HCP is a Dividend Aristocrat with a 7% Yield. Is the Dividend Safe?

HCP Inc. (HCP) is the only real estate investment trust (REIT) in the S&P 500 Dividend Aristocrats Index. With a dividend yield in excess of 7%, it’s no surprise that this stock has been a popular holding for investors living off dividends in retirement.

 

Generally speaking, dividend aristocrats are some of the most reliable dividend-paying stocks in the market. After all, it takes meaningful competitive advantages and a committed management team for a business to pay higher dividends for at least 25 consecutive years.

 

We own several aristocrats in our Top 20 Dividend Stocks portfolio, but HCP possesses several characteristics that require a closer look. With the stock down about 20% over the last year, now is a good time to review if HCP is a high yield dividend aristocrat worth buying or a potential value trap.

 

Business Overview

HCP is a real estate investment trust (REIT) with over 1,200 properties in the healthcare sector. The company went public in 1985 with 24 skilled nursing facilities and primarily grew by investing billions of dollars in acquisitions to expand its portfolio.

 

HCP makes money by renting out its properties to healthcare companies such as senior living centers and doctors’ offices. Roughly half of HCP’s investments are under triple net lease agreements, which are generally thought to have lower risk profiles because they require the tenant to pay property taxes, insurance, and maintenance expenses.

 

By segment, HCP generated 42% of its 2015 revenue from Senior Housing, 24% from Post-Acute/Skilled Nursing, 13% from Life Science, 17% from Medical Office, and 3% from Hospital. The company’s mix of operating income was similar, but it’s worth mentioning that two of HCP’s customers accounted for over 30% of its revenue last year (HCR ManorCare 23%, Brookdale 10%).

 

Business Analysis

The U.S. healthcare real estate market is extremely fragmented. In an investor presentation, HCP estimated that the market is about $1 trillion in size but public REITs own less than 20% of it.

 

As the healthcare industry continues to focus on reducing costs, consolidation is likely and should benefit the bigger players. Acquisitions have fueled much of HCP’s historical growth, and we expect them to play a key role in the company’s future strategy as well.

 

The healthcare market also has attractive demographics. Spending generally continues unabated regardless of economic conditions (sales were flat in 2009), and many of HCP’s properties will benefit as the average age of the U.S. population skews higher over the coming decades to reflect improving standards of living.

 

 

HCP has also built long-term relationships with many of its tenants, which helps it maintain strong occupancy and renewal rates at its properties. As long as its tenants remain financially healthy, they provide a stable source of revenue for HCP over the duration of their lease.

 

Despite its strengths, HCP is a business that will never earn high returns on its invested capital due to the capital-intensive nature of real estate, the large number of competitors, and the industry’s relatively low barriers to entry. As seen below, HCP has generated a low- to mid-single digit return on invested capital over the last five years, which is a little below the market’s average return on capital.

 

 

However, HCP is a reliable cash flow generator because of its long-term leases with customers, the industry’s slow rate of change, and the non-discretionary nature of healthcare spending. Some of these factors make healthcare one of the best stock sectors for dividend income. As seen below, HCP has generated free cash flow in nine of its last 11 fiscal years.

 

 

HCP’s Key Risks

HCP’s main risks are its customer concentration, dependence on government reimbursement programs, and reliance on capital markets.

 

Whenever a business is highly concentrated with a customer or two, its fate will largely be determined by how those customers perform. In 2015, HCP generated 23% and 10% of its total revenue from HCR ManorCare and Brookdale, respectively.

 

HCP acquired a large stake of real estate from HCR ManorCare for about $6 billion in 2011, which significantly increased its customer concentration.

 

Prior to the deal, HCP’s two biggest customers in 2010 were Emeritus (10% of sales) and HCR ManorCare (9%). In other words, the magnitude of its two largest customers has about doubled over the past five years from 19% of sales in 2010 to 33% last year. The company’s mix of post-acute/skilled nursing revenue also increased from 12% of revenue in 2010 to 24% in 2015.

 

Despite HCP’s status as a dividend aristocrat, it has much more customer concentration risk today than it did five years ago. Many income investors assume dividend aristocrats are invincible, but it’s important to be aware of how a company’s business has evolved (for better or worse).

 

Unfortunately, both HCR ManorCare and Brookdale are struggling, which is hurting HCP’s stock and creating greater risk for its dividend payment.

 

Brookdale is the biggest provider of senior living care in the U.S. and is dealing with lower occupancy levels. Many of HCR ManorCare’s issues are being caused by unfavorable trends in skilled nursing facilities and the company’s dependence on Medicare and Medicaid reimbursements.

 

HCP estimates that about 25% of its annualized rental payments received from tenants are dependent on Medicare and Medicaid reimbursements. This is a high level of government assistance and creates risk because reimbursement rates can unexpectedly shift and make certain areas of healthcare more or less attractive and profitable.

 

In addition to customer concentration and government reimbursement risk, HCP’s margin of safety is also less than many other companies because REITs are required to pay out 90% of their taxable earnings as a dividend to keep their REIT classification.

