Recent purchase – OHI

Purchase – OHI

On November 10, 2016 I picked up 492 shares of Omega Healthcare, Inc. (OHI) for $30.46/share, for a total of $14,984.16.

I previously owned 932.739 shares, so this brings me up to a total of 1,424.739 shares. Projected 12-month dividends are $3,476.36 (assuming no change in current dividend).

Investment Thesis

OHI is a Real Estate Investment Trust (REIT) that owns Skilled Nursing Facilities (SNF). It’s a triple-net operator, which means the tenants are responsible for rent, insurance, taxes, and maintenance. OHI owns the property and collects the rent – all of the risk is pushed to the tenants.

I try to invest in companies that have a tailwind. This means investing in companies where trends favor the company’s business. For the foreseeable future, demographic are clearly favorable for companies that provide services to older Americans.

Older Population by Age Group
Census Year Age
60-64
Age
65-74
Age
75-84
Age
85+
Age 60 and older Age 65 and older Total,
all ages
1990 10,616,167 18,106,558 10,055,108 3,080,165 41,857,998 31,241,831 248,709,873
2000 10,805,447 18,390,986 12,361,180 4,239,587 45,797,200 34,991,753 281,421,906
2010 16,757,689 21,462,599 13,014,814 5,751,299 56,986,401 40,228,712 310,232,863
2020 21,008,851 32,312,186 15,895,265 6,597,019 75,813,321 54,804,470 341,386,665
2030 20,079,650 38,784,325 24,562,604 8,744,986 92,171,565 72,091,915 373,503,674
2040 20,512,884 36,895,223 30,145,467 14,197,701 101,751,275 81,238,391 405,655,295
2050 23,490,423 40,112,637 29,393,295 19,041,041 112,037,396 88,546,973 439,010,253

The number of people 65 and older (second column from the right) will increase from 54.8M to 88.5M from 2020 to 2050. That’s a 61.5% increase in 30 years.

The number of people 85 and older will grow from 6.6M in 2020 to 19M in 2050. That’s an enormous group of potential new patients over the next 30 years.

But it’s not just that the overall population is growing. The percentage of the population that’s older is growing disproportionately faster.

Older Population as a Percentage of the Total Population: 1900 to 2050
Census
Year
Age
60-64
Age
65-74
Age
75-84
Age 85 and older Age 60 and older Age 65 and older
1990 4.3% 7.3% 4.0% 1.2% 16.8% 12.6%
2000 3.8% 6.5% 4.4% 1.5% 16.3% 12.4%
2010 5.4% 6.9% 4.2% 1.9% 18.4% 13.0%
2020 6.2% 9.5% 4.7% 1.9% 22.2% 16.1%
2030 5.4% 10.4% 6.6% 2.3% 24.7% 19.3%
2040 5.1% 9.1% 7.4% 3.5% 25.1% 20.0%
2050 5.4% 9.1% 6.7% 4.3% 25.5% 20.2%

Look at the third column from the right. The percent of the population that is 85 or old will increase from 1.9% in 2020 to 4.3% in 2050. That represents an enormous increase in medical costs for the US health care system. This will put further pressure on costs and force an even greater shift away from hospitals and to SNFs when possible.

At today’s price of approximately $29/share OHI is dirt cheap. FFO (Funds From Operation, the REIT equivalent of earnings for common stocks) in 2016 Q2 was $.87/share ($3.48 annualized). At a price of $29/share that equals a P/FFO of just 8.33. That compares very favorably to the S&P’s current P/E of 25. OHI is priced as if profits are declining and the dividend is being cut.

However, the opposite is true, as OHI has been firing on all cylinders. FFO has grown each year for the last 10 years. During that time OHI has grown dividends from $.96/share in 2006 to $2.36/share in 2016, for an annual growth rate of 9.41%/year. That is very impressive growth for such a high yielding investment. OHI has recently been increasing the dividend every quarter (18 of the last 18 quarters).

This is a easy to understand profitable business with solid growth prospects, and it’s currently available at a valuation well below the market average..

 

Potential risks

OHI is a highly specialized REIT. They invest in SNFs and nothing else. Their business is highly dependent on Medicare/Medicaid reimbursements for their tenants. If the Trump administration (or a future administration) were to materially change the way the health care system works in the US, OHI could be adversely affected.

However, SNFs provide health care at costs far below hospitals. According to the 2011 Cost of Care Survey of Home Care Providers, Adult Day Health Care Facilities, Assisted Living Facilities and Nursing Homes from Genworth Financial, the national median daily rate for Skilled Nursing Care is $193 per day for a semi-private room and $219 per day for a private room vs. $1,797 average per day in a hospital.

This means SNFs have the inherent advantage of being the low-cost provider. Any changes to health care reimbursements will likely favor SNFs over hospitals, as they provide the same or better care for significantly less money.

 

The other major threat to OHI comes from their debt load. As a REIT, OHI is required to pay out 90% of its earnings, which means there are few retained profits to be used for making acquisitions to grow the business. REITs grow by taking on debt to finance new properties. REITs have done well in the low-interest rate climate of the last 10 years in part because they have been able to borrow at absurdly low rates. OHI’s current debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) is 4.7x, which is lower than its peers in the REIT healthcare space.

Source: Omega Investor Presentation
Source: Omega Investor Presentation

 

But even though the debt load is lower than its peers, OHI could still be affected if/when interest rates rise. Fortunately, rising rates should have minimal effect on OHI’s profitability. First, all of OHI’s existing outstanding debt is fixed-rate interest, so rising rates will have no effect on existing debt payments. OHI has no debt coming due until 2020, when $600M of bonds are due. OHI had profits of $302M over the last year, which means OHI will almost certainly need to refinance most or all of that debt. Given OHI’s investment grade credit rating of BBB- it shouldn’t be an issue to roll over the debt. However, if interest rates do rise dramatically then the refinancing will be at a higher rate. This would hurt future profitability.

Expectations

OHI’s return over the next 10 years will come a few components. First, we have the current dividend of over 8%. Second, OHI’s leases include annual rent escalators of 2-2.5%. Even if OHI didn’t add any additional properties to their portfolio you’d expect their revenues to increase at 2-2.5%/year.

Next, we need to consider OHI’s absurdly low valuation. If the current P/FFO of 8.33 returns to an average valuation of P/FFO of 15 then we’d see the stock price increase by .5%-1%/year just from P/FFO expansion.

Finally, let’s assume that over the next 10 years OHI grows FFO at half the rate of the last 10 years (4.5% instead of 9%). This would give us the following expected return:

8% dividend + .5% valuation change + 4.5% growth = 13%/year

That’s a solid return based on conservative growth assumptions. Heck, even if there’s NO growth you’d still expect to get 8 + .5 = 8.5% return over the next 10 years. And of course if growth is higher then we can expect even better returns.

 

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