I'll preface this with I haven't done significant amount of research on this to provide an actual recommendation, but I thought someone might have some additional insight they could add if they felt so inclined. I have not done any significant investment analysis before, so this should be taken with a grain of salt. I wholeheartedly recommend you do your own analysis as I would not endorse my numbers as they are back of the napkin type calculations. Additionally, it is not something I currently have a position in, but I'm watching it to see if it drops.
Quality Care Properties ("QCP") is a recent (October 31st) spinoff of HCP Inc. They are both REITs that hold mostly hold post acute/skilled nursing properties. Think of these facilities as where you go to get rehab done on a broken hip or along those lines. I stress at this point however, they are NOT the operating companies of these buildings and only own the real estate. Currently, this is not a business you want to be in as it is downtrending significantly (operating post acute/skilled nursing facilities, not necessarily the REIT).
HCP spun of QCP because the portfolio QCP holds is almost entirely (94%) leased to a single tenant which at this point it is unclear if they'll be able to survive. HCP wanted to stabilize the results from the more consistent portion of its portfolio and split off the more volatile section. The tenant is HCR ManorCare (HCRMC). At this point, I'll re-emphasize HCRMC is not related to either QCP or HCP. HCRMC previously owned these properties, but completed a sale and leaseback in 2011 with QCP (HCP at the time). This informs one important point – the valuations you see on QCP’s books for real estate (outside of the held for sale assets) will be at the 2011 purchase price less depreciation. This suggests that the valuations shouldn’t be wildly different now than then, though you would expect some additional impairment due to the struggling nature of the industry. This will come up later.
HCRMC is also currently run by a private equity company (the Carlyle Group) which as far as I can tell has a negative reputation for bleeding companies dry. Currently, there have been some reasonably significant concessions on the lease to HCRMC thus far.
The TL:DR; of the above is as follows: You can invest in a REIT currently leasing to a troubled tenant and if the lease ends up staying in similar terms as to what it is right now, you’re going to have a nice return. If it ends up out of business, or the lease significantly slashed, you’re not gonna have a great time. Now, to the numbers:
For the 9 months ended September 30, 2016 the QCP unit reported annualized free cash flow of $350 million. For a company with a market cap of 1.48B, this sounds pretty fucking sick. Well, now we get to the issues. First, as part of the spinoff, QCP took out 1.8 billion in debt and paid it out to HCP. This leads to a significant interest expense going forward as well as significant debt repayments in the future. Management said in the 10Q it expects to pay $252 million in interest in 2017 and 2018, $249 million in 2019 and 2020, and $296 million after that. This doesn’t help our distributable cash flows, but it’s not the worst. Here are my expected outcomes:
Rent doesn’t change (This won’t happen, but dare to dream right) – distributable cash flow is 23% of your original investment (were you to invest today) Rent decreases by 10%, DCF is 20% Rent decreases by 20%, DCF is 17% Rent decreases by 34% (this was the amount used in the investor presentation – though specifically not meant to be used as a base for anything as noted by the CEO of QCP), DCF is 13-14%.
Just to establish the ranges above, since the 10Q was filed, there were the following temporary rent reductions given to HCMCR: November 2016 – 12.5% December 2016 – 25% January 2016 – 37.5% As you would likely agree with me, this isn’t promising.
The interest rate on the debt ranges between 6 to 8%, suggesting there are…some concerns about the success of this whole mess. Additionally, the $1 billion secured loan is variable rate debt which isn’t as friendly in what appears to be times of rising interest rates. The debt is all secured by the property as one would expect. In terms of covenants, the main one appears to be a minimum debt service coverage ratio of 1.75x. This gets violated if lease rates are cut by 50-60%, so there's a bit of room to get to this point for sure. If HCRMC goes bankrupt...there will be some bargaining.
So, the return is still pretty reasonable as long as I didn’t screw my numbers up (which I very well could have and fully endorse you to review as I am not remotely experienced with this).
