Some of you may recall that last February 2018 I downgraded shares in Omega Healthcare Investors (NYSE:OHI) from a SWAN to a SALSA. As readers know, to be considered a SWAN – stands for “sleep well at night” – the company must exhibit all of the ingredients of a high-quality enterprise.
Although I had to downgrade the company I explained that “I'm sticking with Omega… because I'm a value investor. That simply means that sometimes I have to go against the herd and even risk being called a dummy. Buying stocks when they are cheap has been the best way to build wealth in the stock market, and companies that are on sale reap the highest returns.”
Let me put this bluntly, I have earned my stripes on Seeking Alpha for digging deep into research, not writing click bait articles, but deep level research that can assist investors with protecting their hard-earned capital at all costs.
While many analysts and investors were fearful of Omega (over a year ago), I became more fixated on the underlying fundamentals, recognizing that eventually the company’s share price would normalize, and eventually return to its SWAN status.Source: Yahoo Finance
I wrote numerous articles in an effort to inspire investors to stay the course as I explained, In April 2018: “I am seeing the “green-shoots” form and ultimately the demographics will drive the dividend growth.
As many know, we have "pulled back the throttle" for Omega, not based on fundamentals, but strictly based on valuation. Since my last article (in November) there has been no material change in the company, except for one significant thing…
New Deal Should 'Jump Start' Growth Mode
Omega and MedEquities Realty Trust (MRT) announced a merger agreement under which Omega will acquire all of the outstanding shares of MedEquities. The transaction represents an enterprise value of approximately $600 million for MedEquities and further diversifies Omega’s assets and operators. The boards of directors of both companies have unanimously approved the transaction.
Under the terms of the agreement, MedEquities stockholders will receive a fixed exchange ratio of 0.235 Omega common shares plus $2.00 in cash for each share of MedEquities common stock held by them, which represents a value of $10.26 per MedEquities share based on the $35.15 closing price for Omega common stock on December 31, 2018.
Separately, MedEquities will declare a special cash dividend of $0.21 per share payable to the holders of record of MedEquities common stock as of the end of trading on the New York Stock Exchange on the trading day immediately prior to the closing date of the transaction. There are no changes planned to Omega’s board of directors or executive officers related to the merger transaction. On the news, Omega’s CEO, Taylor Pickett said,
“This acquisition reinforces our commitment to the skilled nursing and senior housing industry, while adding new asset types to our portfolio furthering our strategic objectives.”
We have covered MedEquities, but up until the recent news, our coverage has been limited, and we have never initiated an actionable BUY. One of the key takeaways from our last research report provided this risk factor,
“In April, MRT’s partners of the Texas Ten Tenant, GruenePointe Holdings, transferred the interest of the operations of the 10 skilled nursing facilities in Texas to a newly formed entity owned by two non-controlling partners of GruenePointe that also own a majority interest in OnPointe Health.”
We initiated a HOLD on MedEquities based upon the company’s limited diversification and muted growth forecast. The primary drain for MedEquities was related to the Texas portfolio and ultimately MedEquities had to take a substantial rent haircut, and the market responded accordingly (shares have traded from the low teens down into the $7.00 range).
Source: Yahoo Finance
Simply put, MedEquities was simply not getting traction and has turned into a “value trap.” The company had little diversification and no meaningful cost of capital to grow. Plain and simple, the company was “boxed in” and the only way out was a take out….(Note: I do want to point out that Simon Bowler had a BUY on MRT and he should be commended. Nice pick!).
So What is Omega Getting?
As viewed below, MedEquities 33 properties that consist of buildings leased to operators that offer an increasing interdependence across the continuum of care. Specifically, these operators are considered “higher acuity” and MedEquities focus is to help drive premium cap rates while mitigating risk.
Source: MRT Investor Presentation
MedEquities focuses on regional operators better suited to quickly adapt to changes in the market. Interesting enough, Omega has no exposure to acure care hospitals and the behavioral sector, and as viewed below, these operators (circled in RED) offer completely new disciplines to Omega’s business model.
Source: MRT Investor Presentation
Taking a closer look you can see that Baylor Healthcare is a new operator for Omega, and the specific asset is an acute care hospital located in Lakeway, Texas. The property is 75,056 square feet and the lease maturity date is August 203. The asset generates $15.13 million in base rent and is 14.8% of the ABR of MedEquities portfolio.
Source: MRT Website
Also, digging deeper inside MedEquities portfolio, there are several non-core properties (i.e. non-core to Omega) such as the Vibra Healthcare (acute care hospital), American Addiction (behavioral), and Prospect (Acute Care). In fact, MedEquities has around 45% invested in Skilled Nursing and the balance (55%) are essentially new categories for Omega.
Source: MRT Investor Presentation
The Problem Tenant
As noted above, MedEquities had a troubled tenant, OnPointe, that operated 10 skilled nursing facilities in Texas (I hi-lighted the operator in yellow in several of the charts above). However, MedEquities entered into a new absolute NNN master lease with Creative Solutions in Healthcare for the portfolio. The initial rent is $7.7 million, that’s a 40% haircut from the original rental stream. The lease commenced on January 1, 2019 and has a 15-year term with two, five-year renewal options (w 2% annual lease escalators).
There are both corporate guarantees from Creative Solutions and personal guarantees from Gary Blake and Malisa Blake-Deane and a Lease deposit of 2 months’ rent and Capex reserve of $500/bed.
