EPR Backs Off Investments, Preserves Balance Sheet in Light of Tough Market Conditions

EPR Properties (EPR) is one of the more exposed REITs to the coronavirus outbreak. Movie theaters drive 45% of EPR's revenue, and Eat & Play businesses such as TopGolf and Pinstripes account for another 23% of sales. Schools represent 11% of revenue as well.

With social distancing becoming the norm across America to help slow down the spread of the novel coronavirus, many of EPR's tenants could be forced to close down temporarily. This would reduce their cash flow and potentially pressure their ability to pay rent.

The market has punished EPR for its exposure to this risk, cutting the stock's price in half since the beginning of March and sending its dividend yield soaring to 16%. However, there's more to the story.

Part of the concern being priced in was a deal management announced earlier this year to acquire a casino resort for $1 billion. This poorly timed acquisition would have expanded EPR's portfolio by about 15% while significantly increasing the firm's leverage from below 5x to nearly 6x.

Fortunately, it was a non-binding agreement, and tonight EPR announced it was deferring this anticipated investment (as well as all other uncommitted investment spending) in light of unfavorable current market conditions. The stock rose more than 5% in after-hours trading on the news.

This prudent decision preserves EPR's investment grade balance sheet and liquidity position; the company holds $500 million in cash, has no debt maturities until 2023, and can tap up to $1 billion of funds via its line of credit. For context, the REITs dividend totals $360 million annually.

The big question is whether or not EPR's tenants will be able to make their rent payments during a period of unprecedented demand disruption.

EPR has over 200 tenants, and its company-level rent coverage ratio is 1.92x (i.e. tenants generate $1.92 in pre-rent cash flow for every $1 of rent they owe EPR).

While that's a reasonable ratio, it doesn't tell the whole story. AMC, Topgolf, and Regal account for 17.6%, 11.2%, and 10.8% of EPR's revenue, respectively. AMC and Topgolf both have junk credit ratings, and Regal did as well until Moody's withdrew its coverage of the company in 2017.

Visibility is low, but it's not hard to imagine that a meaningful portion of EPR's rental revenue is derived from financially weaker operators who could be materially affected by a few extremely weak months of business.

Earlier this month at an investor conference, management stated that EPR believes its movie theaters (45% of revenue) could withstand a 30% to 35% box office drop and still maintain a rent coverage ratio of 1.0x thanks to the variable nature of film costs. Reducing their part-time headcount would provide additional flexibility.

EPR went on to say that during the 2003 SARS outbreak in Toronto, theaters saw a 50% reduction in a month on the box office performance. However, the box office recovered most of it by the end of the year as new movies were just pushed back and everyone was eager to get out of the house to go do something.

The coronavirus is looking like it could have a much more prolonged impact. Studios have already delayed or postponed release dates for a number of films, raising the odds that movie theaters will temporarily close.

Given movie theaters' high debt loads, a rent coverage ratio approaching 1.0x could make it difficult for them to pay rent and keep their balance sheets stable. EPR's payout ratio sits near 90%, so it doesn't have much margin for error if some of its larger customers miss their payments or require rent concessions.

As part of tonight's announcement, management also mentioned that the investments EPR deferred were expected to account for about 11% of its previous cash flow guidance, which it has now withdrawn.

All else equal, this reduction would lower EPR's previous guidance enough to push the REIT's payout ratio up to about 100% before accounting for any potential rent losses.

As a result, we are downgrading EPR's Dividend Safety Score from our lowest Safe rating to Borderline Safe. The macro outlook could get a lot worse before it gets better for the company, especially given EPR's concentrated exposure to financially fragile businesses. 

While EPR's dividend coverage doesn't provide much wiggle room, the firm's decision to defer major investments and preserve its balance sheet and liquidity position should be welcome news for contrarian income investors who are comfortable with the industry's murky outlook.