nothing good in any of these SNF stocks.

MPW, GMRE, etc., lots of better alternatives. OHI and Welltower need to feel the pain of low stock prices for a while. If they can turn around, maybe they will pay closer attention to their own markets in the future. And GMRE is an externally managed debt laden monster, but it stacks up better than OHI or WELL.

Ugh. Talk about letting investors down.

[Panhandler1949]

Good article. I am long OHI and holding for now. Thank you for the good article.

[Blue Harbinger]

Thanks for reading Panhandler1949!

[Thomas Yeggy]

Seem to remember an analyst refer to FAD being near 100% of the dividend for 2018.Also isn't the Affo payout ratio of 89% high but still lower than 100%. The 89% figure seems to imply that utilizing AFFO as the measuring metric that the dividend is not covered by AFFO. Maybe only me but I think the FAD payout which is very close to 100% is a better metric for the thought you are trying to convey.

Very well written article .You may want to edit the "write" to right.

[Blue Harbinger]

Thomas- good point. FAD payout is in the table in the article. 91.9% and going in the wrong direction. Thank you. PS. I see the write vs right thing. Lol. Sorry!

[jarco]

Income seekers generally become less alarmed at sinking asset values as long as the dividend cash flow continues. We all knew that rising interest rates would affect the REIT space. It was a given. The difference with Omega is a singular trait spelled SNF. . . . . pure and simple.

[barehart63]

I am long. Have been since 2014. The divs have lowered the basis below the current price. I am going to hang in there and ride it for now. I might consider selling if I need to lower some tax gains down the road.

[Vandooman]

Not sure what you are saying. Dividends don't lower the tax basis. I guess you mean it reduced the net investment. That seems irrelevant because you could have gotten dividends somewhere else while watching the shares go up. Never be loyal to an investment. Do what you have to do and move on. Invest in companies with the wind at their backs, not in their faces. High yields come from damaged companies with low stock prices. Yield shopping is a dangerous game.

[StockMike]

I won't buy this stock.

[cemanuel]

OHI is my largest REIT position, about 2.5% of my total portfolio. The last two ERs have not been good but haven't pointed to imminent doom either so I'm just holding and collecting dividends. A div cut is becoming more likely but it wouldn't bother me to see it cut to 7% or so. I wouldn't be waving pom-poms either but that risk is part of owning REITs and if things stabilize the company has shown that they would re-grow it.

[Vandooman]

How about if it is cut to 2% or zero?

[bokery1]

I bought OHI recently at ~$27 and plan for very long term. no doubt OHI have seen significant negative fundamentals which ignited a massive sell-of. I tend to think that the negative news are well compensated in the share price cut. of course, it is possible that more problems will show on later. management tend to avoid publicity of negative news until it can't be hidden any further. yet, I think that even moderate negative news are well compensated by the eroded share price, which corresponds now to 10% dividend yield. even if the business deteriorates further, there is yet enough space for dividend cuts while yet providing nice return (after all 8% or even 7% is not that bad on the long run). on the other end, if the worst of all is over and the company preserves it's current level of income or even improves it, it would make an outstanding investment. I hope that this favorable alternative is more probable, which is why I'm very long on OHI. time will tell.

[Vandooman]

Betting on turnarounds where the fundamentals are bad is usually a very costly idea. Companies as big as IBM and GE blathered about turnarounds that never happened. Hope you make out well but I sold OHI before the crash and wouldn't even consider holding it. Being very long is even worse. When you hear bad news, 80% of the time the true picture is worse.