Description
High returns are typically earned by investors owning good quality companies in industries so beaten up that they have been completely written off…provided that catalysts exist which will create strong positive earnings surprises for both the industry and the company.
The nursing home industry is one sector that has been completely and totally written off as being worthy of investment. Investors either hate the sector, or at best are indifferent. Wall Street also hates the sector. Yet…the catalysts are now clearly in place to produce rapidly increasing profits for this industry. Objective analysis confirms this.
Buoyed by a 20% increase in PPS rates for 15 patient categories in 2001 plus 5% across the board increases in all PPS categories for 2001 and 2002, the nursing home industry will once again show profit growth. The majority of the publicly traded firms presently in chapter 11 are poised to emerge from their recapitalizations. Wall Street will once again have a nursing home industry to cover. Growth and health care oriented mutual funds will want/need to own health care stocks in their portfolios.
Those seeking growth and income from this sector would be well advised to purchase Omega Healthcare Preferred A and B shares over the next 12 months. The 52 week range of OHI preferred A has been $7.95-$15.60. The 52-week range of OHI preferred B has been $7.02 to $14.90. The present price of the preferred assumes that the company is insolvent. My analysis clearly concludes otherwise.
OHI A & B preferred shares sell for approximately 43% and 41% of par values respectively. Neither share class is convertible into common, except in the event of a reorganization. The 9.25% preference shares “A” carry cumulative annual dividends of $2.31 per share. The 8.65% preference shares “B” carry cumulative annual dividends of $2.16 per share. Both issues are two quarters in arrears. The total size of both issues is $107,500,000.
Omega Healthcare (hereafter known as OHI) is a health care REIT. The firm owns or manages $946 million of assets. Included in these assets is a mortgage portfolio with a carrying value of $207 million and a fair market value estimated to be greater than $235 million. This fair market value estimate is not part of the balance sheet. OHI also owns 264 healthcare facilities. 27 third party companies operate 198 of these facilities. No one company represents more than 25% of its revenues. OHI has assumed management of 66 facilities representing 5100 beds. I estimate that by the end of fiscal 2001, OHI will have assumed management control of 15 additional units and will earn revenue from over 6200 beds.
As of March 31st, 2001, OHO had total assets of $946.7 million, shareholders equity of $468.5 million and total debt of $478.2 million. Approximately $308 million of long term debt facilities mature in 2002.
OUTLOOK FOR OHI: After careful review of industry trends for nursing home chains as well as improvements in PPS payments for Medicare and Medicaid, I conclude that OHI’s earnings, FFO and debt coverage ratios will turn upward in 2001. Further declines in interest rates will also be beneficial. This should lead to renewed investor confidence. I reach this conclusion using the following methodology.
1. The 20% increase in PPS rates for 15 of 44 categories of patient care, coupled with 4% across the board PPS increases for 2001 and 2002 should result in rapidly rising profits for the entire nursing home sector. Additional relief in the form of interim raises (roughly 1% across the board) has also been signed into law by the federal government. One state (Arkansas) has unilaterally raised Medicaid rates by 24% commencing May 2001. 5% of OHI’s portfolio is in Arkansas. Other states may follow Arkansas’s lead in raising rates shortly. As a result, my analysis concludes that daily nursing home fees will increase by 11% in 2001 and a further 8% in 2002. Should further rate relief occur, my forecast will prove to be conservative.
2. The completion of lessee’s restructuring in 2001 and 2002 will add certainty to the revenue stream, FFO and earnings forecasts for OHI. Due to the complete restructuring of the entire nursing home industry, my forecasts for this stock are (presently) less clearly defined than for other stocks and industries I follow. However, as 100% of OHI’s tenants will have restructured through chapter 11 filings by mid 2002, there should be no bad news left in this stock. Just one example of the benefits to be had when the restructuring is completed; will come in the form of a significant reduction in operating expenses. The reduction of SG&A and legal costs to historic norms will add $.24 per share to fully diluted FFO on an annualized basis.
