We know better than to make mistakes such as HCP (HCP), but we can’t go back now. We’ve been holding onto the company because it was just a sliver of a position in the Dividend Growth Newsletter portfolio, but today we’re saying good-bye. Here’s what we wrote as recently as November 9, “Dividend Growth Newsletter REITs:”
HCP continues to be a lesson learned to us here at Valuentum.
The firm’s dividend track record had far too high of an influence on our decision making in establishing a position in the REIT in the Dividend Growth Newsletter portfolio. The fact that the company is the only REIT included on the list of Dividend Aristocrats was too attractive for us to deny, and we believe many investors feel the same way. This has been an important lesson learned, as we’re going to remain laser-focused on future fundamentals, where we’ve given great weight in every other case.
Since its addition to our Dividend Growth Newsletter portfolio, HCP has been an underperformer; there’s no way around it. One of the major factors in this underperformance has been the uncertainty surrounding the REIT’s largest tenant HCR ManorCare. HCR ManorCare is currently the subject of an ongoing investigation by the U.S. Department of Justice, the Department of Health and Human Services, Office of Inspector General, and certain state attorneys general offices for what amounts to fraudulent uses of Medicare. We highlighted the risks associated with the situation in this June piece, and there have been relatively few new developments since then.
As part of its plan to avoid the inherent risks associated with the HCR ManorCare investigation and to help account for the reduction in the tenant’s master lease, HCP plans to sell 50 non-strategic HCR ManorCare facilities. In the third quarter of 2015 the firm sold 12 of said facilities for a total of $130 million. Also related to HCR ManorCare was the $27 million, or $0.06 per share, impairment charge HCP recorded in the quarter related to the firm’s 9% equity ownership in HCR ManorCare. HCP cited a recent review of its tenant’s operating results, and market and industry data show a declining trend in admissions from hospitals at HCR ManorCare and “continuing trends” in mix and length-of-stay driven by Medicare Advantage and other managed-care plans.
Though the review led to an impairment charge, which has reduced the carrying amount of HCP’s equity investment in HCR ManorCare on the balance sheet, HCP is confident in its tenant’s ability to continue paying its current master lease obligations. For the trailing 12-month period ended September 30, HCR ManorCare’s normalized fixed charge coverage ratio was approximately 1.25x, when considering the master lease amendment and completion of facility sales. When not considering any benefit from the asset sales, the coverage ratio stood at 1.11x. We’re keeping a watchful eye on this situation.
HCP increased funds from operations (FFO) as adjusted 5% in the third quarter on a year-over-year basis to $0.79, but net income was more than halved to $0.25 per share from the year-ago period. Funds available for distribution (FAD) grew 3% in the quarter to $0.67, which was sufficient in covering the firm’s planned quarterly dividend of $0.565. HCP’s payout appears to be on solid ground, but uncertainty surrounding its major tenant HCR ManorCare has muddied the waters a bit, near the point to which we’re growing uncomfortable.
Along with its quarterly results, management changed its FFO as adjusted guidance for the full-year 2015 again. This marks the third time management has changed its guidance range in the year (lowering it, increasing it, and then lowering it again). The firm’s original FFO as adjusted guidance was a range of $3.15-$3.21 and was lowered after the news regarding the investigation of HCR ManorCare, only to be raised to within a penny of the original guidance after the end of the second quarter ($3.14-$3.20). The company now expects FFO as adjusted to be in a range of $3.12-$3.18 for the full year. We’re not sure management has a great handle on the recent developments in its business, and this has us quite concerned. FAD was also revised downward from the second quarter of 2015 to a range of $2.66-$2.72.
Given the developments thus far in 2015, our outlook on HCP has understandably become more cautious. Though we like the REIT’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 the 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.
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 approach 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. We’re viewing HCP as a source of cash, and removing the firm may happen sooner than later.
Today, February 9, we’re now removing the sliver of HCP from the Dividend Growth Newsletter portfolio. HCP’s outlook for 2016 was atrocious. Not including the impact from unannounced future transactions, the REIT is targeting funds from operations (FFO) per share of $2.74-$2.80, funds available for distribution (FAD) per share of $2.62-$2.68, and earnings per share of $1.49-$1.55 for the year. The projected FFO number was well below our forecasts, and the funds available for distribution (FAD) also disappointed, even though it covers the annualized dividend 1.15 times.
Brookdale (BKD) and Medical Properties (MPW) also released disappointing outlooks, respectively, revealing that the healthcare REIT space may face some challenges in 2016. Others operating in the industry, including Health Care REIT (HCN), Healthcare Realty Trust (HR), LTC Properties (LTC), Omega Healthcare (OHI), University Health Realty (UHT), and Ventas (VTR), are also facing widespread selling pressure today. We think investors are also being spooked by language in HCP’s quarterly release, noting the “ongoing change in reimbursement models which reduces rates and lowers census, the result of shorter lengths of stay.”
We’ve been saying time and time again that 2016 will be challenging, and we continue to prefer recently-added Vanguard REIT ETF (VNQ) for diversified REIT exposure as we navigate this tumultuous environment. The market may be over-reacting to the weak outlooks, but we’ve been looking to shed HCP for some time, so none of this should be surprising. On face value, it doesn’t appear any dividends are at immediate risk, but we haven’t had a dividend cut in the Dividend Growth Newsletter portfolio ever, and the risk to us is not worth the reward, particularly in the context of holding Vanguard’s offering.
Your opinion and risk tolerances may differ.