Omega Healthcare (OHI): A High-Yield Healthcare REIT

Omega Healthcare Investors (OHI) is a real estate investment trust (REIT) with a high dividend yield over 6%.

 

The company operates in the healthcare sector, which is generally one of the best stock sectors for dividend income because of its essential products and services.

 

However, a high dividend yield can be a signal that a company’s dividend payment will not be sustainable.

 

We will only invest in safe dividend stocks for our Conservative Retirees dividend portfolio, so let’s see if Omega can make the cut.

 

Business Overview

Omega is a healthcare REIT that provides financing and capital primarily to skilled nursing facilities (SNFs), which account for about 90% of the company’s facilities. The remaining 10% of Omega’s facilities are used for senior housing.

 

Patients discharged from hospitals are sent to SNFs when they still require care or rehab before they can be sent home. Compared to hospitals, SNFs can provide short-term care on a much more affordable basis to save healthcare costs.

 

Omega’s tenants receive revenues through Medicare and Medicaid reimbursements as well as private pay for their services. Omega receives fixed rent payments from its tenants with annual escalators and uses triple net lease agreements, which are generally thought to be lower risk deals because they require the tenant to pay property taxes, insurance, and maintenance expenses.

 

Overall, Omega has more than 930 properties located across over 40 states and operated by more than 80 different operators. The company owns about 84% of its assets with mortgages (9%) and direct financing leases (7%) accounting for the remainder.

 

Business Analysis

Omega is the largest skilled nursing facilities REIT with more than twice as many properties as its next largest competitor and is playing the role of consolidator in this large and fragmented market.

 

The company boosted its property count by nearly 50% with its $3.9 billion acquisition of Aviv on April 1, 2015, which helped Omega gain operating, growth and cost of capital efficiencies.

 

Importantly, the deal also increased Omega’s diversification by state and operator. Unlike HCP, another healthcare REIT that we analyzed earlier, Omega’s largest tenant accounts for less than 7% of rent, and no state accounts for more than 11% of its total rent.

 

This diversification prevents the company from being overly exposed to unexpected headwinds that could emerge at any given tenant or in any particular state as it relates to issues such as Medicaid reimbursement.

 

While the skilled nursing industry certainly has its share of risks (more on that later), there are several elements of it that attract us.

 

Most notably, we continue to believe that the industry’s supply and demand fundamentals remain attractive.

 

From a demand standpoint, Omega’s occupancy rate has consistently remained in excess of 80% thanks to the non-discretionary nature of its operators’ services, and demand should rise as the senior population continues growing.

 

SNFs also seem likely to remain the go-to sites for post-acute care. Simply put, SNFs remain the most cost-effective environment for rehab services in most cases due to their relatively smaller footprints and lower staff counts.

 

As seen below, SNFs have about 50% market share of patients sent to post-acute care.

 

Source: Omega Investor Presentation

 

Looking at industry supply, we can see below that the supply of facilities and beds to meet increasing future demand has been limited due to Certificate of Need (CON) restrictions, which are aimed at restraining health care facility costs and have helped industry occupancy rates:

 

Source: Omega Investor Presentation

 

Overall, we expect Omega’s operators to enjoy higher volumes thanks to expanding Medicare coverage and a growing senior population.

 

We think the company will continue to have plenty of opportunities for acquisitive growth as well. As seen below, Omega has done an outstanding job finding reinvestment opportunities over the last decade (double-digit sales growth in nine of the last 10 years), and tougher reimbursement from Medicare and Medicaid should continue encouraging consolidation.

 

 

Omega’s Key Risks

Omega’s biggest risks are arguably all outside of the company’s control.

 

Skilled nursing generally has higher reimbursement risk than other areas of healthcare such as senior housing because SNFs more on Medicare and Medicaid reimbursements from the government.

 

As a result, changes in federal policies and increased scrutiny over billing practices of SNF operators have potential to materially impact the ability of Omega’s tenants to meet their lease obligations.

 

While Omega has enjoyed rising Medicare and Medicaid rates over time (see below), lengths of stay are declining under alternative payment models such as bundling and managed care.

 

Source: Omega Investor Presentation

 

Despite shifts in rates and the length of patient stays, SNF Medicare patient days are still projected to grow due to increasing enrollment.

 

Source: Omega Investor Presentation

 

Let’s take a closer look at some of these risks as it relates to dividend safety.

 

Dividend Analysis: Omega

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Omega’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.

 

Omega’s Dividend Safety Score of 65 suggests that its current dividend payment is somewhat safer than the average dividend stock.

 

However, one of the first things income investors point to when reviewing Omega is the company’s dividend cut in 2000.

 

As seen below, the company reduced its total dividends paid from $2.80 per share in 1999 to $1.00 per share in 2000 before completely eliminating the dividend in 2001 and 2002.

 

 

Since restarting its dividend in 2003, Omega’s annual dividends have increased every year. However, conservative income investors have every right to question whether Omega’s current dividend payment is really reliable. After all, a company that cuts its dividend once certainly seems more likely to cut it again.

 

Why was Omega forced to cut its dividend in 2000, and could that same risk reemerge in the future?

 

The answer comes from Omega’s 2001 annual report. The Balanced Budget Act of 1997 introduced a new payment system for the reimbursement of Medicare patients in SNFs.

 

A major shift took place in which a cost-based reimbursement system that was historically used was essentially abandoned in favor of a reimbursement system that capped payments per service at a fixed amount. This was done by the government to save money and attempt to balance the federal budget by 2002.