2. OHI should be successful in renewing its long-term debts and reducing its total annual interest expense. Over $300 million of long term debt matures in 2002. Despite operating earnings being achieved over the last nine months, OHI suspended the REIT common and preferred share dividends, pending completion of the long-term debt package. OHI’s asset base is more than $200 million smaller than two years ago, due to asset writedowns and lessee insolvency. This permanently reduces FFO by roughly $.28 per share. The remaining pool of assets is also less profitable than at the peak of the nursing home boom (in early 1998). With a smaller asset base and diminished profitability, it is understandable that credit ratings have declined. Interest rates paid on long term debt will surely increase. A peer (VTR) recently renegotiated its long term debts at rates lower than I have forecast OHI will pay. VTR also has a much weaker balance sheet that does OHI.
OHI has also been diligently reducing total debts. A focused emphasis on debt reduction, coupled with the massive decline in rates seen thus far in 2001…lead me to conclude that OHI’s total interest charges in 2002 should be roughly $34.8 million. This will compare favorably to total interest charges paid of $42.4 million for 2000 and my estimate of $38.1 million for 2001. Should interest rates decline further, these interest expense forecasts will prove to be conservative.
3. OHI may start to receive common shares of some of the reorganized nursing home chains (for creditor claims) upon various tenants’ emergence from chapter 11. For example, “Mariner Post Acute Networks” may emerge from chapter 11 this fall. As a secured creditor through participating mortgages, OHI may stand to receive common equity that I estimate to be worth $10 million more than OHI’s impaired book value of this claim. Additionally, OHI has received a convertible preferred share that is exchangeable for 9.9% of the equity of “Advocat”, another publicly traded nursing home chain. However, I believe that Advocat will seek creditor protection again shortly. Consequently, I have already written the equity and notes received down to zero in my forecast. The remainder of the 27 firms that OHI has leased properties to, are in various stages of chapter 11. Some, including “Sun Healthcare”, are preparing to emerge from chapter 11 shortly.
Any recovery of asset values (written down through the receipt of equity in reorganized firms) would add to earnings in 2002 and beyond.
4. Any additional balance sheet restructuring for OHI should shortly be completed. In addition to the declines caused by the temporary suspension of common and preferred share dividends, common shares have been depressed by the possibility of a need for further equity. One of four resolutions should soon occur.
A. Long term debt refinancing takes place without an insistence upon new equity. This benefits the common shareholders, and is of lesser benefit to preferred shareholders. This is an unlikely scenario.
B. As a condition of bank debt renewals, a significant equity placement may made with the majority shareholder; concurrent with rights offering to common equity holders (possibly extended to preferred shareholders). “Explorer Holdings” has committed $50 million to OHI for growth based investments through to July 31st, 2001. This commitment may or may not be extended beyond July 31st. Whether or not an equity infusion (that may be insisted upon by lenders) falls within the scope of that agreement is uncertain. OHI indicates that it does. However, Explorer purchased $100 million of a 10% convertible preferred in July 2000 and accepted their recent dividend payment in kind so as to preserve OHI’s cash. This privately placed issued issue can be exchanged into common shares with a value of $6.25 each.
Under scenario B, preferred shareholders would benefit more in the short term than would common.
C. A more sweeping reorganization may occur. Under this scenario, all preferred shareholders would be offered either common shares or a package of common and new preferred in exchange for existing shares. This would be relatively bad for existing common shareholders in the short term due the temporary arbitrage pressures. My analysis concludes that that in the short term, it would be neutral for preferred shareholders and very positive after year one. OHI is not in precarious shape from a balance sheet point of view, so any preferred exchange may have to be relatively attractive as a package.
D. This REIT may ultimately be merged into another firm. The results of a merger would be in the form of increased capitalization, improved credit ratings, the spreading G&A and legal costs over a much larger asset base and immediately increased FFO per share for the merged firm. I do see this as a plausible solution in the mid-term. It would be beneficial for both common shareholders as well as preferreds. I cannot speculate on the probability of a merger in the near term.
5. Upon resolution of the bank long term refinancing, at some point OHI will resume the common share dividends and reinstate the preferred share dividends. OHI has until mid 2002 to pay the accumulated FFO earnings out to shareholders without penalty. A resumption of dividends within the next 12 months will preserve the REIT status of the corporation. As well, resumption of dividends will create strong upward buying pressure for both the common and the preferred shares.
