Description

SUMMARY THESIS

The market is conflating uncertainty of outcome with risk of capital impairment.  The risk of capital impairment is low and the distribution of outcomes is heavily skewed toward a favourable result.  The current cheapness provides a significant margin of safety.  Conservative assumptions support at least 60% upside to the current share price (it’s not difficult to underwrite significantly more than that) with a likely near term catalyst to remove uncertainty. 

BULLET POINTS:  

(1) Cheapness: QCP is a REIT.  The current valuation represents a ~20% free cash flow yield to equity using LTM cash flow (Equity Market Value / Enterprise Vale is ~50% so FCF is not artificially juiced by leverage).  As a REIT profits must be distributed as dividends.

(2) Uncertainty:  LTM is not the right cash flow number to use.  The EBITDAR coverage for QCP’s major tenant is <1x.  As such, rent will need to be renegotiated (down).  This is largely what’s creating the uncertainty.  However, (i) rent reductions to market levels still have QCP trading very cheap; (ii) QCP will likely receive some value from its tenant in return for rent reductions provided; and (iii) you are earning 20% cash return to equity while you wait for this to be resolved (the tenant is solvent, is current on rent and has sufficient liquidity to at least 2018 and possibly beyond).  More detail on all of these issues below.

(3) Event: QCP management is currently working to address the issue in (2) above.  I expect this to be resolved in the next 12 months, with a high probability it will be much sooner.  Once the uncertainty is resolved the impediment to rerating to fair value is removed.

(4) Management Incentives: management are highly incentivised to create shareholder value.  Through performance rights and options senior management currently own in excess of 5% of outstanding equity.  The vesting of the options is structured such that 50% only vest if the stock price increases (1/4 if the stock is up each of 25%, 50%, 75% and 100% respectively)

BACKGROUND

HCR Manor Care (HCRMC) is the largest owner and operator of facilities providing post-acute care services and long-term care in the US.  In 2007 Carlyle acquired HCRMC for $6.3 billion.  In 2011 Carlyle sold HCRMC’s real estate assets to US listed REIT HCP Inc. for $6.1 billion.  As part of the transaction a subsidiary of HCRMC and HCP entered into a long-term triple net lease (a master lease structure).  Trends in the markets HCRMC operates in have been challenging.  As a result EBITDAR coverage on the HCRMC lease steadily declined. 

In 2015 HCP and HCRMC agreed to modifications of the original master lease including: (i) HCRMC’s lease payments would reduce by $68 million ($473 million vs. $541 million); (ii) 50 non-strategic assets would be sold (sale proceeds to be retained by HCP); (iii) HCRMC would transfer an additional nine properties to HCP; (iv) HCP would receive from HCRMC a Deferred Rental Obligation for $250 million (more details on this in the valuation section below); (v) the lease term would be extended by 5 years; and (vi) HCP received a corporate guarantee from HCRMC with respect to payments on the master lease (this is important and will be discussed in more detail below).  

In May 2016 HCP announced that it would spin-off the HCRMC assets as well as other post-acute care and memory care assets into a new REIT called Quality Care Properties (QCP).  QCP commenced trading in October 2016.   As at 30 September 2016, QCP owns 274 post-acute/skilled nursing properties, 62 memory care/assisted living properties, one surgical hospital and one medical office building. 

CURRENT SITUATION

The $6.1 billion portfolio sold to HCP in 2011 is currently valued by the market at $3.4 billion (QCP’s current enterprise value).

Since listing QCP management has not engaged with shareholders or the sell side.  There is no analyst coverage and the company will not speak to investors.  Management’s position is that they want to address the situation HCRMC before relaunching the company.  While this is a plausible reason why management has not engaged with investors, it is also worth noting that management was awarded in excess of 5% of the company in performance units and options.  Keeping the share price down (i) lowered the strike price of these awards (certain awards were total dollar amounts agreed pre-spin which converted into units at the share prices post spin) and (ii) increased the probability that all options would vest (50% of the options only vest if the share price increases materially versus the price at the time of the awards – more details below).

What is the situation with HCRMC?

QCP derived 94% of its total revenue from HCRMC in the nine months ended 30 September 2016.  While HCRMC is financially healthy at an EBITDAR level, the rent payments it is making to QCP exceed what it can currently afford.  Despite the amendments made in 2015 described above the HCRMC master lease will need to be further amended.  This is described in more detail below.  The situation will likely need to be resolved before HCRMC’s bank debt facility matures in April 2018, although it’s highly likely it will be resolved much sooner. 

