Description

OHI is healthcare REIT with an asset mix of 85% skilled nursing facilities ("SNF") and 15% assisted living facilities ("ALF"), where OHI is the ProCo/landlord to operator tenants.  ETFs have taken OHI equity's equity to north of $40/share / 6.5% yield, an indefensible valuation.  This valuation implies ~$136K/SNF bed, well north of private market transactions.  I estimate fair equity value is below $25/share.  Notably, insiders consistently print equity north of $30/share and the company sells shares via an ATM, validating that insiders also believe their stock is not worth $40/share.  

Fair value can be implied in terms of a caprate or a $/bed basis.  As a caprate, we value the company at 1.5x coverage ratio (rebase current contracts which are 1.3x covered to 1.5x) and apply an 8% target FCF yield/cap rate; this method implies $24/share.  We have verified these numbers with M&A bankers active in the space.  On a $/bed basis we take TEV, back out the ALF beds at $250K/bed (which is arguably on the high end to be slightly conservative); this math implies the SNF beds are created for $136K/bed (if you look at the QCP write ups that were periodically put up on VIC, you will see that QCP recently traded for < $60K/bed).  If you talk with OHI IR/management, they will corroborate the fair value analysis laid out herein, but push back on it under guise that a company with public currency should trade at higher valuations than a private company (which I would push back on in this industry, which has a fairly liquid M&A market both public-to-private and vice versa).

However, there lacks a catalyst (barring rates or ETF outflows).  On one hand, OHI's dividend is not covered by operating cash flow (OHI has been issuing equity and borrowing debt to fund its dividend) and operator tenant EBITDA has historically declined 5% a year (suggesting rising leverage to cover the dividend).  On the other hand, OHI has demonstrated an ability to issue inflated equity currency and the most recent quarter demonstrated some stability in occupancy/tenant operating trends.

Indeed, I was expecting to be more constructive on the equity short, thinking OHI equity would have to re-rate on back of declining EBITDA/rising leverage to cover its dividend in 2020.  I can't quite predict that this second, so the safer alternative is just shorting the bonds and then rotating into the equity if operations inflect or the equity continues to grind higher.

Accordingly, we would instead recommend shorting OHI's 2028 bonds at 3.5% / 108% dollar price (hedged against 10YR T-Bills to hedge out interest rate risk).  We think the bonds are ~50% LTV (using our $25/share valuation) and yet only yield 3.5%.  I may be old school (or just old), but 50% LTV corporate debt securities (levered at over 6x) should not yield only 3.5%.

I think a short has 3 small ways to win:

1) YTM widens to other debt comps (e.g., SBRA which is a similar LTV), widening to 4.0% YTM is 3pts of downside from here.  We think OHI's assets are not as good as SBRA so could argue for a spread to SBRA debt, which would be 7pts downside. 

2) Spreads widen.  OHI bond spreads to T-Bills are the tightest they have ever been (~200bps for the '28.  Getting back to historical spread to Treasuries would be 4.2%, or 7pts or so downside. 

3) Compound the impact of normalizing spreads to SBRA and Treasuries, and OHI bonds would be down over 10pts.

A bigger way to win would be to see EBITDA resume its SSS decline, forcing a re-rate of the entire structure.  It was not long ago that HFs we speak to were shorting bonds at 95 (13pts lower) on that thesis.  Private market valuations are lower than OHI's public market valuation for a good reason: the industry is pressured by rising costs (drugs and labor), declining length of stay, and largely capped reimbursement fees over a fixed cost structure.  That said, it may be the case that OHI is taking share from mom & pops who are closing doors, giving an occupancy boost, which is reflected in the relatively stable Q2 2019 results.   

I think of a short has having convexity for exposure to this potential return of SSS declines.   Your short a bond that has 3-10pts downside of taking out the manic froth seen the last few weeks, with a chance for 20pts downside if operating results revert to their downward trend.  The cost is 2pts a year hedged with T-Bills (in past I have recommended other securities for a positive basis to the trade.. you just have to find something that yields more than 3.5% with a little duration… that should be doable for most people). 

Negatively for a bond short, OHI has been able to issue equity to support asset acquisitions (trade their inflated currency for cheaper private market assets) and could theoretically issue equity to repay debt.  Positively, OHI has also been issuing debt and hasn't had interest in monetizing their equity to a material degree (their ATM issuances are relatively small albeit persistent).  I imagine OHI management is probably shocked where their debt is trading and imagine they would be happy to issue debt at 3.5% to fund acquisitions (that's cheaper than you can get on a 40% LTV home mortgage with government support!).

Ultimately I think you do the work/short the bonds and wait for a better entry point to short the equity (more absurdity in the stock price or a fundamental turn down in the business).

Catalyst

Technicals: Rates, HY spreads, debt issuance
Fundamentals: Declining SNF operating trends