EARNINGS FORECAST FOR OHI BY SEGMENT. *Please note that all forecasts are based upon information compiled by the author of this report, and are subject to change.
2001 (in $ thousands except for share amounts).
Revenues
Rental Income: $ 59,500
Mortgage Interest Income: $ 20,849
Other Investment Income- Net $ 4,432
Nursing Home Revenues of owned and operated assets $ 207,030
Miscellaneous $ 542
Total $ 292,353
Expenses
Depreciation and Amortization $ 21,946
Interest $ 38,300
G&A $ 9,700
Legal $ 4,704
State Taxes $ 424
Changes for Derivative Accounting $ 1,428
Provision for loss on mortgage notes receivable $ 8,200
Provision for impairment $ 43,800
Nursing home expenses of owned and operated assets $ 204,063
Total $ (332,565)
loss) earnings before gain (loss) on assets sold $ (40,212)
Gain (loss) on assets sold – net $ 562
Net (loss) earnings $ (39,650)
Preferred stock dividends $ (19,632)
Net (loss) earnings available to common $ (59,282)
Net (loss) earnings per common share (fully diluted) $ ( 1.62)
FFO per share (after preferred share dividends) fully diluted $ .44
Interest coverage forecast 1.92x
2002 (in thousands except for share amounts)
Rental Income $ 53,500
Mortgage Interest Income $ 20,223
Other Investment Income – net $ 4,120
Nursing Home revenues of owned and operated assets $ 225,730
Miscellaneous 542
Total $304,115
Expenses
Depreciation and amortization $ 21,516
Interest $ 34,860
G&A $ 8,600
Legal $ 2,467
State Taxes $ 713
Nursing Home expenses of owned and operated assets $ 213,493
Total $(281,649)
(loss) earnings before gains (loss) on assets sold $ 22,466
Preferred stock dividends $ (19,632)
Net (loss) earnings attributable to common stockholders $ 2,834
Net (loss) earnings per share fully diluted $ .07
FFO (after preferred share dividends) per common share fully diluted $ .66
Interest coverage 2.26x
COMPARATIVE ANALYSIS:
Book Value: OHI common and preferred shares are extremely cheap. The common shares presently sell for roughly 55% of my forecast 2001 book value fully diluted. This book value estimate takes into account my forecast losses for this year. OHI was quite proactive in writing down assets in line with revenue expectations. The firm has thus far taken total writedowns since 1999 in excess of $100 million.
Since fiscal year end 2000, 3 more tenants have defaulted (partially and fully) on rental payments and mortgages. All nursing home management firms will have now declared chapter 11 with these final declarations. Consistent with previous trends and taking into account similar writedowns incurred by competitors, I estimate that further one-time charges of up to $52 million will be taken in 2001. After these writedowns take place, I estimate that the fully diluted 2001 book value will be in the range of $5.09 per share.
Going forward, numerous lessees of OHI are set to emerge from bankruptcy. As a result, the asset impairment charges taken previously may, to some extent, be reversed.
At .55 times my adjusted 2001 book the common shares of OHI compare very favorably to the nursing home REIT peer group (selling for an average of 1.6 time’s non-adjusted 2001 book value). OHI should sell for a discount to the group. Nevertheless, resolution of OHI’s balance sheet issues could result in the shares trading up to book value.
Interest Coverage: In the REIT industry, leverage is higher in comparison to traditional corporations. I estimate OHI’s interest coverage to be 1.9 times for 2001. By way of comparison, its peer group’s 2001-interest coverage I forecast to be 2.4 times, rising to 2.6 times in 2002.
Clearly, OHI’s interest coverage is weaker than its peers, but once again, it is not the weakest.