The new leases establishes solid lease coverage: pro forma facility-level EBITDAR lease coverage of 1.32x based on trailing 12 month results as of June 30, 2018 and Pro forma facility-level EBITDAR lease coverage for MRT’s aggregate SNF portfolio of 1.16x based on trailing 12 month results as of June 30, 2018.
Pro Forma for the transaction, the new operator is expected to be second largest SNF operator in TX and the company is focused exclusively in Texas and does not currently operate in other states. Another writer on Seeking Alpha, Trapping Value, wrote:
“So essentially the rent was cut by upwards of 40%. This is pretty much what happens when a tenant gets into trouble. Either the property is sold at a distressed cap rate…or the new tenant pays substantially lower rent. OHI is no stranger to this either, and its Orianna portfolio will see new rents that are on average 30-40% lower.”
That's not completely accurate. The Orianna example that was cited is misleading because Omega stated that the range for rent recovery would be between $32 and $38 million (was $46 million previously) and that means that the worst case scenario is 30% and the best case scenario is 17%.
Anyway, I do side with the author’s statement that MedEquities has substantial exposure in Texas; however, its not “heavily focused on skilled nursing”. As I said, the Baylor hospital has around 15% exposure as well as other non-SNF assets in Texas.
Also, I should also point out that most all skilled nursing landlords (and REITs) have experienced problems in Texas (including LTC who is working through another bankrupt operator now). If you look at skilled nursing data you can see that occupancies are lower in Texas, yet MedEquities has already solved the issues in Texas (with the replacement of a new operator). Keep in mind, the opportunity with Omega is to increase occupancy, that ultimately increases the value of the underlying assets.
“Texas nursing homes struggle with one of the lowest Medicaid reimbursement rates in the nation. This keeps wages low for nurses and other frontline staff, and is responsible for turnover rates of more than 90 percent a year that nursing homes across the state struggle with every day.”
Texas nursing home problems could be solved in the “provider tax” passes, that essentially draws more Federal Funds into the system. If the law is passed, it would be a game changer for skilled nursing landlords in Texas. Lobbying has been very active and the most important benefit is it doesn’t cost the state a nickel. (I plan to cover this in greater detail in my upcoming LTC article).
Omega Can Turn Lemons Into Lemonade
I don’t know about you but when I invest in a REIT, I always conduct due diligence on the management team, recognizing that I am not the one collecting the rent checks that ultimately turn into tasty dividend treats.
Granted, I spent a few hours today to research this article, I am confident that Omega’s management team has spent countess days examining the pros and cons of the MedEquities deal. However, in an effort to determine whether or not there is meaningful value (or not), let me examine two critical aspects of the deal…
First, in regards to whether the deal is accretive, we must start with MedEquities yield on cost. As noted, the purchase price is $600 million and that equates to a back of the napkin yield of around 9.1% ($55 million in rent divided by $600 million). Given Omega’s cost of capital (in the low 7% range), it appears that the profit margin (spread) is roughly 200 basis points, and Omega said it was $.05 accretive (based on FAD/share).
What about synergies?
The other author said “… there will be significant synergies and that is certainly possible as OHI has a big Texas presence at over 9.7% of assets. The multiple though seems to be higher for MRT, than the price at which OHI is issuing shares, so we will wait for management to lay out the case here.”
With the planned merger, there are NO new G&A costs (for OHI) and MedEquities had around $12 million per year (in G&A), and so that equates to around $0.38 per share, so when back into that formula, Omega is paying 8x on an FFO/share basis, so “the purchase price of 13.5X FFO” is completely inaccurate (as the other author stated).
Secondly, I wanted to put together a simple NAV (net asset value) for MedEquities. As I said earlier, a majority (around 55%) of the assets are not skilled nursing buildings, and so you can’t just paint a wide brush, when it comes to valuation.
Source: Brad Thomas
As you can see (above), for the non-skilled nursing operators and I used cap rates of around 8.2% to 8.5% for the post acute and behavioral properties and I used a cap rate of 6.8% for the Baylor Hospital.
To provide a point of reference, Medical Properties Trust acquires assets like the acute care properties and last year Physicians Realty (DOC) acquired an MOB (medical office building) in Dallas leased to Baylor Hospital system…that building “was completed in 2011, and at 468,000 square feet, it is one of the largest medical office facilities in the U.S.” More importantly, that property was acquired at a cap rate in the low 5% range.
Did, Omega overpay for this “lemon”?
Of course not. I used a conservative cap rate of 7% for the Baylor hospital and I value that deal at $116 million. Omega has two options: It can either expand into new sectors (i.e. hospitals like MPW) or it can unload the Baylor hospital and put over $50 million back to work investing in core properties that yield 9%.
More importantly, Omega is moving the needle again, granted $.05 per share is not “moving mountains” but the company is getting closer to its objective of increasing the dividend again.
As far as I’m concerned, Omega is showing us how to turn a lemon into sweet tasting lemonade, and I'm glad to see the company putting a toe in the water with hospitals and behavioral facilities.
This new deal provides Omega with the right momentum to start the year, and closer to an upgrade in the elite SWAN club. By the way, Omega has plenty of power for another deal ($1 billion+)…keep ‘em coming, because I love lemonade and investors (like me) have love to see quality REITs outperform through good times and bad.
Author's note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos and be assured that he will do his best to correct any errors if they are overlooked.
Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.