Omega Healthcare (OHI) announced third quarter results last night that took many investors by surprise, sending the stock down as much as 10% in early trading this morning.


For those who are unfamiliar with the company, Omega Healthcare is a real estate investment trust (REIT) that provides financing and capital primarily to skilled nursing facilities (SNFs). In fact, Omega is the largest SNF-focused REIT and generates 84% of its revenue from SNFs.


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 more affordable basis to save healthcare costs.


Several of Omega’s tenants are under financial pressure, which caused the company to place one of them (Orianna Health Systems) on a cash basis for accounting purposes after the operator continued missing its budget and failed to pay its monthly rent obligations.


In other words, Omega Healthcare will only recognize revenue from this operator as it receives cash. Omega plans to move some or all of Orianna’s properties to new operators over the next six months or so, but annual contracted rent from the properties is expected to decrease from $46 million to a range of $32 million to $38 million once the transition is complete.


In addition to Orianna, management commented that Signature, the company’s third-largest operator (6.7% of annualized third quarter revenue), was facing liquidity challenges to pay rent on a timely basis.


Signature fell further behind schedule during the third quarter, although the vast majority of its rent due is covered by a revolving credit agreement.


Omega was also looking at deferring 10% of total rent from Signature (around 0.67% of company-wide rent) for three years, so this doesn’t seem to be a huge concern for now.


Regardless, when combined with Orianna, these two tenants accounted for close to 12% of annualized contractual rent during the third quarter.


OHI Operators

Source: Omega Healthcare Earnings Release


Omega Healthcare also placed a non-top 10 operator, Daybreak, on a cash basis in September due to a short-term liquidity crunch the company faced; however, Daybreak is expected to pay full rent starting in January and is not comparable to Orianna’s situation.


Signature does have a restructuring plan in place that involves some potential asset sales, and management is taking more powerful steps to right-size performance with the Orianna portfolio, but it’s discomforting to know that important tenants are struggling.


That’s especially true in light of fears that have surrounded the SNF industry for several years. More specifically, skilled nursing generally has higher reimbursement risk than other areas of healthcare because SNFs depend more on Medicare and Medicaid reimbursements from the government.


In fact, private pay only accounted for 12.2% of Omega’s operator revenue mix as of June 30, 2017, with Medicaid (51.9%) and Medicare / Insurance (35.9%) accounting for the remainder.


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 Healthcare’s tenants to meet their lease obligations.


Lengths of stay have already been declining under alternative payment models such as bundling and managed care, for example.


While the company’s percentage of revenue from private payers has been gradually climbing over time, thanks to management’s decision to decrease its reliance on government healthcare funding, Omega’s prosperity is unfortunately at the mercy of Washington for the foreseeable future.


Here’s what Fitch noted earlier this year:


“SNF margins are being pressured by increasing coverage under Medicare Advantage, Department of Justice investigations potentially influencing billing practices, and pilot programs for bundled payments and coordinated care. While the Trump administration appears to be in favor of slowing the growth of bundles and making participation voluntary, we believe the long-term demographic and economic factors will continue to drive the market towards these programs over the long run. We view these as long-term headwinds that stronger operators should be able to manage given they are fairly well-telegraphed.”


Investors were growing worried about the SNF industry even before the various health and tax bills proposed this year.


You can see that the SNF industry has faced declining industry profitability and EBITDAR coverage (earnings before interest, taxes, depreciation, amortization, and rent costs) in recent years:


Source: Omega Healthcare Investors


One of Omega’s four largest tenants, Genesis Healthcare (GEN), has also seen its stock price crumble nearly 90% since the start of 2015 as it faced charges for submitting false claims to Medicare and Medicaid for unnecessary therapy.


As a result of the industry’s challenges and reimbursement uncertainties, many healthcare REITs have decided to exit the SNF space in recent years. Some examples include Ventas (VTR), HCP (HCP), and Sabra Healthcare (SBRA), who are all seeking greater portfolio quality and cash flow predictability.


Even if Medicare and Medicaid policy doesn’t end up shifting too severely, the main growth catalyst for the SNF industry (an aging population) is still about a decade away, meaning that the next few years could remain trying for many of Omega’s customers.


So it’s no surprise that today’s news further rattled investors’ confidence in the SNF industry and Omega Healthcare’s ability to profitably manage its portfolio in an environment where more tenants could be challenged to meet their rent obligations.


What Today’s News Means for Omega Healthcare’s Dividend Safety

With that said, Omega’s report was not all doom and gloom, especially for its dividend.


Omega’s management stated they have built a “very significant cushion” and remain “confident” in the company’s ability to pay quarterly dividends, which seems to be supported by the firm’s fundamentals and Dividend Safety Score.


Omega Healthcare’s payout ratio remains reasonable at 82% of adjusted funds from operations (AFFO) and 89% of funds available for distribution (FAD), for example.


While management lowered Omega’s full-year adjusted FFO per share by 4.5% to $3.27 to $3.28 as a result of converting Orianna to cash basis accounting, the company’s full-year AFFO payout ratio would only be 79%.