 

As a result, REITs have less capital to reinvest in the business for growth and have to turn to the capital markets more often than other types of companies.

 

As seen below, HCP has maintained a reasonable debt to capital ratio near 50%, but its diluted shares outstanding have more than tripled over the last 10 years from 136 million shares in 2005 to 463 million shares last year.

 

 

If HCP experiences unfavorable business developments, it could quickly become financially strained due to its high payout ratio and interest expense payments.

 

If banks are unwilling to lend money to the company at reasonable rates and HCP’s share price is in the dumps, making it costly to issue equity, the company will have a hard time sustaining its dividend and growth spending.

 

Many investors in master limited partnerships (MLPs) have already experienced the pain that capital market risk can inflict, and we wrote an article covering the topic last year.

 

Dividend Analysis: HCP

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. HCP’s long-term dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

HCP’s dividend payment ranks slightly below average for safety with a Dividend Safety Score of 40. One of the first metrics we look at is a company’s payout ratio. REITs are different than other types of companies because their properties record large depreciation charges each year, which lower reported earnings. However, the value of real estate generally rises over time.

 

For this reason and others, REITs report non-GAAP measures that can provide a better representation of their cash flow and dividend coverage. One such measure is funds available for distribution (FAD), which is similar to free cash flow but for a REIT.

 

HCP’s management team expects the company’s FAD to range from $2.62 to $2.68 per share in 2016, which implies a forward-looking payout ratio of about 90%. This would be HCP’s highest FAD payout ratio since 2004.

 

While all REITs will have higher than average payout ratios, HCP’s makes us more nervous than others because its two major customers are facing rather murky headwinds related to changing Medicare and Medicaid reimbursements.

 

Changing reimbursement models has resulted in lower rates and shorter patient stays for HCR ManorCare, and the company is incurring legal costs related to an investigation by the Department of Justice over false Medicare reimbursement claims.

 

As a result, the tenant’s cash flow coverage is deteriorating. According to HCP, HCR ManorCare’s fixed charge coverage (FCC) in 2015 was 1.07x and fell to 0.97x for the last six months of the year.

 

A coverage ratio below 1.0x means that the company’s cash flow is unable to cover its rent and interest expenses. In other words, there is pressure to sell off assets or negotiate lower rent rates.

 

If operating performance continues deteriorating, HCP might be forced to give HCR ManorCare another major rent cut. For now, HCP expects HCR ManorCare’s FCC in 2016 to range from 1.06x to 1.16x, which leaves little cushion if industry trends further deteriorate.

 

HCP is in the process of selling off about $350 million worth of non-core strategic assets from HCR ManorCare as it works to reduce its exposure and improve its credit lease, but nothing will happen overnight.

 

Looking at the balance sheet, HCP has about $400 million in cash compared to book debt of $11.1 billion. This large debt load would usually raise some red flags, but it is backed by the value of HCP’s real estate in this case, reducing some of its risk.

 

In the event that interest rates start to rise, it’s worth noting that over 95% of the company’s debt is fixed rate. This prevents HCP from needing to make significantly higher interest payments on its existing debt load.

 

HCP also has investment grade credit ratings from Fitch (BBB+), Moody’s (Baa1), and Standard & Poor’s (BBB+) with stable outlooks from each.

 

Overall, we think HCP’s current dividend will probably stay safe, but there is some risk of a modest reduction if conditions deteriorate more than expected at HCR ManorCare or Brookdale this year. However, we don’t expect such deterioration would result in a major cut (e.g. 50%) to the dividend.

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Not surprisingly, HCP’s Dividend Growth Score of 19 is pretty weak. Until its major tenants stabilize and become a smaller portion of HCP’s total sales mix, we expect any dividend growth to be very modest.

 

HCP most recently increased its dividend by 1.8% earlier this year, marking its 31^st consecutive annual payout raise. The company is the only REIT member of the dividend aristocrats list and has increased its dividend by 3.0% per year over the last decade.

 

 

Valuation

HCP’s stock trades at 12.3x forward FAD guidance and has a dividend yield of 7.1%, which is significantly higher than its five-year average dividend yield of 5.1%. If HCP can continue its organic operating income growth of 3% per year, the stock appears to offer 10% annual total return potential.

 

Investors are clearly concerned by the company’s exposure to HCR ManorCare and Brookdale, potentially creating an opportunity in the stock. However, it’s ultimately too hard for us to accept the risks facing HCP’s business at this time.

 

Conclusion

Given the murkiness of healthcare reimbursements and HCP’s customer concentration risk, it’s too hard for us to get comfortable with the business. The stock has been very weak because investors are trying to reassess the company’s long-term growth rate, which was immediately adjusted lower in response to deteriorating trends in the post-acute/skilled nursing industry last quarter.

 

The company’s dividend payment seems more likely than not to remain safe, but that could change if HCR ManorCare needs to renegotiate its rent lower again this year. With a focus on capital preservation and safe income growth, we will stick with some of our favorite blue chip dividend stocks instead.