- I had previously criticized EPR for buying back stock and paying an unusually large dividend despite facing a huge decline in revenues.
- The company announced Wednesday that it is suspending both the share buyback and dividend for the foreseeable future.
- This is the correct move by management, and relieves some of my concerns about its capital allocation strategy.
- Unfortunately, the company is still in a bind. I expect shares to trade lower.
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On Wednesday, entertainment and experiences-focused REIT EPR Properties (NYSE:EPR) announced earnings. The earnings themselves weren't that bad. That wasn't too surprising as the virus didn't really start to cause major problems until early March, well into the quarter.
However, the bigger story was that the company decided to make major changes to its capital allocation strategy. That comes as EPR's tenants face a prolonged disruption to operating their businesses.
As a result, EPR scrapped the share buyback that it had just announced back in March. That wasn't too surprising; last month I explained why a buyback was a puzzling move given the economic situation. EPR didn't just axe the buyback either, it also suspended the dividend indefinitely as well. That one stung - the company's bulls had conceded that a dividend cut might be coming, but few were expecting a complete dividend freeze so soon.
What changed? Reading the company's press release Wednesday, it appears that the banks may have forced the company's hand. EPR gave a detailed discussion of the company's debt situation and in particular its covenants:
Because certain financial covenants under [EPR's] bank credit facilities and its private placement notes are calculated based on the most recent quarterly net operating income, the Company expects that it will not be in technical compliance (non-payment related) with such covenants at the end of the second quarter of 2020. Accordingly, the Company is in discussions with its lenders and private placement note holders to obtain a temporary suspension or modification of these covenants, with some suspended financial covenants expected to extend through the first quarter of 2021.
As a reminder, when a company trips covenants, debtholders typically have a range of options at their disposal - some drastic - to handle the situation. An inability to comply with covenants can lead to unpleasant outcomes for shareholders.
This is what made the company's press release a couple weeks ago about the amount of cash it had left so puzzling. EPR gave a detailed explanation of how much cash it would have at various revenue run rates in scenarios where it did or did not keep paying the dividend. Bulls latched onto this as justification for believing that EPR would be able to sustain its then-17% dividend yield.
This cash cushion may have sounded great in theory. But leveraged companies frequently run into trouble because their operating metrics no longer are sufficiently strong to stay in compliance with their debt covenants. This can happen long before they actually spend the last dollar out of their bank account.
That's doubly true when your revenues and EBITDA suddenly disappear almost entirely for a period of time. A bunch of companies with pretty good balance sheets may run into covenant trouble in coming months as a result of the virus. EPR, by contrast, had a balance sheet that was just barely above a junk rating even prior to the economic downturn. It was clear that the company had little to no wiggle room, yet folks were talking about having many months of cash on hand. That simply wasn't the matter at hand, though; the debt covenants were the real sticking point.
On Wednesday, the company acknowledged as much, and ditched the dividend while giving this explanation:
As a part of this process [discussing covenants with lenders], the Company has also determined that it will temporarily suspend its monthly cash dividend to common shareholders after the common share dividend payable May 15, 2020 (except as may be necessary to maintain REIT status and to not owe income tax) and will suspend the share repurchase program upon the effective date of the covenant modification agreements, which is expected to occur in the next 30 days.
An Unpopular But Prudent Decision
I do commend EPR's management for making the right call fairly quickly. I previously criticized the decision to buy back stock last month. And, in fact, EPR actually did repurchase $20 million of its stock in April before suspending the program. However, the company had originally planned to repurchase $150 million of stock. Stopping the buyback now will save it $130 million. That money could be vitally important going forward.
When you are in danger of violating debt covenants and need the goodwill of your banks and lenders to keep operating, you want to put your best foot forward. Obviously, having more cash on hand will make the bankers happier. When it's their decision what happens in the short term, it's far more important to keep as much in the treasury as possible than it is to pay another couple months of dividends or repurchase some stock.
When only 15% of your tenants are currently paying rent, the focus needs to be on survival. EPR was barely investment-grade even before the coronavirus struck. This was not a company with a fortress balance sheet, and now there will be minimal revenues coming in for some undetermined but significant amount of time. This isn't the time to get cute with financial engineering. Conserve your cash, work with your tenants to do whatever is possible for them to eventually be able to reopen in sound financial health, and then focus on bringing back a strong dividend once we're past the acute part of the crisis.
To investors who were disappointed by EPR's decision, I ask you to consider the bigger picture for a second. We're in the biggest economic shock - as measured by figures such as unemployment - since the 1930s. A major chunk of the nation's smaller businesses is on the brink of failure, with a stunning 52% of small business owners expecting to go bust over the next six months. We're in a totally chaotic and unprecedented situation. This is not the time to go buying supposed 17%-yielding stocks for the income.