This is a relatively low AFFO payout ratio for a REIT and indicates that Omega Healthcare retains a relatively high amount of cash flow from which to fund growth investments and its dividend, making it less dependent than some rivals on tapping debt and equity markets for capital.


These payout ratio percentages will further improve once the Orianna portfolio returns to paying rent over the next six months, restoring much of Omega Healthcare’s cushion to continue paying a safe dividend, which it has increased for 21 consecutive quarters (including a dividend increase announced earlier this month).


From a leverage perspective, Omega Healthcare’s balance sheet and dividend remain on solid ground as well. The company maintains an investment grade credit rating and has no material debt maturities until 2022 (assuming allowable credit facility extensions).


As of June 1, 2017, Omega also had approximately $1 billion of liquidity available through its revolving credit facility, which compares to the firm’s annualized dividend payments of approximately $540 million.


Simply put, Omega’s healthy payout ratio, conservative balance sheet, and committed management team are supportive of the dividend. The biggest question is whether or not Orianna, Signature, and Daybreak are canaries in a coal mine (i.a. an advanced warning of widespread danger in the SNF industry).


Management argues that the challenges faced by Orianna are specific to that operator rather than the broader industry. Orianna’s occupancy declined from 92% in 2014 to 89%, and management believes some of the Orianna facilities’ new operators may be able to improve performance.


Perhaps the strongest argument supporting overall industry stability (for now) is the overall trend in operator occupancy and EBITDAR coverage over the last year. You can see that both measures have been fairly steady the last five quarters.


OHI Operator Coverage

Source: Omega Healthcare Earnings Release


Note that the Orianna portfolio is expected to increase its EBITDAR coverage to between 1.2x and 1.5x (from below 1x last quarter) once its properties are transferred, even after assuming a rent hit of $8 million to $14 million.


Based on today’s rent coverage, Omega’s tenants appear likely overall to be able to absorb moderate reimbursement rate reductions and still meet their monthly rent obligations. Management does not expect a big dropoff in occupancy rates going forward, which remains supportive of today’s EBITDAR coverage.


With approximately 90% of portfolio lease expirations occurring after 2021, Omega’s cash flow visibility to support the dividend is also solid so long as operators’ financial health does not deteriorate (combined EBITDAR coverage of leases expiring through 2021 was a reasonable 1.36x at the end of 2016, consistent with last quarter’s level).


Unfortunately, there is very little visibility into the real-time health of Omega’s operators since almost all of them are private companies. It’s also very challenging to predict what impact healthcare and tax reform could have on Medicare and Medicaid.


Management of course believes that today’s proposals are uncomparable to the challenges the industry faced in the late 1990s, when reimbursement rates were slashed dramatically to address a serious fiscal issue (more on that in the Dividend Safety discussion here).


Omega believes today’s proposals are more about fixing policies to prepare the healthcare system for the demographic wave that’s coming. Getting more efficient with patient lengths of stay and making sure people have access to care are larger priorities than the dollar amounts paid.


I tend to agree, but you never desire for an investment thesis to bank on neutral or favorable legislative outcomes.


This creates potential for a wider range of outcomes over the next several years before demographic tailwinds seem likely to start moving the occupancy needle more for the industry.


Overall, given what we know today, Omega Healthcare’s dividend appears to remain on stable ground, especially if the issues hurting the stock are truly operator-specific (i.e. short-term and fixable) rather than indicative of overall industry conditions deteriorating.


With that said, legislative and regulatory changes, especially surrounding reimbursement amounts, can significantly impact the profitability of Omega’s somewhat-fragile tenants going forward.


While Omega Healthcare’s operational and financial conservatism positioned it well to continue paying safe and growing dividends throughout unexpected headwinds such as Orianna, income investors still need to watch how these potential long-term headwinds play out over the coming years (stable occupancy and EBITDAR coverage are key).


Closing Thoughts on Omega Healthcare

Omega Healthcare’s earnings report highlighted challenges that several important operators are facing as the SNF industry works through a number of murky changes.


While the company’s overall property portfolio and financial health continue to look reasonable and supportive of the dividend, it’s fair to say that Omega investors now face even greater uncertainty about the industry’s realities (i.e. are today’s issues isolated to a few underperforming operators, or is the tide starting to go out on all SNF players?).


I have been taking a “wait and see” approach with most healthcare stocks in light of ongoing reform efforts, and I think the jury is still out with how the SNF industry will evolve. Monitoring occupancy and rent coverage metrics closely over the coming quarters will help determine how isolated the cases of Orianna, Signature, and Daybreak really are.


There is certainly risk that Omega Healthcare turns into a value trap (I wouldn’t be interested in adding to an existing position), so maintaining appropriate position sizes and healthy portfolio diversification is important to acknowledge the wide range of outcomes that Omega faces.


Despite the stock’s rising yield, which still looks safe for now thanks to Omega’s conservatism (although industry conditions could change quickly), I would not be opposed to replacing shares of the company with another high dividend stock given the growing uncertainties.

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