Another fun little equity kicker if you think HCRMC will survive for the days to come. QCP owns 9% of HCRMC which is has conservatively valued at…$0. It tracks this investment using the equity method meaning the investment will stay at $0 unless HCRMC has actual income. Additionally, the income will only be added to the investment account balance if there are cash distributions from HCRMC.
Now, one other thing I didn’t mention if the possible equity got you a bit excited which will bring you back down to a normal level. HCRMC has also had false claims suit brought upon them (three in fact!) stating they were fraudulently claiming medicare expenses. This happened in 2015, but there is very little information I can find on any possible monetary effect of this. I reiterate, this is a suit against HCRMC and not QCP.
Now, I think we’ve established we might not want to rely on future lease payments going forward, so I’d like to calculate a liquidation value for this if we are to get to that point. My initial thought is, even if HCRMC goes bankrupt, a separate operator would step in place for a decent portion of the leases as HCRMC is one of the largest operators in the industry and you cannot simply fail to replace that service to cover all the demand. Nonetheless, a basement for this would be nice.
The 10Q puts tangible assets at 4.6 billion which gives us a nice initial barrier as that suggests the equity book value is approximately 2.8 billion giving some wiggle room to get to the current market value. 3.9 billion of this is the buildings and improvements and 600 million is the land. I’d like to think the value of the land is an absolute floor here as the price of the land shouldn’t have really decreased since 2011. However, that doesn’t really help us at this point as the land is worth less than the debt at this point. I know pretty much nothing about how much these facilities are worth, however fortunately QCP actually sold some facilities in the last year that we can try and use for a proxy for the market value compared to book value. During the fiscal year ended December 31, 2015, 22 out of 50 non strategic properties were sold for $219 million with the remaining 28 properties being classified as held for sale. The total impairment charge relating to these properties was $47.1 million. Now, this isn’t that bad all things considered. An impairment charge of ~1 million per property can still get us where we need to be to get a reasonable valuation. 11 additional sales were completed in the 9 months ended September 30, 2016 and a gain on these properties of $6 million was realized. This left 17 properties held for sale which gained an additional impairment of $21 million. Therefore, the net impairment through to September 30, 2016 was $62 million. Working backwards, the cost of these 50 properties was approximately $346 million, and the expected proceeds (realized of $281 million, expected of $65 million) which had a cost basis of approximately $408 million. This is a 15% decrease in value.
If we apply this 15% haircut to the book value over all properties, the real estate assets are worth $3.9 billion. Total tangible assets becomes $4.0 billion and our floor value is $2.2 billion still $700 million above the $1.5 current market cap. Now, let’s assume the properties they sold were actually pretty nice, had those cool chairs that let you go up and down stairs without having to climb the chairs, and the remaining properties are worth even less. Let’s increase the haircut to 30%. This suggests tangible asset value of $3.0 billion and equity value of $1.2 billion. In this case, we are now less than the market cap and there are some losses to be realized. However, I view this scenario as unlikely for the following reasons. QCP didn’t NEED cash when they sold these assets. They weren’t about to default. I don’t picture these properties as model properties that they sold to stay in business. You could argue that as the industry declines the buildings will be worth less. Perhaps, but there also will be an inflection point for the industry. There are more and more seniors coming of age every day and the property value could go up just as easily.
I view the risk as relatively limited because of this. You can go a bit more in depth and see what you think of HCRMC. There is some information in the 10Q about their current operations which is unaudited so you might want to take it with a grain of salt. I think there is significant possible upside if HCRMC pulls through without huge cuts (>40%) to the lease.
Now...some references.
QCP investor presentation: http://ift.tt/2hQTFac
SEC Filings: http://ift.tt/2iC35oM
HCRMC Lawsuit: http://ift.tt/1TYtTwg
Submitted January 04, 2017 at 02:06AM by flyingflail http://ift.tt/2iCb7hH
