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 31st 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.
Source: Simply Safe Dividends
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.
Disclosure: None
