What HCP’s Upcoming Spin Off Means For Dividend Investors

HCP Inc. (HCP)’s 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.

HCP Inc.

Source: Simply Safe Dividends
[drizzle]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

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 (HCN) and Ventas (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

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.

HCP Inc

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), 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 (MCO) 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 help the new HCP achieve faster growth going forward.

HCP Inc

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 Inc

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 just large enough to keep the dividend growth streak alive, but really only big enough to offset inflation.

HCP Inc 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

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