Asset Coverage: OHI does surpass its peer group in equity protection. Total assets exceed total long and short term debts by a 2 to 1 ratio. The quality of the balance sheet is also high, with no goodwill on the asset side. In this department OHI exceeds its peer group by 20%. Furthermore, my analysis of the five peers (Health Care Property, Ventas, Health Care Reit, Healthcare Realty and Nationwide Health) indicates that: with the exception of Ventas, none of the peer group has been as aggressive as OHI in writing down lesser or non performing assets to fair market value. I find this to be surprising. The problems with nursing homes are industry wide, and with the exception of BEV (which owns its own properties and does not serve as a lessee) virtually all public (and most private) nursing home management firms have declared insolvency. Furthermore, the vast majority of the peer group carries goodwill on their books, which I would define as being worthless in this business environment.
FFO: OHI also carries the highest forecast increase in FFO year over year in its peer group, yet sells for the lowest price to FFO of any stock in its sector. OHI common sells for a modest 6.5 times my forecast 2001 FFO and just 4.3 times forecast 2002 FFO. The average stock in OHI’s peer group sells for roughly 9.2 times forecast 2001 FFO and roughly 9 times 2002 FFO.
YIELD: The average forecast REIT yield for the common shares of OHI’s peer group is 9.4% for 2001, and 9.7% for 2002. Although OHI is in arrears, this is not due to an inability to generate FFO…it is a function of their long term debt refinancing. Upon successful conclusion of their debt negotiations, the firm has stated that they will resume dividends, and pay all dividends accrued.
OHI has historically paid out 80% of FFO as dividends. If my forecast is correct, and if you assume that that dividends resume in 2002 at historic averages; this implies common share dividends of roughly $.52 per share. This represents a forecast yield almost twice as high as the 2002 estimate for the peer group.
Absent a share exchange, dividends paid at this rate would support a common share price of up to $4.70 in the near term. This payment would still be more than 200 basis points above the 2002 average forecast yield for its peer group
INVESTMENT RETURN FORECAST: Based upon resumption of dividend payments, the preferred’s A and B could be fairly valued at $19 and $18 respectively within the next thirty-six months (all else being equal). This may result in a total three-year return somewhat greater than 114%. They clearly are preferable to the common shares on a risk/reward basis at present.
REPORT CONCLUSIONS: With both management of nursing homes and REIT status, OHI represents a unique play on both the recovering nursing home sector as well as the nursing home REIT sector. OHI preferreds sell for a considerable discount to par value, and are well covered by assets. Analyst coverage of the sector (as well as OHI) has virtually ceased, as there are few public nursing home chains to follow. The firm has survived the “perfect storm”…rising interest rates for the years 1999 and 2000 coupled with a complete and total insolvency of their entire lessee base.
Although the majority would argue otherwise, I consider the industry’s structural problems and the problems specific to OHI…to be largely resolved. The majority tends to look backward when conducting balance sheet analysis. My analysis looks forward. True value investors should love this stock.
Should my thesis prove to be correct, investors are now presented with a buying opportunity at prices not seen since 1973-1974. Within the next twenty-four months, the nursing home industry will once again be perceived as being viable. Favorable Wall Street coverage will most assuredly increase. One should commit capital now and for the next year to this lightly followed sector. Provided that OHI remains independent, I suggest that the preferred shares represent the most attractive value for your dollar.
Investors who are less value oriented may wish to wait until the earnings trend I am forecasting becomes widely apparent to Wall Street. Of course, the preferred shares will then be considerably higher.
I recommend the preferred instead of the common at this point primarily due to the possibility of arbitrage in the event of an exchange. After a conversion takes place, then one could feel confident in purchasing the common shares. My analysis indicates that, by 2004 (in its present form), OHI will have the ability to generate more than $1.10 per annum of fully diluted FFO.
INVESTMENT CATALYSTS: The catalyst for appreciation (as forecast) for the preferred shares will come about from one or more of the following events:
1. A successful long-term debt refinancing, which may or may not involve additional balance sheet restructuring.
2. Significant increases in operating profits in 2001 and 2002 from nursing home operations.
3. Resumption of Wall Street coverage of the industry, leading to renewed interest from the investing public.
4. Resumption of preferred share dividends.
5. A favorable exchange of the preference shares for common.
Catalyst
successful long term debt restructuring, significant increases in profits, resumption of industry coverage,resumption of preferred share dividends or a favorable exchange for common shares.