If you were running a family business that was deeply in debt and had no money coming in for the foreseeable future, would you be paying out massive distributions to the family members during the early part of the crisis? Probably not. Instead, you'd focus on making sure the business made it through the bust and saw the other side in one piece.
Similarly, public companies that have lost most of their revenues should be taking conservative measures to ensure the survival of the business first and foremost.
Economic Reopening Doesn't Necessarily Equal Revived Share Price
I see a lot of people buying stocks in struggling enterprises such as airlines, cruise lines, and retail REITs under the thesis that life will eventually return to normal, hence the stocks are a buy. I agree that life will return to something fairly close to what it was in 2019. Some businesses that have closed now will never come back. But, by and large, we'll move on and get back to ordinary life.
The same is not true for stock prices, however. With an indebted company, the lenders can call the shots. And they have various mechanisms, such as the debt covenants, to control the situation. If they fear that they aren't going to get paid, they will make decisions that suit their interests, not those of shareholders. As common equity owners of something like EPR, you're at the bottom of a tall capital stack. You only get a recovery to pre-COVID-19 levels if everything goes well. If there are significant impairments, the equity holders take the hit first.
It's perfectly normal - common in fact - for risky levered businesses to fail during garden-variety recessions, let alone whatever this mess is that we're having now. The company goes to Chapter 11, the common stock is wiped out, the former creditors become the new stockholders, and the company eventually is sold to private equity or does another IPO in the future. For customers of the business, life goes on as normal. The airline still has flights, the cruises leave port again, the cinemas open back up. But there's no recovery for the pre-crisis shareholders.
Will that happen to EPR? It's too early to know - it's hard to assess how bad the economic fallout will be at this point. But we do know the simplistic "life will return to normal, thus the stock is a bargain" thinking is incomplete. Already, despite having a significant amount of cash on hand, EPR was seemingly forced to suspend the dividend hardly a month after it launched its audacious share buyback. Management can make bold plans, but creditors may ultimately call the shots.
What To Do Now
I'm not a fan of the idea that you should reflexively sell any stock after a dividend cut. A dividend cut is a warning sign that something has gone wrong, but it doesn't necessarily mean a company is in a downward spiral.
That said, dividend or no dividend, EPR is not a compelling buy at anything close to this price. I was negative on the stock last month, and I've grown more bearish now. EPR is in a uniquely awful situation as it collects only 15% of its rents. Even other hard-hit retail REITs are closer to 50-70% of normal rent collections right now.
EPR's property mix includes a decidedly troubled bunch of tenants given the specifics of the coronavirus. You have few properties that can reopen quickly. When properties eventually do reopen, they'll be operating at limited capacity, and thus, likely generate additional losses. If movie theaters were barely holding on in normal times, how are they going to make money now if they can only sell tickets for a third of their seats?
Similarly, major EPR tenant Topgolf was free cash flow negative and junk-rated in 2019. How do you think its cash flow (and thus rent payments) will be looking in a social distancing world going forward? I'll give you a hint - Moody's just downgraded Topgolf's debt even further into junk this week; it's now Caa2 rated. Moody's bluntly says that Topgolf will need more sources of liquidity to avoid a default. Not paying your landlord is one good way to conserve cash when you're on the brink of failure.
EPR is one of the weakest retail REITs out there right now. The 15% of owed rent being collected is truly astounding. The balance sheet was only worthy of a middling credit rating prior to the crisis. Major tenants like AMC (AMC) and Topgolf are in massive trouble. And with the dividend gone, there will be no support for EPR's share price from income investors.
You can hold on in hopes that it eventually turns around. But what will EPR's properties be worth in a year or two? The company will likely have to make major rent concessions to keep many of its tenants viable.
Thus you'll have a one-two punch to NAV as FFO slumps with the rent concessions and cap rates will have to go way up for entertainment properties post-crisis. No one is going to value movie theaters at pre-2019 levels again, you can be sure of that.
With a weak financial position, an extended period of limited rent collections, no dividend, and a fast-sinking net asset value, EPR stock is a clear avoid. There are far better ways to play a recovery in the entertainment space.
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This article was written by
Ian Bezek is a former hedge fund analyst at Kerrisdale Capital. He has spent the decade living in Latin America, doing the boots-on-the ground research for investors interested in markets such as Mexico, Colombia, and Chile. He also specializes in high-quality compounders and growth stocks at reasonable prices in the US and other developed markets.
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