 

While some of these payments changes were reversed by subsequent legislation in 1999-2000, the result was a major reduction in payments made to nursing home operators.

 

Many of Omega’s tenants were forced to declare Chapter 11 bankruptcy and could no longer make their rent payments. They had generally been levering up to fund acquisitive growth in the years leading up to the legislation and were not prepared for the substantial reimbursement reductions.

 

By all means, the reforms made to the Medicare reimbursement system in the late 1990s were nothing short of transformational.

 

While federal policy is still characterized by a healthy dose of uncertainty today, we believe new legislation aimed at tightening up Medicare payments will be more incremental and will not result in bankruptcies like those that occurred over 15 years ago.

 

Simply put, another transformational shift appears very unlikely. However, the situation is worth monitoring as we all know how unpredictable governmental policies can be.

 

Today, healthcare REITs have been hit by several issues that have resurfaced the events of the late 1990s in many investors’ unforgiving minds.

 

First, Medicare Advantage coverage is increasing which has resulted in lower rates and shorter patient stays under alternative payment models.

 

The Department of Justice is also investigating billing practices of SNFs, which could hurt future revenues and margins. For example, Omega’s largest tenant, Genesis Health Care (~7% of total rent), went under investigation in February 2015 and has accrued a $30 million loss contingency reserve.

 

As a result, there is risk that tenants’ cash flow coverage could deteriorate to levels that compromise their ability to meet their rent obligations.

 

However, we believe Omega is well positioned to deal with these developments and continue paying its dividend for several reasons, beginning with the health of its operators.

 

Omega’s tenants appear very likely to be able to absorb moderate reimbursement rate reductions and still meet their monthly rent obligations.

 

In a recent investor presentation, Omega noted that its portfolio’s rent coverage was 1.4x EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent costs) at the end of 9/30/15, indicating tenants’ strong ability to continue making rent payments even with some adversity.

 

Fitch also notes that Omega’s rent coverage “implies some cushion to sustain annual rental increases and/or unforeseen changes to reimbursement rates.”

 

We also like how well diversified Omega is by tenant (no operator is more than 7% of total rent) and state, helping minimize the impact of Medicaid rate changes in any one state.

 

Even if future operating conditions end up being more challenging than expected, Omega remains on solid financial footing to weather the storm.

 

The company maintains investment grade credit ratings from all three major agencies and has no major long-term debt maturities until 2024. Omega also has $1.1 billion of cash and credit facility availability that it can tap at any time, and the company’s debt ratios are generally more conservative than its peers:

 

Source: Omega Investor Presentation

 

What about the payout ratio? Analyzing payout ratios requires a different perspective for REITs because they book large depreciation charges each year for their properties, reducing their reported earnings.

 

However, the value of real estate typically rises over time. For this reason and others, REITs report non-GAAP measures that better represent their cash flow and dividend coverage. One of these measures is adjusted funds from operation (AFFO), which is similar to free cash flow but for REITs.

 

Omega’s dividend payout ratio using AFFO is 71%, which is quite reasonable for a business with consistent and stable free cash flow.

 

Even during 2009, Omega’s occupancy rate was very healthy at 84.6%. The company’s payout ratio should also be protected thanks to Omega’s favorable lease renewal schedule – about 89% of portfolio expirations occur after 2020.

 

Overall, Omega’s dividend looks safe to us. While we don’t like being exposed to the uncertainties of healthcare reform, we believe the changes being made today are far from the devastating events of the late 1990s.

 

Omega’s diversification, financially healthy tenants, reasonable payout ratio, and relatively conservative financial position give us further confidence in the safety of its 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.

 

Omega’s Dividend Growth Score of 48 suggests that the company’s dividend growth potential is about average. The company’s score was mostly pulled down by Omega’s high payout ratio, which is typical of REITs but makes their dividend growth much more dependent on cash flow growth.

 

Regardless, Omega has raised its dividend for 14 consecutive quarters and increased its dividend payment every year since 2003. As seen below, Omega has consistently grown its dividend at a high-single digit rate over the last decade.

 

 

As long as the regulatory environment remains stable and capital is accessible to fund growth, we expect at least mid-single digit dividend growth to continue.

 

Valuation

OHI’s stock trades at a reasonable multiple of about 11x funds from operations (FFO) and has a dividend yield of 6.5%, which is approximately in line with its five-year average dividend yield.

 

Thanks to its acquisitions, Omega compounded its adjusted EBITDA by 21.6% per year from 2005 through 2015. Growth was significantly boosted by the company’s $3.9 billion acquisition of Aviv in 2015 and is unlikely to remain at such a high rate.

 

Going forward, we think Omega’s cash flow can continue growing at a mid- to high-single digit rate given the number of acquisitive growth opportunities in its large and fragmented markets. Under this assumption, the stock appears to have double-digit annual total return potential.

 

Conclusion

No dividend stock is perfect, and Omega certainly contains its fair share of uncertainties thanks to its indirect dependence on Medicare and Medicaid reimbursements.

 

However, we believe the company’s dividend payment is safe thanks to its client diversification, conservative payout ratio, strong rent coverage metrics, and relatively healthy balance sheet.

 

We don’t view today’s reimbursement changes being anywhere near as dramatic as the events of the late 1990s and expect Omega to be able to power through as it continues consolidating the SNF market.

 

Investors looking for a combination of high yield and value might want to take a closer look at Omega and other high quality dividend stocks in our Conservative Retirees dividend portfolio.