While the QCP assets are unquestionably valuable (private market value for QCP’s portfolio is significantly higher than QCP’s current market enterprise value) and there are many other operators that could (and would willingly) step into HCRMC’s operating role if the portfolio needed to be transitioned the uncertainty around timing, the structure of the ultimate outcome, the unwillingness of management to engage with investors plus the lack of sell side coverage and awareness of the situation has limited the universe of investors looking at this opportunity. 

VALUATION

There are four components of value: 

(1)    Core Portfolio – based on the new (reduced) rental that HCRMC will pay;

(2)     Non-Core Portfolio – per the 2015 lease modifications described above HCRMC and HCP/QCP agreed to sell 50 non-core properties.  As at 30 September 2016, 33 of the 50 properties had been sold.  Sale proceeds from the remaining 17 properties will be retained by QCP;

(3)     Deferred Rental Obligation – per the 2015 lease modifications described above HCP/QCP received a $250 million Deferred Rental Obligation from HCRMC;

(4)     Value to be received from HCRMC in return for rent reductions – value received from HCRMC in return for rent reductions

Each of the four components of value are addressed in detail below.  Important note: QCP has not yet filed its 10-K (due by 31 March 2017).  Information below is based on most recent financials which is the period ending 30 September 2016.     

(1) Core Portfolio Valuation

Two questions need to be answered: (i) the size of the rent reduction/pro-forma rent; and (ii) the right multiple to apply to the new rental stream. 

(i) Pro-Forma Rent:  

EBITDAR coverage on the HCRMC portfolio needs to increase to ~1.25x on average.  From the QCP Information statement:

“We believe market rents for post-acute/skilled nursing facilities typically allow for EBITDAR cash flow coverage ratios of 1.25x to 1.35x and for memory care/assisted living facilities of 1.05x to 1.15x.”  

“In light of the headwinds facing the broader post-acute/skilled nursing industry and HCRMC and the resulting deterioration in HCRMC’s operating performance and declining rent coverage ratios, we have conducted a hypothetical illustrative analysis of the impact to our capital structure and certain of our credit metrics assuming the annualized amount of rental income generated by the HCRMC Properties as of June 30, 2016 was consistent with typical Facility EBITDAR cash flow coverage ratios for these post-acute/skilled nursing and memory care/assisted living facilities. Under this construct we estimate that the average typical Facility EBITDAR cash flow coverages for the HRCMC Properties would be approximately 1.25x. Based upon this hypothetical illustrative rent analysis, our annualized Adjusted EBITDA for the six months ended June 30, 2016 would have been $349 million, as compared to our actual annualized Adjusted EBITDA of $465 million for such period.”

The 1.25x coverage level is consistent with comments of QCP’s listed peers.  For example this is from Omega Healthcare’s most recent quarterly earnings call:

<Q – Michael Knott>: Okay. That’s helpful.  And then just in terms of market coverage levels just given the slippage in coverage that we’ve seen, just curious your thoughts on when you’re underwriting new deals, seems like market convention is still 135 to 140 coverage on EBITDA.  I’m curious, if you are thinking about, if you need more, more coverage than that on new deals?

<A – C. Taylor Pickett>: No, I think it’s still is really leaning more toward one-fourth, that’s what we’ve been looking at for the last couple of years now

The ~1.25x EBITDAR coverage level has also been corroborated with feedback from discussions with a variety of participants in the industry (owners, lenders & operators).    

Using the most recent financial information for HCRMC increasing EBITDAR coverage to 1.25x reduces rent to QCP / EBITDA at QCP by approximately $138 million (note: this is more conservative than the $116 million reduction in EBITDA implied by the commentary in the QCP Information statement above).

* EBITDAR for the trailing 12 months includes (i) $9 million related to 33 non-strategic properties sold to date and (ii) losses of $15 million related to 17 non-strategic properties held for sale that are expected to be sold by the end of Q1’17 (11 of 17 were under contract at 30 September 2016)

Another data-point to consider is that QCP agreed to a one-time rent reduction of $5 million for HCRMC in November 2016.  QCP then agreed to a further $25 million reduction on 30 November 2016 ($15 million for December 2016 and $10 million for January 2017).   Annualising this $30 million (for 3 months) rental reduction is approximately $120 million for a full year, which is broadly in line with the $116 million articulated in the Information Statement and lower than the $138 million calculated above.   Please note, no further rent reductions have been announced (i.e. no announcements regarding rent reductions for periods post January 2017, implying full rent has been paid).    

