Dividend Growth Newsletter portfolio holding HCP’s (HCP) shares have been under pressure as of late, and we’re not happy about it.
Part of the reason we were drawn to HCP, and we posit that many others were lured by the same attribute, was that it is the only REIT that is included in the coveted S&P 500 Dividend Aristocrats index. At the time it was added in 2012, there were only 50 companies in all that fit the bill of 1) a market capitalization in excess of $3 billion and 2) a track record of raising their dividends in each of the past 25 years. Though HCP’s fundamental quality has deteriorated since we added it, some of the share price pressure has been driven by concerns regarding a tightening credit cycle and rising rates.
But not all of it.
There’s no easy way of saying it, but HCP has been an underperformer, a black-eye on our otherwise near-pristine track record. In fact, since we added HCP to the Dividend Growth Newsletter portfolio in mid-September of last year, it has trailed the Vanguard REIT ETF (VNQ), which lists Simon Property Group (SPG), Public Storage (PSA), Equity Residential (EQR), Health Care REIT (HCN), and AvalonBay (AVB) as its top five holdings, by nearly 15%. The orange line is the Vanguard REIT ETF, while the stock chart is that of HCP.
It hasn’t worked out that well thus far.
The reasons behind the underperformance are not all that surprising.
On March 30, HCP cut its outlook for the calendar year 2015 after amending its master lease with HCR ManorCare, whose properties include 333 post-acute, skilled nursing facilities and account for ~25% of HCP’s proforma portfolio income. In April, HCP allowed for a net reduction of $68 million in annual rent from HCR, to $473 million before asset sales, and increasing 3% annually thereafter. Though the length of HCR’s initial lease has been increased by 5 years to 16 years and HCP will receive fee ownership in nine new post-acute facilities valued at $275 million, the change in its outlook for adjusted funds from operations speaks loudly and clearly about the net adjustment of the transaction. The executive team even tried to sweeten the news by saying the amended terms “strengthen” lease coverage and that its portfolio will be optimized by selling 50 non-strategic assets by early 2016, but HCP lowered its 2015 adjusted funds from operations guidance to $3.06-$3.12 per share from $3.15-$3.21 per share previously.
Our ongoing concerns perhaps require more explanation.
In HCP’s 2014 10-K, released February 10, the firm acknowledged the ongoing civil investigation of HCR ManorCare by the U.S. Department of Justice, the Department of Health and Human Services, Office of Inspector General, and certain state attorneys general offices. Since then, the proceedings have intensified. The government has intervened and filed a consolidated complaint against HCR ManorCare that includes three False Claims Act lawsuits. The lawsuits, released on April 20, contend that HCR provided rehabilitation therapy services to Medicare beneficiaries that were not medically reasonable or necessary. According to the accusations, the firm knowingly and routinely submitted false claims to Medicare and Tricare for the unnecessary services. ManorCare insists that it is in full compliance with billing guidelines, and that it will “vigorously defend (itself) in court.” This will likely take a significant amount of time and costs.
Given the developments in the first half of 2015, our outlook on HCP has understandably become more cautious. Though we like the firm’s fundamental strengths and its diverse portfolio–it has more than 1,100 properties–a large portion of its revenue, and ultimately cash flow, has become more unpredictable, making its dividend prospects more unstable. For those that know us well, this is certainly not a typical characteristic of a holding in our Dividend Growth Newsletter portfolio. We’ve given the company the benefit of the doubt up until now, but its equity performance is telling us a different story.
As we noted when we added shares to the Dividend Growth Newsletter portfolio, we were drawn by the REIT’s historical consistency of dividend increases. But frankly, we know better than to put too much emphasis in past performance, which as they say, is history. At the moment, we’re not rushing into action, but we wanted to let you know that the situation has our complete attention, and coupling such developments with the coming of rising interest rates, we’re not as comfortable as we once were in holding HCP’s shares.
At less than 2% of the Dividend Growth Newsletter portfolio, however, we’re going to continue to wait out the storm, as we think management won’t give up its dividend growth track record without a die-hard fight. Shares currently yield 6%, and while the following may seem somewhat counterintuitive, we may “consider selling” if shares reach the 6.5%-yield threshold. At that level, the market, from our perspective, would implicitly be factoring in a potential dividend cut by this Aristocrat, and we certainly don’t want to stick around for that.
The takeaway from HCP is clear: we’re never going to let an entity’s historical dividend track record have such a high influence on our investment-making decisions anymore. We’re going to remain laser-focused on future fundamentals, where we’ve given great weight in every other case.