(ii) What Multiple to Apply to QCP Pro Forma Rent

There are two publicly listed REITs that are directly comparable to QCP: Omega Healthcare Investors (OHI) and Care Capital Properties (CCP).  The asset overlap between QCP and these two REITs is significant.  In general, the macro picture for these assets is that a series of challenges have impacted short term profitability for operators but the demographic tailwinds of an aging population will have a positive impact from late in the decade / early next decade. 

Below are valuation multiples for QCP, OHI and CCP.   

Source: Bloomberg for OHI and CCP

* QCP asset value as at 30-Sep-16.  Leverage and book value based on 30-Sep-16 actual adjusted for $1.8bn of net debt taken on as part of the spin-off (which occurred post balance sheet date).  EBITDA and FFO represents LTM actual assuming zero rental growth (note: QCP rental contracts have annual escalators)

However, this comparison is overly generous to QCP because as described above the rental payments from HCRMC to QCP are likely to be adjusted down.  As such, adjustments need to be made to make the comparison like-for-like.   It’s noteworthy that both OHI and CCP also have leases that are troubled.  Specifically, for the period ended 31 December 2016 approximately 40% of CCP’s leases (by $ received) were <1.2x EBITDAR coverage (approximately 33% were <1x EBITDAR coverage) and 26% of OHI’s leases were <1.2x EBITDAR coverage.  Both companies provide granularity in supplemental disclosures.  The available lease level information allows EBITDA and FFO for OHI and CCP to be adjusted to reflect 1.25x EBITDAR coverage (i.e. so it’s shown on the same basis as QCP when QCP EBITDA and FFO is adjusted for HCRMC leases to have EBITDAR coverage of 1.25x). 

The table below shows adjusted valuation multiples for each of QCP, OHI and CCP such that EBITDAR lease coverage for all leases is at least 1.25x (i.e. all leases below 1.25x adjust down lease payments to result in EBITDAR coverage of 1.25x and the EBITDA and FFO of the REIT is adjusted down accordingly).

Private market data-points are also supportive of NOI valuation yields of between 8-10% (in line with OHI and CCP valuation multiples).  During 2016 CCP sold 18 facilities ($124 million) at a weighted average yield of 8.1% and is guiding for a further $175 million of disposals at a yield of 9.5% in H1 2017.  OHI invested into a large joint venture during 2016 at a 9.5% yield and is looking at further acquisitions at yields of 9.5-10%.  Conversations will private companies in the sector as well as HUD lenders also indicate valuations for assets are at these levels.

Comparable company trading valuations support a valuation for the QCP Core Portfolio of ~12-13x EBITDA.  Using Pro Forma EBITDA of $326 million this would represent an Enterprise Value of approximately $3.9-4.2 billion. 

(2) Non-Core Portfolio Valuation

As at 30 September 2016, 17 out of 50 properties to be sold were still held on balance sheet by QCP of which contracts have been entered with 3^rd parties for the sale of 11 properties (i.e. 6 out of 17 were still uncontracted).  Commentary by QCP in the September 10Q indicated that seven properties were expected to be sold by year end 2016 with the remaining ten properties to be sold in Q1 2017.  As such, at the time of writing cash proceeds should have been received for the vast majority of these properties. 

At 30 September 2016, the carrying value of the 17 non-strategic properties (post asset write-downs) was $65 million.  

(3) Deferred Rental Obligation

The Deferred Rental Obligation (DRO) had an initial principal amount of $250 million on 1 April 2015.  The DRO is payable by HCRMC upon the earlier of: (i) 31 March 2029, which is the end of the initial term of the first renewal pool under the Master Lease; or (ii) certain capital or liquidity events of HCRMC including initial public offering or sale.  The principal amount of the DRO increases each year as follows: 3.0% in April 2016 through 2018, 4.0% in 2019, 5.0% in 2020 and 6.0% in 2021 and annually thereafter.   The principal balance of the DRO on 1 April 2017 will be $265 million. 

There are a number of ways to value this asset.  For example, if one was to assume the instrument was repaid at final maturity (Mar’29) and discount that value back to today at a 15% discount rate the DRO would be worth $95 million (or ~35 cents per dollar of principal).  Alternatively, in a HCRMC restructuring the DRO will have a claim on the estate of HCRMC.  As discussed below, HCRMC has minimal debt and material equity value.

Arguably assuming the DRO is worth 35% of par is conservative.  I expect the DRO to be addressed as part of the broader restructuring of the HCRMC lease.  50-75% recovery of principal value ($130-200 million) seems like a conservative estimate of value (especially in light of the discussion in (4) below).

(4) Value to Be Received From HCRMC in Return For Rent Reduction

As described in the background section one of the important modifications made in 2015 was HCP/QCP received a corporate guarantee from HCRMC.  This is important because HCRMC has profitable businesses outside of the QCP owned facilities it operates.  

Based on the most recently available financial information LTM EBITDAR for HCRMC was $493 million (of which only $350 million related to QCP facilities) and the non-QCP facilities are profitable. 

* Based on taking EBITDAR coverage of QCP properties to 1.25x (per the analysis and calculations in section (1) above)

The table above shows the pro forma impact of the rent reduction described above (i.e. to get QCP facilities to 1.25x coverage).  Pro Forma EBITDA increases to $167 million in this scenario.  Comparable companies (Genesis Healthcare, Brookdale Senior Living) trade at ~12x EBITDA.  The only debt HCRMC has outstanding is a $381 million Term Loan and based on the most recently available financials HCRMC had $164 million of cash.   The term loan is currently trading at 95% of par value (indicating no distress).  

In short,in the event that HCRMC receives a rent reduction from QCP it should remain a viable and valuable entity, likely with an equity value in excess of $1 billion.

HCRMC Indicative Valuation

The average length of HCRMC’s leases with QCP is 15 years.  Assuming the rent reduction described above (i.e. $138 million p.a.) and a 10% discount rate the lost NPV on QCP’s leases is approximately $1.2 billion.  At a 15% discount rate it’s approximately $900 million.  

I struggle to believe that QCP management will provide HCRMC with a large rent reduction (and value transfer) without requiring HCRMC to transfer some value back to QCP (for example in the form of HCRMC equity).  This is where the corporate guarantee is important.  If HCRMC wanted to try and reject the leases with QCP (for example in a Chapter 11 restructuring) QCP would have a claim against the HCRMC estate (including the non-QCP assets).  In this situation QCP would have a claim for lost lease payments and it would retain the real estate assets unencumbered to rent to another party.  Discussions with multiple parties indicate there are a number of operators that would be interested in stepping into operate these assets if the opportunity presented.  The Bankruptcy Code will cap QCP’s claim at three years’ rent, which assuming all leases are rejected would be ~$1.3 billion (i.e. similar to the $1.2 billion described above). 

While I believe a consensual rental modification is the most likely outcome, the dynamic described above makes it very unlikely that QCP will not receive consideration in return for the rent reduction is will likely provide to HCRMC.   QCP management are contemplating various scenarios, including a scenario where they receive HCRMC equity as part of a lease restructuring.  From the Information Statement:

“We intend to proactively engage with HCRMC and our other tenants to enhance the value of our assets. Our management team’s sole focus will be on maximizing the value of our assets by collecting contractual rent, establishing a more secure income stream, if appropriate, and using other available tools to maximize value. Such tools may include a combination of the following: increased equity participation in the operator, new rent payment streams, new master lease terms, asset sales, increased landlord rights, controls and performance-based provisions, and implementation of RIDEA structure for select assets.”

25-50% recovery of the lost lease NPV of $1.2 is approximately $300-600m of value (or a 20-40% interest in HCRMC equity at a 12x EBITDA valuation).

VALUATION SUMMARY

The valuation of the core portfolio alone results in a valuation 30-50% above current market value.  Value from the DRO and HCRMC add addition upside / additional margin of safety in a downside scenario. 

* Cash flow estimate of ~$150-175m has been adjusted down to account for one-time rent reductions for November 2016 ($5m), December 2016 ($15m) and January 2017 ($10m)

As a cross check, if one was to collapse the PropCo/OpCo structure (i.e. recombine QCP with HCRMC on the assumption that HCRMC had zero equity value and HCRMC creditors are the fulcrum security) today’s market enterprise value of $3.4 billion for QCP plus HCRMC’s bank debt of $0.4bn would result in a combined Enterprise Value of $3.8 billion.  This would imply an EV/EBITDA multiple of ~7.5x for the combined/collapsed group (a significant discount to HCRMC’s operating peers which trade at ~12x).  

MANAGEMENT INCENTIVES

The senior management team have both experience in healthcare and restructurings.  The incentive package put in place is a private equity style package.  Specifically, three senior executives (CEO, CFO, CIO) have been granted performance units and options representing in excess of 5% of total shares outstanding.  Half of the options granted do not vest unless the share price increases (1/4 vests if the stock price is +25%, 1/4 vests if the stock price is +50%, 1/4 vests if the stock price is +75% and 1/4 vests if the stock price is +100%). 

Catalyst

• Restructuring of HCRMC lease arrangements removing uncertainty & daylighting value
• Management 'relaunching' the company and engaging with investors and sell-side research
• Initiation of coverage from sell-side research(i.e. this is a direct comp to OHI and CCP)